Economics

Managerial
Economics
Content Managerial Economics
CONTENTS
Chapter No Chapter Name Page No
1 Introduction to Economics..................................................................3
2 National Income................................................................................21
3 Money ...............................................................................................35
4 Inflation .............................................................................................48
5 Interest Rates ....................................................................................63
6 Monetary Policy ................................................................................78
7 Fiscal Policy .......................................................................................91
8 Business Cycles ...............................................................................106
9 Foreign Exchange market and International trade .........................116
10 Demand and its analysis .................................................................131
11 Supply and its analysis ....................................................................150
12 Theory of production ......................................................................157
13 Market structures ...........................................................................168
14 Market failures................................................................................177
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Managerial Economics Chapter 1: Introduction to Economics
CHAPTER 1
INTRODUCTION TO ECONOMICS
Learning Objectives: In this chapter we will:

LO1: Understand what is Economics
LO2: Define the nature and scope of Economics
LO3: Know about economic resources and its optimal utilisation
LO4: Describe the concept of market system
LO5: Distinguish the concept of Micro and Macro Economics
LO6: Understand the Micro and Macro-economic factors in business decision making
1.1. What is Economics?

The word ‘Economics’ was derived from two Greek words, Oikos (a house) and
Nemein (to manage) which would mean ‘managing the household’ using the limited
funds available, in the most satisfactory manner possible. There are a variety of
modern definitions of Economics; some reflect evolving views of the subject or
different views among Economists.
Scottish Economist and Philosopher, Adam Smith who is credited as the father of
Economics, defined “Economics as a science which inquired into the nature and cause
of wealth of nations”.
According to Alfred Marshall, founder of Neo-classical Economics, “Economics is a
study of mankind in the ordinary business of life. It examines that part of individual
and social action which is most closely connected with the attainment and use of
material requisites of wellbeing”.
Economics is the social science that deals with production, exchange and
consumption of various commodities in economic systems. It shows how scarce
resources can be used to increase wealth and human welfare. The central focus of
economics is on scarcity of resources and choices among their alternative uses. The
resources or inputs available to produce goods are limited or scarce. This scarcity
induces people to make choices among alternatives, and the knowledge of economics
is used to compare the alternatives for choosing the best among them. For example,
a farmer can grow paddy, sugarcane, banana, cotton etc. in his land. But he has to
choose a crop depending upon the availability of irrigation water.
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Chapter 1: Introduction to Economics Managerial Economics
1.1.1. Nature of Economics:
Nature of economics refers to whether economics is a science or art or both, and if it

is a science, whether it is positive science or normative science or both.
Economics as a science —
• We have often stated that Economics is a social science.

• Economics is a systematic body of knowledge as it explains cause and effect
relationship between various variables such as
• price, demand, supply, money supply, production, national income,

employment, etc.
• Economic laws, like other scientific laws, state what takes place when certain
conditions (assumptions) are fulfilled.
• The law of demand in economics states that a fall in the price of commodity
leads to a large quantity being demanded ‘given other things’, such as income of
the consumer, prices of other commodities, etc., remaining the same.
• In economics we collect data, classify and analyse these facts and formulate
theories or economic laws.
Economics as an Art—
• Various branches of Economics, like consumption, production, distribution,

money and banking, public finance, etc., provide us basic rules and guidelines
which can be used to solve various economic problems of the society.
• Human actions are not easily measurable, the variables that determine
economic activity are not easily determinable.
• The knowledge of Economic laws helps us in solving practical economic
problems in everyday life.
• Economics is an art that requires an understanding of power, psychology,
philosophy, history and society. Its operative assumption is that we are “utility
maximizing creatures” who are rational and informed.
Therefore, it can be said that economics is a combination of an art and elements of
science. Science is a systematic study of the correlation of cause and effect. In
economics when we use particular method to quantify the value of economic
variables (dependent and explanatory) which can be represented as causes and
effect of economic changes then it considers as a science but when certain
behaviour of economic agents reflect the decision making process then it comes
under the subject matters of arts and humanities.
Economics is based on human actions which is very difficult to quantify, but after
the identification of the problem, scientific methods can be applied to solve the
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economical as well as socio-economical problem. When economic laws are tested

and based on experimental study then it comes under the purview of both “Science
and Arts”.
Economics as a positive science—
• A positive science is that science in which analysis is confined to cause and

effect relationship.
• Positive economics is concerned with the facts about the economy.
• It studies the economic phenomena as they exist.

• It finds out the common characteristics of economic events.
• It generalizes their relationship by formulating economic theories and makes

predictions about future course of these economic events.
Economics as a normative science—

• Normative economics involves value judgment.
• The objective of Economics is to examine real economic events from moral and
ethical angles and to judge whether certain economic events are desirable or
undesirable.
• It deals primarily with economic goals of a society and policies to achieve these
goals.
• It also prescribes the methods to correct undesirable economic happenings.
The above fact can be described by the following example:
If prices have gone up, why have they gone up. In respect of positive science,
problems are examined on the basis of facts. On the other hand, normative science
relates to normative aspects of a problem i.e., what ought to be. Under normative
science, conclusions and results are not based on facts, rather they are based on
different considerations like social, cultural, political, religious and are basically is
subjective in nature, an expression of opinions.
In short, positive science is concerned with 'how and why' and normative science
with 'what ought to be'. The distinction between the two can be explained with the
help of an example of increase in the rate of interest. Under positive science it would
be looked into as to why interest rate has gone up and how can it be reduced
whereas under normative science it would be seen as to whether this increase is
good or bad.
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1.1.2. Economics and the other branches of social sciences:
Economics as a branch of social science is interrelated with the other sub-disciplines

of the social sciences which is explained below:
Economics and Sociology

Sociology is the science of society. Sociology is a general social science. It attempts to
discover the facts and laws of society as a whole. Sociology deals with all aspects of
society. But economics deals only with the economic aspects of a society. It studies
human behaviour in relation to scarce means and unlimited wants. For a student of
sociology, social institutions like marriage, religion, political institutions and economic
conditions are all important subjects for study. But in economics, we are interested in
them only to the extent that they affect the economic life of a society. And we cannot
properly understand the economic conditions of a society without considering its
sociological aspects.
Economics and Politics:

Both economics and politics are social sciences and there is a close connection
between them. Politics is the science of the State or political society. It studies about
man in his relation to the State.
The production and distribution of wealth are influenced to a very great extent by the
government. We have economic planning in our country. And the main aim of
planning is to increase the national income by increasing production and by a proper
distribution of income.
Sometimes, political ideas and institutions are influenced by economic conditions. For
example, socialism was born of economic inequalities and exploitation in England
during the industrial revolution.
Economics and History

Economics is history to the extent that the economist must turn to history for an
understanding of how economic systems have developed (and declined) and of how
they have worked in practice. Economics and history are closely related. History is a
record of the past events. In history, we survey economic, political and social
conditions of the people in the past. We may say economics is the fruit of history and
history in the root of economics: 'Economics without history has no root; History
without economics has no fruit'.
Economics, mathematics and statistics

Among other sciences, economics is related to mathematics and statistics. Statistics
is the science of averages. It is the science of counting. Many tables and diagrams used
in economics are based on statistical analysis. Mathematical methods are largely used
in modern economics.
Now we have a new science called Econometrics. It makes use of statistics and
mathematics in economics. Economist needs statistics to represent data, to track and
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store information, to identify trends, to attribute value, and mathematics to calculate

those figures. The way to look at the relationship between statistics and economics is
that economics is essentially the study of human decisions and trends and how these
have a financial impact.
Economics is a social science

which deals with human wants
and their satisfaction. It is
related to other social sciences
like sociology, politics, history,
ethics, and psychology. For ECONOMICS
example, the economic
development of a nation
depends not only on economic
factors but also on historical,
political and sociological factors.
Our country did not have much of economic progress during the British rule owing to
historical reasons. Again, we have attained a steady economic growth because of
political stability. But in many other countries, there was no steady growth because
of political instability. If there is one government today and another government
tomorrow, there will not be economic development in that country. Therefore, other
social subjects have a great impact on the economic development of a country.
1.2 Economic resources

The numerous human wants are to be satisfied through the scarce resources available
in nature. Economics deals with how the numerous human wants are to be satisfied
with limited resources. Thus, the science of Economics centers on want - effort-
satisfaction.
WANT
SATISFACTION EFFORT
There are four main categories of resources: land, labour, capital and
entrepreneurship.
1. Land: All natural resources both above and below the ground are part of the land
resource including farm land, animals, forests, water, minerals, and air. For the
use of these resources, businesses pay a rental income.
2. Labour: The labour resource includes both the physical and mental contribution
of a worker. As a return for the use of their labour, workers are paid a wage.
Education and job training increase the productivity of the labour resource and
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thus increase wages – as we’ll see later in the course.
3. Capital: Capital includes man-made items such as buildings, machinery, and

equipment. Unlike consumer goods that directly satisfy our needs and wants
today, capital goods, such as machinery, increase our future productivity which
then allow us to produce more of the goods and services we want in the future.
Interest income is the return or payment for the use of capital. Note that while
money is often called capital, it is not an economic resource but simply enables or
facilitates the purchase of one of the resources.
4. Entrepreneurship: The last resource is entrepreneurship, which combines the

other resources and provides a good or service. These individuals take risks and
are rewarded with profits when their ideas are successful. Entrepreneurs play a
key role in any economy. These are the people who have the skills and initiative
necessary to anticipate current and future needs and explore new ideas to
market.
Effective allocation and management of economic resources is an essential task

for countries to maximise the output of the nation. It is important to efficiently
organize and allocate human resources (labour) as well as other available
resources for different sectors, same time avoiding idle resources. Having the
information about the availability of the resource and have them available at the
right time for the activities plays a vital role in managing the costs and smoothly
executing the economic activities.
1.2.1 Economic Efficiency

Economic efficiency implies an economic state in which every resource is optimally
allocated to serve each individual or entity in the best way while minimizing waste
and inefficiency. When an economy is economically efficient, any changes made to
assist one entity would harm another. In terms of production, goods are produced at
their lowest possible cost, as are the variable inputs of production (labour, raw
materials etc.). The principles of economic efficiency are based on the concept that
resources are scarce. Therefore, there are not sufficient resources to ensure that all
aspects of an economy functioning at their highest capacity at all times. Instead, the
scarce resources must be distributed to meet the needs of the economy in an ideal
way while also limiting the amount of waste produced. The ideal state is related to
the welfare of the population as a whole with peak efficiency also resulting in the
highest level of welfare possible based on the resources available. Every country has
limits to production, therefore to achieve economic efficiency nation has to set proper
strategy or planning for producing the optimum combination of goods and services so
that the country can attain highest possible rate of growth.
It is also a fact that without enough economic resources country can accomplish their
highest economic efficiency if the economic policies are properly planned and
country’s policy makers are proactive rather than reactive.
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A good example is Singapore economy which does not have fertile agricultural land, not
have adequate human resources but economy of Singapore is ranked as third highest
per-capita GDP (Gross Domestic Product) in the world in terms of Purchasing Power
Parity (PPP). Singapore’s economic prosperity is due to the strategy to promote
innovation, encourage entrepreneurship and re-train its workforce. The development
of international trade achieved by purchasing raw goods and refining them for re-export
which has high demand across the globe. Singapore has also benefited from the inward
flow of FDI (Foreign Direct Investment) from global investors and institutions due to its
highly attractive investment climate and a stable political environment.
Utilising economic resources country can fulfil its target growth rate. Every country’s
Purchasing Power Parity (PPP) is an economic theory that compares different
countries' currencies through a "basket of goods" approach. According to this
concept, two currencies are in equilibrium or at par when a basket of goods
(taking into account the exchange rate) is priced the same in both countries.
historical, geographical and political structure different, therefore the system in which
country is operating differs from one to another. The way scarce resources get
distributed within an economy determines the type of economic system. In general,
there are three types of economic system which is described below.
1.3. Three major Economic systems:

Economic systems are the means by which countries and governments distribute
resources and trade goods and services. They are used to control the four factors of
production, including: land, labour, capital and entrepreneurship. Different economic
systems view the use of these factors in different ways.
A. The market economy or Free market
It is an economic system based on supply and demand with little or no
government control. It is a summary description of all voluntary exchanges that
take place in a given economic environment. Free markets are characterized by a
spontaneous and decentralized order of arrangements through which individuals
make economic decisions.
Laissez-faire is an economic theory from the 18th century that opposed any
government intervention in business affairs. The driving principle behind laissez-
faire, a French term that translates as "leave alone" (literally, "let you do"), is that
the less the government is involved in the economy, the better off business will
be – and by extension, society as a whole. Laissez-faire economics are a key part
of free market capitalism.
Merits of market economy:

(i) It provides a society with the right goods or services at the right time:
Competition works with supply and demand in a market economy,
businesses and individuals receive access to the exact goods or services
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that they need. Although the quality of these goods may vary based on
who manufacturers them, different socioeconomic classes can access
specific goods within their price range that they wish to own. This
eliminates the ability to have a central authority dictate who should
receive access to specific goods and at specific price.
(ii) A market economy promotes entrepreneurship: The emphasis within a
market economy is on innovation, it creates an environment where
entrepreneurship can thrive. It supports the process of discovering new
products or services that will be wanted, while allowing individuals and
businesses to decide which products or services will best meet their
needs. It is a structure that provides profits for businesses of any size while
creating satisfied customers at the same time.
(iii) It creates competition: A market economy thrives because businesses are
forced to continually innovate to survive. Businesses that refuse to
innovate will be left behind because there will always be someone willing
to look at things in a different way. This motivation is the foundation of a
market economy because it must be there to encourage better products
and services to be offered over time.
(iv) It reduces the need to store products: Because the laws of supply and
demand are enforced in a market economy, manufacturers produce
goods based on the demands that the society requires. This reduces the
need to store surplus products because anything that is extra will be sold
at a deeply discounted price or simply destroyed. The goal is to find a
balance between society’s demands and the number of goods that are
produced.
(v) Market economies tend to provide more jobs: Small businesses in the US
economy represent 99.7% of all businesses. Businesses with fewer than
20 employees in the United States account for 89.6% of the workforce.
With a market economy, the focus on innovation allows these small
businesses to find a niche and provide local jobs that can pay well.
Although larger companies may outsource jobs to save money, local jobs
come from individuals and partnerships that exploit a good idea they may
have.
(vi) Prices are usually kept down in a market economy: Because competition
is present within an industry, prices tend to stay lower because businesses
are attempting to obtain as many customers as possible. It is this element
that is a core philosophy in the Republican health care
proposals that circulated in 2017. By introducing competition in the
insurance markets across state lines, the goal is to drop policy pricing for
many consumers.
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Demerits of market economy:

(i) Market economies tend to produce inferior goods and services: The goal
of a market economy is to find balance between cost and profit.
Businesses will minimize costs and maximize profits. That usually means
skilled workers who demand high wages will be replaced by low or
average-skill workers who can still produce a reasonably good product,
but at a cheaper price. That means a market economy rarely provides the
best possible goods and services that could be produced.
(ii) It harms the environment: A market economy places an emphasis on the
cost of good produced over any other factor. That means there are fewer
environmental concerns that are addressed during the production of
goods. When it costs less to dump waste in nature than it does to properly
dispose of it, the lack of governmental interference or a central authority
would allow such an action to occur.
(iii) Outsourcing is frequent in a market economy: Because the goal is to
produce the highest quality goods at the lowest possible prices, many
companies outsource jobs and manufacturing to foreign providers.
Outside of the developed world, wages are much lower. Most of humanity
lives on less than USD $10 per day. If a local worker needs $10 per hour
for their needs and a worker elsewhere will work for $10 per day,
outsourcing allows a business to create better profits.
(iv) Commodity prices typically rise in a market economy: Commodities are
primary agricultural products or raw materials that are bought or sold.
Coffee is a commodity, as is copper. In a market economy, these are the
items that are essential to the manufacturing process. Without them, a
business cannot create goods or services for sale. Because supply and
demand applies, and most businesses need commodities to function, the
pricing of these goods is higher and that increase gets put into the final
consume price tag.
(v) Economy imbalances occur frequently within a market economy: The
Great Recession in 2007-2009 occurred because of a lack of regulation in
several sectors, including housing, around the world. Similar recessions
have occurred throughout history because a market economy eventually
creates an imbalance. When more businesses attempt to maximize profits
without regard to risk, eventually a negative event occurs and the
consumers tend to be the hardest hit by the fallout.
B. Planned Economy or command economy:
All decisions regarding production, distribution, salaries, investment and prices
are made by a central authority – usually the government. The closest examples
to this type of economy today are North Korea and Cuba (to a lesser extent).
A centrally planned economy is an economic system in which the state or
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government makes economic decisions rather than the these being made by the
interaction between consumers and businesses. Unlike a market economy — in
which private citizens and business owners make production decisions — a
centrally planned economy controls what is produced and the distribution and
use of resources.
Merits of Planned economy:
(i) Limit the monopolizing: Command economy make it difficult for a
monopoly to rule the market, as the major forces are controlled and
regulated by the government. Though monopoly can exist in all the other
type of economies, but not in the command economy.
(ii) Availability of finished goods and rates of production are adjusted:
Command economy enables to get the rate adjusted in order to meet the
exact demands of the population. Though the choices may get limited but
with command economy it can be sure of having no shortage occurring at
any point of time.
(iii) Ensure the resources mobilization in better way: Unique features of
command economy ensures that production is done effectively and
efficiently. Progress becomes fast-paced as the mobilizing of resources is
done at a large scale.
(iv) Acute demands are fulfilled timely: When it comes to command
economy, all the government resources can become active, whenever the
need arises. In case of natural disaster or any other emergency,
government is able to reach the masses in no time, whereas it is not
possible with any other structure of economy.
Demerits of Planned economy:

(i) It is a governmental structure which reduces personal freedoms:
Because all economic structures are at the beck and call of the
government, personal freedoms are limited within a command economy.
In many instances, people can work one type of job and must do so
because the government demands it. People are forced to pursue the
greater good of the government instead of their own greater good.
(ii) It limits innovation: There is no need for production to seek out research
and development within a command economy because the government
dictates everything. People must accept what the government gives them.
This means there is no need to make products better tomorrow than they
are today. Businesses are in the same position because the government
often dictates who gets to work for them. The result is lower motivation
to create a high-quality product or offer a helpful service.
(iii) It eliminates the competition: Within a command economy, the
government owns and controls everything. Competition is discouraged, if
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it is even allowed. Any private business would constantly be under the

threat of a government takeover of their operations and have no options
to recover their assets should that occur. Venezuela seized an auto plant
from General Motors in 2017 and it cost the company $100 million.
C. Mixed Economy:
Market economies sometimes get into trouble, at which point the government
feels compelled to intervene. Sometimes, when lawmakers believe some players
are being exploited unfairly, or the level playing field for business is under threat,
the government may become involved.
Similarly, the leaders of a command economy may decide that more investment
is required, and the only way to accomplish this is by allowing more freedom.
The moment the government of a command economy loosens its grip, or that
of a market economy begins to intervene, they integrate some aspects of the
other. When this occurs, the result is a kind of hybrid system – a mixed economy.
With the exception of North Korea, every country in the world has a mixed
economy. Even Cuba has elements of a mixed economy – it has a huge black
market which the government semi tolerates.
Merits of Mixed Economy:
There are several advantages of mixed economy which are as below:
(i) Encouragement to Private Sector: The most important advantage of
mixed economy is that it provides encouragement to private sector and it
gets proper opportunity to grow. It leads to increase in capital formation
within the country.
(ii) Freedom: In a mixed economy, there is both economic and occupational
freedom as found in capitalist system. Every individual has a liberty to
choose any occupation of his choice. Similarly, every producer can take
decisions regarding production and consumption.
(iii) Optimum Use of Resources: Under this system, both private and public
sectors work for the efficient use of resources. Public sector works for
social benefit while private sector makes the optimum use of these
resources for maximisation of profit.
(iv) Lesser Economic Inequalities: Capitalism enhances economic inequalities
but under mixed economy, inequalities can easily have controlled by the
efforts of government.
(v) Economic Development: Under this system, both government and private
sector join their hands for the development of socio-economic
infrastructures, Moreover, government enacts many legislative measures
to safe guard the interests of the poor and weaker section of the society.
Hence, for any underdeveloped country, mixed economy is a right choice.
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Demerits of Mixed Economy:

The main demerits of mixed economy are as follows:
(i) Un-stability: Some economists claim that mixed economy is most
unstable in nature. The public sector gets maximum benefits whereas
private sector remains controlled.
(ii) Ineffectiveness of Sectors: Under this system, both the sectors are
ineffective in nature. The private sector does not get full freedom; hence
it becomes ineffective. This leads to ineffectiveness among the public
sector. In true sense, both sectors are not only competitive but also
complementary in nature.
(iii) Lack of Efficiency: In this system, both sectors suffer due to lack of
efficiency. In public sector it is so because government employees do not
perform their duty with responsibility, while in private sector, efficiency
goes down because government imposes too many restrictions in the
form of control, permits and licenses, etc.
(iv) Delay in Economic Decisions: In a mixed economy, there is always delay
in making certain decisions, especially in case of public sector. This type of
delay always leads to a great hindrance in the path of smooth functioning
of the economy.
(v) More Wastages: Another problem of the mixed economic system is the
wastages of resources. A part of funds allocated to different projects in
public sector goes into the pocket of intermediaries. Thus, resources are
misused.
(vi) Corruption and Black Marketing: There is always corruption and black
marketing in this system. Political parties and self- interested people take
undue advantages from public sector. Hence, this leads to emergence of
several evils like black money, bribe, tax evasion and other illegal
activities. All these ultimately bring red-tapism within the system.
Table 1. A: Countries under the different types of economic system:
Planned or Command Free market or Laissez Fair

Mixed economy
economy economy (not fully)
Cuba, North Korea, Singapore, USA, Hong

Brazil, India
The former Soviet Union Kong,
China, China once had a totally centrally planned economy, but has since adopted
market economy policies and structures to help grow its economy.
We have described what the subject economics is, what are its resources, how it can
be utilised with the structure of economic system to achieve more creation of
wealth. Next section will be giving a broad overview of the different branches of
Economics, how branches can be separated and in which perspective it is
interlinked.
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1.4. Different branches of Economics:

Economics is a broad subject concerned with the optimal distribution of resources
in society. Within the subject, there are several different branches which focus on
different aspects.
Theory of Theory of
Money
Trade
Fig. 1.A: Subject matter of Economics

1.4.1. Micro Economics
This term has been derived from ‘Mikros’ which is a Greek word for ‘small’
or ‘millionth part’. The approach of microeconomics, however, is very
unique. It only considers a particular economic entity. It either emphasizes
on a particular consumer, one individual price, a single firm, one particular
wage or an individual income. This branch of economics is similar to looking
at the global or national economy under the microscope.
According to Prof. Mac Cannel,” Microeconomics is the study of the specific
economic units and a detailed consideration of the behaviour of these
individual units”.
Scope of Microeconomics
The scope or the subject matter of microeconomics is concerned with:
a. Product pricing: The price of an individual commodity is determined by
the market forces of demand and supply. Microeconomics is concerned
with demand analysis i.e. individual consumer behaviour, and supply
analysis i.e. individual producer behaviour.
b. Factor pricing: Microeconomics helps in determining the factor prices
for land, labor, capital, and entrepreneurship in the form of rent, wage,
interest, and profit respectively.
c. Welfare Economics: Welfare economics in microeconomics is
concerned with solving the problems in improvement and attaining
economic efficiency to maximize public welfare. It attempts to gain
efficiency in production, consumption/distribution to attain overall
efficiency and provides answers for ‘What to produce?’, ‘When to
produce?’, ‘How to produce?’, and ‘For whom it is to be produced?’
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1.4.2. Significance of Microeconomics in Business Decision Making

Microeconomics plays a vital role in assisting the business firms and business
decision makers. Some of the major functions of microeconomics in
business decision making are listed below:
i. Optimum utilization of resources: The study of microeconomics helps
the decision makers to analyse and determine how the productive
resources are allocated for various goods and services. It also helps in
solving the producers’ dilemma of what to produce, how much to
produce and for whom to produce.
ii. Demand analysis: With the help of microeconomic analysis, business
firms can forecast their level of demand within the certain time interval.
The demand for a commodity depends upon various factors affecting it.
Thus, business firms and decision makers can determine the level of
demand for the commodity.
iii. Cost analysis: Microeconomic theories explain various conditions of
cost like fixed cost, variable cost, average cost, and marginal cost. Along
with this, it also provides an analysis of the short run and long run costs
that help the business decision makers determine the cost of production
and other related costs, so they can implement policies to cut down cost
and increase their level of profit.
iv. Production decision optimization: Microeconomics deals with different
production techniques that help to find out the optimal production
decision which helps the decision makers to determine the factors
needed in order to produce a certain product or a range of products.
1.4.3. Macroeconomics
Macroeconomics (from the Greek prefix Makro - meaning "large"), it
is a branch of economics, dealing with the performance, structure,
behaviour, and decision-making of an economy as a whole. This includes
regional, national, and global economies.
Macroeconomists study aggregated indicators such as GDP, unemployment
rates, national income, price indices, and the interrelations among the
different sectors of the economy to better understand how the whole
economy functions.
According to Professor Ackley, “Macroeconomics deals with economic
affairs in the large, it concerns the overall dimensions of economic life.”
Scope of Macro Economics:
a) Theory of national income
b) Theory of employment
c) Theory of money
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d) Theory of general price level

e) Theory of economic growth
f) Theory of international trade
The details of the above mentioned topic will be described in the
subsequent chapters.
Importance of Macroeconomics:
1) It helps to understand the functioning of a complicated modern
economic system. It describes how the economy as a whole functions
and how the level of national income and employment is determined on
the basis of aggregate demand and aggregate supply.
2) It helps to achieve the goal of economic growth, higher level of output
and higher level of employment. It analyses the forces which determine
economic growth of a country and explains how to reach the highest
state of economic growth and sustain it in long run.
3) It helps to bring stability in price level and analyses fluctuations in
business activities. It suggests policy measures to control Inflation and
recession.
4) It helps to solve economic problems like poverty, unemployment,
business cycles, etc., whose solution is possible at macro level only, i.e.,
at the level of whole economy.
5) With detailed knowledge of functioning of an economy at macro level,
it has been possible to formulate correct economic policies and also
coordinate international economic policies.
Interdependence between Micro Economics and Macro Economics
It is important to note the distinction between macroeconomics and
microeconomics. Whereas Macroeconomics looks at the "big picture,"
microeconomics investigates into the study of supply and demand and
factors that impact individual consumer decisions. However, the two are
inherently interrelated, as small decisions at the microeconomic level will
ultimately have an impact on larger economic factors that influence the
entire economy.
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Table 1. B: Five differences between micro and macroeconomics:
Basis For
Microeconomics Macroeconomics
Comparison
Deals with Individual economic variables Aggregate economic variables
Business Applied to operational or internal

Environment and external issues
Application issues
Covers various issues like demand,

Covers various issues like, national
supply, product pricing, factor pricing,
income, general price level,
production, consumption, economic
Scope employment, money etc.
welfare, etc.
Helpful in determining the prices of a Maintains stability in the general

product along with the prices of factors price level and resolves the major
of production (land, labor, capital, problems of the economy like
Importance entrepreneur etc.) within the inflation, deflation, unemployment
economy. and poverty as a whole.
It has been analysed that 'Fallacy of

It is based on unrealistic assumptions, Composition' involves, which
i.e. In microeconomics it is assumed sometimes doesn't proves true
that there is a full employment in the because it is possible that what is
Limitations
society which is not at all possible. true for aggregate may not be true
for individuals too.
1.4.4 Micro and Macroeconomic factors affect economic environment:

