MANAGERIAL ECONOMICS

MGT-103

UNIT-1
The Nature and Scope of Managerial Economics
Managerial economics is a branch of management studies that focuses on decision-making and
problem-solving. Microeconomic and macroeconomic theories are used. It focuses on the
efficient use of scarce resources.
It is a field that integrates business and economic ideas. It provides leaders and managers with
essential data for demand estimates, capital management, pricing decisions, profit management,
cost analysis, and production analysis.

What is Managerial Economics?

Managerial economics investigates the internal and external elements that influence an
organization. It seeks to solve problems through the use of micro and macroeconomic methods.
As a result, it is a practical method in which economic measurements are used to solve business
difficulties. This strategy extends beyond problem solving to the growth and sustainability of a
business.

Managerial economics is a branch of management studies that focuses on addressing business

problems and making decisions using microeconomic and macroeconomic theories and
principles. It is a specialized field that deals with internal challenges within an organization
utilizing various economic approaches. Economics is an essential component of any business.
All business assumptions, projections, and investments are derived from this one premise.

Managerial economics bridges the gap between economic theory and economic practice. It helps
managers solve business problems logically and make rational decisions. The primary role of
management economics is efficient decision making, which selects the best action from two or
more choices. It monitors and guarantees that all scarce resources, such as labor, capital, and
land, are used effectively in order to get better results. Managerial economics plays three critical
functions in corporate organizations: demand analysis and forecasting, capital management, and
profit management. Firms that use management economics make the best decisions about what
to create, how to produce, and for whom to produce.

Managers utilize economic frameworks to optimize profitability, resource allocation, and overall
company output while boosting efficiency and reducing unproductive activities. By assessing
practical challenges at both the micro and macroeconomic levels, these frameworks help
organizations make reasonable, progressive decisions.Forecasting (making decisions about the
future) is involved in managerial decisions, which contain levels of risk and uncertainty.
However, managerial economic techniques can help managers make these decisions by
informing them.

To grasp what managerial economics is, you must first understand what economics is.
Economics is the study of how individuals use resources to meet their needs and desires. It
focuses on the behaviors of individuals, businesses, and governments as they interact in markets.

Managerial economics uses these concepts to assist managers in making decisions that will
improve the performance of their organization. It gives a framework for considering how to
make efficient and effective use of finite resources. Managerial economists examine problems
and forecast outcomes using tools from microeconomics, which focuses on individual conduct,
and macroeconomics, which looks at the economy as a whole.

Nature of Managerial Economics

Managerial economics is a discipline of economics that studies the use of economic methods in
organizational decision-making. The study of the production, distribution, and consumption of
goods and services is known as economics. Managerial economics is the application of economic
theories and concepts to the allocation of limited resources. It assists managers in making
decisions about customers, rivals, suppliers, and internal operations.

Nature of managerial economics:

1. Science and Art:

Making judgements or solving problems in management theory necessitates a high level of

critical and logical thinking as well as analytical skills. Many economists regard it as a
source of study, claiming that it entails utilizing various economic principles,
methodologies, and procedures to solve business problems.

2. Microeconomics:

Managers often deal with challenges that are exclusive to one business rather than the
economy as a whole. As a result, it is regarded as an essential component of
microeconomics.

3. Macroeconomic Applications:

A corporation operates in the outside world, serving the consumer, who is an integral part
of the economy. Managers must assess the impact of numerous macroeconomic elements
on the company, such as market dynamics, economic developments, government
regulations, and so on.

4. Pragmatic:
 The solution to day-to-day business problems is practical and logical. Varied people have
varied perspectives on managerial economics fundamentals. Others may prioritize
customer service over efficiency in production.

5. Multi-disciplinary:

Accounting, finance, statistics, mathematics, production, operation research, human

resource, marketing, and other disciplines are used in managerial economics. This aids in
the development of a great solution.

6. Management-focused and pragmatic:

Managerial economics is a tool that helps managers identify appropriate answers to

business-related difficulties and uncertainties. As previously said, managerial economics
aids in goal setting, policy formulation, and effective decision making. It is a practical
approach to problem solving.
Scope of Managerial Economics
The term management economics refers to the study of numerous business concerns within
organizations. Microeconomics and macroeconomics both have an equal impact on the
organization and its operations. The scopes of managerial economics are explained here.
Managerial economists can provide insight into aspects such as pricing tactics, competition,
market structure, and production efficiency using complicated models. In today's competitive
world, all of these factors contribute to successful decision-making.
 Scope of Managerial Economics

1. Decision making:

Managerial economics assists corporate organizations in making good decisions. It

explains how management can formulate policies and make managerial decisions using
various quantitative tools and economic theories.

Before developing a production schedule and deciding on the resources to be used, a

company must determine its entire output. Forecasted demand acts as a guidance for
management in maintaining its market share in competition with rivals, hence ensuring
profit. Thus, demand analysis helps the identification of the many elements influencing a
firm's product demand. This, in turn, aids the corporation in controlling output demand.

2. Production and cost analysis:

 It aids in estimating production costs and identifying factors that cause variances in cost
estimates. Managerial economics analyses and decides on production activities and
associated costs. It guarantees that all resources are used efficiently, lowering overall costs.

The profitability of a company is heavily influenced by its manufacturing expenses. A

sensible manager would generate cost estimates for a range of output, identify the variables
causing cost changes, and select the output level with the lowest cost, taking into account
the degree of uncertainty in production and cost calculations.

Although engineers are in charge of the production processes, the business manager works
to carry out the production function analysis in order to reduce material and time waste.
Cost control is critical to good pricing practices.

3. Forecasting and Demand Analysis:

Managerial economics assists businesses in analyzing demand and projecting future risks.
An accurate estimation of demand will aid in the creation of appropriate production
schedules and the allocation of resources.

4. Capital administration:

Capital investment decisions are one of the most difficult and complex responsibilities that
any manager faces. Managerial economics aids in the planning and management of all
capital expenditures for businesses that require large investments. It thoroughly examines
investment opportunities before committing any funds to them in order to assure the
profitability of an investment.
 Another difficult topic for modern business management is capital investment planning.
High-level investments are made in plants, machinery, and buildings. As a result, capital
management necessitates top-level choices. It refers to capital management, which is the
planning and control of capital expenditure. It addresses the cost of capital, the rate of
return, and project selection.

5. Profit administration

Managerial economics aids in the profit management of businesses. Profit is the primary
indicator of a company's long-term performance or growth. It aids in the accurate
estimation of all costs and revenues at various levels of output, resulting in the desired
profit.

Conclusion

The application of economic ideas to decision-making in business firms or other management

units is known as managerial economics. The fundamental notions are primarily derived from
microeconomic theory, which investigates the behavior of individual customers, firms, and
industries, but additional analytical tools have been introduced. Statistical tools, for example, are
becoming more significant in estimating present and future product demand.
Economic objectives of firms
The main objectives of firms are:

1. Profit maximisation
2. Sales maximisation
3. Increased market share/market dominance
4. Social/environmental concerns
5. Profit satisficing
6. Co-operatives
Sometimes there is an overlap of objectives. For example, seeking to increase market
share, may lead to lower profits in the short-term, but enable profit maximisation in the long
run.
Profit maximisation

Usually, in economics, we assume firms are concerned with maximising profit. Higher profit
means:

Higher dividends for shareholders.

More profit can be used to finance research and development.
Higher profit makes the firm less vulnerable to takeover.
Higher profit enables higher salaries for workers
See more on: Profit maximisation
Alternative aims of firms

However, in the real world, firms may pursue other objectives apart from profit
maximisation.

1. Profit Satisficing

 In many firms, there is a separation of ownership and control. Those who own the
company (shareholders) often do not get involved in the day to day running of the
company.
 This is a problem because although the owners may want to maximise profits, the
managers have much less incentive to maximise profits because they do not get the
same rewards, (share dividends)
 Therefore managers may create a minimum level of profit to keep the shareholders
happy, but then maximise other objectives, such as enjoying work, getting on with
other workers. (e.g. not sacking them) This is the problem of separation between
owners and managers.
  This ‘principal-agent‘ problem can be overcome, to some extent, by giving managers
share options and performance related pay although in some industries it is difficult
to measure performance.
 More on profit-satisficing.
2. Sales maximisation
Firms often seek to increase their market share – even if it means less profit. This could
occur for various reasons:

 Increased market share increases monopoly power and may enable the firm to put
up prices and make more profit in the long run.
 Managers prefer to work for bigger companies as it leads to greater prestige and
higher salaries.
 Increasing market share may force rivals out of business. E.g. the growth of
supermarkets have lead to the demise of many local shops. Some firms may actually
engage in predatory pricing which involves making a loss to force a rival out of
business.
3. Growth maximisation
This is similar to sales maximisation and may involve mergers and takeovers. With this
objective, the firm may be willing to make lower levels of profit in order to increase in size
and gain more market share. More market share increases its monopoly power and ability
to be a price setter.

4. Long run profit maximisation

In some cases, firms may sacrifice profits in the short term to increase profits in the long
run. For example, by investing heavily in new capacity, firms may make a loss in the short
run but enable higher profits in the future.

5. Social/environmental concerns
A firm may incur extra expense to choose products which don’t harm the environment or
products not tested on animals. Alternatively, firms may be concerned about local
community / charitable concerns.

 Some firms may adopt social/environmental concerns as part of their branding. This
can ultimately help profitability as the brand becomes more attractive to consumers.
 Some firms may adopt social/environmental concerns on principal alone – even if it
does little to improve sales/brand image.
6. Co-operatives
Co-operatives may have completely different objectives to a typical PLC. A co-operative is
run to maximise the welfare of all stakeholders – especially workers. Any profit the co-
operative makes will be shared amongst all members.

Diagram showing different objectives of firms

  Q1 = Profit maximisation (MR=MC)
 Q2 = Revenue Maximisation (MR=0)
 Q3 = Marginal cost pricing (P=MC) – allocative efficiency
 Q4 = Sales maximisation – maximum sales while still making normal profit
(AR=ATC)

Cardinal Utility
Definition: The Cardinal Utility approach is propounded by neo-classical
economists, who believe that utility is measurable, and the customer can express his
satisfaction in cardinal or quantitative numbers, such as 1,2,3, and so on.

The neo-classical economist developed the theory of consumption based on the

assumption that utility is measurable and can be expressed cardinally. And to do so,
they have introduced a hypothetical unit called as “Utils” meaning the units of utility.
 Here, one Util is equivalent to one rupee and the utility of money remains
constant.

Over the passage of time, it was realized that the absolute measure of utility is not
possible, i.e. it was difficult to measure the feeling of satisfaction cardinally (in
numbers). Also, it was difficult to quantify the factors that cause a change in the
moods of the consumer, their tastes and preferences and their likes and dislikes.
Therefore, the utility is not measurable in quantitative terms. But however, it is being
used as the starting point in the consumer behavior analysis.

The consumption theory is based on the notion that consumer aims at maximizing
his utility, and thus, all his actions and doings are directed towards the utility
maximization. The consumption theory seeks to find out the answers to the following
questions:

 How does a consumer decide on the optimum quantity of a commodity that he/she
wishes to consume?
 How consumers allocate their disposable incomes between several commodities of
consumption, such that utility is maximized?
The cardinal utility approach used in analyzing the consumer behavior depends on
the following assumptions to find answers to the above-stated questions:

1. Rationality: It is assumed that the consumers are rational, and they satisfy their
wants in the order of their preference. This means they will purchase those
commodities first which yields the highest utility and then the second highest and so
on.
2. Limited Resources (Money): The consumer has limited money to spend on the
purchase of goods and services and thus this makes the consumer buy those
commodities first which is a necessity.
3. Maximize Satisfaction: Every consumer aims at maximizing his/her satisfaction for
the amount of money he/she spends on the goods and services.
4. Utility is cardinally Measurable: It is assumed that the utility is measurable, and
the utility derived from one unit of the commodity is equal to the amount of money,
which a consumer is ready to pay for it, i.e. 1 Util = 1 unit of money.
5. Diminishing Marginal Utility: This means, with the increased consumption of a
commodity, the utility derived from each successive unit goes on diminishing. This
law holds true for the theory of consumer behavior.
6. Marginal Utility of Money is Constant: It is assumed that the marginal utility of
money remains constant irrespective of the level of a consumer’s income.
7. Utility is Additive: The cardinalists believe that not only the utility is measurable but
also the utility derived from the consumption of different commodities are added up
to realize the total utility.
Thus, the cardinal utility approach is used as a basis for explaining the consumer
behavior where every individual aims at maximizing his/her utility or satisfaction for
the amount of money he spends on the consumption of goods and services.

The Cardinal Utility Theory (Explained With Diagram)

Assumptions:
1. Rationality:

The consumer is rational. He aims at the maximization of his utility subject

to the constraint imposed by his given income.

2. Cardinal Utility:

The utility of each commodity is measurable. Utility is a cardinal concept.

The most convenient measure is money: the utility is measured by the
monetary units that the consumer is prepared to pay for another unit of the
commodity.
ADVERTISEMENTS:

3. Constant Marginal Utility of Money:

This assumption is necessary if the monetary unit is used as the measure of

utility. The essential feature of a standard unit of measurement is that it be
constant. If the marginal utility of money changes as income increases (or
decreases) the measuring-rod for utility becomes like an elastic ruler,
inappropriate for measurement.

4. Diminishing Marginal Utility:

The utility gained from successive units of a commodity diminishes. In

other words, the marginal utility of a commodity diminishes as the con-
sumer acquires larger quantities of it. This is the axiom of diminishing
marginal utility.

5. The total utility of a ‘basket of goods’ depends on the quantities of the

individual commodities. If there are n commodities in the bundle with
quantities x1, x2, ........ , xn, the total utility is
U = f (x1, x2, …, xn)

In very early versions of the theory of consumer behaviour it was assumed

that the total utility is additive,

U= U1(x1)+ U2(x2) + . . . + Un(xn)

The additivity assumption was dropped in later versions of the cardinal

utility theory. Additivity implies independent utilities of the various
commodities in the bundle, an assumption clearly unrealistic, and
unnecessary for the cardinal theory.
Equilibrium of the Consumer:
We begin with the simple model of a single commodity x. The consumer can
either buy x or retain his money income Y. Under these conditions the
consumer is in equilibrium when the marginal utility of x is equated to its
market price (Px). Symbolically we have

MUX = Px

If the marginal utility of x is greater than its price, the consumer can
increase his welfare by purchasing more units of x. Similarly if the marginal
utility of x is less than its price the consumer can increase his total
satisfaction by cutting down the quantity of x and keeping more of his
income unspent. Therefore, he attains the maximization of his utility when
MUX = Px.

If there are more commodities, the condition for the equilibrium of the
consumer is the equality of the ratios of the marginal utilities of the
individual commodities to their prices
 The utility
derived from spending an additional unit of money must be the same for all
commodities. If the consumer derives greater utility from any one
commodity, he can increase his welfare by spending more on that
commodity and less on the others, until the above equilibrium condition is
fulfilled.
Derivation of the Demand of the Consumer:
The derivation of demand is based on the axiom of diminishing marginal
utility. The marginal utility of commodity x may be depicted by a line with a
negative slope (figure 2.2). Geometrically the marginal utility of x is the
slope of the total utility function U = f(qx). The total utility increases, but at
a decreasing rate, up to quantity x, and then starts declining (figure 2.1).
 Accordingly the marginal utility of x declines continuously, and becomes
negative beyond quantity x. If the marginal utility is measured in monetary
units the demand curve for x is identical to the positive segment of the
marginal utility curve. At x1, the marginal utility is MU1 (figure 2.3). This is
equal to P1, by definition. Hence at P1 the consumer demands x1 quantity
(figure 2.4). Similarly at x2 the marginal utility is MU2, which is equal to P2.
Hence at P2 the consumer will buy x2, and so on. The negative section of the
MU curve does not form part of the demand curve, since negative quantities
do not make sense in economics.

Critique of the Cardinal Approach:

There are three basic weaknesses in the cardinalist approach. The
assumption of cardinal utility is extremely doubtful. The satisfaction
derived from various commodities cannot be measured objectively. The
attempt by Walras to use subjective units (utils) for the measurement of
utility does not provide any satisfactory solution. The assumption of
constant utility of money is also unrealistic.

As income increases the marginal utility of money changes. Thus money

cannot be used as a measuring-rod since its own utility changes. Finally, the
axiom of diminishing marginal utility has been ‘established’ from
introspection, it is a psychological law which must be taken for granted.

What is Indifference Curve ?