All businesses, whether domestic or international, are affected by the
dynamic economic environment conditions prevalent in the market. Among
many economic factors affecting business some are; demand and supply,
total and marginal utility, money and banking, business cycles, inflation, etc.
Let us take a look at such economic factors.
a) Demand and Supply: There are two great economic factors affecting
business models work – demand and supply. Demand is how willing and
able a consumer is to purchasing what a business offers and supply is
how able the business is to make available what the consumer needs.
For example, when a mobile phone infused with the latest technology is
introduced to the market, it fetches a higher price due to the high
demand in markets, and the prices remain high if the demand is more
than the supply.
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b) Total and Marginal Utility: The term utility is defined as the quality or
capacity of a goods and services which enables it to satisfy a human
want. In other words, any commodity will have utility as long as it can
satisfy wants. Utility or want satisfying power is a psychological concept.
After continuous and successive consumption of units of same goods,
the fulfilment that is experienced by the consumer starts depreciating.
This is due the law of diminishing marginal utility as the consumer takes
more units of a commodity, intensity of his want for the goods goes on
falling. This results in short-term or long-term fall in sales of the
business.
Ex: When we purchase a pizza, the first few pieces give us great
satisfaction. Nonetheless, there is a down fall in the satisfaction levels
when we continue eating the rest of the pizza. Suppose, the marginal
utility derived on consuming the first slice was 90%. Nonetheless, due to
the dwindling of utility, the second piece had the score of 80% and the
third piece had 70%. The satisfaction derived on consumption will be in
a deteriorating order.
c) Money and banking: Banking facilitates the economic environment by
giving opportunity to increase investment for business and also inducing
loan facilities to consumers which enhances the economic wellbeing of
a nation. Money in circulation dictates the demand of the consumers.
On the contrary, banking facility dictates the borrowing capacity of
individuals as well as the business. Banking polices play a crucial role in
affecting the prices of goods and interest rates together with assets
prices and investments.
d) Business or Trade cycles: Business cycles are the "ups and downs" in
economic activity, defined in terms of periods of expansion or recession.
During expansions, the economy, measured by indicators like jobs,
production, and sales, is growing--in real terms, after excluding the
effects of inflation. Recessions are periods when the economy is
shrinking or contracting. At the time of recession or economic downturn
sales revenues and profits decline, the manufacturer will cut back on
hiring new employees, or freeze hiring entirely. In an effort to cut costs
and improve the bottom line, the manufacturer may stop buying new
equipment, curtail research and development and stop new product
rollouts (a factor in the growth of revenue and market share).
Expenditures for marketing and advertising may also be reduced.
These cost-cutting efforts will impact other businesses, both big and
small, which provide the goods and services used by the big
manufacturer.
e) Inflation: It usually occurs when the supply of money is too much in the
economic environment but market is unable to support by a similar
available of goods and services. The prices of goods have to increase one
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way or the other, in order to sustain the businesses. And so there is an

increase in the cost of raw materials needed for production. This
upsurge in the cost of raw materials obviously translates to the retail
price. The buying power of consumers decreases, their incomes remain
constant, but the prices of products and services shoots up. This will
definitely affect the businesses in that, the demand for the goods is
directly dependent on its availability and its price.
Inflation is the rate at which the general level of prices for goods and services is rising
and, consequently, the purchasing power of currency is falling. Central banks attempt to
limit inflation in order to keep the economy running. smoothly.
The Consumer Price Index (CPI) is a measure of inflation that examines the weighted
average of prices of a basket of consumer goods and services, such as transportation, food
and medical care. It is calculated by taking price changes for each item in the
predetermined basket of goods and averaging them. Changes in the CPI are used to assess
price changes associated with the cost of living; the CPI is one of the most frequently used
statistics for identifying periods of inflation.
This chapter gives an overview of basic micro and macro-economic variables which is
prerequisite to measure any country’s economic performance and the drawbacks that could
be overcome by suitable policy prescription. The concept of economics insight is a broader
one and the optimal use of all potential resources and the proper guidelines by economic
organisation by implementing policies can increase economic growth and development of
any nation. Following chapter will be giving a detail description of Indian economy,
developing mixed economy and the World’s sixth largest economy by nominal GDP.
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Managerial Economics Chapter 2: National Income
CHAPTER 2
NATIONAL INCOME
LO1: understand the conception of national income and its relevance
LO2: comprehend the flow of income in the economy by utilizing resources
LO3: describe the methods for measuring national income
LO4: understand the uses of national income
LO5: examine the difficulties in the measurement of national income
2.1. Understanding the concept of national income:

We all have an understanding of the concept of income on an individual level
and what our own income is. But how should we measure the income of a
whole economy? What is the relation between our income and the value of
what we produce? To find the nation’s income do we just add up the incomes
of the household, business and government sectors? And how does the rest-of-
the-world enter the picture? Where does the nation spend its income and how
does it save? How does savings relate to investment?
One of the pioneers of contemporary economics, Adam Smith, named his most
influential work – An Enquiry into the Nature and Cause of the Wealth of
Nations. What generates the economic wealth of a nation? What makes
countries rich or poor? These are some of the central questions of economics.
It is not that countries which are endowed with a bounty of natural wealth –
minerals or forests or the most fertile lands – are naturally the richest countries.
In fact, the resource rich Africa and Latin America have some of the poorest
countries in the world, whereas many prosperous countries have scarcely any
natural wealth. There was a time when possession of natural resources was the
most important consideration but even then the resources had to be
transformed through a production process. The economic wealth, or well-
being, of a country thus does not necessarily depend on the mere possession
of resources; the point is how these resources are used in generating a flow of
production and how, as a consequence, income and wealth are generated from
that process.
2.1.1. Meaning of National Income
National income of a country is the measure of the size of economic activity
within the economy during a given year. Thus it can be defined as the total
market value of all final goods and services produced in the economy during
a given year. The concept of national income is a monetary measure.
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Chapter 2: National Income Managerial Economics
The concept of national income has three interpretations. It represents total

value of goods produced or total income received or total expenditure
incurred.
National Income = National Product = National Expenditure
Thus there are three measures of national income of a country.
2.1.1.1. It is the sum of values of all final goods (final goods are ultimately
consumed, rather than used in the production of another good) and
services produced in the economy in a given year.
2.1.1.2. It is the sum of all incomes accruing to factors of production in the economy
in a year.
2.1.1.3. It is the sum of consumption expenditure on domestically produced goods,
investment expenditure, government expenditure and net receipts from
foreign trade.
In India national income measures are published by Central Statistical

Organisation (CSO)
National income is the calculation of economic activities but it is important
to understand the interaction with all economic agents. How does the
overall economy work? How do we analyse the macro and micro economic
issues? This is the most frequently thought about question in our mind
whenever there is any debate on some economic issue affecting the nation.
From the explanation of circular flow model, it will be clear to understand
the interaction with economic agents and exchange of goods and services in
respective markets. Following section will give a brief explanation of the
process of income generation from the corresponding economic activities.
2.2. How does income flow within the entire economy?

One model that helps to explain how a market economy works is a circular-flow
diagram. A circular-flow diagram is a visual model of the economy that illustrates how
households, firms, Government and foreign sectors interact through different
markets and generate income or output for an economy as a whole. The size of the
circular flow determines the level of national income which is measured by GDP or
GNP (described in the following section).
A real life modern economy is a very complex in structure consisting of millions of
units engaged in a variety of economic transactions. There are organisations which
produce and distribute a variety of goods and services. There are households which
not only consume goods and services but also offer their labour services to productive
organisations and make their savings available for investment. There are financial
institutions which act as intermediaries between savers and investors. There are state
and central governments who impose and collect taxes to provide a range of public
services. Transactions take place
among the units within an economy as well as with foreigners in the process of
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production and consumption of goods and services, creation and transfer of physical
Fig. 2.A: The circular flow of a Two-Sector Economy
Fig. 2.B: The circular flow of a Four-Sector Economy
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and financial assets, production of public goods and services; etc. National income attempts
to provide a summary picture of the entire gamut of these economic transactions.
The circular flow model in four sector economy provides a realistic picture of the
interaction within different economic agents in an economy. The four sector
economy comprises of:
a) Household
b) Firms
c) Government
d) Foreign sector (Rest of the world) There are two important components:
a) Export: Export refers to an injection into the circular flow that consists of
payment received for goods and services sold to the rest of the world.
b) Import: Import is referred to as a leakage from the circular flow that consists of
payments made for goods and services purchased from the rest of the world.
When firm exports goods and services to the foreign markets, injections are made
into the model. On the other hand, when household, firm or government imports
any goods and services from foreign sector, leakage occurs in the model.
In this model, each sector has dual roles to play in the economy; while one sector
receives certain payments from other sectors, it pays back to those sectors as well.
The circular flow of income in different sector has been explained in the following:
Household Sector
a. Receipts:
1. Factor income from business sector
2. Transfer payments from government sector
b. Payments:
1. To the business sector in the form of consumption expenditure
2. To the government in the form of taxes
3. To the capital market in the form of saving
Business Sector
a. Receipts:
1. Income from selling goods and services
2. Income from exports
3. Subsidies from government
4. Borrowing from capital market
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b. Payments:
1. Factor payments
2. Import payments
3. Savings
Government Sector
a. Receipts:
1. Taxes paid by household
and business sector
2. Interest and dividends
from investment
b. Payments:
1. Business sector for purchasing goods and services
2. Transfer payments to household
3. Surplus to capital market
Foreign sector
a. Receipts:
1. Income from business sector
b. Payments:
1. To business sector from where import has been made
2.4.1. Significance of circular flow of income:
(i) It reflects structure of an economy.
(ii) It shows interdependence among different sectors.
(iii) It gives information about injections and leakages from flow of money.
(iv) It helps in estimation of national income and related aggregates.
The income flows in the circular flow of income model can be calculated by
different measures and techniques. Different techniques are established
due to the availability of data and the comparative analysis of economic
issues and problems lying in the respective country. These measurements
help the country to analyse regarding economical problem and diagnose the
economic ills of the country and at the same time suggest remedies. The
estimates of national income depict a clear picture about the standard of
living of the community.
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2.5. Fundamental concepts of national income:

a. Gross Domestic Product:
GDP is the total value of goods and services produced within the geographical
boundary of a country during a year. This is calculated at market prices and is
known as GDP at market prices.
GDP at market price is “the market value of the output of final goods and
services produced in the domestic territory of a country during an accounting
year.” It can be represented as the following equation:
GDP = C + I + G + (X –M)
Where,
C = Consumption expenditure on domestically produced goods I = Investment
expenditure
G = Government expenditure
(X – M) = Net receipts from foreign trade or net exports (exports = X and imports
= M)
b. Gross National Product (GNP)
GNP is the total measure of the flow of goods and services at market value
resulting from current production during a year in a country, including net
income from abroad.
GNP = GDP + Net factor income from abroad
Net factor income from abroad = Factor income earned from abroad by
residents – Factor income of non-residents in domestic territory.
In a closed economy GNP will be equal to GDP, but in an open economy, GNP
may not be equal to GDP. This will depend on the value of net factor income from
abroad. If net factor income from abroad is positive, then GNP will be greater
than GDP. On the other hand, if net factor income from abroad is negative then
GNP will be less than GDP.
A closed economy is self-sufficient and there is no economic integration with

other countries. An open economy in which a country conducts trade with other
nations.
c. Net National Product(NNP) and Net Domestic Product(NDP)

The NNP and NDP are calculated by subtracting depreciation from GNP and GDP
respectively. The depreciation is an allowance for the amount of capital used.
NNP = GNP – Depreciation and
NDP = GDP – Depreciation
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d. National income at constant and current prices:

The current market prices refer to the prices of goods prevailing in the market
at any given point of time, i.e., it refers to current market prices of goods and
services. Generally, the prices tend to rise, thus national income at current prices
will show an increase.
To calculate national income at constant price a reference year is selected. This
year is known as the base year and it should be a normal year and free from
natural calamities like flood, earthquake, famine etc. The base year is always
revised from time to time. At present the base year used in India to find out GNP,
GDP; etc. at constant prices is 2011-12.
e. Real vs Nominal GNP:
The difference between real and nominal GNP, or gross national product, is that
the nominal GNP is calculated at the current price levels of the economy and the
real GNP is calculated relative to a set base year. In economics, a base period or
reference period is a point in time used as a reference point for comparison with
other periods. It is generally used as a benchmark for measuring financial or
economic data.
Nominal income measures income at current prices with no adjustment for the
effects of inflation e.g. if my nominal income is Rs 40,00000 in 2016 and rises by
5% in the next year, then my nominal income will rise to Rs 42,00000 but if
inflation is also 5 % then in real terms my income remains constant.
When we want to measure growth in the economy we have to adjust for the
consider data inflation and Real GDP measures the An increase in real output
means that aggregate demand has risen faster than the rate of inflation and
therefore the economy is experiencing positive growth.
f. Personal Income:
Personal income refers to all income collectively received by all individuals or
households in a country. Personal income includes compensation from a
number of sources including salaries, wages and bonuses received from
employment or self-employment; dividends and distributions received from
investments; rental receipts from real estate investments and profit-sharing
from businesses.
Personal income = National income + transfer payments – undistributed profits
of corporate sectors – corporate income taxes – social security contributions
Where transfer payments mean a payment made or income received in which
no goods or services are being paid for; such as a benefit payment like pension
or subsidy.
g. Disposable Income:
It is the income which is actually available to the individuals to spend on
consumption and to save. The whole personal income is not available to the
individuals to meet their expenditures. A part of it
BIBS 27
is paid to the government in the form of direct taxes. Thus in order to obtain
disposable income we have to deduct direct taxes paid by the individuals from
the personal income. Thus,
Disposable income = Personal income – Direct taxes paid by individuals
h. Per Capita income
Per capita income is obtained by dividing National income by the population,
that is,
Per capita income = National income / Population
It shows the average income of the people in the country.
2.6. Measurement of national income:
Fig. 2.C: Measurement of National Income
There are three basic ways to determine a nation's income. These methods of
measuring the national income are referred to as national income accounting. They
should provide the same money value of the size of economic activity because each
measure the same circular flow of income in the economy but at different parts in
the flow. The three methods are explained below.
a) The Production Approach
In this method, national income is measured as a flow of goods and services. We
calculate money value of all final goods and services produced in an economy
during a year. Final goods here refer to those goods which are directly consumed
and not used in further production process.
Goods which are further used in production process are called intermediate
goods. In the value of final goods, value of intermediate goods is already
included therefore we do not count value of intermediate goods in national
income otherwise there will be double counting of value of goods.
To avoid the problem of double counting we can use the value-addition method
in which not the whole value of a commodity but value-addition (i.e. value of
final good value of intermediate good) at each stage of production is calculated
and these are summed up to arrive at GDP.
28 BIBS
The following self-explanatory table represents the calculation of income in

respect of value addition in the production stages where in every stage
intermediate consumption is deducted from the output of the respective stages.
Price of
Production stages Cost of input Value added
output
Growing oranges Rs 0 Rs.20 Rs 20
Making orange juices Rs 20 Rs. 30 Rs 10
Distributing juice to stores(wholesale) Rs. 30 Rs 40 Rs 10
Selling juice to consumers (retail) Rs 40 Rs 45 Rs 5
TOTAL Rs 45
b) The Income Approach

Under this method, national income is measured as a flow of factor incomes.
There are generally four factors of production; land, labour, capital and
entrepreneurship. Labour gets wages and salaries, capital gets interest, land
gets rent and entrepreneurship gets profit as their remuneration. Besides, there
are some self-employed persons who employ their own labour and capital such
as doctors, advocates, CAs, etc. Their income is called mixed income. The sum-
total of all these factor incomes is called NDP at factor costs.
The data pertaining to income are obtained from various sources like from
income tax returns, reports, books of accounts of companies as well as estimates
for small incomes. Incomes of both categories of people – paying taxes and not
paying taxes are added to obtain national income. This method of calculating
national income is quite complex, especially in the developing countries where
most of the people are not directly covered by direct taxation.
All transfer income/payments which do not represent earnings from productive
services such as pension, old age pensions, scholarship, gifts, donations, charity,
unemployment benefits, lottery prize, etc. should be ignored as they are not
earned by participating in the current production, these are unilateral
payments. Windfall gains like income from prizes won, lottery etc are not
included in the estimation of national income.
c) The Expenditure Approach
This method of determining GDP adds up the market value of all domestic
expenditures made on final goods and services in a single year, including
consumption expenditures, investment expenditures, government
expenditures, and net exports. Add all of the expenditures together and you
determine GDP.
National income = C + I +G + (X – M)
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Household/private consumption expenditure: – it includes household

consumption and expenditure by non-profit organizations. Expenditure on
durables (including durables of more than one year like TV and furniture) are
included. Rent on self-occupied house is also counted. Further agriculture
produced and consumed for self, interest on self-employed capital is also
included. This is denoted as “C”.
Domestic investment (or capital formation), i.e. expenditure on immoveable
goods, and increase (or accumulation) in stock. It includes buildings, road,
bridges transport equipment, machinery etc. This denoted by “I”.
Government Consumption, i.e. expenditure made by government, e.g.
expenditure to sustain law and justice, health etc. Transfer payments are not
included. This is denoted by “G”
Difference between exports and imports are calculated as X- M.
In order to avoid double counting only expenditure on final goods and services
should be included.
Each one of the three methods is useful, the utility depending upon the problem
being analysed. The best thing for a country then is to have estimates based on
all these methods. In case this is not possible, national income of a country can
be estimated by either of the three methods, or a combination of these.
Which of these methods of measuring national income is most suitable for a
country depends upon its level of development and the availability of data. In
advanced countries, where data required for using all the three methods are
available, all the methods are used at the same time to compute national
income. Estimation from the three angles makes it possible to compare the
three estimates and also helps to analyse problems for different purposes. This
however is not simply possible in India.
2.7. Difficulties in the measurement of National income

There are many difficulties in measuring national income of a country accurately.
The difficulties involved in national income accounting are both conceptual and
statistical in nature. Some of these difficulties involved in the measurement of
national income are discussed below:
1. Non-Monetary Transactions
The first problem in National Income accounting relates to the treatment of non-
monetary transactions such as the services of housewives to the members of
the families. For example, various non-market and domestic activities, like child
care by mothers and sisters, are not taken into account while estimating national
income of a country, for the said reasons. In fact, these activities add to
production when we engage the services of a lady who takes care of a child of a
neighbour against some money payments. But these are not considered in view
of the difficulties of estimating such income.
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However, it is a general principle to exclude such household activities of

housewives, home repairs, washing, cleaning, shaving or ‘do it yourself activities
from national income because of the great practical difficulties in valuing the
output resulting from these activities.
2. Problem of Double Counting
Only final goods and services should be included in the national income
accounting. But, it is very difficult to distinguish between final goods and
intermediate goods and services. The difference between final goods and
services and intermediate goods and services depends on the use of those goods
and services so there are possibilities of double counting.
Firm A produces raw cotton, assuming though unrealistically that it uses no
intermediate inputs and sells it for Rs 1,000 to firm B. Firm B converts it into
cotton yarn and sells it for Rs 1,500 to firm C. Firm C manufactures cotton cloth
and sells it for Rs 2,200 to firm D. Firm D produces garments and sells them for
Rs 3,500 to final consumers. The total value of all these transactions or gross
output is Rs 8,200 (= 1,000 + 1,500 + 2,200 4- 3,500) in which raw cotton has
been counted four times, cotton yarn three times and cotton cloth two times.
On the contrary, value of final goods (garments) which the economy has
produced is t 3,500. Thus, while calculating national income, if we take into
account Rs 8,200 (value of final as well as intermediate goods), it will be a case
of double counting and duplication. In this example it is very difficult to
distinguish cotton yarn as an intermediate or final product.
3. The Underground Economy
The underground economy consists of illegal and unclean transactions, such as
drugs, gambling, smuggling, and prostitution. Since, these incomes are not
included in the national income, the national income seems to be less than the
actual amount as they are not included in the accounting.
4. Petty Production
A Marxist concept which refers to a form of production in which the producer
has ownership of the means of production; the goods or services produced are
commodities (that is, sold through the market); the producer does not
systematically hire wage workers, but may use unpaid family labour; the scale
of production is small and there is little capital accumulation. This concept is
widely used in the study of peasants, family farmers, and artisans. As 67%
population is based on rural India, therefore there are large numbers of petty
producers and it is difficult to include their production in national income
because they do not maintain any account.
5. Transfer Payments
Individuals get pensions, unemployment allowance and interest on public loans,
but these payments create difficulty in the measurement of national income.
These earnings are a part of individual income and they are also a part of
government expenditures. The payments made as relief allowance, pensions,
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etc. do not contribute towards current production.

6. Capital Gains or Loss
When the market prices of capital assets change the owners make capital gains
or loss such gains or losses are not included in national income.
7. Price Changes
National income is the money value of goods and services. Money value
depends on market price, which often changes. The problem of changing prices
is one of the major problems of national income accounting. Due to price rises
the value of national income for particular year appends to increase even when
the production is decreasing.
8. Illiteracy and Ignorance
The main problem is whether to include the income generated within the
country or even generated abroad in national income and which method should
be used in the measurement of national income.
Besides these, the following points are also representing the difficulties in
national income accounting:
a. Second hand transactions;
b. Environment damages;
c. Calculation of depreciation;
d. Inadequate and unreliable statistics; etc.
2.8. The uses of national income data:

2.8.1. National Income as a measure of economic growth - Estimates of national
income at constant prices indicate economic growth of a country
2.8.2. National Income as an indicator of success or failure of planning - If a
country has adopted planning as a means of economic growth then national
income data can help in assessing the achievements of planning.
2.8.3. Useful in assessing the performance of different production sectors -
Production units of a country are broadly classified into primary, secondary
and tertiary sectors. These sectors generate factor incomes. The data on
factor incomes generated by these sectors can be used to measure their
relative contributions to national income.
2.8.4. Useful in measuring inequalities in the distribution of income - All
individuals so not have the same income. It means national income is
unequally distributed among people. The extent of inequality in a country
can be measured from the national income data collected through the
income distribution methods
2.8.5. Makes international comparisons possible - We can compare the
economies of any two countries on the basis of their national income data.
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2.8.1. Calculation of National Income of India and its difficulties:

The first attempt to calculate National Income of India was made by Dadabhai
Naroji in 1867 -68. This was followed by several other methods. The first scientific
method was made by Prof. V.K.R Rao in 1931-32. But this was not very satisfactory.
The first official attempt was made by Prof. P.C. Mahalnobis in 1948-49, who
submitted his report in 1954.
In India, National Income is calculated by the combined method. It combines two
methods i.e product or output method and the income method. This is done to
overcome the problem of deficiency of statistics. The product method endeavours
to find out the net contribution to national income of all producing units. The
income method adds up income and payments accruing of factors of production.
This method is used in the tertiary sector like government services, banking etc and
also in the commodity sector if output data is not available.
There are various difficulties in calculating of the national incomes in India. The
most severe one is the finding of reliable data. Most of the time, it is based on
assumptions. Soon after independence the National Income Committee was
formed to collect data and estimate National Income. The two major problems
which remain in the calculation of National Income are:
A. Most of the data is not from the current year.
B. Even if current data are available then values are underreported.
C. National Income (GDP) trend of India
Chart 2.A: National income (GDP) (in billion dollars) trend of India
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The Gross Domestic Product (GDP) in India was worth 2597.49 billion US dollars in
2017.The GDP value of India represents 4.19 percent of the world economy. GDP in
India averaged 545.81 USD Billion from 1960 until 2017, reaching an all-time high of
2597.49 USD Billion in 2017 and a record low of 36.54 USD Billion in 1960.
Table 2.A: World’s top 10 countries in respect of nominal GDP (2021)
Top Ten Countries by Nominal GDP at Current U.S. Dollar

Exchange Rates
Nominal PPP Adjusted Annual
GDP Per Capita
Country GDP (in GDP (in Growth
(in thousands)
trillions) trillions) (%)
United
$21.43 $21.43 2.2% $65,298
States
China $14.34 $23.52 6.1% $10,262
Japan $5.08 $5.46 0.7% $40,247
Germany $3.86 $4.68 0.6% $46,445
India $2.87 $9.56 4.2% $2,100
United
$2.83 $3.25 1.5% $42,330
Kingdom
France $2.72 $3.32 1.5% $40,493.9
Italy $2.00 $2.67 0.3% $33,228.2
Brazil $1.84 $3.23 1.1% $8,717
Canada $1.74 $1.93 1.7% $46,195
This chapter gives a broad overview of the national income and its importance for policy
makers. The following chapter will be the description of how money matters as the
measurement of national income and the creation of wealth in a nation.
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Managerial Economics Chapter 3: Money
CHAPTER 3
MONEY
Learning Objectives: In this chapter we will

LO1: understand the definition of money
LO2: comprehend the functions of money
LO3: describe about the types of money
LO4: discuss about how money is demanded and supplied
LO5: understand the measures of money
LO6: explain the printing and creation of money
3.1. Understanding the concept of Money:

Money, in just in its physical state means nothing. It can be a shell, a metal coin, or a
piece of paper with a historic image on it. The value that people place on it has nothing
to do with the physical state of the money. Money derives its value by being a medium
of exchange, a unit of measurement and a storehouse for wealth. It allows people to
trade goods and services indirectly, understand the price of goods (prices written in
dollar and cents correspond with an amount in your wallet) and gives us a way to save
for larger purchases in the future.
The History of Money: From Barter to Bitcoin
Money has been a part of human history for almost 3,000 years. From the origins of
bartering to modern money, this is how the system has evolved.
At the dawn of humanity, bartering was used in lieu of money to buy goods. One of
the earliest forms of barter included cattle, sheep, as well as vegetables and grain.
This practice started when early man began to rear domestic livestock,
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Chapter 3: Money Managerial Economics
The first known currency was created by King Alyattes in Lydia, now part of Turkey,
in 600BC. The first minted coin featured a roaring lion.
Coins evolved into bank notes around 1661 AD. The first credit card was introduced
in 1946. The advent of modern bartering has brought the system into full circle.
Bitcoin: Age of Cryptocurrency

Bitcoin is a digital currency of 21st century, It’s a cryptocurrency now gradually
accepted worldwide specially in digital payment systems. The Digital currency
(Bitcoin)uses a system which is peer-to-peer and where transactions take place
between users directly, without any intermediary. These transactions are
verified by network nodes and recorded in a public distributed ledger called a
block chain. Bitcoin was first invented by Satoshi Nakamoto as an open source
technology and was released in 2009.
3.1.1 Money as a stock and flow concept:

The concepts of stock and flow are used more in macroeconomics or in the
theory of income, output and employment. Money is a stock variable,
whereas spending the money is a flow variable. Wealth is stock, income is
flow, saving by a person within a month is flow, while the total saving on a
day is stock.
A stock is measured at one specific time, and represents a quantity existing
at that point in time (say, December 31, 2004), which may have accumulated
in the past. A flow variable is measured over an interval of time. A stock has
no time dimension (length of time) as against a flow which has time
dimension.
3.1. Four Functions of Money

Money for the sake of money is not an end in itself. We cannot eat rupees bills or
wear our bank account. Ultimately, the usefulness of money rests in exchanging it for
goods or services. As the American writer and humourist Ambrose Bierce (1842–1914)
wrote in 1911, money is a “blessing that is of no advantage to us excepting when we
part with it.” Money is what people regularly use when purchasing or selling goods
and services, and thus money is widely accepted by both buyers and sellers.
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Fig. 3.A: Four Functions of Money
A. Primary Functions: Primary Functions include the most important functions of

money, which it must perform in every country. These basic functions help to
create the foundation of the money system.
a. Money serves as a medium of exchange, which means that money acts as
an intermediary between buyer and seller. To serve as a medium of
exchange, it must be very widely accepted as a method of payment in the
markets for goods, labour, and financial instruments. The use of money as a
medium of exchange promotes economic efficiency by minimizing the time
spent in exchanging goods and services, which is called transaction cost. In
a barter economy, transaction costs are high because people have to satisfy
a “double coincidence of wants”; i.e., they have to find someone who not
only has a good or service they want but also wants the good or service they
have to offer. It is very difficult to find another individual who has what you
want, and wants what you have. Therefore, Money reduces the high search
costs that are characteristic of barter exchanges.
b. Money also functions as a unit of account, providing a common measure of
value of goods and services being exchanged. Knowing the value or price of
a good, in terms of money, enables both the supplier and the purchaser of
the good to make decisions about how much to supply and how much to
purchase. A unit of account is something that can be used to value goods
and services, record debts, and make calculations. In other words, it's a
measurement for value.
B. Secondary functions: The relatively less important functions of money are called
secondary function. Since, this function originates from primary functions, these
functions are also called derived functions.
a. Another function of money is that money must serve as a standard of
deferred payment. This means that if money is usable today to make
purchases, it must also be acceptable to make purchases today that will be
paid in the future. Loans and future agreements are stated in monetary
terms and the standard of deferred payment is what allows us to buy goods
and services today and pay in the future.
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b. Finally, Store of value is the function of an asset that can be saved, retrieved
and exchanged at a later time and be predictably used when retrieved. More
generally, a store of value is anything that retains purchasing power in the
future. Money is one of the best stores of value because of
its liquidity, that is, it can easily be exchanged for other goods and services.
An individual's wealth is the total of all stores of value including both
monetary and nonmonetary assets. As a store of value, money is not unique;
many other stores of value exist, such as land, works of art, and even
baseball cards and stamps. Money may not be the best store of value
because it depreciates with inflation. However, money is more liquid than
most of the other stores of value because as a medium of exchange, it is
readily accepted everywhere. Furthermore, money is an easily transported
store of value that is available in a number of convenient denominations.
3.2. Role of money in economy:

Money acts as a crucial financial resources for an economy. It is the major resource
for promoting production and creating employment, which enhance national
income of the economy. Scarcity of monetary resources are the crucial drawbacks
for an underdeveloped economy.
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In modern economics, money has been considered as the most dynamic element in
the economy as well as a link between the present and the future. It influences not
only the level of prices but also the cyclical behaviour of consumption, savings,
investment and employment. Investment of money in the economy enhances
national income by joint forces of consumer and producers side. The following flow
chart can give a clear picture to describe the above mentioned concept of money.
MONEY SUPPLY THROUGH CENTRAL BANK
BANKING SYSTEM
LOAN TO LOAN TO
BUSINESS
INVESTMENT IN
PRODUCTIVE EXPENDITURE
SECTOR
ENHANCES
EMPLOYMENT
AGGREGATE
DEMAND
Fig. 3.B: Money Supply through Central Bank
The above mentioned chart explains the role of money in economic growth through
the increase in aggregate demand. Money supplied by central bank circulates the
economy through the banking system. Bank channelizes this money to business as
well as households via loan. Business loan by firms increases production and
employment, which also increases income of economic agents. This increased
income enhances aggregate demand in the economy. In another aspect loan to
households directly enhances consumption expenditure which also increases
aggregate demand in the economy. Therefore, money can be treated as the major
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fuel for the engine of growth of the country.
3.3. Five Different Types of Money:

There are several kinds of money varying in liability and strength. The society has
modified money at different times and in this way several types of money has been
introduced. When there was ample availability of metals, metal money or
commodity money came into existence later it was substituted by the paper money.
At different times, several commodities were used as the medium of exchange. So,
it can be said that according to the needs and availability of means, the kinds of
money has changed.
So, how many kinds of money are there? There are four major types of Money:
 Commodity Money
 Fiat Money
 Fiduciary Money
 Commercial Bank Money
 Electronic money
Commodity Money
Whenever any commodity is used for the exchange purpose the commodity
becomes equivalent to the money and is called commodity money. There are certain
types of commodity, which are used as the commodity money. Among these, there
are several precious metals like gold, silver, copper and many more. Again, in many
parts of the world, seashells (also known as cowrie shells), tobacco and many other
items were in use as a type of money & medium of exchange; e.g. gold coins, beads,
shells, pearls, stones, tea, sugar and metals.
It is the simplest kind of money which is used in barter system where the valuable
resources fulfill the functions of money. The value of this kind of money comes from
the value of resource used for the purpose. It is only limited by the scarcity of the
resources. Value of this kind of money involves the parties associated with the
exchange process. These moneys have intrinsic value.
Fiat Money
The word fiat would mean the “command of the sovereign”. Historically, most
currencies were based on physical commodities such as gold or silver, but fiat money
is based solely on the faith and credit of the economy. Most modern paper
currencies are fiat currencies; they have no intrinsic value (Intrinsic value is the
calculated value of a company which depends on the fundamental analysis) and are
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used solely as a means of payment. Historically, governments would mint coins out
of a physical commodity, such as gold or silver, or would print paper money that
could be redeemed for a set amount of physical commodity. The value of fiat money
is determined by government order which makes it a legal instrument for all
transaction purposes. The fiat money needs to be controlled as it may affect the
entire economy of a country if it is misused.
Today fiat money is the basis of all the modern money system. The real value of fiat
money is determined by the market forces of demand and supply; e.g. paper money
and coins.
Fiduciary Money
Today’s monetary system is highly fiduciary. Whenever, any bank assures the
customers to pay in different types of money and when the customer can sell the
promise or transfer it to somebody else, it is called the fiduciary money. There are
cheques and drafts, which are the examples of fiduciary money because both are
some kind of token which are used as money and carry the same value.
Fiduciary money depends for its value on the confidence that it will be generally
accepted as a medium of exchange. Unlike fiat money, it is not a declared legal
tender by the government, which means people are not required by law to accept it
as a means of payment. Instead, the issuer of fiduciary money promises to exchange
it back for a commodity or fiat money if requested by the bearer.
As long as people are confident that this promise will not be broken, they can use
fiduciary money just like regular fiat or commodity money. Examples of fiduciary
money include cheques, bank notes and drafts.
Commercial Bank Money

Commercial Bank money or demand deposits are claims against financial institutions
that can be used for the purchase of goods and services. A demand deposit account
is an account from which funds can be withdrawn at any time by cheque or cash
withdrawal without giving the bank or financial institution any prior notice. Here fiat
or fiduciary money is transacted through demand deposit account and develop
another concept of money which is termed as commercial bank money. Banks have
the legal obligation to return funds held in demand deposits immediately upon
demand (or ‘at call’). Demand deposit withdrawals can be performed in person, via
cheques or bank drafts, using automated teller machines (ATMs), or through online
banking.
Electronic Money
The money which exists only in banking computer systems and is not held in any
physical form or rather is present in electronic form is known as electronic money.
In USA and many other developed countries, only a small fraction of the currency or
money in circulation actually exists in physical form. Most of the money in such
countries are in electronic form. Need of physical currency is on the decline as more
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and more citizens use electronic alternatives to physical currency.
3.4. The Demand for Money

The demand for money arises from two important functions of money. Firstly,
money acts as a medium of exchange and secondly, it is a store of value. Thus,
individuals and businesses wish to hold money partly in cash and partly in the form
of assets.
The modern idea about the demand for money was put forward by the late Lord
Keynes, the famous English economist, who gave birth to what has been called the
Keynesian Economics. According to Keynes, the demand for money, or liquidity
preference as he called it, means the demand for money to hold.
Broadly speaking, there are three main motives on account of which money is
wanted by people;
Business Motive
Fig. 3.C: The Demand for Money flow
1. Transactions Motive: Transaction demand for money is the amount of money

required for current transactions of individuals and firms. It is the quantity of
money that all the Individuals and firms desire to keep on hand for the purpose
of financing their forthcoming expenditure. The main reason
to hold money in cash for meeting day-to-day transactions is to bridge the
interval between receipt of income and expenditure. The transaction motive is
further divided into
i) Income motive
ii) Business motive
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i) Income motive: It is the transaction demand for money by the wage and
salary earners. They receive their income once in a month, in few case
weekly or daily. People hold their money to fulfil their regular daily
requirements. Money held for this purpose declines gradually over the
income interval period and at the end of the period the balance being almost
zero.
ii) Business motive: Business entity requires to hold money to meet their day-
to-day transactions. The income interval of the firms may be a month or two
or even longer: as there is always a time gap between production and
realisation of its value. Meanwhile they require liquid balance for the
payment of business expenses. The money held at the beginning of interval
period is high and declines over the period.
2. Precautionary Motive: Precautionary motive for holding money refers to the
desire of the people to hold cash balances for unforeseen contingencies. People
hold a certain amount of money to face the risks of unemployment, sickness,
accidents and other more uncertain perils. The amount of money held under
this motive will depend on the nature of the individual and on the conditions in
which he lives.
3. Speculative Motive: The speculative motive relates to the desire to hold one’s
resources in liquid form in order to take advantage of market movements
regarding the future changes in the rate of interest. Money held under the
speculative motive serves as a store of value as money held under the
precautionary motive does. But it is a store of money meant for a different
purpose. The cash held under this motive is used to make speculative gains by
dealing in bonds, equities or any other financial assets whose prices fluctuate. If
prices of the financial assets are expected to rise, which in other words mean
that the rate of interest is expected to fall, investors will buy those financial
assets which has higher anticipated return.
3.5. Money Supply – Meaning and Measures

Meaning of Money Supply
The money supply is the entire stock of currency and other liquid instruments
circulating in a country's economy as of a particular time. The money supply can
include cash, coins and balances held in checking and savings accounts. Economists
analyse the money supply and develop policies revolving around it through
controlling interest rates and increasing or decreasing the amount of money flowing
in the economy. The supply of money means the total stock of money (paper notes,
coins and demand deposits of bank) in circulation which is held by the public at any
particular point of time.
Briefly money supply is the stock of money in circulation. Thus two components of
money supply are
(i) Currency (Paper notes and coins)
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(ii) Demand deposits of commercial banks (A demand deposit is funds held in

an account which deposited funds can be withdrawn at any time without any
advance notice to the depository institution.)
Sources of Money Supply:

(i) Government (which Issues one-rupee notes and all other coins)
(ii) RBI (which issues paper currency)
(iii) Commercial Banks (which create credit on the basis of demand deposits).
The Reserve Bank of India (RBI) uses four alternative measures of money supply
called M1, M2, M3 and M4. Among these measures M1 is the most commonly used
measure of money supply because its components are regarded most liquid assets.
Each measure is briefly explained below.
C + DD + OD. Here C denotes currency (paper notes and coins) held by

public, DD stands for demand deposits in banks and OD stands for
M1
deposits in RBI. Demand deposits are deposits which can be withdrawn
at any time by the account holders.
M2 M1 (detailed above) + saving deposits with Post Office Saving Banks
M3 M1 + Net Time-deposits of Banks
M3 + Total deposits with Post Office Saving Organisation (excluding

M4
NSC)
Narrow Money (M1) and Broad Money (M3):

Narrow money is a category of money supply that includes all physical money such
as coins and currency, demand deposits and other liquid assets held by the central
bank. Broad money is the most inclusive method of calculating a given country's
money supply. The money supply is the totality of assets that households and
businesses can use to make payments or to hold as short-term investments such as
currency, funds in bank accounts and anything of value resembling money. Narrow
money is the most liquid form of money supply but broad money includes all very
close substitutes of money in the measure of money supply.
Money supply trend in India:

Money Supply M3 in India increased to 1,45,447.49 INR Billion in November, 2018
from 1,44,412.92 INR Billion in October of 2018. Money Supply M3 in India averaged
25,500.58 INR Billion from 1972 until 2018, reaching an all-time high of 1,45,447.49
INR Billion in November of 2018 and a record low of 123.52 INR Billion in January of
1972.
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Chart 3.A: Money Supply Trend in India
It can be seen from the above mentioned chart that money supply growth has been
decreased from 2010 to the end of 2017 and afterwards it has been increased and
maintained a stable rate during 2018. Increasing money supply is linked with low
interest rates and increase in consumption and investment expenditure which leads
to more jobs and increase in GDP, ultimately improving the economic condition. But
it develops the inflation situation which adversely affect the common people in our
country. To overcome the inflationary situation in 2011 to 2015, Reserve bank of
India tried to reduce the growth of money supply which has been increased
recklessly earlier and triggered extreme inflation (price rise) and reduced the value
of currency itself. Hence, money supply is decided with the main aim of controlling
inflation while maintaining sustainable growth rate.
Printing currency by Reserve Bank of India:
 The Reserve Bank of India has the monopoly for printing the currency notes in the
country. It has the sole right to issue currency notes of various denominations
except one rupee note (which is issued by the Ministry of Finance)
 Under the Minimum Reserve System, the RBI has to keep a minimum reserve of
Rs. 200 crore comprising of gold coins and gold bullion and foreign currencies.
Out of total Rs. 200 crores, Rs 115 crore should be in the form of gold coins or
gold bullion.
How is money circulated in the economy?

 After printing the currency, it is stored in Mint until it is being issued by the
Issue department of RBI.
 After issuing the currency it circulates in the country via
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a) Deficit financing of Govt. and

b) Borrowed fund from RBI by commercial banks
 Commercial banks lend money to households and business sectors which
increase aggregate demand of the economy.
Deficit financing is a practice in which a government spends more money than it

receives as revenue, the difference being made up by borrowing or minting new
fund
The demand for new currencies depends upon economic growth rate and inflation.
Higher is the economic growth, higher will be increased money supply but to achieve
economic growth with price stability RBI controls money supply growth from time
to time.
RBI secures assets while issuing new currency into the economy. These assets are
foreign currencies or government bonds. Every unit of new currency is a liability of
the RBI. To match this liability, there should be equal volume of assets as well. The
procured foreign currency and government bonds constitute to the assets of the RBI
whereas the newly issued currency is its liability. Foreign currencies purchased by
the RBI are kept at banking department whereas the reserves used for issuing new
currency (under MRS) is kept at Issue Department.
Why cannot RBI print more money and make India rich?
Increase in the supply of money cannot make any country rich. It makes a country
go back to poorest of poor stages. Reason is simple. Increase in money supply has
no backing from the supply side. Suppose you give money to people for free, what
will they do with that money? Definitely everyone will want to spend that money to
buy something. Therefore, demand for all the commodities will increase. But where
is the supply? Has the Production increased? When resources, like production
capacity, labor force, raw materials and capital, are constraint and demand
increases, ultimately it will lead to increase in the price of commodities. This is called
Inflation. Inflation reduces the real purchasing power of the money. It leads to fall
in the price of rupee. The working class will receive the highest impact. The overall
economy will completely slow down. Increase in inflation rates harms the economy
of a country.
Printing money and the value of a currency
If a country prints money and creates inflation, then there will be a decline in the
value of the currency. Suppose due to higher money supply, inflation in India is
100%, and inflation in the USA is nil. This means Indian prices are doubling compared
to the USA. It need twice as much Indian currency to buy same quantity of goods.
The purchasing power of the Indian currency is declining; therefore, the value of
rupee will fall on exchange rates.
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Being human we should always look for new ways of transaction, either it is goods
or service, making sure the transaction is for the mutual benefit of each other and
is done with lots of trust, transparency and security. This chapter describes the
journey from barter to bitcoin to evolve for the betterment of the human being
where everyone (government agencies, too) works together to exchange goods and
services. The exchange of metals and notes will stay and change with time but must
be only for wellbeing of the humanity at large. As this chapter explains the concept
of money and its usefulness, we can move to the following chapter where we will
describe the concept of inflation and its impact on economy.
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Chapter 4: Inflation Managerial Economics
CHAPTER 4
INFLATION
LO1: understand the concept of Inflation
LO2: comprehend the types and causes of inflation
LO3: describe the measurement of inflation
LO4: discuss the controlling measures of inflation
LO5: examine the impact of inflation on economy
LO6: discuss Inflation: A mixed blessing
4.1. The concept of inflation:

Few topics of macroeconomics are as baffling for global analysts as inflation and
deflation. In some
country, inflation is too
high and officials struggle
to reduce it and in others,
it is too low and officials
struggle to increase it.
Inflation denotes a rise in
general level of prices.
More specifically,
inflation refers to the rate
of general prices of goods
Fig. 4.A: India’s Inflation rate
and services increase over
a period of one year.
It has been observed that inflation worldwide has generally remained in the positive
territory, implying that the general price level typically rises. There have however
been exceptions, when there have been sustained decline in the price level of goods
and services which we call deflation.
Inflation historically has destroyed entire economies and changed the course of
human history. It was one of the forces that unravelled the Roman Empire two
millennia ago and the empire of the Soviet Union two decades ago. The impact of
severe inflation often extends far beyond the economy. In the most telling story in
modern history, the horrific inflation triggered by the Weimer Republic in Germany at
the end of World War I caused prices to rise to such stupendous levels that the
exchange rate of the German Mark to the Dollar exceeded three trillion to one!
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Managerial Economics Chapter 4 : Inflation
4.1. Types of inflation on the basis of its causes
1. Demand Pull Inflation 2. Cost Push Inflation
4.1.1. Demand Pull Inflation:

Demand-pull inflation is used to describe what happens when price levels rise
because of an imbalance in the aggregate supply and demand. When the
aggregate demand in an economy strongly outweighs the aggregate supply,
prices go up. Economists describe demand-pull inflation as a result of too many
rupees chasing too few goods. It results from strong consumer demand. Many
individuals purchasing the same good will cause the price to increase, and when
such an event happens to a whole economy for all types of goods, it is called
demand-pull inflation.
Six reasons for Demand-Pull Inflation:
 Monetary stimulus to the economy: A fall in interest rates may increase
the investment of the economy due to decrease in the cost of fund for
business sector and it also enhances the buy-on-credit behaviour for
household due to cheaper interest rate for available loan. This activity
stimulates the aggregate demand by raising demand for loans.
 Higher demand from a fiscal stimulus: If government expenditure or public
borrowings increases then it creates extra demand in the circular flow of
income. In another channel if disposable income increases due to the
reduction of direct and indirect taxes then aggregate demand will rise which
might be another reason of demand pull inflation.
 A depreciation of the exchange rate: It increases the price of imports and
reduces the foreign price of a country’s exports. If consumers buy fewer
imports than exports, aggregate demand (explained in chapter 3) will rise.
Due to depreciation of currency if export earnings increases then it
enhances the consumption and investment demand for economy which
also have positive impact on aggregate demand.
 Fast growth in other countries: If there is a boost on export growth due to
higher growth rate of other counties (economic expansion of other
countries aggravates the demand for imported goods and services) then
export earnings will increase and it also provide an extra flow of money into
circular flow of income.
 Population: The size of the population is one of the determinants of

demand. In many developing countries population is large in size and still
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increasing. India provides an example where demand outstrips supply due

to the large and increasing population.
 Black money: Social and economic evils like corruption, tax evasion,
smuggling and other illegal activities give rise to unaccounted or black
money. People with black money indulge extravaganza, affecting demand
and thus the price level.
4.1.2. Cost push inflation:

Inflation may take place independent of demand forces. Given the demand,
price level may go up due to an increase in cost or supply price. This termed
as cost push inflation. In this case, the overall price level increases due to
higher costs of production which reflects in terms of increased prices of
goods and commodities which majorly use these inputs. This is inflation
triggered from supply side. Apart from rise in prices of inputs, there could
be other factors leading to supply side inflation such as natural disasters or
depletion of natural resources, monopoly, government regulation or
taxation, change in exchange rates, etc.
Four reasons of Cost push inflation:
1. Supply Shock: When there is a large increase in prices of such necessary
commodities like crude oil, this results in higher transport costs and all
firms would see a rise in costs.
2. Higher Wages: Wages form a large percentage of costs for firms. Strong
labour unions can influence inflation as they push for higher wages,
which will lead to an increase in costs of production for the firm and
hence higher priced goods.
3. Higher Taxes: An increase in indirect taxation like higher GST and excise
duties will increase the prices of goods and services. Taxes on cigarettes
and alcohol were meant to lower demand for these unhealthy products.
That may have happened, but more importantly, it raised the price and
created inflation.
4. Imported Inflation: A devaluation or depreciation of the currency would
result in higher prices of imported goods. If country imports
intermediate goods or it imports necessary products like crude oil,
machinery etc. then the higher price of imported goods increases the
cost of production, therefore to keep the profit margin intact price level
goes up.
5. Natural Disasters: Natural disasters cause inflation by disrupting supply.
A good example is right after Japan's earthquake in 2011. It disrupted
the supply of auto parts. It also occurred after Hurricane Katrina. When
the storm destroyed oil refineries, gas prices soared.
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The depletion of natural resources is a type of natural disaster. It works

the same way, by limiting supply and causing inflation.
6. Monopoly: Companies that achieve a monopoly over an industry create
cost-push inflation. A monopoly reduces supply to meet its profit goal.
A good example is the Organization of Petroleum Exporting Countries. It
sought monopoly power over oil prices. Before OPEC, its members competed
with each other on price. They didn't receive a reasonable value for a non-
renewable natural resource. OPEC members now produce 42 percent of oil
each year. They control 80 percent of the world's proven oil reserves. OPEC
members created cost-push inflation during the 1970s oil embargo. When
OPEC restricted oil in 1973, it quadrupled prices.
4.1.3. Types of inflation in terms of its intensity:
Single digit Double Digit
1. Creeping Inflation 1. Galloping Inflation
2. Walking Inflation 2. Hyper Inflation
3. Running Inflation
Fig 4 B: Five Types of Inflation on the basis of Intensity
4.1.3.1. Creeping Inflation: When the rate of inflation is less than 3 percent per
annum, it is termed as creeping inflation. This is considered as mild
inflation and it is said to be a tolerable one. A mild inflation is said to be
good for the economy as the rise in price will lead to more profits leading
to more investment. (When total revenue increases due to marginal
increase in prices and total cost remain constant then producers get
more incentives to invest)
4.1.3.2. Walking Inflation: When prices rise moderately and the annual inflation
rate is a single digit (3%-10%) it is called walking or trotting inflation.
Inflation at this rate is a warning signal for the government to control it
before it turns into running inflation. Prof. Samuelson clubbed creeping
and walking inflation together and termed it as moderate inflation. In
general moderate inflation is a single digit inflation. According to him
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moderate inflation should not be allowed to become running inflation.

Peoples’ confidence gets lost once moderately maintained rate of
inflation goes out of control and the economy is then caught with the
higher rate of inflation.
4.1.3.3. Running Inflation: When prices rise rapidly like the running of a horse at
a rate of speed of above 10% to 20% per annum, it is called running
inflation. Its control requires strong monetary and fiscal measures,
otherwise it leads to galloping inflation.
4.1.3.4. Galloping Inflation: If prices rise by dual or triple digit inflation rates like
30% or 400% or 999% yearly, then the situation can be termed as
Galloping Inflation. When prices rise by more than 20%, but less than
1000% per annum (i.e. Between 20% to 1000% per annum), Galloping
Inflation occurs. Jumping Inflation is it’s another name.
4.1.3.5. Hyperinflation: Hyperinflation refers to a situation where the prices rise
at an alarming high rate. The prices rise so fast that it becomes very
difficult to measure its magnitude. However, in quantitative terms, when
prices rise above 1000% per annum (quadruple or four-digit inflation
rate), it is termed as Hyperinflation. During a worst-case scenario of
hyperinflation, the value of the national currency (money) of an affected
country reduces almost to zero. Paper money becomes worthless, and
people start trading either in gold and silver or sometimes even use the
old barter system of commerce. Two worst examples of hyperinflation
recorded in the world history are of those experienced by Hungary in the
year 1946 and Zimbabwe during 2004-2009 under Robert Mugabe's
regime.
Chart 4.A: Types of Inflation in terms of intensity
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In the above figure,

X-axis represents the time in years or annum.
Y-axis implies percentage (%) increase or rise in price. OA is a Creeping
Inflation from 0 to 3%.
AB is a Walking Inflation from 3 to 10%. BC is a Running Inflation from 10
to 20%.
CD is a Galloping Inflation from 20 to 1000%. DE is a Hyperinflation from
1000% and above.
OB is an addition of OA and AB. It is a Moderate Inflation.
Chart 4.B: Rate of Inflation from 1951 to 2010
Chart 4.C: Rate of Inflation from 2011 to 2018
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4.2. Three Measurements of Inflation:

Measuring inflation is a difficult problem for statisticians. To do this, a number of
goods that are representative of the economy are put together into what is referred
to as a "market basket." The cost of this basket is then compared over time. This
results in a price index, which is the cost of the market basket today as a percentage
of the cost of that identical basket in the starting year.
4.2.1. Consumer Price Index (CPI)

A comprehensive measure used for estimation of price changes in a basket
of goods and services representative of consumption expenditure in an
economy is called consumer price index.
The calculation involved in the estimation of CPI is quite rigorous. Various
categories and sub‐ categories have been made for classifying consumption
items and on the basis of consumer categories like urban or rural. Based on
these indices and sub-indices obtained, the final overall index of price is
calculated mostly by national statistical agencies. It is one of the most
important statistics for an economy and is generally based on the weighted
average of the prices of commodities. It gives an idea of the cost of living.
We would often hear something like this, ‘Retail inflation rose to 5 months
high to 3.36 per cent in August due to costlier vegetables and fruits.’ Here
we are actually addressing the CPI. The Labor Bureau of the Government of
India publishes the data (CPI) on a monthly basis. In India, we have a CPI for
agricultural labourers and another for urban industrial workers. It divides
the basket of goods and services of consumption expenditure into the
following categories assigning different weights.
From the above chart it is clear that the weightage of food and beverages
are highest for measuring the CPI. Therefore, the CPI measurement is very
much appropriate to forecast Indian inflation rate as it affects common man.
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Primary Articles:
Manufactured
Products:
Fuel and Power:
Fig. 4.D: Wholesale Price Index

4.2.2. Wholesale Price Index (WPI)
It represents the price of goods at a wholesale stage i.e. goods that are sold
in bulk and traded between organizations instead of consumers. The WPI is
released on a monthly basis portraying
the changes in prices by manufacturers and whole sellers. The Office of
Economic Advisor, Government of India publishes the wholesale price index.
We would often hear ‘Higher prices of food and fuel products drove inflation
based on wholesale price index (WPI). Here we are actually talking about the
wholesale price index or the headline inflation. Here the basket of goods
and services can be divided into the following with varied assigned weights,
While the CPI uses retail prices, the WPI uses wholesale prices. CPI gives a
clear picture of the cost of living.
Selection of items in the commodity basket of WPI (considering year 2011-
12) are as follows:
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Table 4.A: Types of commodities in the basket of WPI
Major Groups Number of Products
I. All Commodities 697