Indifference Curve
One cannot put a numerical value on the level of satisfaction gained from the consumption of
goods. However, they can tell their preference between two goods, i.e., which good gives them
more or less satisfaction. This satisfaction level is depicted through an indifference curve.
Therefore, a curve or a graphical representation of the combination of different goods providing
the same satisfaction level to the consumer is known as Indifference Curve
As all the combinations provide the consumer with an equal level of satisfaction, they prefer the
goods equally. In other words, at any point of the indifference curve gives the same satisfaction
level to the consumer. The same satisfaction level gained by the different combinations of two
goods makes the consumer indifferent; hence, the name indifference curve. Because of this
reason, an individual can use the indifference curve to depict the demand pattern and preferences
of a consumer for a different set of commodities.
Indifference Curve Analysis
A process of analyzing a simple two-dimensional graph representing two goods, one on the x-
axis and the other on the y-axis is known as an Indifference Curve Analysis. If the graph of the
combination of goods is on the line or curve, it means that the consumer gains the same
satisfaction level or utility from the goods and thus, does not have any preference for the
goods. For example, a child may gain the same satisfaction level from one ice cream and two
chocolates, or three ice creams and one chocolate.
Indifference Map
When more than one curve is represented on a graph showing a different combinations of two
different goods on each curve, it is known as an Indifference Map. Each indifference curve on
that graph shows one satisfaction level all along the curve. In other words, the representation of
consumer preferences by a number of indifference curves is known as an indifference map. An
indifference map represents every possible indifference curve that the consumer has, which helps
in ranking their preferences. Also, the combination of goods on the higher indifference curve
gives a higher satisfaction level to the consumer. Therefore, the highest of the indifference
curves of an indifference map is preferred by a consumer.
Here, IC1, IC2 and IC3 are three different Indifference Curves, and the complete graph is known
as Indifference Map. Each curve has its own level of satisfaction. However, at any point on each
of the curves gives the same level of satisfaction to the consumer. Also, the higher the
indifference curve, the higher the satisfaction level (for example, IC3 > IC2).
Indifference Schedule
A table or a schedule that shows different combinations of two goods giving the same level of
satisfaction to the consumer is known as an Indifference Schedule. An indifference schedule is
used to plot the different combinations of two goods on a graph for the formation of an
indifference curve.
Indifference Set
All points or bundles on an indifference curve that gives the same level of satisfaction to the
consumer are known as Indifference Set.
Basic Assumptions of an Indifference Curve Analysis
 The first assumption of an indifference curve analysis is that utility is ordinal. It means that
the utility gained from the consumption of a good cannot be measured in cardinal numbers
like 1, 2, 3, etc. It is, therefore, measured in ordinal numbers like 1st, 2nd, 3rd, etc. With
cardinal numbers, one can easily compare the different levels of satisfaction by ranking the
preferences.
 The consumer consuming the two goods is assumed to be rational. In other words, the basic
motive of the consumer is to maximize his/her satisfaction level through the consumption of
two goods.
 There are only two goods purchased and consumed by a consumer. It is because a graph has
only two axes, and the representation of two goods will be easy.
 The consumer is fully aware and has complete knowledge about the price of both goods in
the market.
 The price of both the goods is already given.
 The taste, income and habits of a consumer remain the same all the time.
 The preferences of a consumer are transitive. It means that if a consumer prefers Good X over
Good Y and Good Y over Good Z, then he/she prefers Good X over Good Z.
Example:
Nisha is consuming two goods Chocolate and Ice-Cream, and is willing to consume different
combinations of these goods to gain an equal level of satisfaction with each combination. These
combinations are given in the below indifference schedule. Prepare an indifference curve for the
same.
Solution:

In the above graph, points or combinations A, B, C, D, and E provide the same satisfaction level
to Nisha. It can also be seen that as Nisha is consuming one additional quantity of chocolate, she
has to sacrifice or give up some quantity of ice cream. Therefore, when Nisha moves from
Combination A to B to consume one extra chocolate, she has to sacrifice 8 units of ice-creams.
Similarly, to move from Combinations B to C, C to D, and D to E, she has to sacrifice 4, 2, and 1
unit of ice-creams, respectively, for the consumption of one extra unit of chocolate at each
movement. This sacrifice of units of a good to gain an additional unit of another good is known
as the Marginal Rate of Substitution.
Marginal Rate of Substitution can be defined as the amount of Good Y sacrificed to obtain an
additional unit of Good X without affecting the total satisfaction level.

Properties of Indifference Curve

1. Indifference Curve always slopes downwards from left to right
An indifference curve is defined as a curve that gives an equal level of satisfaction to a consumer
at every possible combination. It is possible when a consumer is willing to sacrifice some
quantity of a good to gain an additional unit of another good. If a consumer is having more of a
good without any fall in another good, the consumer will achieve a higher satisfaction level
instead of equal. This fall in units of one good to gain more of another good gives a downward
slope to the indifference curve.
2. Indifference Curves are always convex to the point of origin
The shape of an indifference curve is based on the Diminishing Marginal Rate of
Substitution. It means that to gain a single extra unit of a good, a consumer is willing to
sacrifice more of another good. As in the case of Nisha (example above), to gain one more unit
of chocolate, she is willing to sacrifice more units of ice-creams. This diminishing marginal rate
of substitution gives a convex shape to an indifference curve.
However, there are two extreme scenarios for the shape of an indifference curve.
 When two goods are the perfect substitute for each other, the shape of the indifference curve
is a straight line. In this case, the Marginal rate of substitution is constant.
 When two goods are perfectly complementary to each other, the shape of the indifference
curve is L-shaped and is convex to the origin.

As it can be seen in the above image, to attain an additional unit of Good X, i.e., to move from 1
unit to 2 units, the consumer has to sacrifice some units of Good Y, i.e., 3 units (from 10 units to
7 units).
The Diminishing Marginal Rate of Substitution refers to the consumer’s willingness to part
with less and less quantity of one good to gain one more additional unit of another good.
3. Higher Indifference Curves represent a higher level of satisfaction
A higher indifference curve represents a higher level of satisfaction, or we can say that an
indifference curve to the right of another gives more satisfaction. This property of the
indifference curve is based on the assumption of monotonic preference. Monotonic
Preference means that a consumer will always prefer a larger bundle, as it gives him/her a
higher satisfaction level. In other words, as a consumer prefers more goods, and a higher
indifference curve will give a higher satisfaction level.

After comparing points A and B on IC1 and IC2, respectively, it can be seen that Bundle A
involves OC of Good X and OE of Good Y. However, Bundle B involves OD of Good X and OF
of Good Y, which shows that the consumer has more goods in Bundle B, which implies more
utility or satisfaction level. Therefore, a higher indifference curve means a higher level of
satisfaction.
4. Two Indifference Curves cannot intersect each other
An indifference curve consists of different combinations of two goods giving the same
satisfaction level to a consumer. It means that every point on an indifference curve gives the
same satisfaction to the consumer. Also, an indifference map consists of different indifference
curves with different satisfaction levels in each curve. If two indifference curves intersect with
each other, it would mean that one point on each curve gives the same level of satisfaction which
contradicts the meaning of an indifference map. Therefore, two indifference curves never
intersect each other.
If the above figure is true and two indifference curves IC1 and IC2 intersect each other, then it
would mean that Point C provides the same satisfaction level to the consumer. However, it has
already been proved under Indifference Map that two indifference curves on a single graph show
different satisfaction levels along the curve. Therefore, two indifference curves can never
intersect each other.
5. An Indifference Curve never touches either of the axes
The indifference curve is based on the assumption that a consumer considers different possible
combinations of two goods and wants both goods. If an indifference curve touches either of the
axes, it would mean that a consumer is consuming the whole of one good only, which is not
possible and contradicts the assumption. Therefore, an indifference curve never touches either of
the axes.

Consumer Surplus
The economic measure of a customer’s benefit

What is Consumer Surplus?

Consumer surplus, also known as buyer’s surplus, is the economic measure of a
customer’s excess benefit. It is calculated by analyzing the difference between the
consumer’s willingness to pay for a product and the actual price they pay, also
known as the equilibrium price. A surplus occurs when the consumer’s willingness to
pay for a product is greater than its market price.

Consumer surplus is based on the economic theory of marginal utility, which is the
additional satisfaction a person derives by consuming one more unit of a product or
service. The satisfaction varies by consumer, due to differences in personal
preferences. According to the theory, the more of a product a consumer buys, the
less willing he/she is to pay more for each additional unit due to the diminishing
marginal utility derived from the product.

Calculating Consumer Surplus

The point where the demand and supply meet is the equilibrium price. The area
above the supply level and below the equilibrium price is called product surplus (PS),
and the area below the demand level and above the equilibrium price is the
consumer surplus (CS).

While taking into consideration the demand and supply curves, the formula for
consumer surplus is CS = ½ (base) (height). In our example, CS = ½ (40) (70-50) =
400.

Consumer Surplus and the Price Elasticity of Demand

Consumer surplus for a product is zero when the demand for the product is perfectly
elastic. This is because consumers are willing to match the price of the product.
When demand is perfectly inelastic, consumer surplus is infinite because a change in
the price of the product does not affect its demand. This includes products that are
basic necessities such as milk, water, etc.

Demand curves are usually downward sloping because the demand for a product is
usually affected by its price. With inelastic demand, consumer surplus is high
because the demand is not affected by a change in the price, and consumers are
willing to pay more for a product.

In such an instance, sellers will increase their prices to convert the consumer surplus
to a producer surplus. Alternatively, with elastic demand, a small change in price will
result in a large change in demand. It will result in a low consumer surplus as
customers are no longer willing to buy as much of the product or service with a
change in price.

Law of Diminishing Marginal Utility

According to economist Alfred Marshall, the more you consume a certain

commodity, the lower the satisfaction derived from each additional unit of
consumption. For example, if you buy one apple for $0.50, you are not willing to pay
more for the second apple. At the same time, the utility derived from consuming the
second apple is lower than it was for the first apple. The concept is described in the
table below:

According to Alfred Marshal: Consumer Surplus = Total Utility – (Price x

Quantity)

Assumptions of the Consumer Surplus Theory

1. Utility is a measurable entity

The consumer surplus theory suggests that the value of utility can be measured.
Under Marshallian economics, utility can be expressed as a number. For example, the
utility derived from an apple is 15 units.

2. No substitutes available

There are no available substitutes for any commodity under consideration.

3. Ceteris Paribus

It states that customers’ tastes, preferences, and income do not change.

4. Marginal utility of money remains constant

It states that the utility derived from the income of a consumer is constant. That is,
any change in the amount of money a consumer has does not change the amount of
utility they derive from it. It is required because without it, money cannot be used to
measure utility.

5. Law of diminishing marginal utility

It states that the more a product or service is consumed, the lower the marginal
utility is derived from consuming each extra unit.

6. Independent marginal utility

The marginal utility derived from the product being consumed is not affected by the
marginal utility derived from consuming similar goods or services. For example, if
you consumed orange juice, the utility derived from it is not affected by the utility
derived from apple juice.

Conclusion

Consumer surplus is a good way to measure the value of a product or service

and is an important tool used by governments in the Marshallian System of
Welfare Economics to formulate tax policies. It can be used to compare the
benefits of two commodities and is often used by monopolies when deciding

the price to charge for its product. Income Effect,

Substitution Effect and Price Effect
on Goods | Economics
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Income Effect, Substitution Effect and Price Effect!

In the above analysis of the consumer’s equilibrium it was assumed that the
income of the consumer remains constant, given the prices of the goods X and
Y. Given the tastes and preferences of the consumer and the prices of the two
goods, if the income of the consumer changes, the effect it will have on his
purchases is known as the income Effect.

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If the income of the consumer increases his budget line will shift upward to
the right, parallel to the original budget line. On the contrary, a fall in his
income will shift the budget line inward to the left. The budget lines are
parallel to each other because relative prices remain unchanged.

In Figure 12.14 when the budget line is PQ, the equilibrium point is R where it
touches the indifference curve I1. If now the income of the consumer increases,
PQ will move to the right as the budget line P1, I1, and the new equilibrium
point is S where it touches the indifference curve I2. As income increases
further, PQ becomes the budget line with T as its equilibrium point.
The locus of these equilibrium points R, S and T traces out a curve which is
called the income-consumption curve (ICC). The ICC curve shows the income
effect of changes in consumer’s income on the purchases of the two goods,
given their relative prices.

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Normally, when the income of the consumer increases, he purchases larger

quantities of two goods. In Figure 12.14 he buys RA of Y and OA of X at the
equilibrium point R on the budget line PQ. As his income increases, he buys
SB of Y and OB of X at the equilibrium point S on P1, Q1, budget line and still
more of the two goods TC of Y and ОС of X, on the budget line P2Q2. Usually,
the income consumption curve slopes upwards to the right as shown in Figure
12.14.
But an income-consumption curve can have any shape provided it does not
intersect an indifference curve more than once. We can have five types of
income consumption curves. The first type is explained above in Figure 12.14
where the ICC curve has a positive slope throughout its range. Here the
income effect is also positive and both X and Y are normal goods.

The second type of ICC curve may have a positive slope in the beginning but
become and stay horizontal beyond a certain point when the income of the
consumer continues to increase. In Figure 12.15 (A) the ICC curve slopes
upwards with the increase in income upto the equilibrium point R at the
budget line P1Q1 on the indifference cure I2. Beyond this point it becomes
horizontal which signifies that the consumer has reached the saturation point
with regard to the consumption of good Y. He buys the same amount of Y (RA)
as before despite further increases in his income. It often happens in the case
of a necessity (like salt) whose demand remains the same even when the
income of the consumer continues to increase further. Here Y is a necessity.
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Figure 12.15 (B) shows a vertical income consumption curve when the
consumption of good X reaches the saturation level R on the part of the
consumer. He has no inclination to increase its purchases despite further
increases in his income. He continues to purchase OA of it even at higher
income levels. Thus X is a necessity here.

The last two types of income consumption curves relate to inferior goods. The
demand of inferior goods falls, when the income of the consumer increases
beyond a certain level, and he replaces them by superior substitutes. He may
replace coarse grains by wheat or rice, and coarse cloth by a fine variety. In
Figure 12.15 (C), good Y is inferior and X is a superior or luxury good.

Upto point R the ICC curve has- a positive slope and beyond that it is
negatively inclined. The consumer’s purchases of Y fall with the increase in his
income. Similarly in Figure 12.15 (D), good X is shown as inferior and Y is a
superior good beyond the equilibrium point R when the ICC curve turns back
upon itself. In both these cases the income effect is negative beyond point R on
the income-consumption curve ICC.
The different types of income-consumption curves are also shown in Figure
12.16 where: (1) ICC1 Alternative Method, has a positive slope and relates to
normal goods; (2) IСС2 is horizontal from point A, X is a normal good while Y
is a necessity of which the consumer does not want to have more than the
usual quantity as his income increases further: (3) IСС3 is vertical from A, К is
a normal good here and X is satiated necessity; (4) ICC4 is negatively inclined
downwards, Y becomes an inferior good form A onwards and X is a superior
good; and (5) ICC5 shows X as an inferior good.

The Substitution Effect:

The substitution effect relates to the change in the quantity demanded
resulting from a change in the price of good due to the substitution of
relatively cheaper good for a dearer one, while keeping the price of the other
good and real income and tastes of the consumer as constant. Prof. Hicks has
explained the substitution effect independent of the income effect through
compensating variation in income. “The substitution effect is the increase in
the quantity bought as the price of the commodity falls, after adjusting income
so as to keep the real purchasing power of the consumer the same as before.
This adjustment in income is called compensating variations and is shown
graphically by a parallel shift of the new budget line until it become tangent to
the initial indifference curve.”

Thus on the basis of the methods of compensating variation, the substitution

effect measure the effect of change in the relative price of a good with real
income constant. The increase in the real income of the consumer as a result
of fall in the price of, say good X, is so withdrawn that he is neither better off
nor worse off than before.

The substitution effect is explained in Figure 12.17 where the original budget
line is PQ with equilibrium at point R on the indifference curve I1. At R, the
consumer is buying OB of X and BR of Y. Suppose the price of X falls so that
his new budget line is PQ1. With the fall in the price of X, the real income of
the consumer increases. To make the compensating variation in income or to
keep the consumer’s real income constant, take away the increase in his
income equal to PM of good Y or Q1N of good X so that his budget line
PQ1 shifts to the left as MN and is parallel to it.
At the same time, MN is tangent to the original indifference curve l1 but at
point H where the consumer buys OD of X and DH of Y. Thus PM of Y or Q1N
of X represents the compensating variation in income, as shown by the line
MN being tangent to the curve I1 at point H. Now the consumer substitutes X
for Y and moves from point R to H or the horizontal distance from В to D. This
movement is called the substitution effect. The substitution affect is always
negative because when the price of a good falls (or rises), more (or less) of it
would be purchased, the real income of the consumer and price of the other
good remaining constant. In other words, the relation between price and
quantity demanded being inverse, the substitution effect is negative.
The Price Effect:
The price effect indicates the way the consumer’s purchases of good X change,
when its price changes, A given his income, tastes and preferences and the
price of good Y. This is shown in Figure 12.18. Suppose the price of X falls. The
budget line PQ will extend further out to the right as PQ1, showing that the
consumer will buy more X than before as X has become cheaper. The budget
line PQ2 shows a further fall in the price of X. Any rise in the price of X will be
represented by the budget line being drawn inward to the left of the original
budget line towards the origin.
If we regard PQ2, as the original budget line, a two time rise in the price of X
will lead to the shifting of the budget line to PQ1, and PQ2. Each of the budget
lines fanning out from P is a tangent to an indifference curve I1, I2, and I3 at R,
S and T respectively. The curve PCC connecting the locus of these equilibrium
points is called the price- consumption curve. The price-consumption curve
indicates the price effect of a change in the price of X on the consumer’s
purchases of the two goods X and Y, given his income, tastes, preferences and
the price of good Y.

UNIT-2
Law Of Demand And Elasticity Of Demand
Now that we are familiar with the concept of demand and the determinants of demand, let us study
about another important concept – the elasticity of demand. We will be studying the meaning and
the types of demand elasticity.

Elasticity of Demand
 (Source: ShutterStock)

The elasticity of demand is an economic term. It refers to demand sensitivity. In other words, it
helps to understand how the demand for good changes is when there are changes in other economic
variables. These economic variables include factors such as prices and consumer income.

Demand elasticity is calculated as the percent change in the quantity demanded divided by a percent
change in another economic variable. A higher value for the demand elasticity with respect to an
economic variable means that consumers are more sensitive to changes in this variable.