II. Primary Articles 117
a. Food Articles 76
b. Non Food Articles 28
11
c. Minerals
2
d. Crude Petroleum & Natural Gas
III. Fuel & Power 16
a. Coal 5
b. Mineral Oils 10
1
c. Electricity
IV. Manufactured Products 564
a. Food products 60
b. Beverages 7
3
c. Tobacco
25
d. Textiles
8
e. Wearing apparel 11
f. Leather and related products 10
g. Wooden products 20
h. Paper and paper products 7
i. Printing and reproduction of media products 77
j. Chemical and Chemical Products 23
38
k. Pharmaceuticals, Medicinal Chemical and Botanical Products
26
l. Rubber and Plastics Products 41
m. Other Non-Metallic Mineral Products 27
n. Basic Metals 18
o. Fabricated Metal Products, Except machinery and Equipment 48
p. Computer, Electronic and Optical products 61
q. Electrical Equipment 24
11
r. Machinery and Equipment
6
s. Motor Vehicles, trailers and Semi-Trailers 13
t. Other Transport Equipment
u. Furniture
v. Other Manufacturing
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In India, wholesale price index is divided into three groups: Fuel and Power
(14.91 percent), Primary Articles (20.12 percent of total weight) and
Manufactured Products (64.97 percent).
Why does inflation measure by CPI more beneficial for the common
man?
Traditionally, India has always used the Wholesale Price Index (WPI) to
measure inflation. But after Raghuram Rajan took over as the governor of
the Reserve Bank of India there has been a change of thought. The central
bank started to look at Consumer Price Index (CPI) to measure inflation
seriously.
The idea is simple: Inflation should be measured based on the rise in price
of a basket of inflationary items that directly affect the common man. CPI-
based inflation captures this better than WPI-based inflation. But critics of
this view argue that WPI is more important since this is the basket that
affects the manufacturing sector or industry.
Inflation measured using the WPI index helps rich industrialists leading to
crony capitalism, where the common man suffers. A high CPI, on the other
hand, is something that directly hurts the common man. Across the world,
CPI is the index that has been used to look at inflation and set interest rates.
4.2.3. Gross Domestic Product (GDP) deflator
It is a measure of general price inflation. It is calculated by dividing nominal
GDP by real GDP and then multiplying by 100.
Nominal GDP is the market value of goods and services produced in an
economy, unadjusted for inflation (It is the GDP measured at current prices).
Real GDP is nominal GDP, adjusted for inflation to reflect changes in real
output (It is the GDP measured at constant prices).
Remembering from the chapter 3 on National Income,
Nominal GDP
GDP Deflator = 100
Real GDP
Concept of Headline and Core inflation:

The inflation indices are developed to understand the levels of inflation for
certain sets of population such as consumers, producers, retailers,
wholesalers etc. Such indices are called Consumer Price Index (CPI),
Wholesale Price Index (WPI) etc.
On the basis of items, the inflation indices are developed to understand the
levels of inflation for certain sets / baskets of items. Since the prices of some
items are more volatile than others like food and fuel, it might give
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conflicting signals to policymakers as the overall inflation could change

because of a selected few goods. Hence, separate indices have been
developed separating the volatile items from the main index. This gives rise
to concepts of Headline inflation and core inflation whereby, the Headline
inflation includes all the items and Core inflation usually excludes food and
fuel items
4.3. Two measures to control inflation:

Inflation is considered to be a complex situation for an economy. If inflation goes
beyond a moderate rate, it can create disastrous situations for an economy;
therefore, is should be under control. It is not easy to control inflation by using a
particular measure or instrument.
The main aim of every measure is to reduce the inflow of cash in the economy or
reduce the liquidity in the market.
4.3.1. Monetary measures

Classical economists are of the view that inflation can be checked by
controlling the supply of money. Some of the important monetary measures
to check the inflation are as under:
 Control over money: It is suggested that to check inflation government
should put strict restrictions on the issue of money by the central bank.
 Credit control: Central bank should pursue credit control policy. In order
to control the credit, it should increase the bank rate, raise minimum
cash reserve ratio etc. It can also issue notice to other banks in order to
control credit.
4.3.2. Fiscal measures
Measures taken by the government to control inflation.
 Decrease in public expenditure: One of the main reasons of inflation is
excess public expenditure like building of roads, bridges etc.
Government should drastically scale down its non-essential
expenditure.
 Delay in payment of old debts: Payment of old debts that fall due can
be postponed for some time so that people may not acquire extra
purchasing power.
 Increase in taxes: Government might levy some new direct taxes and
raise rates of old taxes
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4.4. Effects of Inflation:

The impact of inflation is felt unevenly by the different groups of individuals within
the national economy—some groups of people gain by making big fortune and
some others lose.
4.4.1. Creditors and debtors: During inflation creditors lose because they receive
in effect less in goods and services than if they had received the repayments
during a period of low prices. Debtors, on other hand, as a group gain during
inflation, since they repay their debts in currency that has lost its value (i.e.,
the same currency unit will now buy less goods and services).
4.4.2. Producers and workers: Producers gain because they get higher prices and
thus more profits from the sale of their products. As the rise in prices is
usually higher than the increase in costs, producers can earn more during
inflation. But, workers lose as they find a fall in their real wages as their
money wages do not usually rise proportionately with the increase in prices.
They, as a class, however may gain because they might get more
employment during inflation as producers generally more inclined to invest
as the revenue of the organisation increases during inflation.
4.4.3. Fixed income-earners: Fixed income-earners like the salaried people, rent-
earners, landlords, pensioners, etc., suffer greatly because inflation reduces
the value of their earnings. However, the additional wages, salaries and
dearness allowances granted by the government do not completely
compensate the loss in their real income. All are affected by inflation as their
fixed income brings less and less goods and services as the value of money
falls during inflation.
4.4.4. Investors: The investors in equity shares gain as they get dividends at higher
rates because of larger corporate profits and as they find the value of their
shareholdings appreciated. But the bondholders lose as they get a fixed
interest, the real value of which has already fallen due to the reduction of
purchasing power at the time of inflation.
Thus, inflation brings a shift in the pattern of distribution of income and wealth in
the country, usually making the rich richer and the poor poorer. Thus during inflation
there is more and more inequality in the distribution of income.
4.5. Inflation: A mixed blessing

The trade‐off between inflation and unemployment was first reported by A. W.
Phillips in 1958—and so has been christened the Phillips curve. The simple intuition
behind this trade‐off is that as unemployment falls, workers are empowered to push
for higher wages. Firms try to pass these higher wage costs on to consumers,
resulting in higher prices and an inflationary build-up in the economy. The trade‐off
suggested by the Phillips curve implies that policymakers can target low inflation
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rates or low unemployment, but not both. Therefore, employment above the
natural rate can be reached at the cost of accelerating inflation, if monetary policy
is adopted. In his words, “A little inflation will provide a boost at first—like a small
dose of a drug for a new addict—but then it takes more and more inflation to provide
the boost, just it takes a bigger and bigger dose of a drug to give a hardened addict
a high.” But when inflation increases more than GDP growth rate then it has an
adverse impact on the economy. Therefore, both monetary and fiscal policy is
required to maintain inflation rate at a moderate level which may act as a blessing
for the country by giving boost to national income and employment level.
4.5.1. Why is inflation good for the economy?

Inflation is and has been a highly debated phenomenon in economics. Many
economists, businessmen, and politicians maintain that moderate inflation
levels are needed to drive consumption, operating under the larger
assumption that higher levels of spending are crucial for economic growth.
When the economy is not running at capacity, meaning there is unused labor
or resources, inflation theoretically helps increase production. More rupees
translate to more spending, which equates to more aggregate demand.
More demand, in turn, triggers more production to meet that demand.
Inflation also makes it easier on debtors, who repay their loans with money
that is less valuable than the money they borrowed. This encourages
borrowing and lending, which again increases spending on all levels.
4.5.2. Why Deflation decreases growth momentum?
4.5.2.1. Deflation is the general decline in prices for goods and services
occurring when inflation rate is 0%.
4.5.2.2. Deflation may have negative impacts on an economy by showing the
following flow chart.
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4.5.2.3. Deflation can be compared to a terrible winter: The damage can be

intense and be experienced for many seasons afterwards. Unfortunately,
some nations never fully recover from the damage caused by deflation.
Hong Kong, for example, never recovered from the deflationary effects
that gripped the Asian economy in 2002.
4.5.3. What is Stagflation?
ECONOMIC
GROWTH
STAGFLATION INFLATION
UNEMPLOYMENT
Stagflation is an unusual situation when the economy is in a state of high
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inflation and high unemployment primarily caused by supply shocks in one

sector which increases the prices of affiliated sectors dramatically.
Suppose there is a sudden supply drop in crude oil, not only will the prices
of crude oil increase due to the decreased supply, people will start hoarding
it thereby increasing demand which in turn will drive the supplies lower and
the prices higher. This will affect all the affiliated sectors such as logistics
and transportation, which will drive the costs of all the products and
decrease revenues
for the firms, which shall result in decreased investments and even lower
profits. Manufacturing shall slow down which shall again decrease revenues
and companies will not be able to pay the workers, thus wages will plummet,
and soon employments will be terminated and unemployment shall rise.
This chapter gives a broad concept about inflation and its impact on overall economy. Next
chapter will demonstrate about interest rate which is the crucial macroeconomic factor to
affect the level of money supply in the economy.
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Managerial Economics Chapter 5: Interest Rates
CHAPTER 5
INTEREST RATES

LO1: understand the concept of interest rate and its determination
LO2: know the difference between nominal and real rate of interest
LO3: describe the policy rates and its impact on lending interest rate
LO4: examine the relationship of interest rate with inflation and exchange rate
LO5: describe the impact of interest rates on business and individual
LO6: comprehend Interest rate structure of few countries
5.1. What is Interest Rate?

Like any other commodity, money has a price. The price of money is known as the
interest rate. For a saver, interest is the return that is received for money deposited
in banks or financial institutions. This interest is the price that the banks or financial
institutions pays savers for using their money to on-lend to individuals or businesses.
For a person borrowing, interest is the extra amount that is paid to lending institutions
for borrowing money from them. In other words, when repaying a loan, the borrower
pay the amount borrowed (known as the principal) plus some extra money (which is
the interest) to the lending institution for using their funds. In economics, interest has
been defined in a variety of ways which is described below.
5.1.1 Theories of interest rates:
The five theories of interest are as follows:
a. Productivity Theory
b. Abstinence or Waiting Theory
c. Austrian or Agio Theory
d. Classical or Real Theory
e. Loanable Fund Theory.
a. Productivity theory: According to productivity theory, interest can be
defined as a payment for availing the services of capital for the production
purpose. Labor that is having good amount of capital produces more as
compared to the labor who is not assisted by good amount of capital. For
example, farmer having tractor to plough the field produces more as
compared to the farmer who does not have it. Therefore, the productivity
increases when labor adjusted with sufficient amount of capital. Thus,
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Chapter 5: Interest Rates Managerial Economics
according to Productivity theory, interest is the payment for the

productivity of capital.
But this theory focuses only on the causes for what the interest is paid,
not on the determination of interest rates. It lays emphasis on the
demand of capital, but ignores the supply side of capital. It also fails to
explain how the interest is paid for the loan borrowed for consumption
purposes.
b. Abstinence or Waiting Theory:
The abstinence theory was propounded by Nassau William Senior, an
English lawyer known as an economist According to him, interest is a
reward for abstinence. When an individual saves money out of his/her
income and lends it to other individual, he/she makes sacrifice. The term
sacrifice implies that the individual refrains from consuming his/her
whole income that he/she could have spent easily. Senior advocated that
abstaining from consumption is unpleasant. Therefore, the lender must
be rewarded for this. Thus, as per Senior, interest can be regarded as the
reward for refraining the present satisfaction.
c. Austrian or Agio Theory: Austrian theory is also termed as psychological
theory of interest. According to the Austrian theory, interest came into
existence because present goods are preferred over future goods.
Therefore, the present goods have premium with them in the form of
interest. In other words, present satisfaction is of greater concern as
compared to future satisfaction. Therefore, future satisfaction has certain
type of discount if compared with present satisfaction. The interest is the
discounted amount that is required to be paid for motivating people to
invest or transfer their present requirements to future. For example,
people save money due to the return received by it which is termed as
interest. But if they save money, they are sacrificing their present
consumption, the price of the present sacrifice is termed as interest which
will be received in future.
d. Classical or Real Theory: Classical theory helps in the determination of
rate of interest with the help of demand and supply forces. Demand refers
to the demand of investment and supply refers to the supply of savings.
According to the theory, rate of interest refers to the amount paid for
saving. Therefore, the rate of interest can be determined with the help of
demand for saving money to be invested in the capital goods and the
supply of savings.
e. Loanable Fund Theory: Loanable fund theory agrees with the view that
time preference plays an important role in determining the occurrence of
interest. This theory is also termed as neo-classical theory of interest.
According to the neo-classical economists, interest is the amount paid for
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loanable funds. It focuses on the determination of rate of interest with

the help of demand and supply of loanable funds in the credit market.
From the above theory of interest rate, it is crucial to know about the
determination of interest rates. The demand comes from firms who like
to invest in business for capital formation. The lower the rate of interest,
the higher is the profitability margin for firms. Therefore, there is an
inverse relationship between rate of interest and demand for loan. The
supply of loanable funds come from savings. If there is more propensity
to save in an economy, then supply of loanable fund increases. But how
will people be motivated for savings? It depends on the reward for
savings, that is deposit rates which is received by savers in the economy.
If the interest is high, then people will be encouraged to save and lend
more. If the interest is low, then people will be discouraged from saving
and lending. Hence there is a direct relationship between rate of interest
and supply of loanable funds. The market rate of interest therefore is
determined by the equilibrium between demand for and supply of
loanable fund.
5.1.2 Concept of Nominal and Real interest rates
a. Nominal interest rate refers to the interest rate before taking inflation
into account. The nominal interest rate is in the actual monetary price
that borrowers pay to lenders to use their money.
b. Real interest rate is the interest rate that is adjusted to remove the
effects of inflation to reflect the real cost of funds to the borrower. In
simple terms, it is the rate of interest an investor expects to receive after
subtracting inflation. The real interest rate of an investment is calculated
as the amount by which the nominal interest rate is higher than the
inflation rate.
Real Interest Rate = Nominal Interest Rate ‐ Inflation
For example, if a loan has a 12 percent
lending interest rate and the inflation
rate is 8 percent, then the real return on
that loan is (12 – 8) = 4 percent.
Why Interest is Paid or Charged:
There are two views regarding Interest
paid or charged:
(i) From Debtor’s point of view,
(ii) From Creditor’s point of view.
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From Debtor’s Point of View:

Debtors pay interest on capital because they are aware that capital has
productivity and if it can be used in production there can be an increase in
income. Therefore, out of the earned income, a part of the income is paid to
the creditor or a lender from whom money has been taken as loan is known
as interest.
From Creditor’s Point of View:
Creditors or lender of money demands interest because he has taken pain in
saving money, has suffered inconveniences in postponing his needs and has
taken risk of bad debts. If he will not get interest or some advantage of
interest, he may lose interest in saving money or he may not be ready to bear
inconveniences. Then, the formation of capital in the market will stop.
Therefore, it can be said that the debtor’s give interest to creditors as capital
has productivity and creditors demand interest as the lender of money has
taken risk and has faced inconveniences, so he must get some reward for the
pain of inconvenience and risk.
5.1.3 The impact of lending interest rates on economy:
Lending interest rate is the rate that usually meets the short- and medium-
term financing needs of the private sectors. This rate is normally
differentiated according to creditworthiness of borrowers and objectives of
financing. The terms and conditions attached to these rates differ by country.
Lending interest rates control the flow of money in the economy. Lower
lending rates stimulate the economy but could lead to inflation. Therefore, it
is required to know not only whether rates are increasing or decreasing, but
what other macroeconomic factors responding over time. The following flow
chart represents the impact of lending interest rates on economy.
The lending interest rate and different economic scenarios:
Cost of borrowing Decreasing

Lending Interest
increases (restrict consumption leads
rate
credit) to recession
Lending Interest Worry about

Encourage borrowing inflation due to too
rate (Buy on credit) much borrowings
Fig. 5.A: The impact of Lending interest rate
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 If lending interest rates are increasing and the Consumer Price Index
(CPI) is decreasing, this means the economy is not overheating, which is
satisfactory.
 But, if lending rates are decreasing and the CPI is increasing, the economy
is headed towards inflation.
 But, if lending interest rates are increasing and the Gross Domestic
Product (GDP) is decreasing, the economy is slowing too much, which
could lead to a recession.
 If lending interest rates are decreasing and GDP is increasing, the
economy is speeding up, and that means economy is moving toward
recovery.
Trend of lending interest rate (%) in India from 1990 to 2017
Fig. 5.B: Trend of lending interest rate (%0 in India from 1990 to 2017
From the above chart it is clear that lending rates were very high in 1990-91
and it has a decreasing trend afterwards. As we know that lower lending rates
increases the flow of money due to lower borrowing cost, therefore it pushes
the economy to a higher GDP growth. GDP growth data of India has a positive
trend from 1990 to recent time due to declining lending rates which gives
more incentive to invest and increases aggregate demand.
5.2 What is Policy interest rates?

The policy interest rate is an interest rate that the monetary authority (i.e. the central
bank) sets in order to overcome the economic recession and inflationary situation of
the economy by either injecting more money or removing excess money from the
economy. The policy interest rate determines the levels of the rest of the interest
rates in the economy, since it is the price at which private agents-mostly commercial
banks borrow money from the central bank. These banks will then offer financial
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products to their clients at an interest rate that is normally based on the policy rate.
Different policy rates will be described in the subsequent chapters.
5.2.1 Interrelationship between policy interest rates and available Money supply:
The following flow chart represents how policy interest rate by central bank
affect the available money supply in the economy. Policy interest rate is
determined in the monetary policy and the rate depends on the economic
condition of the country. In general, there are mainly two crucial economic
scenarios, one is recession and the other is inflation. At the time of recession
people have less money, therefore aggregate demand also become less which
demotivate business sector to invest in the production. In this scenario,
monetary policy becomes effective if they reduce policy rates which reduces
lending rates of the economy. Reduction of lending interest rates lead to
cheap credit and insist people and business sector for borrowings. Therefore,
cheap credit increases the available money supply and enhances the trade
and business activity in the economy. In similar way, higher policy rates of RBI
lead to high lending interest rates which demotivate people and business
sector for borrowings, therefore, reduces money supply in the country.
5.2.2 Interest rate and Monetary policy:
Interest rate targets are a vital tool of monetary policy and are taken into
account when dealing with variables like investment, inflation, and
Policy interest rates increases Policy interest rates decreases
Commercial Bank’s borrowings Commercial Bank’s borrowings

from RBI reduces from RBI increases
Banks need to increase lending rates to Banks decrease lending rates to

maintain profit margin deploy supply of loanable fund
Investors borrow less money Investors borrow more money
Money supply reduces in economy Money supply increases in economy
unemployment. The central banks of countries generally tend to reduce policy

rates when they want to increase investment and consumption to fight
recession in the economy. However, a lower policy rates as a macro-economic
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policy can be risky and may lead to the creation of an economic bubble, in
which large amounts of investments are poured into the real-estate market
and stock market. For ex. In 1930’s Great depression time in USA, policy
interest rate was very low, which led to lower lending interest rates. Cheap
credit insisted people for investing in real estate and stock market as well
which is riskier investment. This wrong policy of central bank in USA created
bubble in economy which was a crucial factor of economic depression.
Lending interest-rate adjustments are made to keep inflation within a target
range for the health of economic activities or cap the interest rate
concurrently with economic growth to safeguard economic momentum. If the
trend of inflation moves downward significantly then it is worthwhile to
reduce lending interest rates vis policy rates to enhance economic activity.
But if the trend of inflation moves beyond the targeting level then it is
essential for central bank to increase lending interest rates via policy rates.
5.2.3 Why does RBI want lending rates to be linked with policy rates?
The Reserve Bank of India (RBI) has proposed a major change in the way banks
price their loans. It is said that banks will now have to link the lending interest
rates charged by them on different categories of loans to the policy interest
rates instead of the internal discretion of commercial banks.
The biggest problem with the current financial system is the lack of required
transmission of policy rates. When the RBI cuts repo rate there is no
guarantee a borrower will get the benefit of the rate cut or that it will be
transmitted down to him. Due to internal benchmarking (relates with bank’s
internal strategy) of loan price, policy rate cuts often don't reach the
borrowers.
It will help better transmission of policy rate cuts which means an RBI rate cut
will immediately reach the borrower in the current system. Second, it will
make the system more transparent since every borrower will know the fixed
interest rate and the spread value decided by the bank. It will help borrowers
to compare loans in a better way from different banks. Under the new system,
a bank is required to adopt a uniform external benchmark (relates with policy
rates) within a loan category so that there is transparency, standardisation
and ease of understanding for the borrowers. This would mean that same
bank cannot adopt multiple benchmarks within a loan category.
5.3 Relationship Between Interest Rate and Inflation:

 In general, as lending interest rates are reduced, more people are able to borrow
more money. The result is that consumers have more money to spend, causing
the economy to grow and inflation to increase.
 The opposite holds true for rising lending interest rates. As interest rates are
increased, consumers tend to save as returns from savings are higher. With
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less disposable income being spent as a result of the increase in the interest rate,
the economy slows and inflation decreases.
 A change in the policy rate alters all other short term interest rates in the
economy, thereby influencing the level of economic growth and inflation.
5.4 Relationship between interest rate and exchange rate:

 When lending interest in India increases, it means that better return on lending
money to India.
 Foreign investors attracted to invest in India as return on investment in India is
higher compare to their domestic markets.
 It increases the supply of foreign currency in India
 Therefore, there will be appreciation in the value of Indian currency
5.5.1. Impact of increase in interest rates

Impact on Individual Impact on Economy
 Increased cost of borrowings  Inflation will tend to be lower as money
 Improved return for savers, therefore supply will be less
propensity to save will increase  Economic growth will tend to be slower
 Decreased consumption demand due as less investment in productive unit.
to higher cost of borrowings  Unemployment could rise because of
less investment which curb employment
opportunities.
 Government’s borrowing cost will be
high
5.5.2 Impact of decrease in interest rates

Impact on Individual Impact on Economy
 Decreased cost of borrowings  Inflation will tend to increase as money
 Declined return for savers, therefore supply will be more as more people will
propensity to save will reduce borrow funds.
 Increased consumption demand due  Economic growth will tend to be faster as
to lower cost of borrowings there is more aggregate demand due to
cheap credit
 Unemployment could reduce due to
more investment in productive sector
that lead to more employment
opportunities.
 Government’s borrowing cost will be less,
therefore government expenditure will
increase which will boost country’s
economy
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5.6 What are negative interest rates?

Negative interest rates mean depositors pay money to save their money, a reversal of
the normal rules of economics. In this case, the depositors are banks. Like regular
people keeping accounts at a local bank, lenders (local banks) hold their unused cash
at central banks like Reserve Bank of India, the United States Federal Reserve, the
European Central Bank and the Bank of Japan. Normally, they receive a small amount
of interest in return. But with negative rates, central banks charge a fee instead. The
idea is to encourage banks to put their money to more productive use, lending it to
households and businesses. Negative rates are supposed to then ripple through
economies by lowering the cost of borrowing for everyone — something that should
encourage economic growth.
Why do negative interest rates exist?
A Negative Interest Rate Policy (NIRP) is an uncommonly used monetary policy tool
through which the central bank sets nominal interest rates below the theoretical level
of zero. Countries like Switzerland, Sweden, Denmark and Japan all have a negative
central bank interest rate. Interest rate is lowered by the central bank of a country
when it wants to provide a boost to spending and investment in the economy.
During a period of deflation, individuals and institutions alike prefer to hoard money
instead of spending or investing it, which leads to a collapse in demand, a fall in prices
and a decrease in industrial output. In order to combat this, the central bank would
typically opt for a lowering of its policy rates. However, if the prevalent deflationary
forces are too strong, merely cutting the central bank interest rate to zero will not be
enough to battle them. This is when central banks opt for NIRP, which would mean
that the central bank and perhaps even individual banks will charge a negative interest
rate.
Japan’s central bank followed in January 2016 announcing that it would charge
commercial banks a fee of 0.1 percent on a portion of their reserves that they keep
with it.
What does the Bank of Japan hope to accomplish?
The bank is trying to lift consumer prices, which have been sliding for most of the past
20 years. Falling consumer prices hurt corporate revenues, keeping companies from
raising wages or spending on new projects.
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5.7 Interest rate structure of few countries:
Chart 5.A: United States Fed fund rates
Chart 5.B: Policy interest rate in Germany
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Chart 5.C: China policy rates
Chart 5.D: Policy interest rates in India
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Chart 5.E: Policy interest rates in Srilanka
Chart 5.F: Interest rates Qatar
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Chart 5.G: Interest rates in Nigeria
Chart 5.H: Interest rate in Argentina
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Chart 5.I: Interest rate in Ghana
Chart 5.J: Interest rate in Venezuela
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If we look at the graph given above we can see that under developed countries like
Argentina, Ghana, Venezuela etc. have highest interest rates but developed countries like
USA, Germany, Japan have very low and also negative interest rates.
Consider the behavior of entrepreneurs, who in any advanced economy are by far the
most important source of sustainable long term growth. We all know how
entrepreneurs respond if interest rates are too high. If the cost of capital is higher
than the return they can expect to earn by making new investments in their
businesses, then entrepreneurs will simply stop investing, and growth will grind to a
halt. But what if interest rates are too low? Conventional wisdom holds that the more
you cut interest rates, the more entrepreneurs will be encouraged to borrow to invest
in new productive capacity, and the faster growth will accelerate. The trouble with
this view is that investing in new projects is risky. As a result, if interest rates are very
low or negative, it makes more sense for the owners of capital to leverage up and
invest in existing assets like property or financial instruments than to risk their money
on uncertain new ventures. The expected returns may not be as exciting, but leverage
can juice them up, and the pay-off is more reliable. But investing in existing assets
doesn’t add to the productive capacity of the economy. So if interest rates are too
low, leverage expands and financial assets surge in price, but investment in productive
new business projects dwindles and economic growth evaporates.
This chapter examines the structure of interest rates and its impact on economy. Interest rate
is a crucial economic variable which is also linked with other variables like inflation, exchange
rate, GDP growth rate etc. It is considered as major policy rate for the framework of economic
policy (Monetary policy, described in chapter 7). Economy can be tuned up with the changes
of policy rates from time to time. The following chapter “Monetary Policy” will explain how
monetary policy has an impact to control recessionary and inflationary situation as well.
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Chapter 6: Monetary Policy Managerial Economics
CHAPTER 6
MONETARY POLICY

LO1: understand the concept of monetary policy and its importance
LO2: comprehend the objectives of monetary policy
LO3: discuss about the different instruments of monetary policy
LO4: describe the types of monetary policy
LO5: discuss Monetary policy scenarios in India from 2010 - 2018
LO6: explain in brief about the role of monetary policy in a developing economy
6.1 Definition and Concept:

Monetary Policy is a regulatory policy by which the central bank or a monetary
authority of a country controls supply of money, availability of bank credit and rate of
interest. It is the macroeconomic policy laid down by the central bank. It involves
management of money supply and interest rate of a country to achieve
macroeconomic objectives like taming inflation, increasing economic growth and
employment.
In the context of developing countries like India, monetary policy acquires a wide role
and it has to be designed to meet the particular requirements of the economy. In
modern times, developing countries are concerned with the problem of how to use
the monetary policy successfully to stimulate economic growth. This involves not
merely the restriction of credit expansion to curb inflation but also the provision of
adequate funds to meet the legitimate requirements of industry and trade. In India,
the three major objectives of monetary policy are:
 Growth with social justice (equitable distribution of income and wealth)
 Price stability
 Exchange rate stability
The Reserve Bank of India (RBI) is vested with the responsibility of conducting
monetary policy in India. This responsibility is explicitly mandated under the Reserve
Bank of India Act, 1934. Price stability is a necessary precondition to sustainable
growth.
In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a
statutory basis for the implementation of the flexible inflation targeting framework.
The amended RBI Act also provides for the inflation target to be set by the
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Managerial Economics Chapter 6: Monetary Policy
Government of India, in consultation with the Reserve Bank, once in every five years.
Accordingly, the Central Government has notified in the Official Gazette 4 per cent
Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016
to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower tolerance
limit of 2 per cent.
On the basis of economic performance of a country the crucial purpose of monetary
policy is two-fold:
 To control economic downturn or recession
 To fight against inflation
To stabilise economy from the above mentioned two foremost scenarios, the
Monetary Policy Committee of Reserve bank of India takes its policy in every two
months (bi-monthly) by using its different policy instruments.
6.2 Four crucial objectives of monetary policy:

There are various objectives of monetary policy, which may have conflict with each
other and there is a problem of selecting the right objective for the monetary policy
of a country. The proper objective of the monetary policy is to be selected by the
monetary authority keeping in view the specific conditions and requirements of the
economy. Various objectives or goals of monetary policy are:
1. Price Stability:
This has been a dominant objective of monetary policy. Fluctuations in the prices
bring uncertainty and instability to the economy. The stability objective includes
maintaining the domestic as well as external value of the currency (exchange
rate). But the determination of a satisfactory price level is a difficult task.
All the economies suffer from inflation or deflation. It can also be called price
instability. Thus the monetary policy having an objective of price stability tries to
keep the value of money stable. It helps in reducing the income and wealth
inequalities. When the economy suffers from recession the monetary policy
should be an “easy monetary policy” (excess money supply) but when there is an
inflationary situation there should be a “dear monetary policy” (restricted money
supply).
2. Economic Growth:
This objective of monetary policy has acquired considerable significance in recent
years. Economic growth is defined as the process whereby the real per capita
income of the country increases over a long period of time. Monetary policy can
lead to economic growth, by having a control on the lending interest rate which
is inversely related to borrowings. By following an easy credit policy and lowering
lending interest rates, the level of borrowings can be raised which promotes
economic growth. Monetary policy also contributes towards growth by helping in
maintaining the stability of income and prices. By moderating economic
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fluctuations and avoiding depression, monetary policy helps in achieving the

growth objective. Because fluctuations in the rates of inflation have an adverse
impact on growth and monetary policy also helps in controlling hyperinflation.
3. Full Employment:
Full-Employment is the ultimate objective of monetary policy. According to
Keynes, "full employment means the absence of involuntary unemployment".
Involuntary unemployment occurs when a person is willing to work at the
prevailing wage yet is unemployed. It needs to be noted that although full
employment means a situation where all resources in the economy land, labour,
capital, etc.—are fully employed but for simplification, meaning of full
employment is restricted to labour market only, i.e., a situation where all able
bodied persons who are willing to work at the prevailing wage rate find jobs. To
attain this objective, it is necessary to increase production and demand. During
the expansionary phase of business cycle, the position is automatically achieved
as there is rapid increase in demand and thereby production is also increased. But
during a depression there is low production because of low demand and wide
unemployment. Hence the objective of monetary policy is to check rising
unemployment during depression period. As the available money supply is less
during the phase of depression, therefore the purpose of monetary policy is to
inject more money supply by reducing lending interest rates (explained in chapter
6).
4. Exchange rate stability
Exchange rate stability is the traditional objective of monetary authority. It must
be noted that if there is instability in the exchange rates, it would result in excess
outflow or inflow of capital resulting in unfavourable balance of payments.
Therefore, stable exchange rates play a key role in international trade. This is
through Managed Floating Rate System, a system in which the foreign exchange
rate is determined by market forces and central bank, RBI influences the exchange
rate through intervention in the forex market. In this system the RBI intervenes in
the foreign exchange market to restrict the fluctuations in the exchange rate up
to a certain limit. When RBI realises that the market value of domestic currency is
heavily depreciating (against dollar), it restores its value by selling US dollars in
the international market. In this way the bank expects to increase the supply of
dollar to reduce the price of dollar in relation to the domestic currency. On the
other hand, when RBI realises that the market value of the domestic currency is
rising (causing a fall in foreign demand for domestic goods), it may start buying
the foreign currency.
Every monetary policy uses the same set of the tools or instruments. Major policy
instruments are described in the following section.
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6.3 Six major policy instruments of Monetary Policy in India

There are several direct and indirect instruments that are used in the implementation
of monetary policy.
1. Repo rate: Repo rate is the rate at which the central bank of a country (Reserve
Bank of India in case of India) lends money to commercial banks in the event of
any shortfall of funds. Repo rate is used by monetary authorities to control
inflation. In the event of inflation, central banks increase repo rate as this acts as
a disincentive for banks to borrow from the central bank. This ultimately reduces
the money supply in the economy and thus helps in arresting inflation. It is
decided by the Monetary Policy Committee of RBI in their bi-monthly Monetary
Policy Review.
Salient Features of Repo Rate
 Banks enter into an agreement with the RBI to repurchase the same pledged
government securities at a future date at a pre-determined price.
 In general, funds are borrowed for short durations, up to 2 weeks.
 Higher the repo rate, higher will be the cost of borrowing and vice versa.
 Higher repo rate may tend to slowdown the growth of the economy.
 If the repo rate is low, banks can charge lower interest rates on the loans
offered to households and business as the borrowing cost of capital from RBI
reduces.
2. Reverse Repo Rate: Reverse repo rate is the rate at which the central bank of a
country (Reserve Bank of India in case of India) borrows money from commercial
banks within the country. It is a monetary policy instrument, which is used to
control the money supply in the country. In practical terms, it refers to the surplus
funds that these commercial banks park with the central bank. It is decided by the
Monetary Policy Committee of RBI in their bi-monthly Monetary Policy Review.
Salient Features of Reverse Repo Rate
 The banks earn interest on such funds.
 Reverse Repo Rate is normally held for 45 to 90 days.
 The RBI uses this tool when it feels there is too much liquidity in the market.
 An increase in the reverse repo rate means that the banks will get a higher
rate of interest from RBI and make more money.
 As a result, banks prefer to lend their money to RBI, which is always safest.
Why is Repo rate always more than Reverse repo rate?
 Repo rate and reverse repo rate are two opposite terms used in the banking
sector. The major difference between these two are that increase in repo rate
will make commercial banks borrow less and therefore pumps less money
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into the economy, while increase in reverse repo rate will allow commercial
banks to transfer more funds to RBI which will eventually contribute less to
the supply of money in the country.
 Since RBI is a very secure institution, banks will prefer parking their money in
RBI rather than giving loans to businesses and individuals. Reverse repo rate
is not kept high in order to avoid this scenario. This will ensure that the
commercial banks will have sufficient funds to invest elsewhere or use as
liquidity thereby increasing the buying capacity of the people.
 Reverse repo rate is always lesser than repo rate so that the flow of money is
there from RBI to commercial banks. RBI doesn't want to keep all the money.
The commercial banks and businesses need the money so that the economy
has enough purchasing power.
Chart 6.A: Trend of Repo and Reverse Repo rates from 2008 to 2018
3. Cash Reserve Ratio (CRR): It is a specified minimum fraction of the total deposits
of customers, which commercial banks have to hold as reserves either in cash or
as deposits with the central bank. CRR is set according to the guidelines of the
central bank of a country. The amount specified as the CRR is held in cash and
cash equivalents, is stored in bank currency vaults or parked with the Reserve
Bank of India. The aim here is to ensure that banks do not run out of cash to meet
the payment demands of their depositors. CRR is a crucial monetary policy tool
and is used for controlling money supply in an economy.
Salient Features of CRR:
 These deposits can also be held with currency chests (branches of selected
banks authorized by the RBI to stock rupee notes and coins), which are
considered as equivalent to keeping with RBI.
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 The banks do not earn any interest on this slice of money kept aside.
 CRR is decided by the Monetary Policy Committee (MPC) in their bi-monthly
Monetary Policy Review., it may so happen that the MPC may decide not to
alter the CRR every time they meet.
 By changing CRR, RBI can effectively drain excess liquidity from the system, or
supply money in the system.
4. Statutory Liquidity Ratio (SLR): Statutory Liquidity Ratio (SLR): It refers to the
amount that the commercial banks are required to maintain in the form of gold
or government approved securities before providing credit to the customers (i.e.,
borrowers). The banks have to invest certain percentage of their deposits in
specified financial securities like Central Government or State Government
securities.
Salient Features of SLR:
 It is determined as a percentage of total demand and time liabilities.
 SLR is determined and maintained by the RBI in order to control the expansion
of bank credit (banks to enhance lending).
 Unlike CRR, banks earn a return on SLR.
 If any Indian bank fails to maintain the required level of SLR, then it becomes
liable to pay penalty to Reserve Bank of India.
Chart 6.B: Trend of SLR and CRR from 2008 to 2018
5. Open Market Operations (OMO)

OMO refers to the buying and selling of government securities by the RBI in the
open market in order to expand or contract the amount of money in the banking
system. Securities' purchases inject money into the banking system and stimulate
growth, while sales of securities do the opposite and contract the economy. These
operations are often conducted on a day-to-day basis in a manner that balances
inflation while helping banks continue to lend. Although the name states open
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market operations but it is not offered to general public, only commercial banks
and RBI take part in the operation.
Salient Features of OMO
 Auction trading (An auction is a process of buying and selling goods or
services by offering them up for bid, taking bids, and then selling the item to
the highest bidder) in securities between the RBI and banks is performed via
the web platform.
 Auctions may be fixed rate auctions (where securities are purchased/sold at
a fixed interest rate predefined and announced by the RBI) and variable rate
auctions (where securities are purchased /sold at an interest rate set based
on supply and demand in trade transactions).
 All banks meeting the prescribed requirements may take part in the
purchase/sale transactions with the RBI.
6. Marginal Standing Facility (MSF):
Marginal standing facility (MSF) is a
window for banks to borrow from the 1% change = 100 basis points
Reserve Bank of India in an emergency
situation when inter-bank liquidity dries
up completely.
Banks borrow from the central bank by pledging government securities at a rate
higher than the repo rate under liquidity adjustment facility. The MSF rate is 0.25
basis points above the repo rate. Under MSF, banks can borrow funds up to one
percentage of their net demand and time liabilities (NDTL).
The Reserve Bank of India seeks to influence monetary conditions through the
management of liquidity by operating in varied instruments. Since 1991, the
market environment has been deregulated and liberalised where in the interest
rates are largely determined by the market forces. The relative emphasis on any
one of the objectives is governed by the prevailing circumstances.
6.3.1 Current Policy rates in India (as of June 2021)
Repo rates 4.00
Reverse repo rates 3.35
Marginal Standing Facility 4.25
Cash reserve ratio 4.00
Statutory liquidity ratio 18.00
By using the above mentioned policy instruments, RBI can accomplish its
objectives of GDP growth along with price stability. These objectives can be
fulfilled by two types of policies which is described below.
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6.4 Two Types of monetary policy:
EXPANSIONARY CONTRACTIONARY
(Easy Monetary Policy) (Dear Monetary Policy)
(To increase money supply) (To reduce money supply)
6.4.1 Expansionary Monetary policy:

Whenever actual real GDP falls short of the potential real GDP then a
recessionary real GDP gap is created. To fulfil the gap, the policies designed
by the central bank to stimulate aggregate demand can ensure recovery. In
such a case the central bank can utilise the monetary policy tools effectively
to reduce the real interest rates (explained in chapter 6). This policy will
gradually increase planned investment expenditure and other interest
sensitive purchases which will increase aggregate demand.
Reasons for implementing expansionary policy:
 Country is suffering less money supply, which can be termed as economic
recession.
 Unemployment rate is increasing due to less job opportunities.
 Individual and business entities are not willing to take loan from financial
institution due to higher prevailing rate of interest.
An example of expansionary Monetary policy:

Let’s start with a simple example:
Suppose Mr A wants to take Rs 1000 crores to set up his factory
Previous interest rate: 10% Current interest rate: 8%
Total amount of annual interest Total amount of annual
payable in 1 year = Rs 1000 cr × 10% interest payable in 1 year
= Rs 100 cr = Rs 1000 cr × 9%
= Rs 90 cr
Therefore, from the above example it is clear that if interest rate on loan
comes down from 10% to 9% the interest cost will be reduced for Mr A to set
up his business and it can be concluded that he will have more willingness to
borrow fund from financial institutions. As we discussed in the previous
chapter about the relationship of policy rates and lending interest rate,
therefore the following flow chart can explain the effectiveness of
Expansionary monetary policy to combat recession or economic downturn.
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6.4.1.1 Impact of Repo rate cuts on national income:
Reduction of Repo rates
Lending interest rate reduces
Borrowing from Banks by firms and individual increases
More money circulates in the economy
Aggregate demand increases
National income(GDP) increases
6.4.2 Contractionary Monetary policy:

Contractionary monetary policy is a form of economic policy used to fight
inflation which involves decreasing the money supply in order to increase the
cost of borrowing which in turn decreases GDP and dampens inflation. The
central bank can employ the instruments available to it to control the supply
of money. It can restrain the creation of new credit by the banking system and
thereby regulate the unanticipated expansion of economic activity.
Contractionary monetary policy has some side effects too. It results in an
increase in the unemployment rate and a decrease in the growth rate of the
GDP
Reasons for implementing contractionary policy:
 Country is suffering with high inflation due to the extended period of
economic growth.
 Volume of credit is increasing in the economy due to lower lending
interest rate.
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 Money supplies in the economy increases due to expansionary fiscal

policy (increasing public expenditure or lowering tax rate) adopted by
government.
An example of Contractionary Monetary policy:
 Like earlier example (if lending rate goes up then Mr A’s willingness to
borrow fund from financial institution will be reduced due to higher
interest burden for loan.
 Therefore, he will not borrow capital to set up his factory as borrowing
fund will be costlier for him
 Therefore, his plan for setting up the factory will be stopped due to high
lending interest rates.
 This decision of Mr. A will reduce the expected job opportunity in the
economy
 Therefore, economy’s expected demand also will be reduced.
 It will reduce the inflation rate of the country.
6.4.2.1 Impact of Repo rate hike on price stability:
Repo rates hike
Lending rate increases
Borrowing from Banks by firms and individual declines
Less money circulated in the economy
Aggregate demand reduces
Price level goes down
Inflation controlled in some extent
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From the above flow chart (6.4.1.1 and 6.4.2.1), it is clear that if Reserve Bank
of India changes its policy rates then it also transmits to lending interest rates
through the banking system which can control the overall money supply of
the country. Higher repo rates have already translated into higher lending
rates. This would effectively means higher EMIs on Home Loans, Car Loans as
well as Personal Loans. Higher lending rates lead to lower consumption
expenditure due to increased EMI of loan, therefore inflation can be
controlled through reduced aggregate demand. Repo rate cut transmits via
reduction of borrowing cost thereby boosting both business loan and private
loan (home loans, car loans etc). It increases national income through the
positive growth of aggregate demand. Like repo rates RBI has other policy
instruments like CRR, SLR, purchase and sell of government securities to
control the money supply through the available credit expansion and
contraction. The following chart shows the problem and the required
measures taken by RBI for accomplishing its goal of macro-economic stability.
Expansionary Contractionary
Problem: Recession and unemployment Problem: Inflation
Measures: Measures:
1. RBI reduces Repo rates 1. RBI increases repo rates
2. RBI reduces CRR and SLR 2. RBI increases CRR and SLR
3. RBI buys securities through open 3. RBI sells securities through open market
market operation to inject operation to suck excess liquiduty from the
liquidity into the economy. economy.
6.5 Monetary policy scenario in India from 2010 to 2018eonetar
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The above chart of monetary policy scenario depicts expansionary and

contractionary policy regarding the economic situation.
2010-11: RBI adopted contractionary policy to fight against inflation. In 2010 CPI
inflation was 12% which was crossed single digit inflation. To achieve economic
stability RBI tried to absorb excess money supply from the economy by increasing
repo rates from 5% in 2010 to 8% in 2012.
2012 -14: As CPI was controlled and reduced at 9.30% in 2012, therefore RBI reduced
it to 7.5% in 2013 to increase available money supply in the economy.
2014-16: RBI reduced the repo rate from 8% in 2014 to 6% in 2016 to inject more
money supply in to economy as inflation rate was stable at 5% to 6%, therefore main
objective of monetary policy was to drive economy at a higher growth path.
2016-18: Mild increase of repo rates from 5 % in 2016 to 6.5 % in 2018 to maintain
inflation rate at its targeted level and to keep projected growth rate at 7.50 %.
6.6. Role of Monetary Policy in a Developing Economy:

In modern times, any newly-developing country may be concerned with the problem
of how to use the monetary policy successfully to stimulate economic growth. In an
under-developed country, the monetary policy has to play a vital role in developing
the economy from a stage of primary backwardness to a stage of self-sustained
growth.
Naturally, the economic ends and means and conditions of developed and developing
nations are bound to be different, and hence the role of monetary policy should also
vary in both cases. Advanced countries of today can afford the luxury of debating
whether full employment should take precedence over price stability or whether the
aim should be to achieve internal or external balance at the expense of growth.
However, poor countries cannot at any time think of anything but the policy of
promoting rapid economic growth.
Under the growth-oriented monetary policy, monetary management by the central
bank becomes a strategic factor of development in a developing and underdeveloped
country, on the following counts:
1. When the country aspires for rapid economic development, it adopts economic
planning. In the process, financial planning needs the support of credit planning
and appropriate monetary management.
2. Underdeveloped countries are most susceptible to inflation. Inflation in an under-
developed economy generally occurs when there is an abnormal increase in the
effective demand exerted mainly by huge government expenditures under the
planning process. However, the maintenance of stability in the domestic price
level and a fixed, realistic exchange rate are very essential preconditions for
achieving a maximum rate of sustained economic growth. This needs equilibrium
of savings and investment.
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3. Above all, the growth objective of monetary policy in underdeveloped countries

implies the promotional role of monetary authorities. Briefly, the promotional
role of the monetary authority in an under developed country may be to improve
the efficiency of the banking system as a whole or extend sound credit where
needed and to respond promptly to changing conditions.
4. It is an important task of the monetary authority to improve the conditions of
unorganised money and capital markets in developing and underdeveloped
countries in the interest of rapid economic development and the successful
working of monetary management.
This chapter explains the need and effectiveness of monetary policy to achieve
macroeconomic stabilisation. The following chapter will explain another policy formulated by
Government named as Fiscal policy to combat inflation and achieve economic growth as well.
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Managerial Economics Chapter 7: Fiscal Policy
CHAPTER 7
FISCAL POLICY

LO1: understand the requirement of Fiscal Policy
LO2: define the objectives of fiscal policy for a developing country
LO3: learn about Expansionary and Contractionary Fiscal Policy
LO4: explain the tools of Fiscal Policy
LO5: understand the architecture of Indian Fiscal policy
LO6: discuss about the advantages and shortcomings of Fiscal Policy in India
7.1. Definition and concept:

The term fiscal comes from the Latin word fiscalis which in turn comes from fiscus, i.e.
a basket used for collecting money. In Italian il fisco refers to the agency that collects
taxes. Thus ‘fiscal policy’ means policy related to taxes. The same is the case in
Spanish, French and Portuguese. In English the expression fiscal policy was apparently
first used by Edwin R.A. Seligman, a prominent professor of public finance at Columbia
University in the early part of the 20th century. He used this expression to criticize
Adolf Wagner, a German economist, who had suggested that governments should
engage in some redistribution of income through their budgetary activities. This
seems to be the genesis of the ‘redistribution branch’ of the trilogy made popular by
Richard Musgrave (1959). The Keynesian revolution changed the meaning of fiscal
policy, moving it away from the tax or the revenue side of the budget to include both
revenue and spending. For the Keynesians and now for economists generally, fiscal
policy refers to the manipulation of taxes and public spending to influence aggregate
demand.
The economy does not always work smoothly. There often occur fluctuations in the
level of economic activity. At times the economy finds itself in the grip of recession
when levels of national income, output and employment are far below their full
potential levels. During recession, there is a lot of idle or unutilized productive
capacity, that is, available machines and factories are not working to their full
capacity. As a result, unemployment of labour increases along with the existence of
excess capital stock. On the other hand, at times the economy is ‘over heated’ which
means inflation (i.e. rising prices) occurs in the economy. Thus, in a free market
economy (Discussed in chapter 1) there is a lot of economic
instability. The classical economists believed that an automatic mechanism works to
restore stability in the economy, recession would cure itself and inflation will be
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Chapter 7: Fiscal Policy Managerial Economics
automatically controlled.
However, the empirical evidence during the 1930s when severe depression took place
in the western capitalist economies and also the evidence of post Second World War
II period amply shows that no such automatic mechanism works to bring about
stability in the economy. That is why Keynes argued for intervention by the
government to cure depression and inflation by adopting appropriate tools of macro-
economic policy. According to Keynes, Monetary policy was ineffective to lift the
economy out of depression. He emphasized the role of fiscal policy as an effective tool
of stabilizing the economy.
Before the Great Depression, which lasted from Sept. 4, 1929, to the late 1930s or
early 1940s, the government's approach to the economy was laissez‐faire (explained
in chapter 1). Following World War II, it was determined that the government had to
take a policy by which the government adjusts its levels of spending as well as taxation
to influence and control an economy.
Fiscal policy is based on the theories of British economist John Maynard Keynes. Also
known as Keynesian economics, this theory basically states that governments can
influence macroeconomic productivity levels by increasing or decreasing tax levels
and public spending. This influence, in turn, curbs inflation (generally considered to
be healthy when between 2-3%), increases employment and maintains a healthy
value of money. Fiscal policy plays a very important role in managing a country's
economy.
Fiscal policy is the means by which a government adjusts its spending levels and tax
rates to monitor and influence a nation's economy. The ultimate goal of Fiscal policy
is the long run stabilization of the economy. Governments know how much they own,
or how they use those assets for the public’s wellbeing. Knowing what a government
owns and how they can put their assets to better use matters because they can earn
more revenues from tax and other receipts, and can use this revenue toward welfare
development programme like better schools, hospitals, or other priority spending.
7.1.1. Objectives of Fiscal policy:

Some of the key objectives of Fiscal Policy are,
 To maintain and achieve full employment:
The first and foremost objective of fiscal policy in a developing economy
is to achieve and maintain full employment in an economy. In such
countries, even if full employment is not achieved, the main aphorism is
to avoid unemployment and to achieve a state of near full employment.
Therefore, to reduce unemployment and under-employment, the state
should spend sufficiently on social and
economic overheads. These expenditures would help to create more
employment opportunities and increase the productive efficiency of the
economy.
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In this way, public expenditure and public sector investment have a

special role to play in a modern state. A properly planned investment will
not only expand income, output and employment but will also step up
effective demand through multiplier process and the economy will march
automatically towards full employment. Besides public investment,
private investment can also be encouraged through tax holidays,
concessions, subsidies etc.
In the rural areas attempts can be made to encourage domestic industries
by providing them training, cheap finance, equipment and marketing
facilities. Expenditure on all these measures will help in eradicating
unemployment and under-employment.
 To stabilize the price level.
There is a general agreement that economic growth and stability are joint
objectives for underdeveloped countries. In a developing country,
economic instability is manifested in the form of inflation. Prof. Nurkse, a
prominent international economist and policy maker, believed that
“inflationary pressures are inherent in the process of investment but the
way to stop them is not to stop investment. They can be controlled by
various other ways of which the chief is the powerful method of fiscal
policy.”
Therefore, in developing economies, inflation is a permanent
phenomenon where there is a tendency to the rise in prices due to
expanding trend of public expenditure. As a result of rise in income,
aggregate demand exceeds aggregate supply. Capital goods and
consumer goods fail to keep pace with rising income.
Thus, these result in inflationary gap. The price rise generated by demand
pull reinforced by cost push inflation leads to further widening the gap.
The rise in prices raises demand for more wages. This further gives rise to
repeated wage-price spirals. If this situation is not effectively controlled,
it may turn into hyperinflation.
In short, fiscal policy should try to remove the bottlenecks and structural
rigidities which cause imbalance in various sectors of the economy.
Moreover, it should strengthen physical controls of essential
commodities, granting of concessions, subsidies and protection in the
economy. In short, fiscal measures as well as monetary measures go side
by side to achieve the objectives of economic growth and stability.
 To stabilize the growth rate of the economy
Primarily, fiscal policy in a developing economy, should aim at achieving
an accelerated rate of economic growth. But a high rate of economic
growth cannot be achieved and maintained without
stability in the economy. When any economy is suffering with
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recessionary situation then fiscal policy can boost the economy by

enhancing government expenditures (construction of road, bridges, more
employment generating schemes etc.) There are other fiscal measures
such as taxation, public borrowing and deficit financing that also can be
used properly so that production, consumption and distribution may also
have a positive impact on aggregate demand of the economy. It should
promote the economy as a whole which in turn helps to raise national
income and per capita income.
 Optimum Allocation of Resources:
Fiscal measures like taxation and public expenditure programmes, can
greatly affect the allocation of resources in various occupations and
sectors. As it is true, the national income and per capita income of
underdeveloped countries is very low. In order to gear the economy, the
government can push the growth of social infrastructure through fiscal
measures. Public expenditure, subsidies and incentives can favourably
influence the allocation of resources in the desired channels.
Tax exemptions and tax concessions may help a lot in attracting resources
towards the favoured industries. On the contrary, high taxation may draw
away resources in a specific sector. Above all, direct curtailment of
consumption and socially unproductive investment may be helpful in
mobilization of resources and the further check of the inflationary trends
in the economy. Sometimes, the policy of protection is a useful tool for
the growth of some socially desired industries in an underdeveloped
country.
7.2. What are the tools of Fiscal Policy?