The elasticity of demand = (% Change in demanded quantity)/(% Change in another economic

variable)

Types of Demand Elasticity

Let us take a look at the types of demand elasticity. There are broadly three types of demand
elasticity.

1] Price Elasticity of Demand

This refers to the change or sensitivity in the customer’s demand for the quantity of a good with
respect to a change in its price. Companies often collect this data on the consumer response to price
changes. This helps them adjust the price to maximize profits.
2] Income Elasticity of Demand
This is the responsiveness of demand for a product with respect to the change in income. So it will
help measure the increase or decrease in demand when the income of the consumer increases or
decreases.

3] Cross Elasticity of Demand

This value is calculated by using the percent change in demanded quantity for a good and dividing it
by the percent change in the price of some other good. Moreover, this indicates the consumer
reaction to demand a particular good in accordance with price changes of other goods.

Demand elasticity is generally measured in absolute terms. This implies the sign of the variable is
ignored. If the value is greater than 1, it is elastic. Furthermore, this implies demand is responsive to
economic changes (like price). If the value is less than 1 is inelastic.

This further implies demand does not show change according to economic changes such as price.
Demand is unit elastic when its value is equal to 1. This implies the value of demand moves
proportionately with economic changes.

Law of Demand

Economists use the term demand as a reference to the quantity of a good or service that a consumer
is willing and has the ability to purchase at a price. Demand is based on needs and the ability to pay.
Ability to pay is important as in its absence the demand becomes ineffective.

The law of demand states that if all other factors remain constant, then the price and the demanded
quantity of any good and service are inversely related to one another. This implies that if the price of
an article increases then its corresponding demand decreases. Similarly, if the price of an article
decreases then its demand should increase accordingly.

The price of the good and its price are plotted to form the demand curve. The demand quantity at a
particular price can be calculated from the demand curve. This price and value relation is
represented in a table known as the demand schedule.

Demand Forecasting
Demand forecasting is a combination of two words; the first one is Demand and another forecasting.
Demand means outside requirements of a product or service. In general, forecasting means making
an estimation in the present for a future occurring event. Here we are going to discuss demand
forecasting and its usefulness.

Demand Forecasting
It is a technique for estimation of probable demand for a product or services in the future. It is based
on the analysis of past demand for that product or service in the present market condition. Demand
forecasting should be done on a scientific basis and facts and events related to forecasting should be
considered.

Therefore, in simple words, we can say that after gathering information about various aspect of
the market and demand based on the past, an attempt may be made to estimate future demand. This
concept is called forecasting of demand.

For example, suppose we sold 200, 250, 300 units of product X in the month of January, February,
and March respectively. Now we can say that there will be a demand for 250 units approx. of
product X in the month of April, if the market condition remains the same.

Usefulness of Demand Forecasting

Demand plays a vital role in the decision making of a business. In competitive market conditions,
there is a need to take correct decision and make planning for future events related to business like a
sale, production, etc. The effectiveness of a decision taken by business managers depends upon the
accuracy of the decision taken by them.

Demand is the most important aspect for business for achieving its objectives. Many decisions of
business depend on demand like production, sales, staff requirement, etc. Forecasting is the
necessity of business at an international level as well as domestic level.

Demand forecasting reduces risk related to business activities and helps it to take efficient decisions.
For firms having production at the mass level, the importance of forecasting had increased more. A
good forecasting helps a firm in better planning related to business goals.

There is a huge role of forecasting in functional areas of accounting. Good forecast helps in
appropriate production planning, process selection, capacity planning, facility layout planning, and
inventory management, etc.

Demand forecasting provides reasonable data for the organization’s capital investment and
expansion decision. It also provides a way for the formulation of suitable pricing and advertisement
strategies.

Following is the significance of Demand Forecasting:

 Fulfilling objectives of the business

 Preparing the budget
 Taking management decision
 Evaluating performance etc.
Moreover, forecasting is not completely full of proof and correct. It thus helps in evaluating various
factors which affect demand and enables management staff to know about various forces relevant to
the study of demand behavior.

Source: Alamy

The Scope of Demand Forecasting

The scope of demand forecasting depends upon the operated area of the firm, present as well as
what is proposed in the future. Forecasting can be at an international level if the area of operation is
international. If the firm supplies its products and services in the local market then forecasting will
be at local level.

The scope should be decided considering the time and cost involved in relation to the benefit of the
information acquired through the study of demand. Cost of forecasting and benefit flows from such
forecasting should be in a balanced manner.

Types of Forecasting

There are two types of forecasting:

 Based on Economy
 Based on the time period

1. Based on Economy
There are three types of forecasting based on the economy:
 i. Macro-level forecasting: It deals with the general economic environment relating to the
economy as measured by the Index of Industrial Production(IIP), national income and general
level of employment, etc.
ii. Industry level forecasting: Industry level forecasting deals with the demand for the
industry’s products as a whole. For example demand for cement in India, demand for clothes
in India, etc.
iii. Firm-level forecasting: It means forecasting the demand for a particular firm’s product. For
example, demand for Birla cement, demand for Raymond clothes, etc.

2. Based on the Time Period

Forecasting based on time may be short-term forecasting and long-term forecasting

i. Short-term forecasting: It covers a short period of time, depending upon the nature of the
industry. It is done generally for six months or less than one year. Short-term forecasting is
generally useful in tactical decisions.
ii. Long-term forecasting casting: Long-term forecasts are for a longer period of time say, two
to five years or more. It gives information for major strategic decisions of the firm. For
example, expansion of plant capacity, opening a new unit of business, etc.

What Is Elasticity of Demand?

Elasticity of demand refers to the shift in demand for an item or service when a change occurs in
one of the variables that buyers consider as part of their purchase decisions. It’s a relationship
between demand and another variable, such as price, availability of substitutes, advertising
pressure and customer income.

When a change in any one of those variables causes a significant alteration in demand for a
product or service, its elasticity of demand is considered high. Thought of another way, elasticity
shows that a customer’s buying behavior is highly flexible, or stretchy — like an elastic
waistband. The more willing customers are to change purchasing decisions, the more elastic a
product or service is. If a customer is willing to buy a different brand of coffee simply because
it’s on sale that week or completely forgo buying coffee because its price has gone up, coffee can
be said to have elastic demand.

By contrast, products that are inelastic do not experience large shifts in demand due to changes
in their purchase-consideration variables. Customers remain rigid or firm in their buying choices
for certain products and are unwilling or unable to be flexible. Tobacco products and utilities are
 classic examples of inelasticity of demand because, most times, a change in price or increase in
advertising won’t significantly influence consumer demand.

Key Takeaways

 Elasticity of demand describes the potential for variation in demand for a product or service
arising from changes in price, customer income, advertising and other related factors.
 Many factors influence elasticity, such as price, availability of substitutes, necessity, brand
loyalty and urgency.
 Understanding elasticity of demand can help guide a business’s marketing and selling strategies
to maximize profitability.
 Executing tactics to influence demand requires keen market insight and robust data for analysis.

Elasticity of Demand Explained

Elastic demand equates to flexibility in purchasing decisions — whether in quantities purchased,

the chosen brand or product substitution. Inelastic demand is unwavering, up to a point. For this
reason, reducing elasticity is often considered to be a marketer’s primary goal: to position a
product as so essential that customers will continue to buy in most circumstances. Imagine a
business that can increase its product price without a significant falloff in demand. Or one with
customers so loyal they continue to purchase in the same quantity even when their own income
drops. Understanding elasticity helps move the needle toward inelasticity.

Certain industries are said to be recession-resistant, largely because their products are inelastic:
Demand for those products remains constant despite any economic downturn. Health care,
utilities and certain “vices” like alcohol and tobacco are items that tend to have consistent
demand, regardless of price or the customer’s income. They also tend to generate high brand
loyalty or barriers to switching, adding to customers’ unwillingness (or inability) to swap brands,
as with doctors and utilities.

Four Types of Elasticity

There are four types of elasticity, categorized by the instigating variable — price, related
products, customer income and advertising. Formulas for calculating each type of elasticity can
be used for scenario-planning or retrospective analysis, but it’s important to note that customer
behavior is not an exact science and predictions can be difficult.

1. Price Elasticity of Demand (PED):

When customers are highly sensitive to changes in price, there is a high PED. This
means, for example, that if inflation causes prices to increase, customers will reduce the
quantity they purchase by switching, substituting or skipping. It can also indicate,
conversely, that price reductions may spur additional sales. The formula for PED is:

PED = % change in quantity / % change in price

Or
PED = [(Q2–Q1)/Q1] / [(P2–P1)/P1]
Q1 = initial quantity of demand
Q2 = new quantity of demand
P1 = initial price
P2 = new price

For an application of this formula in action, see the example section, below.

2. Cross Elasticity of Demand (XED):

Cross elasticity happens when changes in the price of one product prompt changes in
demand for another. The two products must be related, either as complements or
substitutes for each other. When products are substitutes for each other, a rise in the price
of one will usually cause a rise in demand for the other. For example, if coffee prices rise,
then demand for breakfast tea is likely to increase as customers substitute tea for coffee.
When two products are complementary, a rise in the price of one will usually cause a
decrease in the demand for the other. For example, if coffee prices rise, demand for
coffee creamer will likely decline as people drink less coffee. XED does not apply to
unrelated products, such as airline tickets and oranges. The formula for XED is:
 XED = % change in quantity for product A / % change in price for product B
Or
XED = [(Q2a – Q1a) / (Q2a + Q1a)] / [(P2b – P1b) / (P2b + P1b)]
Q1a = initial quantity of demand of product A
Q2a = new quantity of demand of product A
P1b = initial price of product B
P2b = new price of product B

3. Income Elasticity of Demand (YED):

YED — with a “Y” because that’s the notation economists use for income — is the
relationship between demand and a customer’s income. As income decreases, quantity of
demand tends to decline, even if all other factors remain the same, including price. YED
tends to differ according to the priority of a product, meaning that what economists refer
to as “normal goods,” like food, clothes and other necessities, are likely to be prioritized
over luxury goods when customers’ income declines. Further, spending on normal goods
is more likely to increase first when income increases, and increase of luxury goods
happens on a lag. The formula for YED is:

YED = % change in quantity / % change in income

Or
YED = [(Q2–Q1)/Q1] / [(Y2–Y1)/Y1]
Q1 = initial quantity of demand
Q2 = new quantity of demand
Y1 = initial income
Y2 = new income

4. Advertising Elasticity of Demand (AED):

This type of elasticity focuses on the relationship between customer demand and a
seller’s advertising. It’s a measure of advertising effectiveness that assesses whether
 increases in advertising elevate customers’ impressions to the point where they respond
by buying more. The formula for AED is:

AED = % change in quantity / % change in advertising

Or
AED = [(Q2–Q1)/Q1] / [(A2–A1)/A1]
Q1 = initial quantity of demand
Q2 = new quantity of demand
A1 = initial advertising expenditure
A2 = new advertising expenditure

Five Categories of Elasticity of Demand

Economists describe elasticity as a spectrum of customer sensitivity, calibrated into five

categories using “relative” and “perfect” to describe the level of elasticity. Any product’s or
service’s elasticity lands in one of the five categories, based on the values produced by the
formulas above and by its demand curve. Because the formulas are independent of each other,
even when applied to the same product, the different types of elasticity — price, cross, income
and advertising — may end up in different categories for the same product or service.

Elastic Demand vs. Inelastic Demand vs. Unitary Elasticity

The elasticity of demand spectrum starts at the left with perfectly inelastic demand, ends at the
right with perfectly elastic demand and has unitary elasticity at its theoretical center. I’ve used
the price elasticity formula — PED — to illustrate the values for each category, because price
elasticity is the most widely used type of elasticity in business and because the other types can
become far more complex to interpret. For example, income elasticity requires additional
dimensions to visualize because different curves apply to people at different income levels.
 Elasticity as a
spectrum, showing change in demand from low sensitivity at left to high sensitivity at right.
1. Perfectly inelastic demand
is when demand does not change, regardless of changes in other factors. Products that are
considered a necessity, with no substitutes, are in this zone, such as essential foods and
lifesaving drugs. Perfectly inelastic demand has a PED of zero.

Perfectly
inelastic demand.
2. Relatively inelastic demand
means that it takes large changes in a factor, such as price, to cause a small change in
demand. Gasoline and salt are common examples of relatively inelastic products.
Relatively inelastic demand has a PED of less than one.

Relatively
inelastic demand.
3. Unitary elastic demand
is a special case that arises when the impact on demand is an equal, one-for-one change
compared with another factor. For example, a 10% increase in price causes a 10%
decrease in demand quantity. Unitary elastic demand is mostly a hypothetical concept, as
it is unusual to find a product with such perfect correlation. Unitary elastic demand has a

PED of exactly one. Unitary

elastic demand.
4. Relatively elastic demand
means a small change in one factor creates a disproportionately larger change in demand.
For example, if a 5% increase in the price of a streaming service caused a 10% decrease
in subscribers, it would be considered relatively elastic. Most products and services fall
into this zone. Relatively inelastic demand has a PED greater than one. Higher values
indicate greater elasticity.

Relatively elastic demand.

5. Perfectly elastic demand
is the extreme scenario where demand drops 100% due to changes in one of the factors.
This is relatively rare, since characteristics like accessibility, brand loyalty and quality
will often cause some customers to continue to purchase a product. As an example, if the
price of organic bananas goes up at Fred’s Supermarket but not at Barney’s Grocery,
under perfect elasticity of demand no shoppers would purchase the bananas at Fred’s.
However, some customers might decide to pay the higher price to save time and effort,
especially if they believe Fred’s produce is fresher. The result of the PED calculation for
perfect elasticity is infinity — representing the all-or-nothing buying decision.
 Perfectly elastic demand.

What Determines Elasticity of Demand?

Elasticity of demand is influenced by several factors to which customers respond with differing
levels of intensity.

 Availability of substitutes. When customers perceive that a product lacks significant

differentiation or is easily substituted, the product tends to have a higher elasticity of demand.
This means customers will easily swap one brand for another or one product for another. A good
example is the plethora of breakfast cereal substitutes, from swapping flakes for O’s to switching
to granola bars. The opposite also holds true: Products that have no substitute, such as gasoline,
are highly inelastic.
 Urgency of purchase. When customers are not in a rush to make a purchase, they can put it off
if prices are increasing. This means there is a higher elasticity of demand for optional or
discretionary purchases. Conversely, when a purchase is urgent, such as plumbing services for a
leaky pipe, customers are more willing to pay a higher price in return for quicker service. Their
viewpoint is inelastic.
 Duration of price change. Customers react differently to price changes that are expected to last
a short period of time versus a long-term shift. Flash sales that are perceived to be short-term can
cause greater increases in demand than discounts that are expected to be around longer. Consider
the changes in demand around Black Friday and Cyber Monday.
 Percentage of income. Purchases that represent a higher percentage of a household budget tend
to be more elastic than those that are smaller. For example, customers demonstrate a higher level
of price elasticity when buying clothing than when purchasing computer paper. The same
percentage of change in price would cause a greater change in demand for sweaters than for
paper because sweaters are a bigger-ticket item relative to the customer’s income.
 Necessity. The essential/inessential nature of goods is a primary driver of elasticity. Customers
tend to have unchanging levels of demand for products they consider essential. Customers will
 be rigid when purchasing products considered indispensable for survival or quality of life.
Conversely, buying habits tend to be more elastic for luxury goods. This dynamic occurs, in part,
because purchasing necessities cannot be postponed. Addictive products, such as alcohol,
tobacco and drugs, are an extreme variation of inelasticity caused by necessity.
 Brand loyalty. When customers have a high level of brand loyalty, they are less likely to swap
brands, resulting in a higher level of inelasticity of demand. This typically happens when
substitutes are perceived to be of inferior quality or a poor match, so customers are willing to pay
a little more rather than reduce their demand. Marketers focus on these characteristics when
positioning their products. Items seen as commodities, where one brand is the same as the next,
have a higher level of elasticity of demand, and therefore their sales fluctuate more significantly
with price.
 Buyer. The “other people’s money” concept shows that the same product may be susceptible to
different levels of price elasticity depending on who pays for the goods. Customers tend to be
more willing to pay higher prices when they aren’t the one actually paying for the product, such
as for company-reimbursed travel and entertainment.

Example of Elasticity of Demand

The following example illustrates the concept of elasticity of demand, again using price elasticity
because it is the most common.

KMR Inc. is in the online retail shoe business. In 2021, KMR sold 1,500 pairs of snow boots at
an average price of $100 per pair. During 2022, KMR lowered the price to $90 and sold 1,800
pairs. In both years, KMR’s cost of goods sold was $40. The price elasticity of demand can be
calculated as:

PED = % change in quantity / % change in price

PED = [(Q2–Q1)/Q1] / [(P2–P1)/P1]
Q1 = 1,500
Q2 = 1,800
P1 = $100
P2 = $90

= [(1,800–1,500)/1,500] / [($90–$100)]/$100
= 0.2 / 0.1
=2

The calculation above indicates that the snow boots are relatively elastic since the change in
volume exceeded the change in price. The volume sold increased by 300 pairs (20%) when the
price dropped by $10 (10%).

Whether this change was beneficial for KMR’s business is subject to interpretation. In this case,
the price change increased volume and helped KMR increase total snow boot revenue from
$150,000 ($100 x 1,500) to $162,000 ($90 x 1,800), an increase of $12,000 (8%). However,
KMR’s gross profit remained the same: 2021 = $90,000 [($100–$40) x 1,500]; and 2022 =
$90,000 [($90–$40) x 1,800]. Of course, a larger volume of business may bring along other
additional costs of operations, beyond the cost of goods sold.