Fiscal policy instruments or tools are those over which the government has the sole
authority. Taxation, government spending and budget are the vital instruments of
Fiscal Policy. Fiscal policy involves using either one or the combination of fiscal
instruments to accomplish country’s short-run and long-run goals.
A. Taxation:
Taxes affect the aggregate demand by affecting the disposable income available
for consumption spending; they are also a source of revenue for Government
spending. Taxes can be further classified into,
a. Direct Tax: These are taxes placed on incomes (households ‘incomes and
firms ‘profits). The burden of such taxes is borne by those on whom they are
levied. Examples of direct taxes include: income tax, corporation tax, capital
gain tax and property taxes.
b. Indirect Tax: Indirect taxes can be defined as taxation on an individual or
entity, which is ultimately paid by another person. The body that collects the
tax will then remit it to the government.
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Understanding Indirect tax system in India (GST):

Prior to July 2017, indirect taxes in India were a complex set of tax laws. A host of
taxes such as sales tax, service tax, customs duty, excise tax, VAT and so on existed.
It was a complex task to account for so many taxes, cesses and duties. A need was
felt for structuring and introducing a convenient method for indirect taxation.
Therefore, on 1 July 2017, the Government of India introduced the Goods and Ser-
vice Tax (GST) by making the 101st amendment to Constitution and passing the GST
Act. It is considered to be country’s most significant indirect tax reform till date.
Goods and Services Tax or GST is a comprehensive, multi-stage and value-added tax
that is levied at all points in the supply chain and is applicable on both goods and
services, having minimum exemptions. GST would be levied on manufacturing, sale
and consumption of goods and services across India. In India, GST is levied and
collected by both the Centre (CGST) and the states (SGST)
 Someoftheimportant indirect taxes that the GST has replaced are,
 Value Added Taxes
 Service Tax
 Central Excise Duty (CENVAT)
 Additional Excise Duties
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 Surcharge and Cess

 Purchase tax
 GST is applicable to tobacco and tobacco products and the government is
authorized to levy additional excise duty.
 GST will also be applicable on five specified petroleum products including crude,
petrol, diesel, ATF and natural gas from a date to be recommended by the GST
Council.
Apart from GST, a few other types of indirect taxes are as follows:
 Customs duty: Customs duty is a kind of tax that is imposed on the import and
export of goods. Customs duty on imports is called import duty, whereas that on
exports is called export duty. There are distinctive standards for diverse products
and divisions. The government continuously revises these rates to advertise
imports and exports of particular products.
 Stamp duty: Stamp duty is a tax that is levied on the sale and transfer of
immovable property in the states. It is collected by state governments and the
rate varies from one state to another. For ex-ample, in Delhi, stamp duty and
transfer duty are 4% if the vendee (buyer) is a female and 6% if the vendee is a
male. In addition, there is a registration fee of 1% of the total value of the sale
deed plus `100/- pasting charges.
B. Public spending / Expenditure

Traditionally public expenditure represents a form of government intervention
designed to promote allocative efficiency through correction of inefficiencies in
the market, redistribute resources equitably and promote economic growth and
stability. The redistributive powers of the state, through public expenditure,
emanates from the normative arguments in favor of greater equality.
The increased public spending will have a multiple effect upon income, output
and employment exactly in the same way as increased investment has its effect
on them. Similarly, a reduction in public spending, can reduce the level of
economic activity through the reverse operation of the government expenditure
multiplier.
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The government spending can strongly affect aggregate demand and hence can
be effectively used to manipulate the level of aggregate demand of an economy.
In economics, a multiplier refers to an economic factor that, when increased

or changed, causes increases or changes in many other related economic
variables.
In terms of gross domestic product, the multiplier effect causes gain in total
output to be greater than the change in spending that caused it. The term is
usually used in reference to the relationship between government spending
and total national income.
Example of government expenditures: For example, expenditure on education,
public health, transport, defense, law and order, general administration. special
benefits to all: Expenditures that confer special benefits on all. For example,
administration of justice, social security measures, community welfare.
Provision of public goods is one important head of the government expenditure
in all economies, and amongst them, the defense expenditure is a very
important one.
In developing countries, government intervenes in a big way to provide for the
infrastructure required for the development process. They also manufacture
certain critical goods and provide budgetary support to their enterprises.
Government expenditure can be used to stimulate the macro‐ economy at times
of low and negative growth. This works by increasing the level of aggregate
demand, and can compensate for failings in other components of aggregate
demand, such as a fall in household spending on consumer goods and firms
spending on capital goods.
C. Government Budget:
“A government budget is an annual financial statement showing item wise
estimates of expected revenue and anticipated expenditure during a fiscal year.”
The government plans expenditure according to its objectives and then tries to
raise resources to meet the proposed expenditure. Government earns money
broadly from taxes, fees and fines, interest on loans given to states and dividend
by public sector enterprises. Government spends mainly on
(i) securing and providing goods and services to citizens
(ii) on law and order
(iii) internal security, defence, staff salaries, etc.
In India there is constitutional requirement to present budget before Parliament
for the ensuing financial year. The financial (fiscal) year starts on April 1 and ends
on March 31 of next year.
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Budgets are of three types: Balanced, Surplus and Deficit budgets—depending

upon whether the estimated receipts are equal to, less than or more than
estimated receipts, respectively its three types are explained hereunder.
a. Balanced budget: A government budget is said to be a balanced budget in
which
government estimated receipts are equal to government estimated
expenditure.
Features of balanced budget:
 It ensures financial stability
 It avoids wasteful expenditure.
 Process of economic growth is hindered
 Scope of undertaking welfare activities is restricted.
b. Surplus Budget: When government receipts are more than government
expenditure in the budget, the budget is called a surplus budget. In other
words, a surplus budget implies a situation where in government revenue is
in excess of government expenditure.
Features of surplus budget:
 In times of severe inflation, which arises due to excess demand, a surplus
budget is the appropriate budget as the government is taking away more
money than what it is pumping in the economic system.
 In situation of deflation and recession, surplus budget will trigger
economic crisis.
c. Deficit Budget: When government estimated expenditure exceeds
government receipts in the budget, the budget is said to be a deficit budget.
In other words, in a deficit budget, government estimated revenue is less
than estimated expenditure. These days’ popular democratic governments
adopt mostly deficit budget to meet the growing needs of the people. It may
be mentioned that British economist, John Maynard Keynes had advocated
a deficit budget to remedy the situation of unemployment and recession.
Features of deficit budget:
 It accelerates economic growth
 It enables to undertake welfare programmes of the people
 It is a cure for deflation as it checks downward movement of prices.
 It encourages unnecessary and wasteful expenditure by the
government,
 It may lead to financial and political instability,
 It shakes the confidence of foreign investors
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7.3. Types of Fiscal Policy:

Fiscal policy is the use of government spending and tax policy to influence the path
of the economy over time. There are two types of policies for stabilizing country from
different economic situations.
A. The Expansionary Fiscal Policy
B. The Contractionary Fiscal Policy
A. The Expansionary Fiscal Policy
Expansionary fiscal policy increases the level of aggregate demand, through
either increases in government spending or reductions in taxes. The crucial
objective of this policy is to increase the GDP growth rate of the economy and
generating more employment opportunities. Expansionary policy can do this by:
 Increasing consumption by raising disposable income through cuts in
personal income taxes or payroll taxes;
 Increasing investments by raising after-tax profits through cuts in business
taxes; and
 Increasing government purchases through increased spending on final
goods and services and raising grants to state and local governments to
increase their expenditures on final goods and services.
B. The Contractionary Fiscal policy
Contractionary fiscal policy decreases the level of aggregate demand, through
either decreases in government spending or increases in taxes. The main
purpose of this policy is to control the inflationary situation of the economy. This
policy can be effective by executing the following mechanism:
 Decreasing consumption by declining disposable income through increase in
personal income taxes or payroll taxes
 Declining investments by reducing after-tax profits through increases in
business taxes; and reducing government purchases through declining
spending on final goods and services and reducing grants to state and local
governments to decline their expenditures on final goods and services.
 Reducing expenditures on welfare activities and transfer payments.
7.4. The optimality of Fiscal policy in terms of Laffer curve

The Laffer Curve states that if tax rates are increased above a certain level, then total
tax revenues can actually fall because higher tax rates discourage people from
working. Equally, the Laffer Curve states that cutting taxes could, in theory, lead to
higher tax revenues.
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 It starts from the premise that if tax rates are 0% – then the government gets
zero revenue.
 If tax rates are 100% – then the government would also get zero revenue –
because there is no point in working.
 If tax rates are very high, and then they are cut, it can create an incentive for
business to expand and people to work longer. This boost to economic growth
will lead to higher tax revenues – higher income tax, corporation tax and GST.
 The maximum revenue earned by government is Rmax, and tax rate is X%.
 After X % tax rate, tax revenue of the government will decline due to higher
burden of tax.
As the impact of Laffer is long-term, which Laffer describes as the "economic" effect.
It works in the opposite direction. Lower tax rates put money into the hands of
taxpayers, who then spend it. It creates more business activity to meet consumer
demand. For this, companies hire more workers, who then spend their additional
income. This boost to economic growth generates a larger tax base. It eventually
replaces any revenue lost from the tax cut. The following transmission channel gives
a clear idea about the implication of Laffer Curve:
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Lower tax Higher tax

rate rate
More incentive to work Less incentive to work and

and invest invest
Less disposable
More disposable
income
income
Less consumption
More consumption spending
spending
Less tax revenue

More tax revenue
(Long term decline in tax
Long term increase in tax revenue
revenue
> Immediate revenue loss
Fig. 7.B: Relationship between Tax Rate and the collection of Tax Revenue
Therefore, in accordance with Laffer curve, it can be concluded that higher tax rate
may be fruitful for short term increase in public revenue but in long run it makes a
revenue loss due to less incentive for business and individual.
Fiscal Deficits:
Fiscal Deficit refers to the financial situation wherein the government’s total budget
for public expenditures exceeds the total receipts excluding borrowings made during
the fiscal year. A deficit is usually financed through borrowing from either the central
bank of the country or raising money from capital markets by issuing different
instruments like treasury bills and bonds.
7.5. India’s Fiscal Policy architecture:

 The Indian Constitution provides the overarching framework for the country’s
fiscal policy. India has a federal form of government with taxing powers and
spending responsibilities being divided between the centre and the state
governments according to the Constitution. There is also a third tier of
government at the local level.
 The central government is accountable for the whole country, i.e. national
highways, shipping, airways, national defense, foreign policy, railways, post and
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telegraphs, banking and foreign trading.

Whereas, the state government is concerned with state related issues such as
law and order, agriculture, fisheries, water supply and irrigation, and public
health. There are certain other profiles which are the responsibilities of both
state as well as central government. These are forests, economic and social
planning, education, trade unions and industrial disputes, price control and
electricity.
 The recent changes in the institutional and fiscal architecture of the country
following the constitution of NITI Aayog and release of report of the Fourteenth
Finance Commission, have implications for public financing of a range of social
sector as well as environment related government interventions in the country.
Constitutionally, both Union and the State Governments are responsible for
delivering on subjects falling in concurrent list and most of the subjects
pertaining to Climate Change interventions such as promotion of clean energy
resources, adaptation strategies in agriculture and other developmental sector,
are part of concurrent list.
 Taxes are the main source of government revenues. Direct taxes are so named
since they are charged upon and collected directly from the person or
organization that ultimately pays the tax (in a legal sense). Taxes on personal and
corporate incomes, personal wealth and professions are direct taxes. In India the
main direct taxes at the central level are the personal and corporate income tax.
Both are till date levied through the same piece of legislation, the Income Tax
Act of 1961.
 Indirect taxes are charged and collected from persons other than those who
finally end up paying the tax (again in a legal sense). For instance, a tax on sale
of goods is collected by the seller from the buyer. The legal responsibility of
paying the tax to government lies with the seller, but the tax is paid by the buyer.
GST is one indirect tax for the whole nation, which will make India one unified
common market. Keeping in mind the federal structure of India, there are two
components of GST – Central GST (CGST) and State GST (SGST). Both Centre and
States will simultaneously levy GST across the value chain. Tax will be levied on
every supply of goods and services. Centre would levy and collect Central Goods
and Services Tax (CGST), and States would levy and collect the State Goods and
Services Tax (SGST) on all transactions within a State. The input tax credit of CGST
would be available for discharging the CGST liability on the output at each stage.
Similarly, the credit of SGST paid on inputs would be allowed for paying the SGST
on output.
Tax credit is an amount that offsets the overall tax liability of a person. It is
basically the sum that can be subtracted from the total payable tax by an
individual.
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Fiscal policy trend in India:

 The initial years of India’s planned development strategy were characterized by
a conservative fiscal policy whereby deficits were kept under control.
 The tax system was geared to transfer resources from the private sector to fund
the large public sector driven industrialization process and also cover social
welfare schemes. However, growth was anemic and the system was prone to
inefficiencies.
 In the 1980s some attempts were made to reform particular sectors. But the
public debt increased, as did the fiscal deficit.
 India’s balance of payments crisis of 1991 led to economic liberalization. The
reform of the tax system commenced. The fiscal deficit was brought under
control.
 When the deficit and debt situation again threatened to go out of control in the
early 2000s, fiscal discipline legalizations were instituted. The deficit was
brought under control and by 2007-08 a benign macro-fiscal situation with high
growth and moderate inflation prevailed.
 During the global financial crisis fiscal policy responded with counter-cyclical
measures including tax cuts and increases in expenditures. The post-crisis
recovery of the Indian economy is witnessing a correction of the fiscal policy path
towards a regime of prudence.
 Recent tax reforms by the implementation of GST would brought a transparent
and sound fiscal system which will increase the revenue collection in the long
run.
7.6.1. Advantages of Fiscal Policy of India:
 Capital Formation: Fiscal policy of the country has been playing an
important role in raising the rate of capital formation in the country both
in its public and private sectors. The gross domestic capital formation as
per cent of GDP in India increased from 8.4 per cent in 1950- 51 to 19.9
per cent in 1980-81 and then to 39.1 per cent in 2007-08 and 31 percent
in 2016-
17. Therefore, it has created a favourable impact on the public and
private sector investment of the country.
 Incentives to Savings: The fiscal policy of the country has been providing
various incentives to raise the savings rate (a savings rate is the amount
of money, expressed as a percentage or ratio, that a person deducts
from his disposable personal income) both in household and corporate
sector through various budgetary policy changes, viz., tax exemption, tax
concession etc. The saving rate increased from a mere 8.6 per cent in
1950-51 to 37.7 per cent in 2007-08 and 30 percent in 2017-18.
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 Reduction of Inequality: Fiscal policy of the country has been making

constant endeavour to reduce the inequality in the distribution of
income and wealth. Progressive taxes on income and wealth tax
exemption, subsidies, grant etc. are making a consolidated effort to
reduce such inequality. Moreover, the fiscal policy is also trying to
reduce the regional disparities through its various budgetary policies.
 Export Promotion: The Fiscal policy of the Government has been making
constant endeavour to promote export through its various budgetary
policy in the form of concessions, subsidies etc. As a result, the export
to GDP ratio has been increased from 4.51 % in 1960 to 25.43% in 2013
and 18.87% in 2017-18.
1. Integrated Rural Development Programme (IRDP)
2. Jawahar Rozgar Yojana (JRY)
3. Prime Ministers Rozgar Yojana (PMRY)
4. Swarna Jayanti Shahari Rozgar Yojana (SJSRY)
5. National Rural Employment Guarantee Act (NREGA)
 Alleviation of Poverty and Unemployment: Another important merit of

Indian fiscal policy is that it is making constant effort to alleviate poverty
and unemployment problem through its various poverty eradication and
employment generation programmes, like, IRDP, JRY, PMRY, SJSRY,
NREGA etc.
7.6.2. Shortcomings of Fiscal Policy in India:
Fiscal policy of the country has failed to attain stability on various fronts
which is described below.
7.6.2.1. Defective Tax Structure: Fiscal policy has also failed to provide a
suitable tax structure for the country. Tax structure has failed to raise
the productivity of direct taxes and the country has been relying much
on indirect taxes. Therefore, the tax structure has become
burdensome to the poor.
7.6.2.2. Inflation: Fiscal policy of the country has failed to contain the
inflationary rise in price level. Increasing volume of public expenditure
on non-developmental heads has resulted in demand- pull inflation.
Higher rate of indirect taxation has also resulted in cost-push inflation.
Moreover, the direct taxes have failed to check the growth of black
money which is again aggravating the inflationary spiral (described in
chapter 5, Inflation) in the level of prices.
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7.6.2.3. Negative Return of the Public Sector: The negative return on capital
invested in the public sector units has become a serious problem for
the Government of India. In-spite of having a huge total investment to
the extent of Rs 4,21,089 crore in 2007 on PSUs the return on
investment has remained mostly negative or lower. In order to
maintain those PSUs, the Government has to keep huge amount of
budgetary provisions, thereby creating a huge drainage of scarce
resources of the country.
7.6.2.4. Growing Inequality: Fiscal policy of the country has failed to contain the
growing inequality in the distribution of income and wealth throughout
the country. Growing trend of tax evasion has made the tax machinery
ineffective for the purpose. Growing reliance on indirect taxes has made
the tax structure regressive.
This chapter comprehends about the relevance of fiscal policy and its effectiveness on
economy in different phases of economic cycles. Next chapter will be explaining about the
importance of public finance and its positive as well as negative impact on economy in long
run.
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Chapter 8: Business Policy Managerial Economics
CHAPTER 8
BUSINESS CYCLE
LO1: understand the concept of Business cycle
LO2: know the causes of Business cycle
LO3: discuss the phases of Business cycle
LO4: know the measures to control Business cycle
8.1. Introduction
The business cycle is the periodic but irregular up-and-down movement in economic
activity, measured by fluctuations in real gross domestic product (GDP) and other
macroeconomic variables. A business cycle is typically characterized by four phases—
recession, recovery, growth, and decline—that repeat themselves over time.
Economists note, however, that complete business cycles vary in length. The duration
of business cycles can be anywhere from about two to twelve years, with most cycles
averaging six years in length. Some business analysts use the business cycle model
and terminology to study and explain fluctuations in business inventory and other
individual elements of corporate operations. But the term "business cycle" is still
primarily associated with larger (industry-wide, regional, national, or even
international) business trends.
8.1.1. Stages of a Business Cycle
PEAK PEAK
PROSPERITY RECESSION
RECOVERY DEPRESSION
Trough
Four Phases of Business Cycle
Figure 8. A - The business cycle starts from a trough (lower point) and passes through a
recovery phase followed by a period of expansion (upper turning point) and prosperity. After
the peak point is reached there is a declining phase of recession followed by a depression.
Again the business cycle continues similarly with ups and downs.
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Managerial Economics Chapter 8: Business Policy
8.2. Explanation of Four Phases of Business Cycle

The four phases of a business cycle are briefly explained as follows: -
1. Prosperity Phase
When there is an expansion of output, income, employment, prices and profits,
there is also a rise in the standard of living. This period is termed as Prosperity
phase.
The features of prosperity are:-
 High level of output and trade.
 High level of effective demand.
 High level of income and employment.
 Rising interest rates.
 Inflation.
 Large expansion of bank credit.
 Overall business optimism.
A high level of MEC (Marginal efficiency of capital) and investment:
Due to full employment of resources, the level of production is Maximum and
there is a rise in GNP (Gross National Product). Due to a high level of economic
activity, it causes a rise in prices and profits. There is an upswing in the economic
activity and economy reaches its Peak. This is also called as a Boom Period.
2. Recession Phase
The turning point from prosperity to depression is termed as Recession Phase.
During a recession period, the economic activities slow down. When demand
starts falling, the overproduction and future investment plans are also given up.
There is a steady decline in the output, income, employment, prices and profits.
The businessmen lose confidence and become pessimistic (Negative). It reduces
investment. The banks and the people try to get greater liquidity, so credit also
contracts. Expansion of business stops, stock market falls. Orders are cancelled
and people start losing their jobs. The increase in unemployment causes a sharp
decline in income and aggregate demand. Generally, recession lasts for a short
period.
3. Depression Phase
When there is a continuous decrease of output, income, employment, prices
and profits, there is a fall in the standard of living and depression sets in.
The features of depression are:-
 Fall in volume of output and trade.
 Fall in income and rise in unemployment.
 Decline in consumption and demand.
 Fall in interest rate.
 Deflation.
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 Contraction of bank credit.

 Overall business pessimism.
 Fall in MEC (Marginal efficiency of capital) and investment.
In depression, there is under-utilization of resources and fall in GNP (Gross
National Product). The aggregate economic activity is at the lowest, causing a
decline in prices and profits until the economy reaches its Trough (low point).
4. Recovery Phase
The turning point from depression to expansion is termed as Recovery or
Revival Phase.
During the period of revival or recovery, there are expansions and rise in
economic activities. When demand starts rising, production increases and this
causes an increase in investment. There is a steady rise in output, income,
employment, prices and profits. The businessmen gain confidence and become
optimistic (Positive). This increases investments. The stimulation of investment
brings about the revival or recovery of the economy. The banks expand credit,
business expansion takes place and stock markets are activated. There is an
increase in employment, production, income and aggregate demand, prices and
profits start rising, and business expands. Revival slowly emerges into
prosperity, and the business cycle is repeated.
Thus we see that, during the expansionary or prosperity phase, there is inflation and
during the contraction or depression phase, there is a deflation.
8.3. Factors that Shape Business Cycles

For centuries, economists in both the United States and Europe regarded economic
downturns as "diseases" that had to be treated; it followed, then, that economies
characterized by growth and affluence were regarded as "healthy" economies. By the
end of the 19th century, however, many economists had begun to recognize that
economies were cyclical by their very nature, and studies increasingly turned to
determining which factors were primarily responsible for shaping the direction and
disposition of national, regional, and industry-specific economies. Today, economists,
corporate executives, and business owners cite several factors as particularly
important in shaping the complexion of business environments.
• Volatility of Investment Spending
Variations in investment spending are one of the important factors in business
cycles. Investment spending is considered the most volatile component of the
aggregate or total demand (it varies much more from year to year than the largest
component of the aggregate demand, the consumption spending), and empirical
studies by economists have revealed that the volatility of the investment
component is an important factor in explaining business cycles in the United
States. According to these studies, increases in investment spur a subsequent
increase in aggregate demand, leading to economic expansion. Decreases in
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investment have the opposite effect. Indeed, economists can point to several
points in American history in which the importance of investment spending was
made quite evident. The Great Depression, for instance, was caused by a collapse
in investment spending in the aftermath of the stock market crash of 1929.
Similarly, the prosperity of the late 1950s was attributed to a capital goods boom.
There are several reasons for the volatility that can often be seen in investment
spending. One generic reason is the pace at which investment accelerates in
response to upward trends in sales. This linkage, which is called the acceleration
principle by economists, can be briefly explained as follows. Suppose a firm is
operating at full capacity. When sales of its goods increase, output will have to be
increased by increasing plant capacity through further investment. As a result,
changes in sales result in magnified percentage changes in investment
expenditures. This accelerates the pace of economic expansion, which generates
greater income in the economy, leading to further increases in sales. Thus, once
the expansion starts, the pace of investment spending accelerates. In more
concrete terms, the response of the investment spending is related to the rate at
which sales are increasing. In general, if an increase in sales is expanding,
investment is spending rises, and if an increase in sales has peaked and is
beginning to slow, investment spending falls. Thus, the pace of investment
spending is influenced by changes in the rate of sales.
• Momentum
Many economists cite a certain "follow-the-leader" mentality in consumer
spending. In situations where consumer confidence is high and people adopt
more free-spending habits, other customers are deemed to be more likely to
increase their spending as well. Conversely, downturns in spending tend to be
imitated as well.
• Technological Innovations
Technological innovations can have an acute impact on business cycles. Indeed,
technological breakthroughs in communication, transportation, manufacturing,
and other operational areas can have a ripple effect throughout an industry or an
economy. Technological innovations may relate to production and use of a new
product or production of an existing product using a new process. The video
imaging and personal computer industries, for instance, have undergone
immense technological innovations in recent years, and the latter industry in
particular has had a pronounced impact on the business operations of countless
organizations. However, technological innovations—and consequent increases in
investment—take place at irregular intervals. Fluctuating investments, due to
variations in the pace of technological innovations, lead to business fluctuations
in the economy.
There are many reasons why the pace of technological innovation varies. Major
innovations do not occur every day. Nor do they take place at a constant rate.
Chance factors greatly influence the timing of major innovations, as well as the
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number of innovations in a particular year. Economists consider the variations in

technological innovation as random (with no systematic pattern). Thus,
irregularity in the pace of innovations in new products or processes becomes a
source of business fluctuations.
• Variations in Inventories
Variations in inventories—expansion and contraction in the level of inventories of
goods kept by businesses—also contribute to business cycles. Inventories are the
stocks of goods firms keep in hand to meet demand for their products. How do
variations in the level of inventories trigger changes in a business cycle? Usually,
during a business downturn, firms let their inventories decline. As inventories
dwindle, businesses eventually use down their inventories to the point where
they are short. This, in turn, starts an increase in inventory levels as companies
begin to produce more than is sold, leading to an economic expansion. This
expansion continues as long as the rate of increase in sales holds up and producers
continue to increase inventories at the preceding rate. However, as the rate of
increase in sales slows, firms begin to cut back on their inventory accumulation.
The subsequent reduction in inventory investment dampens the economic
expansion, and eventually causes an economic downturn. The process then
repeats itself all over again. It should be noted that while variations in inventory
levels impact overall rates of economic growth, the resulting business cycles are
not really long. The business cycles generated by fluctuations in inventories are
called minor or short business cycles. These periods, which usually last about two
to four years, are sometimes also called inventory cycles.
• Fluctuations in Government Spending
Variations in government spending are yet another source of business
fluctuations. This may appear to be an unlikely source, as the government is
widely considered to be a stabilizing force in the economy rather than a source of
economic fluctuations or instability. Nevertheless, government spending has
been a major destabilizing force on several occasions, especially during and after
wars. Government spending increased by an enormous amount during World War
II, leading to an economic expansion that continued for several years after the
war. Government spending also increased, though to a smaller extent compared
to World War II, during the Korean and Vietnam Wars. These also led to economic
expansions. However, government spending not only contributes to economic
expansions, but economic contractions as well. In fact, the recession of 1953—54
was caused by the reduction in government spending after the Korean War
ended. More recently, the end of the Cold War resulted in a reduction in defense
spending by the United States that had a pronounced impact on certain defense-
dependent industries and geographic regions.
• Politically Generated Business Cycles
Many economists have hypothesized that business cycles are the result of the
politically motivated use of macroeconomic policies (monetary and fiscal policies)
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that are designed to serve the interest of politicians running for re-election. The
theory of political business cycles is predicated on the belief that elected officials
(the president, members of Congress, governors, etc.) have a tendency to
engineer expansionary macroeconomic policies in order to aid their re-election
efforts.
• Monetary Policies
Variations in the nation's monetary policies, independent of changes induced by
political pressures, are an important influence in business cycles as well. Use of
fiscal policy—increased government spending and/or tax cuts—is the most
common way of boosting aggregate demand, causing an economic expansion. The
Central Bank, in the case of India, the Reserve Bank of India (RBI), has two
legislated goals—price stability and full employment. Its role in monetary policy
is a key to managing business cycles and has an important impact on consumer
and investor confidence as well.
• Fluctuations in Exports and Imports
The difference between exports and imports is the net foreign demand for goods
and services, also called net exports. Because net exports are a component of the
aggregate demand in the economy, variations in exports and imports can lead to
business fluctuations as well. There are many reasons for variations in exports and
imports over time. Growth in the gross domestic product of an economy is the
most important determinant of its demand for imported goods—as people's
incomes grow their appetite for additional goods and services, including goods
produced abroad, increases. The opposite holds when foreign economies are
growing—growth in incomes in foreign countries also leads to an increased
demand for imported goods by the residents of these countries. This, in turn,
causes U.S. exports to grow. Currency exchange rates can also have a dramatic
impact on international trade—and hence, domestic business cycles—as well.
8.4. Business Cycle Variants, Stagflation and the Jobless Recovery

Business cycles are difficult to anticipate accurately, in part because of the number of
variables involved in large economic systems. Nonetheless, the importance of tracking
and understanding business cycles has led to a great deal of study of the subject and
knowledge about the subject. It was as a result somewhat surprising when, in the
1970s, the nation found itself stuck in a period of seemingly contradictory economic
conditions, slow economic growth and rising inflation. The condition was named
stagflation and paralyzed the U.S. economy from the mid-1970s through the early
1980s.
Another somewhat unexpected business cycle phenomenon has occurred in the early
2000s. It is what has come to be known as the "jobless recovery." According to the
National Bureau of Economic Research's Business Cycle Dating Committee, in a late
2003 report, "the most recent economic peak occurred in March 2001, ending a
record-long expansion that began in 1991. The most recent trough occurred in
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November 2001, inaugurating an expansion." The problem with the expansion has
been that it has not included a rise in employment or real personal income, something
seen in all previous recoveries.
The reasons for the jobless recovery are not fully understood but are the cause of
much debate within the economic and political circles. Within this debate there are
four leading explanations that analysts have given for the jobless recovery. According
to a study published in Economic Perspectives in the summer of 2004, these four
explanations are:
 An imbalance in labor available by sector.
 The emergence of just-in-time hiring practices.
 The rising cost of health care benefits.
 Rapidly increasing productivity not being off-set by aggregate demand.
 Only time and further analysis will show which of these factors, or which
combination of factors explains the advent of a jobless recovery. Neil Shister,
editorial director of the World Trade summarizes a discussion of the jobless
recovery this way, "The culprit is ourselves. We have become dramatically more
productive." This assessment suggests that much more will need to be
understood about modern business cycles before we can again anticipate them
and plan for their effects on the economy generally.
8.5. Keys to Successful Business Cycle Management

Small business owners can take several steps to help ensure that their establishments
weather business cycles with a minimum of uncertainty and damage. The concept of
cycle management is earning adherents who agree that strategies that work at the
bottom of a cycle need to be adopted as much as those which work at the top of a
cycle. While there is no definitive formula for every company, the approaches
generally emphasize a long-term view focused on a company's core strengths and
stressing the need to plan with greater discretion at all times. Essentially, efforts are
made to adjust a company's operations in such a manner that it maintains an even
keel through the ups and downs of a business cycle.
 Specific tips for managing business cycle downturns include the following:
 Flexibility—Having a flexible business plan allows for development times that
span the entire cycle and includes various recession-resistant funding structures.
 Long-term Planning—Consultants encourage small businesses to adopt a
moderate stance in their long-range forecasting.
 Attention to Customers—This can be an especially important factor for businesses
seeking to emerge from an economic downturn. Maintaining close relations and
open communication with customers is a tough discipline to maintain in good
times, but it is especially crucial coming out of bad times. Customers are the best
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gauges of when a company is likely to begin recovering from an economic

slowdown.
 Objectivity—Small business owners need to maintain a high level of objectivity
when riding business cycles. Operational decisions based on hopes and desires
rather than a sober examination of the facts can devastate a business, especially
in economic down periods.
 Study—Timing any action for an upturn is tricky. The consequences of getting the
timing wrong, of being early or late, can be serious. How, then, does a company
strike the right balance between being early or late? Listening to economists,
politicians, and media to get a sense of what is happening is useful. The best route,
however, is to avoid trying to predict the upturn. Instead, listen to your customers
and know your own response-time requirements.
8.6. Theories of Business Cycle

Macroeconomics emphasizes the interrelatedness of the various sectors of the
economy. Hence, disturbances in one part of the economy can result in symptoms in
other parts that seem far removed. Two central questions of macroeconomics are
where does disturbance originates in the system, and where the forces prevent the
system from quick and smooth readjustment when it is disturbed.
Many economists see the process of money creation and destruction as a source of
past macroeconomic disturbances. This group of readings will add the short-run story
that many economists who believed the quantity theory of money told (and tell). The
readings also introduce another story that many economists tell, that economic
disturbances can originate not in the supply and demand for money, but in goods
markets.
The central idea of business-cycle literature, that the economy has regular and
periodic waves—a cycle—lasting for several years, has few adherents today. Perhaps
such cycles never existed, or perhaps they once did but no longer do because the
government now plays a large and active role in the economy. However, the business-
cycle approach remains useful because it is an easy way to introduce a number of
macroeconomic topics, including the adjustment process that remains central in
macroeconomics. It also provides a transition from our examination of monetary
theories to an introduction to Keynesian economics, a very different way of viewing
the macroeconomy.
8.6.1. Economic Stabilization Policies
A macroeconomic strategy enacted by governments and central banks to
keep economic growth stable, along with price levels and unemployment.
Ongoing stabilization policy includes monitoring the business cycle and
adjusting benchmark interest rates to control aggregate demand in the
economy. The goal is to avoid erratic changes in total output, as measured by
Gross Domestic Product (GDP) and large changes in inflation; stabilization of
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these factors generally leads to moderate changes in the employment rate as

well.
Stabilization policies are also used to help an economy recover from a specific
economic crisis or shock, such as sovereign debt defaults or a stock market
crash. In these instances, stabilization policies may come from governments
directly through overt legislation, securities reforms, or from international
banking groups, such as the World Bank.
As economies become more complex and advanced, top economists believe
that maintaining a steady price level and pace of growth is the key to long-
term prosperity. When any of the aforementioned variables becomes too
volatile, there are unforeseen consequences and effects to the broad
economy that keep markets from functioning at their optimum level of
efficiency. Most modern economies employ stabilization policies, with much
of the work being done by central banking authorities.
During periods of high or rising unemployment associated with a business-
cycle contraction, the appropriate action is to stimulate the economy through
expansionary policies. During periods of high or rising inflation associated
with a business-cycle expansion, the appropriate action is to dampen the
economy through contractionary policies.
8.6.2. Fiscal and Monetary
The two most frequently used stabilization policies are fiscal policy and
monetary policy.
Fiscal Policy:
This policy makes use of government spending and/or taxes, the two
components of the government's "fiscal" budget. When government
increases or decreases spending, especially by changing the quantity of gross
domestic product purchased, then aggregate, employment, and national
income are also affected. Government can change the amount of taxes
collected from the public, as well, which then affects the amount of income
available to purchase gross domestic product. This also triggers changes in
aggregate production, employment, and national income.
Monetary Policy:
This policy involves the total amount of money in circulation throughout the
economy, as well as interest rates in financials. By changing the amount of
money in circulation, the public has more or less of an ability to purchase
gross domestic product, which then triggers changes in overall economic
activity. Money supply changes also invariably cause changes in interest rates,
which subsequently affect the willingness and ability to borrow the funds
used for expenditures.
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Expansionary and Contractionary

Stabilization policies can be either expansionary or contractionary, depending
on whether the most pressing problem is excessive unemployment or
excessive inflation.
Expansionary Policy:
This policy is designed to stimulate the economy and to reduce
unemployment by countering or preventing a business-cycle contraction.
Expansionary fiscal policy is an increase in government spending and/or a
decrease in taxes. Expansionary monetary policy is an increase in the money
supply and/or a decrease in the interest rate.
Contractionary Policy:
This policy is designed to dampen the economy and to reduce inflation by
countering or preventing the inflationary excesses of a business-cycle
expansion. Contractionary fiscal policy is a decrease in government spending
and/or an increase in taxes. Contractionary monetary policy is a decrease in
the money supply and/or an increase in the interest rate.
In this chapter we have an overview of Business cycle and we discussed the features and
causes of business cycle. We have also comprehended the requirement policies to control the
adverse impact of business cycle from time to time.
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Chapter 10: Demand and its Analysis Managerial Economics
CHAPTER 9
FOREIGN EXCHANGE MARKET
AND INTERNATIONAL TRADE

LO1: understand the concept of international trade
LO2: describe the significance of foreign exchange market in international trade
LO3: determine of exchange rate in foreign exchange market
LO4: describe an overview of the types of exchange rate
LO5: examine the impact of balance of payment on exchange rate
9.1 Concept of International Trade:

International trade between different countries is an important factor in raising living
standards, providing employment and enabling consumers to enjoy a greater variety
of goods. International trade has occurred since the earliest civilizations began
trading, but in recent years’ international trade has become increasingly important
with a larger share of GDP devoted to exports and imports.
The concept of international trade is based on the following three criterions.
1) Gains from trade – The first important issue is about the gains from trade. Do
countries gain from international trade? Where do the gains come from, and how
are they divided among the trading countries?
2) Structure of trade – The second relevant issue is the structure or direction or
pattern of international trade. In other words, which goods are exported and
which are imported by each trading country? What are the fundamental laws that
govern the international allocation of resources and the flow of trade?
3) Terms of trade – The third relevant issue is the terms of trade. In other words, at
what prices are the exported and imported goods exchanged? Countries engage
in international trade for two basic reasons, each of which contributes to their
gains from trade. First, countries trade because they are different from each
other. Nations, like individuals, can benefit from their differences by reaching an
arrangement in which each does the things it does relatively well. Second,
countries trade to achieve economies of scale in production. In real world,
patterns of international trade reflect the interaction of both these motives.
4) Absolute advantage describes a situation in which an individual, business or
country can produce more of a good or service than any other producer with the
same quantity of resources.
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Managerial Economics Chapter 10: Demand and its Analysis
The United States, for example, has a skilled workforce, abundant natural resources,
and advanced technology. Because of these three things, the US can produce many
goods more efficiently than potential trading partners, giving it an absolute advantage
in the production of goods from corn to computers, to maple syrup and cars. This does
not, however, mean that the US does not benefit from trading for these goods with
other nations.
Comparative advantage describes a situation in which an individual, business or
country can produce a good or service at a lower opportunity cost than another
producer.
For example, because it has an abundance of maple trees, Canada can produce maple
syrup at a very low opportunity cost in relation to avocados, a fruit for which its
climate is less suited. Mexico, on the other hand, with its ample sunshine and warm
climate. can grow avocados at a much lower opportunity cost in terms of maple syrup
given up than Canada.
9.2 The importance of payment system in international trade:

We live in a global economy. Buying and selling goods and services internationally is
taken for granted. Imports are goods and services we buy from abroad for which a
payment is made to a foreign business. For example, buying a German car involves a
car moving from Germany to the India, with the payment for the car moving from the
India to Germany. Exports refer to goods and services sold abroad by an Indian
business. If an Indian exporter sells Darjeeling tea to UK it will receive a payment.
Imports mean money goes out of the country to pay for the item whereas exports
mean money comes into the country in payment. The direction of the payment is
important in identifying imports and exports. For example, if a Management College
visits on a business studies trip to UK, is this an import for the India or an export? The
answer is that it represents an import because the college is buying the tourist
services provided by the UK and payments are made to the UK.
So it is obvious to know about the payment system to exchange goods and services
within the countries as every country has their own currency for exchange. Therefore,
it is required to understand the role of exchange rates in international trade and how
exchange rates are determined. At first it is important to learn how exchange rates
allow us to compare the prices of different countries ‘goods and services. Then we
should learn the international currency market in which currencies are traded and
show how equilibrium exchange rates are determined in that market.
9.2.1 Foreign Exchange Market:
The foreign exchange market is the generic term for the worldwide
institutions that exist to exchange or trade the currencies of different
countries. It is loosely organized in two tiers: the retail tier and the wholesale
tier.
 The retail tier is where the small agents buy and sell foreign exchange.
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 The wholesale tier is an informal, geographically dispersed, network of

about 2,000 banks and currency brokerage firms that deal with each other
and with large corporations.
Foreign exchange trading begins each day in Sydney, and moves around the
world as the business day begins in each financial center, first to Tokyo,
London and New York. Computer screens, around the world, continuously
show exchange rate prices. A trader enters a price for the USD/CHF (The rate
at which 1 Swiss Franc will be converted to US Dollar) exchange rate on her
machine, and can then receive messages from anywhere in the world from
people willing to meet that price. It does not matter to her whether the
counterparties are sitting in London,
Singapore, or anywhere. The foreign
exchange market has no physical venue USD = United States Dollar
where traders meet to deal in currencies. EUR = Euro
Currency markets are the largest of all JPY = Japanese Yen
financial markets in the world. GBP = Great Britain Pound
In April 2016, the major markets were
London, with 36.97% of the daily volume,
New York (19.5%), Singapore (7.9%), Hong Kong (6.7%), Tokyo (6.1%), and
Zurich (2.4%). Frankfurt, Paris, and Amsterdam are small players. The top
traded currency was the USD, which was involved in 88% of transactions. It
was followed by the EUR (31%), the JPY (22%), and the GBP (13%). The
USD/EUR was by far the most traded currency pair in 2016 and captured 23%
of global turnover, followed by USD/JPY with 18% and USD/GBP with 9%.
Trading in local currencies in emerging markets captured about 21% of foreign
exchange activity in 2016.
9.3 Exchange rates and International transactions

Exchange rates play a central role in international trade because they allow us to
compare the prices of goods and services produced in different countries. A consumer
in India deciding to buy an imported American car must compare dollar price
converted to Indian rupees. To make this comparison, he or she must know the
relative price of dollars and INR.
Households and firms use exchange rates to translate foreign price into domestic
currency terms. Once the money price of domestically produced goods and imports
have been expressed in terms of the same currency, households and firms can
compute the relative prices that affect international trade flows.
9.3.1 Determination of Exchange rate in Foreign exchange market
An exchange rate is the amount of one currency that has to be given up to
acquire another currency. An exchange rate of $1 = Rs 71 means that an
individual or business has to give up Rs 71 to get 1 dollar. Exchange rates
change every day. When the exchange rate changes this can affect different
stakeholders in different ways depending on the direction of the change. The
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terms ‘strengthened’ and ‘weakened’ are used when exchange rates change
and it is important to understand what is meant when an exchange rate has
strengthened or weakened.
Strengthening exchange rate (Appreciation)
Exchange rates can be tricky to understand, and come with their own
terminology. If the rupees increase in value, it is said to strengthen. This
means that a rupee will buy (be exchanged for) more of a foreign currency.
Look at the example below.
Suppose in April, $ 1 = Rs. 71, therefore, Rs 1 = $ 1/71 and in June, the
exchange rate is $1 = Rs 65, therefore Rs 1 = $ 1/65 The value of the rupee
has risen (strengthened) because Rs. 1 can now be exchanged for $ 1/65
rather than $ 1/71 (1/65 > 1/71). It is stronger in the sense that it will buy
more of a foreign currency.
Weakening exchange rate (Depreciation)
The reverse is the case when the rupee falls in value; when this happens it is
said to weaken.
Suppose the rupee has weakened against the dollars. In June $1 could be
exchanged for Rs. 67. And in November $ 1 = Rs. 72. Therefore now one rupee
can buy less dollars compare to June.
Like any other market, exchange rate is determined by demand for and supply
of foreign exchange. Let us discuss the factors that influence the demand and
supply.
9.3.2 The Demand for Foreign Exchange
Generally, the demand for foreign currency arises from the traders who have
to make payments for imported goods. If a person wants to invest his capital
in foreign countries, he requires the currency of that country. The functional
relationship between the quantity of foreign exchange demanded
and the rate of foreign exchange is expressed in the demand schedule for
foreign exchange (which shows the different rates of foreign exchange). It
is understood from the demand schedule that the relationship, between
the quantities of the foreign exchange demanded that the rate of foreign
exchange is inverse in such a way that a fall in the rates of exchange is
followed and inverse in the quantity of the foreign exchange demanded. The
main reason for this relationship is that, a higher rate of foreign exchange
(stronger foreign currency or depreciation of domestic currency) by rendering
imports more expensive reduces the demand for them and consequently,
also reduces the amount demanded of foreign exchange which is required to
pay for imports. On the other hand, a lower rate of exchange (weaker foreign
currency or appreciation of appreciation of domestic currency) by making the
imports cheaper causes the demand for them to rise and consequently
increases the demand for foreign exchange needed to pay for higher imports.
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9.3.3 The Supply of Foreign Exchange

The need for and supply of foreign currency arises from the exporters who
have exported goods and services to foreign countries. The supply schedule
of foreign exchange shows the different quantities of foreign exchange, which
would be available at different rate of foreign exchange, in the
foreign exchange market. The sources of supply of foreign exchange depend
largely upon the decisions of foreigners. The total quantity of the different
goods and services, which a country can export and, therefore, the quantity
of foreign currencies which it can acquire depends upon the foreign
counterpart’s willing to import from a particular country.
Thus, we conclude that if the demand for a foreign currency increases, its rate
of exchange must go up, and if its supply exceeds its demand, the rate
must decline.
9.3.4 Are all businesses affected by changes in exchange rates?
Exchange rate play a crucial role for any business in the economy due to the
intense impact of globalization. There are direct and direct impact of
exchange rate changes.
Direct impact will happen in three cases:
 If the business buys any products from another country. The cost of those
products will change if the exchange rate changes.
 If the business sells any products to a foreign country, the sale price (and
therefore profits) will change if the exchange rate changes.
 If the business has borrowed money from, or lent money to, someone in
a foreign country. The amount to be repaid, and the interest amount, will
change if the interest rate changes.
There is also an indirect impact.
 Any business depends upon other businesses which might be affected by
exchange rates. For example, an Indian business which neither sells nor
buys nor borrows from another country. However, it uses trucks to move
its products around the country. If the foreign exchange rate changes, the
cost of the fuel those trucks use changes (because it is imported from
abroad) and that affects the costs of the business.
 Suppose a restaurant in India may not import or export anything, but a
weakening exchange rate of the rupee against other currencies will be
likely to mean that foreign tourism to the India increases. If there are
more tourists in India, then the restaurant may benefit from increased
business.
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9.4 Two concepts of Currency Rates

Currency is complicated and its value can be measured in several different ways. For
example, a currency can be measured in terms of other currencies, or it can be
measured in terms of the goods and services it can buy. An exchange rate between
two currencies is defined as the rate at which one currency will be exchanged for
another. However, that rate can be interpreted through different perspectives. Below
are descriptions of the two most common means of describing exchange rates.
Nominal Exchange Rate
A nominal value is an economic value expressed in monetary terms (that is, in units of
a currency). It is not influenced by the change of price or value of the goods and
services that currencies can buy. Therefore, changes in the nominal value of currency
over time can happen because of a change in the value of the currency or because of
the associated prices of the goods and services that the currency is used to buy.
When you go online to find the current exchange rate of a currency, it is generally
expressed in nominal terms. The nominal rate is set on the open market and is based
on how much of one currency another currency can buy.
For example, if the value of the Euro in terms of the dollar is 1.37, this means that the
nominal exchange rate between the Euro and the dollar is 1.37. If the value of INR in
terms of dollar is 71.38, this means the nominal exchange rate between INR and dollar
is 71.38.
Real Exchange Rate
The real exchange rate is the purchasing power of a currency relative to another at
current exchange rates and prices. It is defined as the ratio of the price level abroad
and the domestic price level, where the foreign price level is converted into domestic
currency units via the current nominal exchange rate. Formally, R= (E.P*)/P, where
the foreign price level is denoted as P* and the domestic price level as P and E is
defined as the number of units of the domestic currency that can purchase a unit of a
given foreign currency. A decrease in R is termed appreciation of the real exchange
rate, an increase is termed depreciation. The real exchange rate is the nominal rate
adjusted for differences in price levels.
Ex. Suppose Mc. Donald’s chicken burger price in India = Rs.105
Mc. Donald’s chicken burger price in USA = $ 1.29
E = Rs.71.38
Real exchange rate = (71. 38 * 1.29) / 105 = 0.87
A low (high) Real Exchange Rate implies that foreign goods are relatively cheap
(expensive) and domestic goods are relatively expensive (cheap).
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Purchasing Power Parity:

A measure of the differences in price levels is Purchasing Power Parity (PPP). The
concept of purchasing power
parity allows one to estimate
what the exchange rate
between two currencies would
have to be in order for the
exchange to be at par with the
purchasing power of the two
countries’ currencies. Using
the PPP rate for hypothetical
currency conversions, a given
amount of one currency has the same purchasing power whether used directly to
purchase a market basket of goods or used to convert at the PPP rate to the other
currency and then purchase the market basket using that currency.
In simpler form PPP states that the currency of two countries are in equilibrium when
the purchasing power in both the countries are same. To put in another way, the
expenditure incurred in purchasing an item in two different countries must be the
same.
Ex. The cost of Jeans in India is Rs. 2000. Taking the dollar rate at Rs. 70/ per dollar,
the same Jeans in the US should cost $ 28.57. If the costs are identical in both the
countries for the same commodity, it is termed as equilibrium in purchasing power
parity.
If all goods were freely tradable, and foreign and domestic residents purchased
identical baskets of goods, purchasing power parity (PPP) would hold for the exchange
rate and price levels of the two countries, and the real exchange rate would always
equal. However, since these assumptions are almost never met in the real world, the
real exchange rate will never equal 1
9.5 Types of Exchange rates:
FLOATING FIXED EXCHANGE

EXCHANGE RATES RATES
Completely Fixed against either the value of another

determined by market single currency to a basket of other currencies
forces or to another measure of value, such as gold.
Chart 9.A: Types of Exchange Rates
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One of the key economic decisions a nation must make is how it will value its currency
in comparison to other currencies. An exchange rate regime is how a nation manages
its currency in the foreign exchange market. An exchange rate regime is closely related
to that country’s monetary policy. There are two basic types of exchange regimes:
Floating exchange and Fixed exchange.
 The Floating Exchange Rate - A floating exchange rate, or fluctuating exchange
rate, is a type of exchange rate regime wherein a currency’s value is allowed to
fluctuate according to the foreign exchange market. A currency that uses a
floating exchange rate is known as a floating currency. The dollar is an example of
a floating currency. Many economists believe floating exchange rates are the best
possible exchange rate regime because these regimes automatically adjust to
economic circumstances. These regimes enable a country to dampen the impact
of shocks and foreign business cycles, and to preempt the possibility of having a
balance of payments crisis. However, they also engender unpredictability as the
result of their dynamism.
 The Fixed Exchange Rate - A fixed exchange rate system, or pegged exchange rate
system, is a currency system in which governments try to maintain a currency
value that is constant against a specific currency or good. In a fixed exchange-rate
system, a country’s government decides the worth of its currency in terms of
either a fixed weight of an asset, another currency, or a basket of other currencies.
The central bank of a country remains committed at all times to buy and sell its
currency at a fixed price. To ensure that a currency will maintain its “pegged”
value, the country’s central bank maintain reserves of foreign currencies and gold.
They can sell these reserves in order to intervene in the foreign exchange market
to make up excess demand or take up excess supply of the country’s currency.
The most famous fixed rate system is the Gold standard, where a unit of currency
is pegged to a specific measure of gold. Regimes also peg to other currencies.
These countries can either choose a single currency to peg to, or a “basket”
consisting of the currencies of the country’s major trading partners.
Table 8.A: List of countries with different exchange rate regimes:
Country Exchange rate regime

Japan Free-floating exchange rate
Korea Free-floating exchange rate since 1997
Hong Kong Currency Board Arrangement
Singapore Managed-float exchange rate
Thailand Free-floating exchange rate
India Managed-float exchange rate
China Managed-float exchange rate
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Free floating: Currency price is set by the forex market based on supply and demand
Managed floating: Exchange rates fluctuate from day to day, but central banks
attempt to influence their countries' exchange rates by buying and selling currencies
to maintain a certain range.
Currency Board Management: A currency board is a monetary authority which is
required to maintain a fixed exchange rate with a foreign currency.
9.5.1 Why do Floating exchange rates change?
The flexible exchange rates change frequently over time: over years, months,
weeks and even during a given day. The reasons can be related to supply and
demand. Economists often cite the following factors for changes in exchange
rates:
 Changes in preferences for foreign goods: For example, if Americans
want to buy more goods from India, they will demand more Indian rupee
(and supply more U.S. dollars in exchange for the rupee). The dollar/rupee
exchange rate would change and the Indian rupee would be worth more
dollars (and the dollar would be worth fewer Indian rupee).
 Changes in prices in different countries: For example, if Russia has high
inflation compared with the United States, Russian goods would become
more expensive compared with U.S. goods. Russians would demand more
U.S. dollars to buy cheaper U.S. goods (and supply more Russian rubles in
exchange for the dollars). The dollar/ruble exchange rate would change
and the dollar would be worth more rubles (and the ruble would be worth
fewer dollars).
 Changes in interest rates in different countries: For example, if you could
earn 10 % on a savings account in Europe and only 3 % on a savings
account in the United States, Americans would want to supply their
dollars and demand more euros in order to deposit their money in a
European bank. The dollar/euro exchange rate would change and the
euro would be worth more dollars (and the dollars would be worth fewer
euros).
 Changes in incomes in different countries: For example, if incomes in the
United States were increasing compared with those in Mexico, people in
the United States could afford to buy more Mexican goods and more U.S
goods as well. Demand for pesos would go up, and the supply of dollars
would increase in exchange for pesos. The dollar/peso exchange rate
would change and the dollar would be worth fewer pesos (and the peso
would be worth more dollars).
 Speculation: For example, if many people think the dollar will increase in
value compared with Indian rupee, they will buy (demand) dollars today
(and supply rupee) in hopes of selling the dollars back at higher prices
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later. The dollar/rupee exchange rate would change, and the dollar would
be worth more rupee (and the rupee would be worth fewer dollars).
9.5.2 What is the impact of FII on the foreign exchange rates?
To understand the implications of FII on the exchange rates we have to
understand how the value of one currency goes up (appreciates) or goes
down (depreciates) against the other currency. The simple way of
understanding is through Demand and Supply (explained in section 10.2). If
say US imports from India it is creating a demand for Rupee thus the Indian
rupee appreciates w.r.t the dollar. If India imports, then the dollar appreciates
w.r.t the Indian rupee.
Now considering FII’s for every dollar that they bring into the country, there
is a demand for rupee created and the RBI has to print and release the money
in the country. Since the FII’s are creating a demand for rupee, it appreciates
w.r.t the dollar. Thus if for e.g. if prior to the demand the exchange rate was
1 USD = Rs 70, it could become 1 USD = Rs 69 after they invest. Similarly, when
FII withdraw the capital from the markets, they need to earn back the green
buck (USD) so that leads to a demand for dollars the rupee depreciates. 1 USD
goes back to Rs. 70. Thus FII inflows make the currency of the country invested
in appreciate (e.g. FII investing in India may lead to Rupee appreciating w.r.t
several other currencies) and their selling and disinvestment may lead to
depreciation.
9.6 How does Balance of Payment important for international trade?

As we know that the purpose of international trade is maximizing wealth of nation by
increasing the volume of trade. The trade consists of exports and imports. The
difference between these two is called as Net exports. If the value of net exports
increases, then the national income also enhances.
Most of the exports and imports involve finance, i.e., receipts and payments in
currency. An account of all receipts and payments is termed as Balance of payments.
The Balance of Payments or BOP is a statement or record of all monetary and
economic transactions made between a country and the rest of the world within a
defined period (every quarter or year). These records include transactions made by
individuals, companies and the government. Keeping a record of these transactions
helps the country to monitor the flow of money and develop policies that would help
in building a strong economy.
A BOP surplus indicates that a country’s exports are more than its imports. A BOP
deficit, on the other hand, indicates that a country’s imports are more than exports.
Both scenarios have short-term and long-term effects on the country’s economy.
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9.6.1 The structure of Balance of Payment account

The balance of payment statement is vertically divided into many categories.
Broadly, the main divisions are: Trade account, current account, overall
balance and foreign reserves. Specific items of exports and imports enter into
each category and balance is drawn of each main account. Table below
explains the structure or components of a balance of payments statement.
Table 9.B: The structure of Balance of Payment account
Trade account: It is the difference between exports and imports of good,

usually referred as visible or tangible items. Trade account balance tells as
whether a country enjoys a surplus or deficit on that account. An industrial
country with its industrial products comprising consumer and capital goods
(whose price is high) always had an advantageous position. Developing
countries with its exports of primary goods (price is less) had most of the time
suffered from a deficit in their trade account.
Current account: Current account includes exports and imports of goods and
services, interests, profits and dividends received and paid and unilateral
receipts and payments (Nos 1,2,3 and 4 in the above table).
For rich countries, earnings in the form of interest, profits and dividends are
increasing as against most of the developing countries who make substantial
payments on this count. Many of the poor countries, specially least developed
countries receive large amount of money under unilateral receipts
(donations, grants, gifts).
A surplus on current account is always welcome but a deficit need not
necessarily a matter of worry. An excess import of goods and services for
productive investment purpose which will help in earning higher GDP in
future should not be discouraged.
Capital account: The transaction under this title involve direct investment in
terms of physical assets in foreign country, portfolio investment refers to
financial assets in foreign countries and other short term and long term
borrowings.
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Direct investment is undertaken mostly by multinationals in terms of physical

assets. Portfolio investment refers to the acquisition of financial assets in
foreign countries. Purchase of shares of a foreign company, bonds issued by
a foreign government are some examples.
Capital account also includes inflow and outflow of external assistance. To
cover up deficit in current account, countries resort to borrowing.
9.6.2 List of exported and imported goods in India
In recent years, India exported mostly: pearls, precious and semi-precious
stones and jewelry (16 percent of total shipments); mineral fuels, oils and
waxes and bituminous substances (12 percent); vehicles, parts and
accessories (5 percent); nuclear reactors, boilers, machinery and mechanical
appliances (5 percent); pharmaceutical products (5 percent); and organic
chemicals (4 percent). India’s main export partners are: United States (15
percent of the total exports), United Arab Emirates (11 percent), Hong Kong
(5 percent), China (4 percent), Singapore (4 percent) and United Kingdom (3
percent). This page provides the latest reported value for - India Exports - plus
previous releases, historical high and low, short-term forecast and long-term
prediction, economic calendar, survey consensus and news. India Exports -
actual data, historical chart and calendar of releases - was last updated on
January of 2019.
India main imports are: mineral fuels, oils and waxes and bituminous
substances (27 percent of total imports); pearls, precious and semi-precious
stones and jewelry (14 percent); electrical machinery and equipment (10
percent); nuclear reactors, boilers, machinery and mechanical appliances (8
percent); and organic chemicals (4 percent). India’s major import partners
are: China (16 percent of total imports), the United States (6 percent), United
Arab Emirates (6 percent), Saudi Arabia (5 percent) and Switzerland (5
percent). This page provides the latest reported value for - India Imports - plus
previous releases, historical high and low, short-term forecast and long-term
prediction, economic calendar, survey consensus and news. India Imports -
actual data, historical chart and calendar of releases - was last updated on
January of 2019.
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Chart 9.A: India’s volume of imports (USD million) from 2010 to 2018
Chart 9.B: India’s volume of exports (USD million) from 2010 to 2018
9.6.3 India’s foreign trade account for April 2018:

The foreign trade scenario of April 2018 in India has largely been witnessing a
positive growth as compared to April 2017, with both exports and Imports
experiencing visible increase. Talking in terms of exports which includes re-
exports of merchandise goods, a significant positive growth of 5.17% has been
witnessed. The exports in April 2018 increased to US $25.91 billion compared
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to US $24.64 billion in April 2017. Non-Petroleum and Non gems and jewelry
exports experienced a yearly increase of 11.73%.
Import value of merchandise goods also went through a similar phase of
increase in value, with the growth being 4.60% in dollar terms against that of
imports valued at US $37.88 billion in April 2017. There has been a sea change
in the level of imports of oil in April 2018, the growth being 41.5% higher than
oil imports of April 2017 valued at US $ 7.36 billion. Contrastingly, the non-oil
imports declined by 4.3% as compared to April 2017.
Few points can be noted from the above mentioned data:

 India is exporting more plastic and engineering products followed by cotton/
Fabric/handloom and chemicals.
 Although the products which are exporting to other countries has huge demand
potential still it is not basic necessities.
 The volume of exports depends upon the comparative advantage and elasticity of
demand for exports.
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 In other side major contributor of import bill is crude oil which is treated as basic
necessities. Therefore, import payment has an increasing trend over the years.
 India is importing capital goods(machinery) whose price is high and without these
production capacity of the economy will not be generated.
 From the above major exported and imported products, it can be said that our
country is always under pressure of deficit in trade account.
Chart 9.C: Balance of Trade (in USD million) from 2010 to 2018
India has been recording sustained trade deficits since 1980 mainly due to the strong
imports growth, particularly of mineral fuels, oils and waxes and bituminous
substances and pearls, precious and semi-precious stones and jewellery. From the
above chart it is shown that there is a downward trend in balance of trade from 2010
to 2018 (Trend line AA/).
With the available statistics and information related to India’s foreign trade, a
progress was witnessed in India’s foreign trade. There has mostly been a positive
growth in both imports and exports. Both the sectors, that is the service sector and
the merchandise sector, experienced a growth and at different levels. The exports and
imports in the service sector of March 2018 were compared to that of the previous
month and a positive growth was measured in that sphere as well.
This chapter examines the subject matter of International economics: the gains from trade,
the patterns of trade, exchange rate determination, exchange rate systems and Balance of
Payments. It is said that foreign trade helps to increase capital formation. The capacity to save
increases as real income rises through the more efficient resource allocation associated with
international trade. Foreign trade also provides stimulus for investment and thus it tends to
raise the rate of capital formation.
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CHAPTER 10
DEMAND and its ANALYSIS
Learning Objectives: In this chapter we will understand:

LO1: the concept of the demand
LO2: the concept of Law of Demand
LO3: Individual Demand Vis-à-vis Market Demand
LO4: Factors affecting demand for a product
LO5: The concept of Elasticity of Demand & its various types
LO6: Demand Forecasting & Its techniques
10.1. What is Demand?