UNIT-3
Theory of Cost – Meaning, Types,
Concepts, Diagram
Theory of Cost: Money value of inputs is called the cost of
production. Let’s discuss.

Laws of production are expressed in terms of physical quantities Example:

labor, capital, and output in terms of units.

However, business decisions regarding production are taken on the basis of the
money value of inputs and the money value of output.

So money value of inputs is called the cost of production and the money
value of output is referred to as sales revenue.

Theory of Cost: Cost Concepts

A variety of cost concepts are used in economic analysis and firm’s decision
making. In general cost, concepts are classified into three categories.

1. Accounting cost concepts

2. Analytical cost concepts
3. Policy related cost concepts

Accounting Cost Concepts

Theory of Cost

 Actual and Opportunity Costs

Actual cost is the expenditures that are actually incurred by the firm in
payment for the use of resources obtained from the outside such as payments
for labor, material, plant, traveling and transport, fuel, and so on.

Opportunity cost is the losses of income due to opportunity forgone.

Opportunity cost is also called economic cost. Opportunity cost comes under
economic rent. Economic rent is the difference between the actual earnings and
the opportunity cost (expected returns from the second-best alternative use of
the resources).

 Business Cost and Full Cost

Business cost includes all the expenses which are incurred carrying out the
business. Business cost includes all the payments and contractual obligations
made by the firm and depreciation.

The concept of full costs includes opportunity cost and normal profit. Normal
profit is a necessary minimum earning in addition to alternative cost, which a
firm must get to remain in its present occupation.

 Explicit Cost and Implicit Cost

Explicit cost is those which are actually incurred by the business firms and are
entered in the books of accounts.

The costs which do not take the form of cash outlays are known as implicit
costs. Implicit cost is similar to opportunity cost. The implicit cost includes
implicit wages, implicit rents, implicit interest, and so on.

Analytical Cost Concepts

 Theory of Cost: Analytical Cost
Concepts

 Total, Average and Marginal Cost

Total cost (TC) shows the total resources used in the production of
goods and services. It includes total outlays of money expenditure both
explicit and implicit on the resources used to produce a given output.

Average cost is the ratio between total cost (TC) and total output (Q).

Total cost – (TC)

Total output – (Q)

AC = 𝑇𝑇/𝑇

Marginal cost (MC) is the addition to the total cost of producing one additional
unit of product.

MC = ∆𝑇𝑇/∆𝑇

 Fixed and Variable Costs

The costs that do not vary over a certain level of output are known as fixed
cost. Variable costs are those which vary with the variation in the total output.

 Short-run and Long-run Costs

A short-run cost includes fixed cost and variable cost. In the long run there is
no fixed cost. All the costs are variable cost.
Policy Related Cost
Private and Social Costs

 Private costs are those which are actually incurred by the firm on the
purchases of goods and services from the market. For a firm, all the actual
costs include both explicit and implicit are private cost.

 Social cost implies the cost which a society bares on account of the
production of a commodity. Social cost includes both private cost and
external cost (positive and negative externalities).

Theory of Short-run Cost

Short-run total cost (TC) consists of fixed cost and variable cost.

TC = TFC + TVC

Where

TC = Total Cost
TFC = Total Fixed Cost
TVC = Total Variable Cost

Average cost = TC/Q = TFC/Q + TVC/Q

Marginal cost = ∂TC/∂Q
∂TC = ∂TFC + ∂TVC
∂TFC = 0
∂TC/∂Q = ∂TVC
MC = ∂ TVC

The Short Run Cost-Output Relationship

In the short-run production takes place under the laws of returns to variable
input or the law of diminishing returns.

As long as output increases at an increasing rate, the cost of production

increases at a decreasing rate, and when output increases at decreasing rate
cost of production increases at a decreasing rate.
Graph (A)

The Short Run Cost-Output Relationship

(Graph A)
Graph (B)

The Short Run Cost-Output Relationship

(Graph B)
Graph (C)
 The Short Run Cost-Output Relationship
Graph (D)

The Short Run Cost-Output

Relationship

Cost-output Relationship in Short- run

 The short-run cost output relationship is shown in graphs (a) and (b).
 As the graph (a) shows when labor increases from 0 to L1, output increases
at an increasing rate.
 When labor is increased beyond OL1 output increases but at a decreasing
rate and output is maximized at OL3.
 graph (b) shows, over the 0L1 range, TC increases at decreasing rate. The
increase in TC at decreasing rate is indicated by the decreasing slope
(∆𝑇𝐶/∆𝐿) of the TC curve. Similarly, the increasing TC at an increasing rate
corresponds to the range of TP increasing at a diminishing rate.
 The trend of the relationship between cost and output proves the point that
laws of returns to variable input in the form of the theory of cost.
Therefore, the short run theory of cost can be summarized as below.

(1) Total Cost (TC) increases with increase in total production (TP).
(2) As long as TP increases at increasing rate, TC increases at
decreasing rate.
(3) When TP increases at a constant rate, total cost also increase at
constant rate.
(4) When TP increases at decreasing rate, TC increasing at increasing
rate.

The Average and Marginal Cost Behavior

MPL goes on increasing until OL1 labor and MC goes on decreasing till the
corresponding output Q1. MPL reaches its maximum at OL1 and MC reaches its
minimum at the same level of output (0Q). As MPL begins to decline MC begins
to rise.

Further, it can be observed from panels that as AP goes on increasing, AC goes

on decreasing, where AP reaches its maximum, AC decreases to its minimum
and when AP begins to decline, AC begins to rise.

Short-run Cost Functions and Cost Curves

The cost function of a firm is derived on the basis of the actual cost and
production data of the firm.

Given the cost and production, the data cost function may take a variety of
forms. It may be a linear, quadratic, or cubic cost function. The simple total cost
functions which produce U-shaped average and marginal cost curves are at
cubic polynomial form as given below.

TC = A + bQ – cQ2 + dQ3

A = Total Fixed Cost (TFC)

b,c and d = Parametric constants

The AFC, AVC, AC and MC can be derived from the total cost function.
AFC = 𝐴/𝑄

AVC = 𝑇𝑉𝐶/𝑄 = (𝑇𝐶−𝐴)/𝑄 = (𝑏𝑄−〖𝐶𝑄〗^2+ 𝑑𝑄^3)/𝑄

= b – cQ + dQ2

AC = 𝑇𝐶/𝑄 = (𝐴+𝑏𝑄− 𝑐𝑄^(2 )+ 𝑑𝑄^3)/𝑄

= 𝐴/𝑄 + b – cQ + dQ2

MC = 𝜕𝑇𝐶/𝜕𝑄 = b – 2cQ + 3dQ2

Long Run Cost-Output Relationship

In the long run, firms can hire more of both labor and capital, more of raw
materials and other inputs, while technology remains constant.

The long run means the sum of short runs.

Long-run cost curves would be composed of a series of short-run cost curves.

Total Long-run Cost Curve (LTC)

At the beginning, the short-run total cost is given by STC1. Let the firm add
another plant to its size in the short-run 2.

As a result, the firm’s TC increases, and increase in the cost increase the
output.

When the cost of the second plant is added to the first one, the TC curve shifts
upward from STC1 to STC2.

Similarly, we will get STC3 and STC4. LTC can get by drawing a curve tangent
to the bottom of the STCs.

Long-run Total and Average Cost

Theory of Cost : Long-run Total and Average Cost

Theory of Cost: Long Run Average Cost Curve (LAC)

Note that the SAC of the second plant is lower than that of the first plant due to
the economies of scale. However, when the third plant is added economies of
scale is disappeared. Therefore SAC begins to rise.

Long run average cost curve is drawn by drawing a curve tangent to SAC1,
SAC2, and SAC3. The LAC is called as ‘envelope curve’ or planning curve as it
serves as a guide to the entrepreneurs in their planning to expand the
production in the future.

Theory of Cost: Long Run Marginal Cost Curve (LMC)

The long LMC is derived from the short run marginal cost curves. The procedure
of derivation of LMC is exactly the same as the process of derivation of the LAC.

Theory of Cost: Marginal Cost Curve (LMC)

Theory of Cost: Optimum Size of The Firm in

The Long Run
Long run cost curves LAC and LMC can be used to determine the optimum size
of the firm.
The optimum scale of production is one that gives the most efficient utilization
of resources –determined by the minimum LAC.

The optimum size is at the minimum cost, where LAC=LMC=SAC=SMC.

Theory of
Cost: Optimum Size of The Firm in The Long Run

Economies and Diseconomies of Scale

When we talk about the scale of production of a firm, we often hear
about the fact that large-scale production, usually, helps in reducing the
cost of production. Economies of scale refer to these reduced costs per
unit arising due to an increase in the total output. Diseconomies of
scale, on the other hand, occur when the output increases to such a great
extent that the cost per unit starts increasing. In this article, we will look
at the internal and external, diseconomies and economies of scale.

Internal and External Economies

When a firm opts for large-scale production, the economies arising out
of it are grouped into two categories:
1. Internal economies – economies of production that the firm accrues
when it increases the output leading to a drop in the cost of
production. These arise due to endogenous factors like
entrepreneurial efficiency, talents of the management team, type of
machinery, etc. These economies arise within the firm and help the
firm only.
2. External economies – these are the benefits that each member firm
of the industry accrues due to the expansion of the entire industry.

Browse more Topics under Theory Of Cost

 Cost Concepts
 Short Run Average Costs
 Short Run Total Costs
 Long Run Average Cost Curve

Internal Diseconomies and Economies of Scale

While studying returns to scale, we observed that they increase during

the initial stages, remain constant for a while, and then start decreasing.
The reason is simple – initially, the firm enjoys internal economies of
scale and after a certain limit, it suffers from internal diseconomies of
scale. Let’s look at the types of economies and diseconomies:

Technical

Large-scale production is linked to technical economies. When a firm

increases its scale of operations, it needs to use a more specialized and
efficient form of capital equipment and machinery. Such machinery
helps to produce larger outputs at a lower unit cost.
Further, as the scale of production increases and the amount of labor
and other factors becomes larger, the firm manages to reduce costs by
introducing a degree of division of labor and specialization.

However, beyond a certain point, the firm experiences diseconomies of

scale. This happens because after reaching a large enough output, the
firm utilizes almost all possibilities of the division of labor
and employment of efficient machinery.

Post this, any increase in the size of the plant causes the costs to rise.
When the scale of operations becomes too large, the management finds
it more difficult to control and coordinate the operations.

Managerial

As the output increases, the firm can apply the division of labor to the
management as well. For example, the production manager can look
after production, the sales manager can look after sales, etc. When the
scale of production increases further, the firm divides each department
into sub-departments like sales is divided into advertising, exports, and
service.

Thus helps in increasing the efficiency and productivity of the

management team since a specialist manages each sub-department.
Further, the firm has the option to decentralize decision-making
authority enhancing the efficiency further. Therefore, specialized
management allows the firm to reduce managerial costs.

However, as the firm increases its scale of operations beyond a certain

limit, the management finds it difficult to control and coordinate
between departments. This leads to managerial diseconomies.
Commercial

As a firm increases its volume of production, it requires large amounts

of raw material and components. Hence, it places a bulk order for such
material and components and enjoys discounted pricing for them.

Economies are also achieved during sales. If the sales staff is working
under-capacity, then the firm can sell additional output at little extra
cost.

Further, as the scale of production increases, the advertising cost per

unit fall. Hence, the firm benefits from economies
of advertising too. After an optimum level, these economies start
becoming diseconomies though.

Financial

When a firm wants to raise finance, a large-scale firm has many benefits
like:

 Better security to bankers

 Well-known
 Can raise finance at lower costs, etc.
However, after the optimum scale of production, the financial costs rise
faster due to the increased dependence on external finances.

Risk-bearing

A firm enjoys the economies of risk-bearing if it has a large-scale

operation with diverse and multi-production capabilities. However, if
the diversification increases the economic disturbances rather than
covering them, then the risk increases.
Learn more about Sources of Internal Economies of Scale here.

External Diseconomies and Economies of Scale

External diseconomies and economies of scale are very important to a

firm. These are a result of the expansion of output of the entire industry
and not limited to an individual firm. They are available to one or more
firms in the following forms:

Cheaper Raw materials and Capital Equipment

At times, the expansion of an industry results in new and cheaper

sources of raw material, machinery, and other capital equipment. It also
results in an increased demand for the various types of materials and
equipment required by the industry.

Hence, such materials/equipment can be purchased from other

industries on a large scale. This, eventually, leads to a lower cost of
production and lower price. Therefore, firms using these
materials/equipment get them at lower prices.

Technological External Economies

Usually, when an entire industry expands, new technical knowledge is

discovered leading to new and improved machinery for the said
industry. This changes the technological coefficient of production and
enhances the productivity of the firms in the industry. Hence, the cost of
production reduces.

Development of Skilled Labor

As the industry expands, the labor gets accustomed to managing various

production processes and learns from the experience. This increases the
number of skilled workers which in turn has a favorable effect on the
levels of productivity.

Growth of Ancillary Industries

When a certain industry expands, many ancillary industries start

specializing in the production of raw materials, tools, machinery, etc.
These ancillary industries offer the materials/machinery at a low price.

Similarly, some ancillary industries also start processing industrial

waste and create a useful product out of it. Overall, it leads to a lower
cost of production.

Better Transportation and Marketing Facilities

An expanding industry, usually, results in better transportation and

marketing networks. These aspects help reduce the cost of production in
the firms from the industry.

It is important to note that, certain disadvantages can neutralize the

advantages of the expansion of industry and cease the external
economies of scale. These are external diseconomies. When an industry
expands, the demand for certain materials and skilled labor increases.

If these factors are in short supply, then their prices can increase.
Further, the geographical concentration of firms from the industry can
lead to higher transportation costs, marketing costs, pollution control
costs, etc.
Monopolistic Competition
In monopolistic competition, the market has features of both perfect
competition and monopoly. A monopolistic competition is more
common than pure competition or pure monopoly. In this article, we
will understand monopolistic competition and look at the features,
price-output determination, and conditions for equilibrium.

Monopolistic Competition
In order to understand monopolistic competition, let’s look at the
market for soaps and detergents in India. There are many well-known
brands like Lux, Rexona, Dettol, Dove, Pears, etc. in this segment.

Since all manufacturers produce soaps, it appears to be an example of

perfect competition. However, on close scrutiny, we find that each seller
varies the product slightly to make it different from its competitors.

Hence, Lux focuses on making beauty soaps, Liril on freshness, Dettol

on antiseptic properties, Dove on smooth skin, etc. This allows each
seller to attract buyers to itself based on some factor other than price.

This market has a mix of both perfect competition and monopoly and is
a classic example of monopolistic competition.

Browse more Topics under Determination Of Prices

 Intro to Determination of Prices

 Changes in Demand
 Changes in Supply
 Simultaneous changes in Demand and Supply
 Features of Perfect Competition
 Price Determination under Perfect Competition
 Long Run Equilibrium of Competitive Firm and Industry
 Monopoly Market
 Monopolist’s Revenue Curve
 Price Discrimination
 Oligopoly
 Kinked Demand Curve
Features of Monopolistic Competition

1. Large number of sellers: In a market with monopolistic competition,

there are a large number of sellers who have a small share of the
market.
2. Product differentiation: In monopolistic competition, all brands try to
create product differentiation to add an element of monopoly over
the competing products. This ensures that the product offered by
the brand does not have a perfect substitute. Therefore, the
manufacturer can raise the price of the product without having to
worry about losing all its customers to other brands. However, in
such a market, while all brands are not perfect substitutes, they are
close substitutes for each other. Hence, the seller might lose at least
some customers to his competitors.
3. Freedom of entry or exit: Like in perfect competition, firms can enter
and exit the market freely.
4. Non-price competition: In monopolistic competition, sellers compete
on factors other than price. These factors include aggressive
advertising, product development, better distribution, after sale
services, etc. Sellers don’t cut the price of their products but incur
high costs for the promotion of their goods. If the firms indulge in
price-wars, which is the possibility under perfect competition, some
firms might get thrown out of the market.

Price-output determination under Monopolistic Competition:

Equilibrium of a firm

In monopolistic competition, since the product is differentiated between

firms, each firm does not have a perfectly elastic demand for its
products. In such a market, all firms determine the price of their own
products. Therefore, it faces a downward sloping demand curve.
Overall, we can say that the elasticity of demand increases as the
differentiation between products decreases.
Fig. 1 above depicts a firm facing a downward sloping, but
flat demand curve. It also has a U-shaped short-run cost curve.

Pricing under monopolistic and oligopolistic

competition

Introduction

Pricing decisions tend to be the most important decisions made by any firm in any kind
of market structure. The concept of pricing has already been discussed in unit . The
price is affected by the competitive structure of a market because the firm is an integral
part of the market in which it operates.

We have examined the two extreme markets viz. monopoly and perfect competition in
the previous unit. In this unit the focus is on monopolistic competition and oligopoly,
which lie in between the two extremes and are therefore more applicable to real world
situations.

Monopolistic competition normally exists when the market has many sellers
selling differentiated products, for example, retail trade, whereas oligopoly is said to be
a stable form of a market where a few sellers operate in the market and each firm has a
certain amount of share of the market and the firms recognize their dependence on
each other. The features of monopolistic and oligopoly arediscussed in detail in this unit.
MONOPOLISTIC COMPETITION

Edward Chamberlin, who developed the model of monopolistic competition, observed

that in a market with large number of sellers, the products of individual firms are not at
all homogeneous, for example, soaps used for personal wash. Each brand has a
specific characteristic, be it packaging, fragrance, look etc.,though the composition
remains the same. This is the reason that each brand is sold Pricing
Decisions individually in the market. This shows that each brand is highly differentiated
in the minds of the consumers. The effectiveness of the particular brand may be
attributed to continuous usage and heavy advertising. As defined by Joe S.Bain
‘Monopolistic competition is found in the industry where there are a large number of
sellers, selling differentiated but close substitute products’. Take the example of Liril and
Cinthol. Both are soaps for personal care
but the brands are different. Under monopolistic competition, the firm has some freedom
to fix the price i.e. because of differentiation a firm will not lose all customers when it
increases its price. Monopolistic competition is said to be the combination of perfect
competition as well as monopoly because it has the features of both perfect competition
and monopoly. It is closer in spirit to a perfectly competitive market, but because
of product differentiation, firms have some control over price. The characteristic features
of monopolistic competition are as follows: PURE

 A large number of sellers: Monopolistic market has a large number of sellers of a

product but each seller acts independently and has no influence on others.

 A large number of buyers: Just like the sellers, the market has a large number of
buyers of a product and each buyer acts independently.

 Sufficient Knowledge: The buyers have sufficient knowledge about the product to
be purchased and have a number of options available to choose from.
For example, we have a number of petrol pumps in the city. Now it depends on the
buyer and the ease with which s/he will get the petrol decides the location of the petrol
pump. Here accessibility is likely to be an important factor. Therefore, the buyer will go
to the petrol pump where s/he feels comfortable and gets the petrol filled in the vehicle
easily.

 Differentiated Products: The monopolistic market categorically

offers differentiated products, though the difference in products is marginal, for
example, toothpaste.

 Free Entry and Exit: In monopolistic competition, entry and exit are quite easy
and the buyers and sellers are free to enter and exit the market at their own
will.Nature of the Demand Curve

The demand curve of the monopolistic competition has the following characteristics:

 Less than perfectly elastic: In monopolistic competition, no single firm dominates

the industry and due to product differentiation, the product of each firm seems to
be a close substitute, though not a perfect substitute for the products of the
competitors. Due to this, the firm in question has high elasticity of demand.

 Demand curve slopes downward: In monopolistic competition, the demand curve

facing the firm slopes downward due to the varied tastes and preferences of
consumers attached to the products of specific sellers. This implies that
the demand curve is not perfectly elastic.

PRICE AND OUTPUT DETERMINATION INSHORT RUN

In monopolistic competition, every firm has a certain degree of monopoly power

i.e.every firm can take initiative to set a price. Here, the products are similar but
notidentical, therefore there can never be a unique price but the prices will be in agroup
reflecting the consumers’ tastes and preferences for differentiated products.In this case
the price of the product of the firm is determined by its cost function,demand, its
objective and certain government regulations, if there are any.

As the price of a particular product of a firm reduces, it attracts customers from its
rival groups (as defined by Chamberlin). Say for example, if ‘Samsung’ TV reduces
its price by a substantial amount or offers discount, then the customers from the
rival group who have loyalty for, say ‘BPL’, tend to move to buy ‘Samsung’ TV sets. As
discussed earlier, the demand curve is highly elastic but not perfectly elastic and slopes
downwards.

The market has many firms selling similar products, therefore the firm’s output is quite
small as compared to the total quantity sold in the market and so its price and output
decisions go unnoticed. Therefore, every firm acts independently and for a given
demand curve, marginal revenue curve and cost curves, the firm maximizes profit or
minimizes loss when marginal revenue is equal to marginal cost. Producing an output of
Q selling at price P maximizes the profits of the firm.

In the short run, a firm may or may not earn profits. Figure shows the firm, which is
earning economic profits. The equilibrium point for the firm is at price P and quantity Q
and is denoted by point A. Here, the economic profit is given as area PAQR. The
difference between this and the monopoly case is that here the barriers to entry are low
or weak and therefore new firms will be attracted to enter. Fresh entry will continue to
enter as long as there are profits. As soon as the super normal profit is competed away
by new firms, equilibrium will be attained in the market and no new firms will be
attracted in the market. This is the situation corresponding to the long run and is
discussed in the next section.

PRICE AND OUTPUT DETERMINATION INLONG RUN

We have discussed the price and output determination in the short run. We now discuss
price and output determination in the long run. You will notice that the long run
equilibrium decision is similar to perfect competition. The core of the discussion under
this head is that economic profits are eliminated in the long run, which is the only
equilibrium consistent with the assumption of low barriers to entry. This occurs at an
output where price is equal to the long run average cost. Thedifference between
monopolistic competition and perfect competition is that in monopolistic competition the
point of tangency is downward sloping and does not occur at minimum of the average
cost curve and this is because the demand curve is downward sloping.
Looking at figure , under monopolistic competition in the long run we see that LRAC is
the long run average cost curve and LRMC the long run average marginal curve. Let us
take a hypothetical example of a firm in a typical monopolistic situation where it is
making substantial amount of economic profits.

Here it is assumed that the other firms in the market are also making profits.
This situation would then attract new firms in the market. The new firms may not sell the
same products but will sell similar products. As a result, there will be an increase in the
number of close substitutes available in the market and hence the demand curve would
shift downwards since each existing firm would lose market share. The entry of new
firms would continue as long as there are economic profits.

The demand curve will continue to shift downwards till it becomes tangent to LRAC at a
given price P1 and output at Q1 as shown in the figure. At this point of equilibrium, an
increase or decrease in price would lead to losses. In this case the entry of new firms
would stop, as there will not be any economic profits.

Due to free entry, many firms can enter the market and there may be a condition
where the demand falls below LRAC and ultimately suffers losses resulting in the exit
of the firms. Therefore under the monopolistic competition free entry and exit must lead
to a situation where demand becomes tangent to LRAC, the price becomes equal to
average cost and no economic profit is earned. It can thus be said that in the long run
the profits peter out completely.

One of the interesting features of the monopolistically competitive market is the variety
available due to product differentiation. Although firms in the long run do not produce at
the minimum point of their average cost curve, and thus there is excess capacity
available with each firm, economists have rationalized this by attributing the higher price
to the variety available. Further, consumers are willing to pay the higher price for the
increased variety available in the market.

OLIGOPOLISTIC COMPETITION

We define oligopoly as the form of market organization in which there are fewsellers of
a homogeneous or differentiated product. If there are only two sellers, we have a
duopoly. If the product is homogeneous, we have a pure oligopoly. If the product is
differentiated, we have a differentiated oligopoly.

While entry into anoligopolistic industry is possible, it is not easy (as evidenced by the
fact that thereare only a few firms in the industry).

Oligopoly is the most prevalent form of market organization in the manufacturingsector

of most nations, including India. Some oligopolistic industries in India areautomobiles,
primary aluminum, steel, electrical equipment, glass, breakfast cereals,cigarettes, and
many others. Some of these products (such as steel and aluminum)are homogeneous,
while others (such as automobiles, cigarettes, breakfast cereals,and soaps and
detergents) are differentiated.

Oligopoly exists also whentransportation costs limit the market area. For example, even
though there aremany cement producers in India, competition is limited to the few local
producers ina particular area.Since there are only a few firms selling a homogeneous or
differentiated product inoligopolistic markets, the action of each firm affects the other
firms in the industryand vice versa.

For example, when General Motors introduced price rebates in thesale of its
automobiles, Ford and Maruti immediately followed with price rebates oftheir own.
Furthermore, since price competition can lead to ruinous price wars,oligopolists usually
prefer to compete on the basis of product differentiation,advertising, and service.
These are referred to as nonprice competition. Yet, evenhere, if GM mounts a major
advertising campaign, Ford and Maruti are likely tosoon respond in kind. When Pepsi
mounted a major advertising campaign in theearly 1980s Coca-Cola responded with a
large advertising campaign of its own inthe United States.From what has been said, it is
clear that the distinguishing characteristic ofoligopoly is the interdependence or rivalry
among firms in the industry.

This is the natural result of fewness. Since an oligopolist knows that its own actions will
have a significant impact on the other oligopolists in the industry, each oligopolist
mustconsider the possible reaction of competitors in deciding its pricing policies,
the degree of product differentiation to introduce, the level of advertising to
be undertaken, the amount of service to provide, etc. Since competitors can react
in many different ways (depending on the nature of the industry, the type of
product, etc.) We do not have a single oligopoly model but many-each based on
the particular behavioural response of competitors to the actions of the first. Because of
this interdependence, managerial decision making is much more complex
under oligopoly than under other forms of market structure. In what follows we
present some of the most important oligopoly models. We must keep in mind, however,
that each model is at best incomplete. The sources of oligopoly are generally the same
as for monopoly. That is,

(1) economies of scale may operate over a sufficiently large range of outputs as
to leave only a few firms supplying the entire market;

(2) huge capital investments and specialized inputs are usually required to enter an
oligopolistic industry (say, automobiles, aluminum, steel, and similar industries), and this
acts as an important natural barrier to entry;

(3) a few firms may own a patent for the exclusive right to produce a commodity or to
use a particular production process;

(4) established firms may have a loyal following of customers based on product quality
and service that new firms would find very difficult to match;

(5) a few firms may own or control the entire supply of a raw material required in the
production of the product; and

(6) the government may give a franchise to only a few firms to operate in the market.
The above are not only the sources of oligopoly but also represent the barriers to other
firms entering the market in the long run. If entry were not so restricted, the industry
could not remain oligopolistic in the long run. A further barrier to entry is provided by
limit pricing, whereby, existing firms charge a price low enough to discourage entry into
the industry. By doing so, they voluntarily sacrifice short-run profits in order to maximize
long-run profits. As discussed earlier oligopolies can be classified on the basis of type of
product produced. They can be homogeneous or differentiated. Steel, Aluminium etc.
come under homogeneous oligopoly and television, automobiles etc. come
under heterogeneous oligopoly.

The type of product produced may affect the strategic behaviour of oligopolists.
According to economists, two contrasting behaviour of oligopolists arise that is the
cooperative oligopolists where an oligopolist follows the pattern followed by rival firms
and the non-cooperative oligopolists where the firm does not follow the pattern followed
by rival firms. For example, a firm raises price of its product, the other firms may keep
their prices low so as to attract the sales away from the firm, which has raised its price.
But as stated above, price is not the only factor of competition. As a matter of fact other
factors on the basisof which the firms compete include advertising, product quality and
other marketing strategies. Therefore, we normally have four general oligopolistic
market structures, two each under cooperative as well as non-cooperative structures.

We have firms producing homogeneous and differentiated products under each of the
two basic structures. All these differences exist in the oligopolistic market. This shows
that each firm tries to make an impact in the existing market structure and have
an effect on the rival firms. This tends to be a distinguishing characteristic of
anoligopolistic market.Price Rigidity: Kinked Demand CurveOur study of pricing and
market structure has so far suggested that a firmmaximizes profit by setting MR = MC.
While this is also true for oligopoly firms, itneeds to be supplemented by other
behavioural features of firm rivalry.

This becomes necessary because the distinguishing feature of oligopolistic markets is

interdependence. Because there are a few firms in the market, they also need toworry
about rival firm’s behaviour. One model explaining why oligopolists tend notto compete
with each other on price, is the kinked demand curve model of PaulSweezy. In order to
explain this characteristic of price rigidity i.e. prices remainingstable to a great extent,
Sweezy suggested the kinked demand curve model for theoligopolists. The kink in the
demand curve arises from the asymmetric behaviour ofthe firms. The proponents of the
hypothesis believe that competitors normallyfollow price decreases i.e. they show the
cooperative behaviour if a firm reducesthe price of its products whereas they show the
non-cooperative behaviour if a firmincreases the price of its products.Let us start from
P1 in Figure .
 If one firm reduces its price and the other firmsin the market do not respond, the price
cutter may substantially increase its sales.This result is depicted by the relative elastic
demand curve, dd. For example, aprice decrease from P1 to P2 will result in a
movement along dd and increase salesfrom Q1 to Q2 as customers take advantage of
the lower price and abandon othersuppliers. If the price cut is matched by other firms,
the increase in sales will be less.

lSince other firms are selling at the same price, any additional sales must result from
increased demand for the product. Thus the effect of price reduction is a movement
down the relatively inelastic demand curve, DD, then the price reduction from P1 to P2
only increases sales to Q2.

Here we assume that P1 is the initial price of the firm operating in a

noncooperative oligopolistic market structure producing Q1 units of output. P is also the
point of kink in the demand curve and is the initial price and DD is the relatively elastic
demand curve above the existing price P1.

When the firm is operating in the non-cooperative oligopolistic market it results in

decline in sales if it changes its price to P1. Now if the firm reduces its price below P1
say P2, the other firms operating in the market show a cooperative behaviour and follow
the firm. This is shown in the figure as the curve below the existing price P1.

The true demand curve for the oligopolistic market is dD and has the kink at the existing
price P1. The demand curve has two linear curves, which are joined at price
P. Associated with the kinked demand curve is a marginal revenue function. This
is shown in Figure . Marginal Revenue for prices above the kink is given by MR1 and
below the kink as MR2.
At the kink, marginal revenue has a discontinuity at AB and this depends on the
elasticities of the different parts of the demand curve. Therefore, in the presence of a
kinked demand curve, firm has no motive to change its price. If the firm is a profit
maximizing firm where MR=MC, it would not change its price even if the cost changes.
This situation occurs as long as changes in MC fall within the discontinuous range i.e.
AB portion.

The firm following kinked model has a U-shaped marginal cost curve MC. The new MC
curve will be MC1 or MC2 and will remain in the discontinued area and the equilibrium
price remains the same
at P .

Price Competition: Cartels and Collusion

Cartel Profit Maximization
We already know now that in an oligopolistic competition, the firms can compete
in many ways. Some of the ways include price, advertising, product quality, etc.
Many firms may not like competition because it could be mutually disadvantageous.
For example, advertising. In this case many oligopolies end up selling the products
at low prices or doing high advertising resulting in high costs and making lower
profits than expected. Therefore, it is possible for the firms to come to a consensus
and raise the price together, increasing the output without much reduction in sales.

In some countries this kind of collusive agreement is illegal e.g. USA but in some it is
legal. The most extreme form of the collusive agreement is known as a cartel. A cartel is
a market sharing and price fixing arrangement between groups of firms where the
objective of the firm is to limit competitive forces within the market.
The forms of cartels may differ. It can be an explicit collusive agreement where
the member firms come together and may reach a consensus regarding the price
and market sharing or implicit cartel where the collusion is secretive in
nature. Throughout the 1970s, the Organization of Petroleum Exporting Countries
(OPEC) colluded to raise the price of crude oil from under $3 per barrel in 1973 to over
$30 per barrel in 1980.

The world awaited the meeting of each OPEC price-setting meeting with anxiety. By the
end of 1970s, some energy experts were predicting that the price of oil would rise to
over $100 per barrel by the end of the century. Then suddenly the cartel seemed to
collapse. Prices moved down, briefly touching $10 per barrel in early 1986 before
recovering to $18 per barrel in 1987. Today the price of a barrel is about $24. OPEC is
the standard example used in textbooks when explaining cartel behaviour. The cartel
profit maximizing theory can be explained using figure

The market demand for all members of the cartel is given by DD and marginal revenue
(represented by dotted line) as MR. The cartels marginal cost curve given by MCc is the
horizontal sum of the marginal cost curves of the member firms. In this the basic
problem is to determine the price, which maximizes cartel profit. This is done by
considering the individual members of the cartel as one firm i.e. a monopoly. In the
figure this is at the point where MR= MCc, setting price = P.

The problem is regarding the allocation of output within the member firms. Normally a
quota system is quite popular, whereby each firm produces a quantity such that its MC
= MCc. One serious problem that arises from this analysis is that while the joint profits
of the cartel as a whole are maximised, each individual member of the cartel has an
incentive to cheat on its quota. This is because the price for the product is greater than
the members marginal cost of production. This implies that an individual member can
increase its profit by increasing production. What would happen if all members did the
same?
The market sharing arrangement will breakdown and the cartel would collapse. Here
lies the inherent instability of cartel type arrangement and can be summarized as
follows.There is an incentive for the cartel as a whole to restrict output and raise
price, thereby achieving the joint profit maximizing result, but there is an incentive on
the part of the members to increase individual profit. If this kind of situation occurs,
it leads to break-up of the cartel. The difficulty with sustaining collusion is often
demonstrated by a classic strategic game known as the prisoner’s dilemma. The story is
something like this. Two KGB officers spotted an orchestra conductor examining the
score of Tchaikovsky’s Violin Concerto.

Thinking the notation was a secret code, the officers arrested the conductor as a spy.
On the second day of interrogation, a KGB officer walked in and smugly proclaimed,
“OK, you can start talking. We have caught Tchaikovsky”. More seriously, suppose the
KGB has actually arrested someone named Tchaikovsky and the conductor separately.
If either the conductor or Tchaikovsky falsely confesses while the other does not, the
confessor earns the gratitude of the
KGB and only one year in prison, but the other receives 25 years in prison. If both
confess each will be sentenced to 10 years in prison; and if neither confesses
each receives 3 years in prison. Now consider the outcome. The conductor knows that if
Tchaikovsky confesses, he gets either 25 years by holding out or 10 years by
confessing. If Tchaikovsky holds out, the conductor gets either 3 years by holding out or
only one year confessing. Either way, it is better for the conductor to confess.

Tchaikovsky, in a separate cell, engages in the same sort of thinking and also decides
to confess. The conductor and Tchaikovsky would have had three-years rather than 10-
year jail sentences if they had not falsely confessed, but the scenario was such that,
individually, false confession was rational. Pursuit of their own self interests made each
worse off.

This situation is the standard prisoner’s dilemma and is represented in the above matrix.
This first payoff in each cell refers to Tchaikovsky’s, and the second is the conductors.
Examination of the payoffs shows that the joint profit maximizing strategy for both is
(Cooperate-Cooperate).2 The assumption in this game is that both the parties decided
their strategies independently. Let us assume both parties are allowed to consult each
other before the interrogation.
Do you think cooperation will be achieved? It is unlikely since each of them will
individually be concerned about the worst outcome that is 25 years in jail. Cooperation
in this prisoner’s dilemma becomes even more difficult, because it is a one shot
game. This scenario is easily transferred to the pricing decision of a company.
Consider two companies setting prices. If both companies would only keep prices high,
they will jointly maximise profits.

If one company lowers price, it gains customers and it is thus in its interests to do so.
Once one company has cheated and lowered price, the other company must follow suit.
Both companies have lowered their profits by lowering price. Clearly, companies
repeatedly interact with one another, unlike Tchaikovsky and the conductor. With
repeated interaction, collusion can be sustained. Robert Axelrod, a well-known political
scientist, claims a “tit-for-tat” strategy is the best way to achieve co-operation. A tit-for-
tat strategy always co-operates in the first period and then mimmics the strategy of its
rival in each subsequent period. Axelrod likes the tit-for-tat strategy because it is nice,
retaliatory, forgiving the clear. It is nice, because it starts by co-operating, retaliatory
because it promptly punishes a defection, forgiving because once the rival returns to co-
operation it is willing to restore co-operation, and finally its rules are very clear:
precisely, an eye for an eye.

A fascinating example of tit-for-tat in action occurred during the trench warfare of

the First World War. Front-line soldiers in the trenches often refrained from shooting to
kill, provided the opposing soldiers did likewise. This restraint was often in direct
violation of high command orders.

Price Leadership
Price leadership is an alternative cooperative method used to avoid tough competition.
Under this method, usually one firm sets a price and the other firms follow. It is quite
popular in industries like cigarette industry. Here any firm in the oligopolistic market can
act as a price leader. The firm, which is highly efficient, and having low cost can be a
price leader or the firm, which is dominant in the market acts as a leader. Whatever the
case may be, the firm, which sets the price, is the price leader. We have two forms of
price leadership-Dominant price leadership and Barometric price leadership.

In dominant price leadership, the largest firm in the industry sets the price. If the small
firms do not conform to the large firm, then the price war may take place due to which
the small firms may not be able to survive in the market. It is more or less like a
monopoly market structure. This can be seen in the airlines industry in India where the
dominant firm Indian Airlines (IA) sets prices and the others Jet and Sahara follow the
price changes of IA.

Barometric price leadership is said to be the simpler of the two. This normally occurs in
the market where there is no dominant firm. The firm having a good reputation in the
market usually sets the price. This firm acts as a barometer and sets the price to
maximize the profits. Here it is important to note that the firm in question does not have
any power to force the other firms to follow its lead. The other firms will follow only as
long as they feel that the firm in action is acting fairly. Though this method is quite
ambiguous regarding price leadership, it is legally accepted. These two forms are an
integral part of different types of cooperative oligopoly. Barometric price leadership has
been seen in the automobile sector.

Monopolistic Competition
In monopolistic competition, the market has features of both perfect
competition and monopoly. A monopolistic competition is more
common than pure competition or pure monopoly. In this article, we
ill understand monopolistic competition and look at the features,
price-output determination, and conditions for equilibrium.

Monopolistic Competition
In order to understand monopolistic competition, let’s look at the
market for soaps and detergents in India. There are many well-known
brands like Lux, Rexona, Dettol, Dove, Pears, etc. in this segment.

Since all manufacturers produce soaps, it appears to be an example of

perfect competition. However, on close scrutiny, we find that each seller
varies the product slightly to make it different from its competitors.

Hence, Lux focuses on making beauty soaps, Liril on freshness, Dettol

on antiseptic properties, Dove on smooth skin, etc. This allows each
seller to attract buyers to itself based on some factor other than price.

This market has a mix of both perfect competition and monopoly and is
a classic example of monopolistic competition.

Browse more Topics under Determination Of Prices

 Intro to Determination of Prices

 Changes in Demand
 Changes in Supply
 Simultaneous changes in Demand and Supply
 Features of Perfect Competition
 Price Determination under Perfect Competition
 Long Run Equilibrium of Competitive Firm and Industry
 Monopoly Market
 Monopolist’s Revenue Curve
 Price Discrimination
 Oligopoly
 Kinked Demand Curve
Features of Monopolistic Competition

1. Large number of sellers: In a market with monopolistic competition,

there are a large number of sellers who have a small share of the
market.
2. Product differentiation: In monopolistic competition, all brands try to
create product differentiation to add an element of monopoly over
the competing products. This ensures that the product offered by
the brand does not have a perfect substitute. Therefore, the
manufacturer can raise the price of the product without having to
worry about losing all its customers to other brands. However, in
such a market, while all brands are not perfect substitutes, they are
close substitutes for each other. Hence, the seller might lose at least
some customers to his competitors.
3. Freedom of entry or exit: Like in perfect competition, firms can enter
and exit the market freely.
4. Non-price competition: In monopolistic competition, sellers compete
on factors other than price. These factors include aggressive
advertising, product development, better distribution, after sale
services, etc. Sellers don’t cut the price of their products but incur
high costs for the promotion of their goods. If the firms indulge in
price-wars, which is the possibility under perfect competition, some
firms might get thrown out of the market.

Price-output determination under Monopolistic Competition:

Equilibrium of a firm

In monopolistic competition, since the product is differentiated between

firms, each firm does not have a perfectly elastic demand for its
products. In such a market, all firms determine the price of their own
products. Therefore, it faces a downward sloping demand curve.
Overall, we can say that the elasticity of demand increases as the
differentiation between products decreases.

Fig. 1 above depicts a firm facing a downward sloping, but

flat demand curve. It also has a U-shaped short-run cost curve.

Conditions for the Equilibrium of an individual firm

The conditions for price-output determination and equilibrium of an

individual firm are as follows:

1. MC = MR
2. The MC curve cuts the MR curve from below.
In Fig. 1, we can see that the MC curve cuts the MR curve at point E. At
this point,
 Equilibrium price = OP and
 Equilibrium output = OQ
Now, since the per unit cost is BQ, we have

 Per unit super-normal profit (price-cost) = AB or PC.

 Total super-normal profit = APCB
The following figure depicts a firm earning losses in the short-run.

From Fig. 2, we can see that the per unit cost is higher than the price of
the firm. Therefore,

 AQ > OP (or BQ)

 Loss per unit = AQ – BQ = AB
 Total losses = ACPB
Long-run equilibrium

If firms in a monopolistic competition earn super-normal profits in the

short-run, then new firms will have an incentive to enter the industry.
As these firms enter, the profits per firm decrease as the total demand
gets shared between a larger number of firms. This continues until all
firms earn only normal profits. Therefore, in the long-run, firms, in such
a market, earn only normal profits.

As we can see in Fig. 3 above, the average revenue (AR) curve touches
the average cost (ATC) curve at point X. This corresponds to quantity
Q1 and price P1. Now, at equilibrium (MC = MR), all super-normal
profits are zero since the average revenue = average costs. Therefore, all
firms earn zero super-normal profits or earn only normal profits.

It is important to note that in the long-run, a firm is in an equilibrium

position having excess capacity. In simple words, it produces a lower
quantity than its full capacity. From Fig. 3 above, we can see that the
firm can increase its output from Q1 to Q2 and reduce average costs.
However, it does not do so because it reduces the average revenue more
than the average costs. Hence, we can conclude that in monopolistic
competition, firms do not operate optimally. There always exists an
excess capacity of production with each firm.

In case of losses in the short-run, the firms making a loss will exit from
the market. This continues until the remaining firms make normal
profits only.

What Is a Shutdown Point?

A shutdown point is a level of operations at which a company experiences no
benefit for continuing operations and therefore decides to shut down
temporarily—or in some cases permanently. It results from the combination of
output and price where the company earns just enough revenue to cover its
total variable costs. The shutdown point denotes the exact moment when a
company’s (marginal) revenue is equal to its variable (marginal) costs—in
other words, it occurs when the marginal profit becomes negative.

KEY TAKEAWAYS

 A shutdown point is a level of operations at which a company

experiences no benefit for continuing operations and therefore decides
to shut down temporarily—or in some cases permanently.
 A shutdown point results from the combination of output and price
where the company earns just enough revenue to cover its total
variable costs.
 Shutdown points are based entirely on determining at what point the
marginal costs associated with operation exceed the revenue being
generated by those operations.
 When a company can earn a positive contribution margin, it should
remain in operation despite an overall marginal loss.

How the Shutdown Point Works

At the shutdown point, there is no economic benefit to continuing production.
If an additional loss occurs, either through a rise in variable costs or a fall in
revenue, the cost of operating will outweigh the revenue.

At that point, shutting down operations is more practical than continuing. If

the reverse occurs, continuing production is more practical. If a company can
produce revenues greater or equal to its total variable costs, it can use the
additional revenues to pay down its fixed costs, assuming fixed costs, such as
lease contracts or other lengthy obligations, will still be incurred when the firm
shuts down. When a company can earn a positive contribution margin, it should
remain in operation despite an overall marginal loss.

A shutdown point can apply to all of the operations a business participates in

or just a portion of its operations.

Special Considerations
The shutdown point does not include an analysis of fixed costs in its
determination. It is based entirely on determining at what point the marginal
costs associated with operation exceed the revenue being generated by
those operations.

Certain seasonal businesses, such as Christmas tree farmers, may shut

down almost entirely during the off-season. While fixed costs remain during
the shutdown, variable costs can be eliminated.

Fixed costs are the costs that remain regardless of what operations are
taking place. This can include payments to maintain the rights to the facility,
such as rent or mortgage payments, along with any minimum utilities that must
be maintained. Minimum staffing costs are considered fixed if a certain
number of employees must be maintained even when operations cease.

Variable costs are more closely tied to actual operations. This can include but
is not limited to, employee wages for those whose positions are tied directly
to production, certain utility costs, or the cost of the materials required for
production.

Types of Shutdown Points

The length of a shutdown may be temporary or permanent, depending on the
nature of the economic conditions leading to the shutdown. For non-seasonal
goods, an economic recession may reduce demand from consumers, forcing a
temporary shutdown (in full or in part) until the economy recovers.

Other times, demand dries up completely due to changing consumer

preferences or technological change. For instance, nobody produces
cathode-ray tube (CRT) televisions or computer monitors any longer, and it
would be a losing prospect to open a factory these days to produce them.

Other businesses may experience fluctuations or produce some goods year-

round, while others are only produced seasonally. For example, Cadbury
chocolate bars are produced year-round, while Cadbury Cream Eggs are
considered a seasonal product. The main operations, focused on the
chocolate bars, may remain operational year-round, while the cream egg
operations may go through periods of a shutdown during the off-season.

UNIT-4
Factors Determining Economic
Development in India
Business environment is the sole determinant of economic
development of a country. In order to attain higher level of economic
development, the business environment in the country should be very
much conducive towards development. The path of economic
development in an under-developed country like India is full of
hurdles and impediments.

Attaining higher level of economic development is a function of level

of technology. Economic development is thus a process of raising the
rate of capital formation, i.e., both physical capital and human capital.
Moreover, the task of economic development is influenced by a
number of factors such as economic, political, social, technological,
natural, administrative etc.

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Regarding the determinants of economic growth Prof. Ragner Nurkse

observed that, “Economic development has much to do with human
endowments, social attitude, political condition and historical
accidents.” Again, Prof. PT. Bauer also mentioned that “The main
determinants of economic development are aptitude, abilities,
qualities, capacities and facilities.”

Thus economic development of a country depends on both economic

and non-economic factors. The following are some of the economic
and non-economic factors determining the pace of economic
development in a country like India.

A. Economic Factors:
Economic environment is working as an important determinant of
economic development of a country. Economic environment can
determine the pace of economic development as well as the rate of
growth of the economy. This economic environment is influenced by
the economic factors like— population and manpower resources,
natural resources and its utilization, capital formation and
accumulation, capital output ratio, occupational structure, external
resources, extent of the market, investing pattern, technological
advancement, development planning, infrastructural facilities,
suitable industrial relations etc.

1. Population and Manpower Resources:

Population is considered as an important determinant of economic
growth. In this respect population is working both as a stimulant and
hurdles to economic growth. Firstly, population provides labour and
entrepreneurship as an important factor service.

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Natural resources of the country can be properly exploited with

manpower resources. With proper human capital formation,
increasing mobility and division of labour, manpower resources can
provide useful support to economic development.

On the other hand, higher rate of growth of population increases

demand for goods and services as a means of consumption leading to
increasing consumption requirements, lesser balance for investment
and export, lesser capital formation, adverse balance of trade,
increasing demand for social and economic infrastructural facilities
and higher unemployment problem.
Accordingly, higher rate of population growth can put serious hurdles
on the path of economic development. Moreover, growth of population
at a higher rate usually eats up all the benefits of economic
development leading to a slow growth of per capita income as it is seen
in case of India.

But it has also been argued by some modern economists that with the
growing momentum of economic development, standard of living of
the general masses increases which would ultimately create a better
environment for the control of population growth.

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Moreover, Easterlin argued that population pressure may favourably

affect individual motivation and this may again lead to changes in
production techniques. Thus whether growing population in a country
practically retards economic growth or contributes to it that solely
depends on the prevailing situation and balance of various other
factors determining the growth in an economy.

2. Natural Resources and Its Utilization:

Availability of natural resources and its proper utilization are
considered as an important determinant of economic development. If
the countries are rich in natural resources and adopted modern
technology for its utilization, then they can attain higher level of
development at a quicker pace. Mere possession of natural resources
cannot work as a determinant of economic development.
In spite of having huge variety of natural resources, countries of Asia
and Africa could not attain a higher level of development due to lack of
its proper utilization. But countries like Britain and France have
modernized their agriculture in spite of shortage of land and the
country like Japan has developed a solid industrial base despite its
deficiency in natural resources. Similarly, Britain has developed its
industrial sector by importing some minerals and raw materials from
abroad.

However, an economy having deficiency in natural resources is forced

to depend on foreign country for the supply of minerals and other raw
materials in order to run its industry. Thus in conclusion it can be
observed that availability of natural resources and its proper
utilization is still working as an important determinant of economic
growth. As India is having sufficient natural resources, thus it has
helped the country to maintain economic environment for attaining
development.

3. Capital Formation and Capital Accumulation:

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Capital formation and capital accumulation are playing an important

role in the process of economic development of the country. Here
capital means the stock of physical reproducible factors required for
production.

The increase in the volume of capital formation leads to capital

accumulation. Thus it is quite important to raise the rate of capital
formation so as to accumulate a large stock of machines, tools and
equipment by the community for gearing up production.

In an economy, capital accumulation can help to attain

faster economic development in the following manner:
(a) Capital plays a diversified role in raising the volume of national
output through changes in the scale or technology of production.
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(b) Capital accumulation is quite essential to provide necessary tools

and inputs for raising the volume of production and also to increase
employment opportunities for the growing number of labour force.
(c) Increase in capital accumulation at a faster rate results increased
supply of tools and machinery per worker.
Various developed countries like Japan have been able to attain higher
rate of capital formation to trigger rapid economic growth. Normally,
the rate of capital formation in under-developed countries like India is
very poor.

Therefore, they must take proper steps, viz., introduction of

compulsory deposit schemes, curtailing the conspicuous consumption,
putting curbs on imports of consumption goods, inflow of foreign
capital etc. In order to attain a rapid economic growth, the rate of
domestic savings and investment must be raised to 20 per cent.

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Naturally, in the initial period, it is not possible to step up the rate of

capital formation at the required rate by domestic savings alone.
Initially, to step up the rate of investment in the economy, inflow of
foreign capital to some extent is important.

But with the gradual growth of domestic savings in the subsequent

years of development, the dependence on foreign capital must
gradually be diminished. Being a technologically backward country,
India has decided to permit foreign direct investment in order to
imbibe advanced technology for attaining international
competitiveness under the present world trade and industrial
scenario.

4. Capital-Output Ratio:
Capital-output ratio is also considered as an important determinant of
economic development in n country. By capital-output ratio we mean
number of units of capital required to produce per unit of output. It
also refers to productivity of capital of different sectors at a definite
point of time. But the capital output ratio in a country is also
determined by stage of economic development reached and the
judicial mix of investment pattern. Moreover, capital-output ratio
along with national savings ratio can determine the rate of growth of
national income.

This is a simplified version of Harrod-Domar Model. This equation

shows that rate of growth of GNP is directly related to savings ratio
and inversely related to capital-output ratio. Thus to achieve a higher
rate of growth of national income, the country will have to take the
following two steps, i.e., (a) to raise the rate of investment and (b) to
generate necessary forces for reducing capital-output ratio.

5. Favourable Investment Pattern:

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Favourable investment pattern is an important determinant of

economic development in a country. This requires proper selection of
industries as per investment priorities and choice of production
techniques so as to realize a low capital—output ratio and also for
achieving maximum productivity.

Thus in order to attain economic development at a suitable rate, the

Government of the country should make a choice of suitable
investment criteria for the betterment of the economy. The suitable
investment criteria should maximise the social marginal productivity
and also make a balance between labour intensive and capital
intensive techniques.

6. Occupational Structure:
Another determinant of economic development is the occupational
structure of the working population of the country. Too much
dependence on agricultural sector is not an encouraging situation for
economic development. Increasing pressure of working population on
agriculture and other primary occupations must be shifted gradually
to the secondary and tertiary or services sector through gradual
development of these sectors.
In India, as per 1991 census, about 66.0 per cent of the total working
population was absorbed in agriculture. As per World Development
Report 1983, whereas about 45 to 66 per cent of the work force of
developed countries was employed in the tertiary sector but India
could absorb only 18 per cent of the total work force in this sector.

The rate of economic development and the level of per capita income
increase as more and more work force shift from primary sector to
secondary and tertiary sector. As A.G.B. Fisher writes, “We may say
that in every progressive economy there has been a steady shift of
employment and investment from the essential ‘Primary activities’ …
to secondary activities of all kinds and to a still greater extent into
tertiary production.”

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Thus to attain a high rate of economic development, inter-sectoral

transfer of work force is very much necessary. The extent and pace of
inter-sectoral transfer of work force-depend very much on the rate of
increase in productivity in the primary sector in relation to other
sectors.

7. Extent of the Market:

Extent of the market is also considered as an important determinant
of economic development. Expansion of the scale of production and its
diversification depend very much on the size of the market prevailing
in the country.
Moreover, market created in the foreign country is also working as a
useful stimulant for the expansion of both primary, secondary and
tertiary sector of the country leading to its economic development.
Japan and England are among those countries which have successfully
extended market for its product to different foreign countries.
Moreover, removal of market imperfections is also an important
determinant of economic development of under-developed countries.

8. Technological Advancement:
Technological advancement is considered as an important
determinant of economic environment. By technological advancement
we mean improved technical know-how and its broad-based
applications.

It includes:
(a) Use of technological progress for economic gains,

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(b) Application of applied sciences resulting in innovations and

inventions and

(c) Utilisation of innovations on a large scale.

With the advancement of technology, capital goods become more

productive. Accordingly, Prof. Samuelson rightly observed that “High
Invention Nation” normally attain growth at a quicker pace than “High
Investment Nation”.
There may be three forms of technological advancement,
i.e.,
(a) Capital saving,

(b) Labour saving or

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(c) Neutral.

The following three conditions must be satisfied for

attaining technological advancement in a country:
(a) Making provision for large investments in research,

(b) Ability to realize the possibilities of using scientific inventions and

innovations for commercial purposes and expansion and
diversification of the market for its product.

As the underdeveloped countries like India have failed to fulfill these

conditions thus their development process is neither self-sustaining
nor cumulative. Thus in order to attain a higher rate of development,
the under-developed countries should adopt only that type of
technology which can suit their requirements.

9. Development Planning:
In recent years, economic planning has been playing an important role
in accelerating the pace of economic development in different
countries. Economic development is considered as an important
strategy for building various social and economic overhead or infra-
structural facilities along with the development of both agricultural,
industrial and services sectors in a balanced manner.

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Planning is also essential for mobilization of resources, capital

formation and also to raise the volume of investment required for
accelerating the pace of development. Countries like former U.S.S.R.
and even U.S.A. and West Germany have achieved a rapid
development through the adoption of economic planning.

10. External Factors:

The present situation in the world economy necessitates the active
support of external factors for sustaining a satisfactory rate of
economic growth in under-developed economies. Moreover, domestic
resources alone cannot meet the entire requirement of resources
necessary for economic development.

Therefore, at certain levels, availability of foreign resources broadly

determines the level of economic development in a country.

The external factors which are playing important role in

sustaining the economic development include:
(a) Growing export earnings for financing increasing import bills
required for development,

(b) Increasing flow of foreign capital in the form of direct foreign

investment and participation in equity capital and

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(c) International economic co-operation in the form of increasing flow
of foreign aid from advanced countries like U.S.A., Japan etc. and also
increased volume of concessional aid from international institutions
like I.M.F., I.B.R.D. (World Bank) and other regional bodies on
economic co-operation like ASEAN, OPEC, E.E.C. etc.

11. Infrastructural Facilities:

Development of infrastructural facilities is also an important
component of economic environment in a country like India.

12. Suitable Industrial Relations:

Suitable industrial relations are also an important determinant
economic development in a country like India. Healthy trade union
activities and cordial relations between employer and employee
promote such economic environment for development.

B. Non-Economic Factors:
Economic factors alone are not sufficient for determining the process
of economic development in a country like India. In order to attain
economic development, proper social and political climate must be
provided. In this connection, United Nations Experts observed,
“Economic Progress will not occur unless the atmosphere is favorable
to it. The people of a country must desire progress and their social,
economic, legal and political situations must be favorable to it.”

Emphasizing the role of non-economic factors Prof. Cairn-cross

observed, “Development is not governed in any country by economic
forces alone and the more backward the country, the more this is true.
The key to development lies in men’s minds, in the institutions in
which their thinking finds expression and in the play of opportunity on
ideas and institutions.”

Again Prof. Macord Wright writes, “The fundamental factors making

economic growth are non-economic and non-materialistic in
character. It is spirit itself that builds the body.” Prof. Ragnar Nurkse
has further observed, “Economic development has much to do with
human endowments, social attitudes, political conditions and
historical accidents.”

Under-developed countries are facing various socio-political hurdles

in the path of economic development. Thus in order to attain
economic growth, raising the level of investment alone is not sufficient
rather it is also equally important to gradually transform the out dated
social, religious and political institutions which put hindrances in the
path of economic progress.

Thus following are some of the important non-economic

factors determining the pace of economic development in a
country:
(a) Urge for Development:
It is the mental urge for development of the people in general that is
playing an important determinant for initiating and accelerating the
process of economic development. In order to attain economic
progress, people must be ready to bear both the sufferings and
convenience. Experimental outlook, necessary for economic
environment must grow with the spread of education.
(b) Spread of Education:
Economic progress is very much associated with the spread of
education. Prof. Krause has observed that, “Education brings
revolutions in ideas for economic progress.” Education provides
stimulus to economic growth as it teaches honesty, patriotism and
adventure. Thus education is working as an engine for economic
development.

In this connection, Prof. H.W. Singer has rightly observed,

“Investment in education is not only highly productive but also yields
increasing returns. So, education plays pioneer role for the creation of
human, capital and social progress which in turn determines the
progress of the country.”

(c) Changes in Social and Institutional Factors:

Conservative and rigid social and institutional set up like joint family
system, caste system, traditional values of life, irrational behaviour
etc. put severe obstacle on the path of economic development and also
retards its pace. Thus to bring social and institutional change as per
changing environment and to realize the modern values of life are very
much important for accelerating the pace of economic development in
a country.

(d) Proper Maintenance of Law and Order:

Maintenance of law and order in a proper manner also helps the
country to attain economic development at a quicker pace. Stability,
peace, protection from external aggression and legal protection
generally raises morality, initiative and entrepreneurship.
Formulation of proper monetary and fiscal policy by an efficient
government can provide necessary climate for increased investment
and also can stimulate capital formation in the country.

Thus in order to accelerate the pace of economic development the

government must make necessary arrangement for the maintenance of
law and order, defence, justice, security in enjoyment in property,
testamentary rights, assurance to continue business covenants and
contracts, provision for standard weights and measures, currency and
formulation of appropriate monetary and fiscal policy of the country.

But the economies of under-developed countries like India are now

facing serious threat from large scale disorder, terrorism, disturbances
in the international border etc. All these have led to diversion of
resources and initiatives from developmental to non-developmental
ends.

Moreover, under such a chaotic situation, capital formation process,

business initiatives and enterprise of private firms are seriously
suffered and distorted leading to a stagnation of economy in these
countries. In this connection, Prof. Arthur Lewis has rightly stated,
“No country has made progress without positive stimulus from
intelligent government.” Thus to attain economic development at a
quicker pace’, proper maintenance of law and order and stability are
very important.
(e) Administrative Efficiency:
Economic development of a country also demands existence of a
strong, honest, efficient and competent administrative machinery for
the successful implementation of government policies and
programmes for development. The existence of a weak, corrupt and
inefficient administrative machinery, leads the country into chaos and
disorder.

Prof. Lewis has rightly observed, “The behaviour of the government

plays an important role in stimulating or discouraging economic
activity.” Therefore, maintenance of proper administrative set up is a
determinant of economic development of a country.

(f) Cultural Set Up:

Sound cultural set up also build up a better non-economic
environment which are conducive towards economic development.
Cultural activities improve the mental set up of the people in general
and develop simultaneously a sense of bond-ness among various
sections of people living in the society. All these create a belter
environment for development.

(g) Politico-Legal Environment:

The politico-legal environment of the country is also an important
determinant of economic development. Political stability and legal
support for developmental activities creates a better environment for
development. Reforms in the form of industrial policy reforms, labour
reforms etc. should be enacted through proper legislation.
Side by side, the judicial system in the country should be developed in
such a manner so that it can maintain wide network to serve for the
course of development. The legislature and the judiciary in the country
should work hand in hand to create a better investment-friendly
environment for development.

Such politico-legal environment can play an important role towards

creating a better business environment in the country. The politico-
legal environment in India has not yet been developed to the accepted
level. Accordingly, the Chambers of Commerce, foreign investors are
demanding various changes in the politico-legal environment in the
country so as to reap maximum benefit from economic reforms.

(h) Natural Environment:

Suitable natural environment is also an important component of non-
economic environment determining the business environment in the
country. Thus the business environment in the country needs a natural
support which includes suitable climate, balanced wealthier, suitable
natural environment, i.e., free from flood and draught etc.

Moreover, the maintenance of eco- friendly, atmosphere is also quite

important for the promotion of developmental activities in an
economy. In a country like India, the natural environment always
promotes the developmental activities. But in certain exceptional
situations, the country usually faces extreme natural environment
resulting flood, draught etc. which disturbs the developmental process
of the country.
Thus three is a great importance of both economic as well as non-
economic factors on the maintenance of business environment in a
country. Moreover, in a vast country like India having a large land and
population, the economic and non-economic environment are playing
a very important role for maintaining a sound business environment
within the country.

What Is the Business Cycle?

DEFINITION

The business cycle is the natural rise and fall of economic growth that occurs
over time. The cycle is a useful tool for analyzing the economy and can help
you make better financial decisions.

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 The business cycle goes through four major phases: expansion, peak,
contraction, and trough.
 All economies go through this cycle, though the length and intensity of
each phase varies.
 The Federal Reserve helps to manage the cycle with monetary policy,
while heads of state and governing bodies use fiscal policy.
 Consumer and investor confidence play roles in influencing economic
 performance and the phases in the cycle.

How Does the Business Cycle Work?

The business cycle is a term used by economists to describe the increase and
decrease in economic activity over time. The economy is all activities that
produce, trade, and consume goods and services within the U.S.—such as
businesses, employees, and consumers. Thus, the measured amount of
productivity is what the business cycle refers to.

When businesses are increasing production, they need more employees. As a

result, more people are hired, there is more money to spend, and businesses
make more profits and can focus on growth. The rate at which production and
consumption change positively is called "economic expansion." It continues
until circumstances occur that cause production to slow.

If business production slows, not as many employees are needed. As a result,

consumers have less spending money, and businesses reduce spending on
growth. The rate at which production and consumption as a whole change
negatively is called "economic contraction."

The duration of a business cycle is the period containing one expansion and
contraction in sequence. One complete business cycle has four phases:
expansion, peak, contraction, and trough. They don’t occur at regular intervals
or lengths of time, but they do have recognizable indicators.

It's important to understand that there are mini-fluctuations within an economic

phase that can make it appear as if the economy is transitioning to another
phase. The National Bureau of Economic Research (NBER) determines which
cycle the economy is in using quarterly gross domestic product (GDP) growth
rates.1 It also uses monthly economic indicators, such as employment, real
personal income, industrial production, and retail sales.2

Note
While you'll hear speculation in the media about the state of the economy,
there is no official notice of what cycle the economy is in until it's already in
progress—or complete—and the NBER has had a chance to analyze the data
and declare it.

Three factors can contribute to each phase of the business cycle: the forces of
supply and demand, the availability of capital, and consumer and investor
confidence.3 Confidence in the future plays a key role. When consumers and
investors have faith in the future and policymakers, the economy tends to
expand. It does the opposite when confidence levels drop.4

The Four Phases of the Business Cycle

A business cycle typical goes through four phases before it's complete:
expansion, peak, contraction, and trough.

Expansion

An economic expansion is a period of growth throughout an economy.

Because productivity is increasing, it is generally represented on a curve as
an upward movement. In some cases, the expansion phase is also known as
the "economic recovery" phase because it occurs after the economy has
contracted for a long period.

Gross domestic product is the measurement often used to gauge economic

output. During the expansion phase, GDP increases. Economists consider a
GDP growth rate range of around 2% to be healthy.5

Note

The Federal Reserve's goal is to keep inflation, the measurement of the

change in prices, at around 2%—also considered healthy by economists and
officials.6

In an expansion, the stock market experiences rising prices, and investors are
confident. Businesses receive more funding and make more, and consumers
have more money to spend. An economy can remain in the expansion phase
for years.

The expansion phase nears its end when the economy begins to grow too
fast. This is called "overheating"—the unemployment rate is well below the
natural rate, and inflation is increasing. Stock market investors are in a state
of "irrational exuberance" where they become overly enthusiastic about prices
and believe they will continue to rise—this causes stock prices to rise to a
point where they are very overvalued.7

Peak

The peak is the second phase of the cycle. It occurs when all of the
expansionary indicators begin to level off before heading into a contraction.
The economy might take weeks or a year to transition into the contraction
phase. The GPD growth rate falls below 2% and continues to decline. The
peak is displayed on a graph as the highest portion of the curve before
moving downward.8

Contraction

The third phase is the contraction stage. It begins after the economy peaks
and ends when GDP and other indicators cease to decrease. In this stage, the
economy does not experience growth; instead, it shrinks. When the GDP rate
turns negative, the economy enters a recession. Businesses lay off
employees, the unemployment rate rises above normal levels, and prices
begin to decline.9

A contraction is generally portrayed on a graph as the part of the curve that is

consistently decreasing8.

Trough

The trough is the fourth phase of the business cycle. The declining GDP
begins to decrease its rate of negative change, eventually turning positive
again. The economy begins a transition from the contraction phase to the
expansion phase. A trough is displayed on a graph as the lowest point of the
curve. The business cycle begins again when GDP begins to increase, and
the curve moves upward consistently.8

Note

The business cycle's four phases can be so severe that they have been called
the "boom-and-bust cycle."10

Example of a Business Cycle

The peak that preceded the 2008 recession occurred in the third quarter of
2007, when GDP growth was 2.4%. The 2008 recession was a rough one,
because the economy immediately contracted by 1.6% in the first quarter of
2008. It rebounded 2.3% in the second quarter, an optimistic sign. However, it
contracted 2.1% in the third quarter and then 8.5% in the fourth quarter. In the
first quarter of 2009, it contracted by 4.6% .11

During 2008, the unemployment rate rose from 4.9% in January to 7.2% by
December.1213

The trough occurred at the end of the second quarter of 2009, according to
the NBER.14 GDP only contracted by 0.7%. Unemployment, however, rose to
10.2% by October 2009 because it is a lagging indicator.15

The expansion phase started in the third quarter of 2009 when GDP rose
1.5%. Four years into the expansion phase, the unemployment rate was still
above 7%, because the contraction phase moved the economy so low that it
took much longer to recover.1611

What Influences the Business Cycle?

The government monitors the business cycle, and legislators attempt to
influence it by implementing tax and spending changes. When the economy is
expanding, taxes can be increased, and spending can be decreased. If it's
contracting, the government can lower taxes and increase spending. This is
called fiscal policy

DEFINITION

Fiscal policy refers to decisions the government makes about spending and
collecting taxes and how these policy changes influence the economy. When
the government makes fiscal policy decisions, it has to consider the effect
those decisions will have on businesses, consumers, foreign markets, and
other interested entities.

More >

.3

The Federal Reserve, the nation's central bank, influences the business cycle
by influencing inflation and unemployment with targeted rates. It uses tools
 designed to change interest rates, lending, and borrowing by businesses,
banks and consumers. This is called monetary policy.

The Fed lowers its target interest rates to encourage borrowing in attempts to
end a contraction or trough. This is called expansionary monetary policy
because they are attempting to push the business cycle back into the
expansionary phase.

To keep the economy from growing too quickly, the central bank raises its
target interest rates to discourage borrowing and spending. This is called
"contractionary monetary policy," because the bank is trying to contract
economic output to keep expansion under control.17
Iiiiiii
Inflation
According to data released by the National Statistical Office (NSO) as of February 2023, India’s retail inflation once again increased to 6.52%
in January 2023 after a two-month streak below the 6% mark mainly due to an increase in food inflation driven by higher prices of cereals and
products.

is a general rise in the price level of an economy over a period of time. When the general price level rises, each unit of currency buys fewer
goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium
of exchange and unit of account within the economy.

As per RBI, an inflation target of 4 per cent with a +/-2 per cent tolerance band, is appropriate for the next five years (2021-2025).

Inflation Latest News [Feb 2023]

 India’s retail inflation once again increased to 6.52% in January 2023 mainly due to an increase in food inflation driven
by higher prices of cereals and products.
 The retail inflation based on the Combined Price Index (Combined) had reduced to 5.72% in December 2022.
 Also, the Combined food price inflation (CFPI) increased to 5.94% in January 2023 as compared to 4.19% in
December 2022 and 5.43% in the year-ago period.
 Further, rural inflation has overtaken urban inflation in recent months as it increased from 6.05% in December 2022 to
6.85% in January 2023.
 And, urban consumers have experienced a retail price rise of 6% in January 2023 as compared to 5.4% in
December 2022.
 Economists believe that the higher-than-expected increase in January’s prices may continue for a few more months on
account of ongoing pass-through of higher input costs by producers, amidst robust demand for services and may force the
RBI to consider yet another rate hike in its next monetary policy review.
 According to the latest data, Telangana recorded the highest inflation in January at 8.6% among the major States which
was followed by Andhra Pradesh (8.25%), Madhya Pradesh (8.13%), Uttar Pradesh (7.45%) and Haryana (7.05%).
 Furthermore, the core inflation which includes non-food and non-fuel components also remained sticky at 6.1% in
January 2023 which indicates pricing power from the suppliers and manufacturers.
Significance of the spike in inflation in January 2023:

 After making a high in September at 7.4%, the inflation rate has been declining and reached 5.7% in December ’22.
  As a surprise to everyone, MPC which met in February, increased the repo rate by 25 basis points (0.25%), indicating
that RBI was not believing that inflation was under control.
 Recently published official data now shows that in January the rate of inflation increased to 6.5%, indicating that RBI
might go for a further increase in repo rate when MPC meet again in April ’23.
 In light of the new figures, it looks highly likely that inflation figures in India will remain above the crucial 4% (4% is
the target level under the current monetary policy regime).

 Economic Growth and price stability: There is a constant tussle between boosting economic growth (which could
translate into new job creation and reducing unemployment) and maintaining price stability (containing inflation).
 If the rate of inflation remains at high levels, RBI will be forced to increase the repo rate. This could make
borrowing costlier, will have a negative impact on investment and will thus hurt the economic recovery,
especially from the twin shocks of Covid19 pandemic and the Russia-Ukraine war.
What caused the spike in January ’23?

There were 2 main reasons for the spike in inflation and they are:

1. Higher food inflation as a result of the spike in cereal prices.

2. Higher core inflation: It provides the underlying inflation of the economy. Core inflation rose from 6.1% to 6.2% and
super core inflation rose to 6.3% from 6.2%.

What is causing India’s inflation to persist?

 The initial shock of rising food and fuel prices gradually spread and became more widespread in the following months,
resulting in persistent core inflation that remained high.
 Despite weak demand and limited pricing power, input cost pressures were unprecedented and resulted in higher output
prices, particularly for goods.
 As the direct impact of the conflict diminished and global commodity prices eased, the domestic economy began to
recover and demand increased, leading to the pass-through of pent-up input costs. And this resulted in the persistence of
elevated inflationary pressures.
 Core goods inflation increased to 7.6% year on year in January from 7.5% in December.
 It is not just India, the US and many other EuroZone countries are also affected by the sticky inflation.
Additional Information:

 Core inflation: It is the measure of inflation calculated after deducting the prices of food and fuel.
 Super core inflation: It is the measure of inflation calculated after deducting the gold and silver price inflation from the
core inflation.


 Types of Inflation
The different types of inflation in an economy can be explained as follows:

Demand-Pull Inflation
This type of inflation is caused due to an increase in aggregate demand in the economy.

Causes of Demand-Pull Inflation:

 A growing economy or increase in the supply of money – When consumers feel confident, they spend more and take on
more debt. This leads to a steady increase in demand, which means higher prices.
 Asset inflation or Increase in Forex reserves– A sudden rise in exports forces a depreciation of the currencies involved.
 Government spending or Deficit financing by the government – When the government spends more freely, prices go up.
 Due to fiscal stimulus.
 Increased borrowing.
 Depreciation of rupee.
 Low unemployment rate.
Effects of Demand-Pull Inflation:

 Shortage in supply
 Increase in the prices of the goods (inflation).
 The overall increase in the cost of living.

Cost-Push Inflation
This type of inflation is caused due to various reasons such as:

 Increase in price of inputs

 Hoarding and Speculation of commodities
 Defective Supply chain
 Increase in indirect taxes
 Depreciation of Currency
 Crude oil price fluctuation
 Defective food supply chain
 Low growth of Agricultural sector
 Food Inflation
 Interest rates increased by RBI
Cost pull inflation is considered bad among the two types of inflation. Because the National Income is reduced along with the reduction in
supply in the Cost-push type of inflation.

Built-in Inflation
This type of inflation involves a high demand for wages by the workers which the firms address by increasing the cost of goods and services
for the customers.

Also, read about Inflation Targeting in the linked article.

Remedies to Inflation
The different remedies to solve issues related to inflation can be stated as:

 Monetary Policy (Contractionary policy)

The monetary policy of the Reserve Bank of India is aimed at managing the quantity of money in order to meet the requirements of different
sectors of the economy and to boost economic growth.

This contractionary policy is manifested by decreasing bond prices and increasing interest rates. This helps in reducing expenses during
inflation which ultimately helps halt economic growth and, in turn, the rate of inflation.

 Fiscal Policy
 Monetary policy is often seen separate from fiscal policy which deals with taxation, spending by government
and borrowing. Monetary policy is either contractionary or expansionary.
 When the total money supply is increased rapidly than normal, it is called an expansionary policy while a slower
increase or even a decrease of the same refers to a contractionary policy.
 It deals with the Revenue and Expenditure policy of the government.
Tools of fiscal policy

1. Direct Taxes and Indirect taxes – Direct taxes should be increased and indirect taxes should be reduced.
2. Public Expenditure should be decreased (should borrow less from RBI and more from other financial institutions)
To know more about the Fiscal policy in India, refer to the linked article.

 Supply Management measures

 Import commodities that are in short supply
 Decrease exports
 Govt may put a check on hoarding and speculation
 Distribution through Public Distribution System (PDS).

Measurement of Inflation

1. Wholesale Price Index (WPI) – It is estimated by the Ministry of Commerce & Industry and measured on a monthly
basis.
2. Consumer Price Index (CPI) – It is calculated by taking price changes for each item in the predetermined lot of
goods and averaging them.
3. Producer Price Index – It is a measure of the average change in the selling prices over time received by domestic
producers for their output.
4. Commodity Price Indices – It is a fixed-weight index or (weighted) average of selected commodity prices, which may be
based on spot or futures price
5. Core Price Index – It measures the prices paid by consumers for goods and services without the volatility caused by
movements in food and energy prices. It is a way to measure the underlying inflation trends.
6. GDP deflator – It is a measure of general price inflation.
Know more about the Cash reserve ratio in this article.

Effect of Inflation on the Economy

The effect of inflation on the economy can be stated as:

 The effect of inflation is not distributed evenly in the economy. There are chances of hidden costs for different goods
and services in the economy.
  Sudden or unpredictable inflation rates are harmful to an overall economy. They lead to market instability and thereby
make it difficult for companies to plan a budget for the long-term.
 Inflation can act as a drag on productivity as companies are forced to mobilize resources away from products and
services to handle the situations of profit and losses from inflation.
 Moderate inflation enables labour markets to reach equilibrium at a faster pace.

Fiscal Policy ffffffFiscal Policy

What is Fiscal Policy? Fiscal Policy deals with the revenue and expenditure policy of the Govt. The word fiscal has been derived from the
word ‘fisk’ which means public treasury or Govt funds.

Latest Update about Fiscal Policy of India:

1. The Union Budget 2021 has signalled the emphasis on the Development Financial Institutions (DFIs) in the pursuit
of long-term infrastructure creation for the revival of the economy.
2. The establishment of the Dispute Resolution Committee (DRC) has been proposed in the Union Budget 2021 that can
help provide quick relief to taxpayers in tax disputes.

Objectives of Fiscal Policy

The following are the objectives of the Fiscal Policy:

1. Higher Economic Growth

2. Price Stability
3. Reduction in Inequality
The above objectives are met in the following ways:

1. Consumption Control – This way, the ratio of savings to income is raised.

2. Raising the rate of investment.
3. Taxation, infrastructure development.
4. Imposition of progressive taxes.
5. Exemption from the taxes provided to the vulnerable classes.
6. Heavy taxation on luxury goods.
7. Discouraging unearned income.

What are the components of Fiscal Policy?

There are three components of the Fiscal Policy of India:

1. Government Receipts
2. Government Expenditure
3. Public Debt
Aspirants should note that all the receipts and expenditures of the government are credited and debited from the following:

1. Consolidated Fund of India

2. Contingency Fund of India
3. Public Account of India
Download the notes on the types of funds in India from the linked article.
 Government Receipts
The categorisation of the government receipts is given below:

1. Revenue Receipt
 Tax Revenue
 Direct Tax
 Indirect Tax
 Non Tax Revenue
 Fees
 License and Permits
 Fines and Penalties, etc
2. Capital Receipt
 Loans Recovery
 Disinvestments
 Borrowing and other liabilities
Debt Trap – Situation where the borrower has to borrow again for the payment of an instalment on the previous debt. A borrower unable to
meet debt service obligations without borrowing is known to be in a debt trap.

Direct Tax Code Bill 2010

It hasn’t been implemented yet. The bill seeks to replace the following taxes:

1. Income Tax Act of 1961

2. Wealth Tax Act of 1957
Learn about the Direct Tax Code (DTC) comprehensively from the linked article.

For more on taxation in India, check the linked article.

Disinvestment
When the government sells or liquidates its assets of Central Public Sector Enterprises, State Public Sector Enterprises or other assets; it is
referring to disinvestment. This approach caters to the objective of fiscal burden reduction.

Learn more about Disinvestment and Department of Investment and Public Asset Management (DIPAM) in the linked article.

Government Expenditure
There are two classifications of public expenditure:

1. Revenue Expenditure – It is a recurring expenditure:

 Interest Payments
 Defence Expenses
 Salaries to Central Government employees, etc are examples of revenue expenditure
2. Capital Expenditure – It is a non-recurring expenditure
 Loans repayments
 Loans to public enterprises, etc.
Candidates must note that plan and non-plan expenditure have been scrapped with the abolishing of the Planning Commission of India.
 What is Fiscal Consolidation?
The measures that are taken to improve the fiscal deficit comes under the process of fiscal consolidation. Through fiscal consolidation, the
government tries for:

1. Improvement in revenue receipts

2. Better alignment in the public expenditure
The government introduced the FRBM Act aiming for fiscal consolidation. Read about it below:

Fiscal Responsibility and Budget Management Act (FRBMA), 2003

The objective of this FRBM Act is to impose fiscal discipline on the government.

It means fiscal policy should be conducted in a disciplined manner or a responsible manner i.e. government deficits or borrowings should be
kept within reasonable limits and the government should plan its expenditure in accordance with its revenues so that the borrowing should be
within limits.

Fiscal Federalism
It refers to the distribution of resource between centre and states.

The distribution of taxes between centre and states is mentioned in the 7th schedule of the Indian constitution.

There are 3 lists where the taxes are distributed

 Union List
 State List
 Concurrent List
Some related topics to fiscal policy are linked below:

Fiscal Deficit Central Board of Direct Taxes (CBDT)

Value-Added Tax (VAT) Goods and Services Tax (GST)

Minimum Alternate Tax (MAT) Tax Policy Council & Tax Policy Research
Unit

Difference Between Monetary Stimulus and Difference Between Monetary Policy and
Fiscal Stimulus Fiscal Policy

Monetary Policy
Monetary policy is adopted by the monetary authority of a country that controls either the interest rate payable on very short-term borrowing
or the money supply. The policy often targets inflation or interest rate to ensure price stability and generate trust in the currency.

The monetary policy in India is carried out under the authority of the Reserve Bank of India.

What are the main objectives of monetary policy?

Simply put the main objective of monetary policy is to maintain price stability while keeping in mind the objective of growth as price stability
is a necessary precondition for sustainable economic growth.

In India, the RBI plays an important role in controlling inflation through the consultation process regarding inflation targeting. The current
inflation-targeting framework in India is flexible.

What role does the Monetary Policy Committee play?

The Reserve Bank of India Act, 1934 (RBI Act) was amended by the Finance Act, 2016, to provide for a statutory and institutionalized
framework for a Monetary Policy Committee, for maintaining price stability, while keeping in mind the objective of growth. The Monetary
Policy Committee is entrusted with the task of fixing the benchmark policy rate (repo rate) required to contain inflation within the specified
target level.

The Government of India, in consultation with RBI, notified the ‘Inflation Target’ in the Gazette of India dated 5 August 2016 for the period
beginning from the date of publication of the notification and ending on March 31, 2021, as 4%. At the same time, lower and upper tolerance
levels were notified to be 2% and 6% respectively.

What are the instruments of monetary policy?

Some of the following instruments are used by RBI as a part of their monetary policies.

 Open Market Operations: An open market operation is an instrument which involves buying/selling of securities like
government bond from or to the public and banks. The RBI sells government securities to control the flow of credit and
buys government securities to increase credit flow.
 Cash Reserve Ratio (CRR): Cash Reserve Ratio is a specified amount of bank deposits which banks are required to
keep with the RBI in the form of reserves or balances. The higher the CRR with the RBI, the lower will be the liquidity
in the system and vice versa. The CRR was reduced from 15% in 1990 to 5 % in 2002. As of 31st December 2019, the
CRR is at 4%.
 Statutory Liquidity Ratio (SLR): All financial institutions have to maintain a certain quantity of liquid assets with
themselves at any point in time of their total time and demand liabilities. This is known as the Statutory Liquidity Ratio.
The assets are kept in non-cash forms such as precious metals, bonds, etc. As of December 2019, SLR stands at 18.25%.
 Bank Rate Policy: Also known as the discount rate, bank rates are interest charged by the RBI for providing funds and
loans to the banking system. An increase in bank rate increases the cost of borrowing by commercial banks which results
in the reduction in credit volume to the banks and hence the supply of money declines. An increase in the bank rate is the
symbol of the tightening of the RBI monetary policy. As of 31 December 2019, the bank rate is 5.40%.
 Credit Ceiling: With this instrument, RBI issues prior information or direction that loans to the commercial bank will be
given up to a certain limit. In this case, a commercial bank will be tight in advancing loans to the public. They will
allocate loans to limited sectors. A few examples of credit ceiling are agriculture sector advances and priority sector
lending.

What is Balance of Payment (BOP)

Balance of Payment (BOP)
The balance of payment is the statement that files all the transactions between the entities, government anatomies, or individuals of one
country to another for a given period of time. All the transaction details are mentioned in the statement, giving the authority a clear vision of
the flow of funds.

After all, if the items are included in the statement, then the inflow and the outflow of the fund should match. For a country, the balance of
payment specifies whether the country has an excess or shortage of funds. It gives an indication of whether the country’s export is more than
its import or vice versa.

Types of Balance of Payment

The balance of payment is divided into three types:

Current account: This account scans all the incoming and outgoing of goods and services between countries. All the payments made for raw
materials and constructed goods are covered under this account. Few other deliveries that are included in this category are from tourism,
engineering, stocks, business services, transportation, and royalties from licenses and copyrights. All these combine together to make a BOP
of a country.

Capital account: Capital transactions like purchase and sale of assets (non-financial) like lands and properties are monitored under this
account. This account also records the flow of taxes, acquisition, and sale of fixed assets by immigrants moving into the different country. The
shortage or excess in the current account is governed by the finance from the capital account and vice versa.

Finance account: The funds that flow to and from the other countries through investments like real estate, foreign direct investments,
business enterprises, etc., is recorded in this account. This account calculates the foreign proprietor of domestic assets and domestic proprietor
of foreign assets, and analyses if it is acquiring or selling more assets like stocks, gold, equity, etc.

Importance of Balance of Payment

A balance of payment is an essential document or transaction in the finance department as it gives the status of a country and its economy. The
importance of the balance of payment can be calculated from the following points:

 It examines the transaction of all the exports and imports of goods and services for a given period.
 It helps the government to analyse the potential of a particular industry export growth and formulate policy to support
that growth.
 It gives the government a broad perspective on a different range of import and export tariffs. The government then
takes measures to increase and decrease the tax to discourage import and encourage export, respectively, and be self-
sufficient.
  If the economy urges support in the mode of import, the government plans according to the BOP, and divert the cash
flow and technology to the unfavourable sector of the economy, and seek future growth.
 The balance of payment also indicates the government to detect the state of the economy, and plan expansion.
Monetary and fiscal policy are established on the basis of balance of payment status of the country.
The above-mentioned is the concept that is elucidated in detail about ‘Balance of Payment’ for the commerce students. To know more, stay
tuned to BYJU’S.

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Balance of Payments - BOP

Balance of Payments
The BoP or balance of payments records the undertakings or transactions of commodities, assets, and services between the citizens of a nation
with the rest of the world for a stated time frame frequently every year. There are two main accounts in the BoP.

 Current account
 Capital account

Meaning

 The balance of payment is a systematic record of all the economic/monetary transactions between the residents (all the
units) of a country and the rest of the world in an accounting year.
 It is prepared on the principles of the double-entry system.

Current Account Definition

The current account is a record of businesses in commodities, transfer payments, and services. Trade-in commodities comprise the exports and
imports of commodities. Trade-in services comprise factor income and non-factor income transactions or undertakings.

Transfer payments are the receipts that the citizens of a nation get for free’, without having to provide any commodities or services in return.
They consist of remittances, grants, and gifts. They could be provided by the government or by private residents living abroad.
 Capital Account Definition
The capital account records all the international undertakings of assets. An asset is any one of the types in which wealth can be held. For
instance, stocks, bonds, government debt, money, etc. The purchase of assets is a debit on the capital account. If an Indian purchases a UK car
company, it enters the capital account undertakings as a debit (as foreign exchange is going out of India).

On the other hand, the sale of assets, like the sale of the share of an Indian company to a Japanese customer, is a credit on the capital account.
These items are foreign direct investments (FDIs), foreign institutional investments (FIIs), assistance, and external borrowings.