Two words economists use most; one is Demand & the other is Supply. These are the
twin driving forces of the market economy. Demand is not just about measuring what
people want; for economists, it refers to the amount of a good or service that people
are both willing and able to buy.
Technically we can describe demand as,
Desire to Buy + Willingness to pay + Ability to pay
All three must be checked to identify and establish demand. For example: A poor
man’s desires to stay in a five-star hotel room and his willingness to pay rent for that
room is not ‘demand’, because he lacks the necessary purchasing power; so it is
merely his wishful thinking. Similarly, a miser’s desire for and his ability to pay for a
car is not ‘demand’, because he does not have the necessary willingness to pay for a
car.
The quantity demanded by an economic agent refers to the quantity that economic
agent is ready, willing, and able to buy.
It is worth noting that this definition of demand incorporates three important
concepts:
1 It involves three parameters – price, quantity and time.
2 It refers to quantities in the plural, therefore a whole relationship, not a single
quantity.
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3 It involves the ceteris paribus (other things being equal) assumption, which is a
very common one in making statements in economics.
10.1.1. Law of Demand:
The law of demand states that other factors being constant (ceteris paribus), price and
quantity demand of any good and service are inversely related to each other. When
the price of a product increases, the demand for the same product will fall.
This Law of Demand is standing on THREE conceptual pillars –
 Demand Function;
 Demand Schedule;
 Demand Curve.
Demand Function:
Demand function is an algebraic expression that shows the functional relationship
between the demand for a commodity and its various determinants affecting it. This
includes income and price along with other determining factors.
Here, the demand for the commodity is the dependent variable, while its
determinants are the independent variables.
The influence of various factors on the quantity demanded can be stated in the form
of a function. The demand function for a commodity can be written as follows.
DX = f (PX, PR, Y, T, EP, EY, N, TX, O)
Where DX = Demand for good X
PX = Price for good X
PR = Price of other related commodities
Y = Consumer’s income
T = Tastes and preferences
Ep = Expectations about future prices
EY = Expectations about future income
N = Number of consumers
TX = Tax rate
O = other factors influencing the demand
Demand Schedule
Price of Onion (Rs. Per Kg) Quantity sold (Kilograms per day)
15 500
30 400
50 320
75 280
90 240
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Table 10.A: Demand Schedule of Onion
We see that with a change in price, there is a corresponding change in quantity sold.
The data say that with the rise in price of onion per kg, there is a downward trend
shown in the quantity sold figures.
The features of Demand Schedule:
 A demand schedule is a discrete version of the demand curve, specifying demand
values for a number of different prices.
 It refers to a tabular representation of the relationship between price & quantity
demanded.
 It demonstrates the quantity of a product demanded by an individual or a group
of individuals at specified period & time.
 Thus, given the price level, it is easy to determine the expected quantity
demanded.
 It is used to highlight the law of demand.
 This demand schedule can be graphed as a continuous demand curve on a chart
having the Y-axis representing price and the X-axis representing quantity.
Then a wholesome definition of Demand Schedule could be written as:
“A table that represents the amount of some goods that buyers are willing and able
to purchase at various prices, assuming all determinants of demand other than the
price of the goods in question, such as income, tastes and preferences, the price of
substitute goods, and the price of complementary goods, remain the same.”
Demand curve:
The demand curve is a curve drawn with:
 The vertical axis is the price axis, measuring the price per unit of the commodity.
 The horizontal axis is the quantity axis, measuring the quantity of the good
demanded in total by all the economic actors chosen above.
Y D
P
PRICE
P1
D
O M M1 X
QUANTITY
Fig. 10 A: Individual Demand curve
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This curve slopes downwards. This important property is called the “law of downward
sloping demand”. The demand curve measures the relationship between the price of
a good and the amount of it demanded. Usually, as the price rises, fewer people are
willing and able to buy it; in other words, demand falls. When demand changes,
economists explain this in one of two ways. A movement along the demand curve
occurs when a price change alters the quantity demanded; but if the price were to go
back to where it was before, so would the amount demanded. A shift in the demand
curve occurs when the amount demanded would be different from what it was
previously at any chosen price, for example, if there is no change in the market price,
but demand rises or falls. The slope of the demand curve indicates the elasticity of
demand.
10.1.2. Determinants of Individual Demand:

Income of the individual consumer
Change in consumer’s level of income also influences their demand for
different commodities. Normally, the demand for certain goods increase with
the increasing level of income and vice versa.
Tastes and preferences

The taste and preferences of individuals also determine the demand made for
certain goods and services. Factors such as climate, fashion, advertisement,
innovation, etc. affect the taste and preference of the consumers.
Expectation of change in price in the future

If the price of the commodity is expected to rise in the future, the consumer
will be willing to purchase more of the commodity at the existing price.
However, if the future price is expected to fall, the demand for that
commodity decreases at present.
Size and composition of population

The market demand for a commodity increases with the increase in the size
and composition of the total population. For instance, with the increase in
total population size, there is an increase in the number of buyers. Likewise,
with an increase in the male composition of the population, the demand for
goods meant for male increases.
Season and weather

The market demand for a certain commodity is also affected by the current
weather conditions. For instance, the demand for cold beverages increase
during summer season.
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10.1.3. Factors Determining Demand

Controllable Uncontrollable
Income
Tastes
Price
Competitive factors
Government policy
Product Demographic factors
DEMAND
Climatic factors
Seasonal factors
Promotion
Macroeconomic factors
Institutional factors
Place Technological factors
Prices of substitutes and complements
Shifts of the Demand Curve
The shift of a demand curve takes place when there is a change in any non-
price determinant of demand, resulting in a new demand curve. Non-price
determinants of demand are those things that will cause demand to change
even if prices remain the same—in other words, the things whose changes
might cause a consumer to buy more or less of a good even if the good's own
price remained unchanged. Some of the more important factors are the prices
of related goods (both substitutes and complements), income, population,
and expectations. However, demand is the willingness and ability of a
consumer to purchase a good under the prevailing circumstances; so, any
circumstance that affects the consumer's willingness or ability to buy the
good or service in question can be a non-price determinant of demand. As an
example, weather could be a factor in the demand for umbrella in a rainy
winter in Kolkata.
Demand shifters
 Price of the product: Price of the product can effect individual demand.
(If the price is high, demand will fall and if the price is less, low demand
will rise)
 Changes in disposable income, the magnitude of the shift also being
related to the income elasticity of demand.
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 Changes in tastes and preferences - tastes and preferences are assumed

to be fixed in the short-run.
 This assumption of fixed preferences is a necessary condition for
aggregation of individual demand curves to derive market demand.
 Changes in expectations.
 Changes in the prices of related goods (substitutes and complements)
 Population size and composition
P
D1 D2 S
P2
P1
Fig. 10. B: ShiftQ1 Q2

of the Demand Curve Q
This happens when there is a change in price of the product, but other things
are assumed to be constant. In this case, following the Law of Demand, with
the rise in the price of the product there will be fall in the quantity demanded
for the said product.
P1 B
A
P2
Price
C
P3
D
O Q1 Q2 Q3
Quantity Demanded
Fig. 10. C: Movement along the Demand Curve
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In the diagram above, at point A on the demand curve, price is P2 and the
respective quantity demanded is Q2. Now, if the price moves up to P1 then
the quantity demanded will fall to Q1 which is essentially the point B in the
demand curve. Or, if the price goes down from P2 to P3, the quantity
demanded goes up from Q2 to Q3 and eventually we are at point C on the
demand curve.
Hence, change in quantity demanded is a movement along the demand
curve.
Exceptions of Law of Demand
Conspicuous Consumption: The goods which are purchased for ‘Snob appeal’
are called as the conspicuous consumption. They are also called as ‘Veblen
goods’ because Veblen coined this term. For e.g. diamonds, curios. They are
the prestige goods. They would like to hold it only when they are costly and
rare. So, what can be the policy implication for the manager of a company
who produces it? A producer can take advantage by charging high premium
prices.
Speculative Market: In this case the higher the price the higher will be the
demand. It happens because of the expectation to increase the price in the
future. For e.g. shares, lotteries, gamble and ply-win type of markets.
Giffen’s Goods: It is a special type of inferior goods where the increase in the
price results into the increase in the quantity demanded. This happens
because these goods are consumed by the poor people who would like to buy
more if the price increases. For e.g. a poor person who buys inferior quality
vegetables. If the price of such vegetable increase, then they prefer to buy
because they think that it would be of a better quality.
Ignorance: Many a times consumer judges the quality of a good from its price.
Such consumers may purchase high price goods because of the feeling of
possessing a better quality. The exceptional demand curve shows a positive
relation between the price and the quantity demanded.
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10.2. Individual Demand and Market Demand
Demand
Individual Market
It refers to demand for a It refers to total demand of all

commodity from individuals buyers taken together. Aggregate
point of view or from that of of the quantities
family or households point of of a product demanded by
view individual buyers
At a given price over a given

period of time
Individual demand curves are demand curves for a single economic actor. This actor
could be an individual, a household, or a firm (where the firm may be a for-profit, a
non-governmental non-profit, or a governmental agency).
The market demand curve aggregates (or adds up) the demand curves for a number
of economic actors. For instance, the market household demand curve for a good in
a town is obtained by adding up the demand curves for all the households in the
demand curve. The market demand curve for steel in the automobile industry is
obtained by adding up the demand curves for steel for all firms in the automobile
industry.
Market Demand is the aggregate of the demands of all potential customers (market
participants) for a specific product over a specific period in a specific market.
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Market Demand Curve from Individual Demand Curves

Consumer 1’s Consumer 2’s Market demand curve
3 demand curve for 3 demand curve for 3 for good X
good X good X
Price of good X
2 2 2 1+0=1
1 1 1 2+1=3
0 0 0
0 1 2 3 0 1 2 3 0 1 2 3 4 5
Fig. 10 D: Derivation of Market Demand Curve: Horizontal Summation of
Individual Demand Curves
10.3. Concept of Elasticity:

What do we understand by the word “Elasticity” in Economics?
In economics, elasticity is the measurement of how responsive an economic variable
is to a change in another.
For example:
 "If I lower the price of my product, how much more will I sell?"
 "If I raise the price of one good, how will that affect sales of the other good?"
 "If we learn that a resource is becoming scarce, will people scramble to acquire
it?"
Theoretically we could discuss elasticities for all the different controllable and
uncontrollable factors affecting demand but in practice there are four main types of
elasticity that tend to be measured and examined, corresponding to four particularly
important factors in the demand function: price, promotion, income and the price of
a related products.
Hence, elasticity can be defined as “The rate of responsiveness (i.e., the change) in
the demand of a commodity (or, a product, or a service) for a given change in price or
any other determinants of demand.”
10.3.1. Price Elasticity of Demand (PED)
PED is the percentage change in quantity demanded in response to a 1 per
cent change in price.
In symbols we can write:
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐴
PED =
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐴
Now, depending on the value of the PED, there are 5 types of Price Elasticity
of Demand.
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The quantity of a commodity demanded per unit of time depends upon

various factors such as the price of a commodity, the money income of
consumers, the prices of related goods, the tastes of the people, etc.
Whenever there is a change in any of -the-variables stated above, it brings
about a change in the quantity of the commodity purchased over a specified
period of time. The elasticity of demand measures the responsiveness of
quantity demanded to a change in any one of the above factors by keeping
other factors constant.
When the relative responsiveness or sensitiveness of the quantity demanded
is measured to changes in its price, the elasticity is said to be price elasticity
of demand. When the change in demand is the result of the given change in
income, it is named income elasticity of demand. Sometimes, a change in the
price of one good causes a change in the demand for the other. The elasticity
here is called cross electricity of demand. The three Main types of elasticity
are now discussed in brief.
They are as follows:
1. Perfect Elasticity of Demand (PED = Infinity, i.e., Undefined)
2. Perfect Inelasticity of Demand (PED = 0)
3. Relatively Elastic Demand (PED > 1)
4. Relatively Inelastic Demand (PED < 1)
5. Unit Elasticity of Demand (PED = 1)
Perfectly Elastic Demand:
When any quantity can be sold at a given price, and when there is no need to
reduce the price, the demand is said to be perfectly elastic.The quantity
demanded increases from OQ to OQ1, from OQ1 to OQ2 even though there
is no change in price. Price is fixed at OP*.
Price
P*
O Q Q1 Q2 Quantity
Fig. 10. E: Perfectly Elastic Demand Curve
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The degree of change in price leads to little change in the quantity demanded,
then the elasticity is said to be perfectly inelastic.
Increase the price from OP1 to OP2, the quantity demanded has not fallen.
And there is fall in the price from OP3 to OP2, the quantity demanded remains
unchanged.
Price
P3
P2
P1
O Q* Quantity
Fig. 10. F: Perfectly Inelastic Demand Curve
Relatively
Elastic Demand:
The demand is said to be relatively elastic when the change in demand is more
then the change in the price.The quantity demand increase from OQ1 to OQ2
because of a fall in Price from OP1 to OP2. The extent of increase in the quantity
demanded is greater than the extent of fall in the price.
Price
P1
P2
O Q1 Q2
Fig. 10. G: Relatively Elastic Demand Curve
Quantity
Relatively Inelastic Demand:
The demand is said to be relatively inelastic when the change in demand is
less than the change in the price.The quantity demanded increases from OQ1
to OQ2 because of adecrease in the price from OP1 to OP2. The extent of rise
in the quantity demanded is less than the extent of fall in the price.
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Price
P1
P2
O Q1 Q2
Unit Elasticity of Demand:
Fig. 10. H: Relatively Inelastic
QuantityDemand Curve
The elasticity of demand is said to be unity when the change in demand is
equal to the change in price.
The quantity demanded increases from OQ1 to OQ2 because of a decrease in
the price from OP1 to OP2. The extent of increase in the quantity demanded
is equal to the extent of fall in the price.
Price
P1
P2
O Q1 Q2 Quantity
Fig. 10.I : Unitary Elastic Demand Curve
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Value of Price Elasticity

Descriptive Terms
Coefficients
Perfectly inelastic demand, when Demand doesn’t change at
Ed = 0
all with the change in Price
Inelastic or relatively inelastic demand, when % change in
0 < Ed< 1
Demand is less than the % change in Price
Unitarily elastic demand, when % change in Demand is
Ed = 1
exactly the same with the % change in Price
Elastic or relatively elastic demand, when % change in

1 < Ed<α
Demand is more than the % change in Price
Perfectly elastic demand, when a minute change of Price

Ed = α results in an infinitely large change in Demand, mostly
theoretical.
Table 10. B: Interpretation of different types of elasticity of demand
Measurement of Price Elasticity of Demand

There are main methods like:
1. Percentage Method or Proportionate Method
2. Geometric Method or Point Method
3. Point Elasticity of Demand
Percentage method or proportionate method
• Price elasticity of demand is measured by a ratio between the
proportionate change in the quantity of a product demanded as a result
of a proportionate change in its price
• Formula for calculate this is given further as following
PED = Proportionate change in demand for x / Proportionate change in
price for x
Geometric Method or Point Method
• This method attempts to measure numerical elasticity of demand at a
particular point on the demand curve
• Price elasticity can be measure by following method
Lower segment of the demand curve
PED =
Upper Segment of the demand curve
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Point Elasticity
• Measures the change between two observed points.
Qd Qb  Qa
Q Qa
Ed  
P Pb  Pa
P Pa
10.3.2. Cross Price Elasticity of Demand(PEDx,y):
• Cross price elasticity (PEDx,y) measures the responsiveness of demand for
good X following a change in the price of good Y.
• In effect we are measuring to which degree a good is a substitute or
complement.
• PEDx,y describes the important distinction between substitutes and
complements quantitatively.
Cross Elasticity of Demand (PEDx,y) – Substitutes
• Substitutes:
– With substitute goods such as brands of razors, an increase in the
price of one good will lead to an increase in demand for the rival
product
– Cross price elasticity will be positive
– Weak substitutes – low PEDx,y
– Close substitutes – high PEDx,y
Cross Elasticity of Demand (PEDx,y) – Complements
• Complements:
– Goods that are in complementary demand
– The cross price elasticity of demand for two complements is
negative
Weak complements – low PEDx,
– Close complements – high PEDx,y
• Note the higher the magnitude (ignoring the sign) the closer the
complement.
10.3.2. Income Elasticity of Demand
• Income elasticity of demand (YED -- notation used for this type of
elasticity) measures the responsiveness (or, change in) of quantity
demanded to changes in realor disposable income.
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• YED = % change in demand for a commodity (or a product) / % change in

income of the consumer
• Example:
– A rise in consumer real income of 7% leads to an 9.5% rise in
demand for pizza deliveries.
– The income elasticity of demand: = 9.5/ 7 = +1.36.
Effect Income elasticity

Classification of good
coefficient
A proportionately YED > 1
larger change in the Luxury good
quantity demanded
A proportionately 0 < YED < 1
smaller change in the Normal
quantity demanded
A negative change in YED < 0
Inferior good
the quantity demanded
Table: 10.C: Interpretation of Income Elasticity of demand
Inferior Goods:
Definition: An inferior good is a type of good whose demand declines when
income rises. In other words, demand of inferior goods is inversely related to
the income of the consumer.
Description:For example, there are two commodities in the economy -- wheat
flour and jowar flour -- and consumers are consuming both. Presently both
commodities face a downward sloping graph, i.e. the higher the price the lesser
will be the demand and vice versa. If the income of consumer rises, then he
would be more inclined towards wheat flour, which is a little costly than jowar
flour. The mindset of the consumer behind this behavior is that now he can
afford wheat flour because of his increase in income. Therefore, he will switch
his flour demand from jowar to wheat. Hence jowar, whose demand has fallen
due to an increase in income, is the inferior good and wheat is the normal good
• Inferior goods have a negative income elasticity of demand. Demand
falls as income rises.
• For example:
– A 12% rise in incomes leads to a 3% decrease in the demand for bus
travel
– The income elasticity of demand = -3 / +12
– Yed = -0.25.
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Different Types of Goods and their Income Elasticity (Indicative List)
Luxury Normal Necessity Inferior Good
Air travel Fresh vegetables Frozen vegetables
Private Fruit juice Margarine

education
Private health Spending on utilities Tinned meat
care
Antique Shampoo / toothpaste / Value “own-brand”
furniture detergents bread
Designer clothes Rail travel Bus travel
Table: 10.D: Different Types of Goods and their Income Elasticity
10.4. Practical Limitations of the Concept of Elasticity of Demand

In theory, the various measures of elasticity of demand help managers to understand
the impact of changes in different variables on their sales. This is important to their
planning: when estimating their production and financial requirements, or required
staffing and stock. However, whilst knowledge of the price, income, and cross-price
elasticities of demand can certainly be useful, in reality using them can be difficult for
the following reasons.
 Each of the equations for the elasticity of demand measures the relationship
between one specific factor and demand: for example, the price elasticity of
demand analyses the impact of a change in price on the quantity demanded. In
reality, many factors may be changing at the same time, such as spending on
advertising, competitors’ promotional strategies, and customers’ incomes, as well
as the firm’s price. It may therefore be difficult to know what specifically has
caused any change in the quantity demanded. A fall in price may be accompanied
by an increase in quantity demanded, but this may not be the cause -- it could
have been due to other factors that also changed at the same time, such as the
weather. A value on the price elasticity of demand that is calculated assuming the
change in quantity demanded was all due to the price change may be very
misleading.
 To know the elasticity of demand, managers must either look back at what
happened in the past when, for example, prices or incomes were changed (but
the conditions are likely to have altered since then), or estimate for themselves
what the values are now (in which case, they may be wrong because it is an
estimate). The value of elasticity is, therefore, not actually known at any moment;
rather, it is merely estimated – perhaps based on past data. This means that
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managers should be careful about basing decisions on their estimates of the

elasticity, because the values will be changing all of the time as demand conditions
change.
10.5. The Context of Demand Forecasting

Demand forecasting is the activity of estimating the quantity of a product or service
that consumers will purchase. Demand forecasting involves techniques including both
informal methods, such as educated guesses, and quantitative methods, such as the
use of historical sales data or current data from test markets. Demand forecasting
may be used in making pricing decisions, in assessing future capacity requirements,
or in making decisions on whether to enter a new market.
Forecasting product demand is crucial to any supplier, manufacturer, or retailer.
Forecasts of future demand will determine the quantities that should be purchased,
produced, and shipped. Demand forecasts are necessary since the basic operations
process, moving from the suppliers' raw materials to finished goods in the customers'
hands, takes time. Most firms cannot simply wait for demand to emerge and then
react to it. Instead, they must anticipate and plan for future demand so that they can
react immediately to customer orders as they occur. In other words, most
manufacturers "make to stock" rather than "make to order" – they plan ahead and
then deploy inventories of finished goods into field locations. Thus, once a customer
order materializes, it can be fulfilled immediately – since most customers are not
willing to wait the time it would take to actually process their order throughout the
supply chain and make the product based on their order. An order cycle could take
weeks or months to go back through part suppliers and sub-assemblers, through
manufacture of the product, and through to the eventual shipment of the order to
the customer.
Firms that offer rapid delivery to their customers will tend to force all competitors in
the market to keep finished goods inventories in order to provide fast order cycle
times. As a result, virtually every organization involved needs to manufacture or at
least order parts based on a forecast of future demand. The ability to accurately
forecast demand also affords the firm opportunities to control costs through leveling
its production quantities, rationalizing its transportation, and generally planning for
efficient logistics operations.
In general practice, accurate demand forecasts lead to efficient operations and high
levels of customer service, while inaccurate forecasts will inevitably lead to inefficient,
high cost operations and/or poor levels of customer service. In many supply chains,
the most important action we can take to improve the efficiency and effectiveness of
the logistics process is to improve the quality of the demand forecasts.
The Nature of Customer Demand
Most of the procedures which are discussed here are intended to deal with the
situation where the demand to be forecasted arises from the actions of the firm’s
customer base. Customers are assumed to be able to order what, where, and when
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they desire. The firm may be able to influence the amount and timing of customer
demand by altering the traditional "marketing mix" variables of product design,
pricing, promotion, and distribution. On the other hand, customers remain free
agents who react to a complex, competitive marketplace by ordering in ways that are
often difficult to understand or predict. The firm’s lack of prior knowledge about how
the customers will order is the heart of the forecasting problem – it makes the actual
demand random.
However, in many other situations where inbound flows of raw materials and
component parts must be predicted and controlled, these flows are not rooted in the
individual decisions of many customers, but rather are based on a production
schedule. Thus, if TDY Inc. decides to manufacture 1,000 units of a certain model of
personal computer during the second week of October, the parts requirements for
each unit are known. Given each part supplier’s lead-time requirements, the total
parts requirement can be determined through a structured analysis of the product's
design and manufacturing process. Forecasts of customer demand for the product are
not relevant to this analysis. TDY, Inc., may or may not actually sell the 1,000
computers, but that is a different issue altogether. Once they have committed to
produce 1,000 units, the inbound logistics system must work towards this production
target. The Material Requirements Planning (MRP) technique is often used to handle
this kind of demand. This demand for component parts is described as dependent
demand (because it is dependent on the production requirement), as contrasted with
independent demand, which would arise directly from customer orders or purchases
of the finished goods. The MRP technique creates a deterministic demand schedule
for component parts, which the material manager or the inbound logistics manager
must meet. Typically a detailed MRP process is conducted only for the major
components (in this case, motherboards, drives, keyboards, monitors, and so forth).
The demand for other parts, such as connectors and memory chips, which are used in
many different product lines, is often simply estimated and ordered by using statistical
forecasting methods.
General Approaches to Forecasting
All firms forecast demand, but it would be difficult to find any two firms that forecast
demand in exactly the same way. Over the last few decades, many different
forecasting techniques have been developed in a number of different application
areas, including engineering and economics. Many such procedures have been
applied to the practical problem of forecasting demand in a logistics system, with
varying degrees of success. Most commercial software packages that support demand
forecasting in a logistics system include dozens of different forecasting algorithms that
the analyst can use to generate alternative demand forecasts.
1. Judgmental Approaches. The essence of the judgmental approach is to address
the forecasting issue by assuming that someone else knows and can tell you the
right answer. That is, in a judgment-based technique we gather the knowledge
and opinions of people who are in a position to know what demand will be. For
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example, we might conduct a survey of the customer base to estimate what our
sales will be next month.
2. Experimental Approaches. Another approach to demand forecasting, which is
appealing when an item is "new" and when there is no other information upon
which to base a forecast, is to conduct a demand experiment on a small group of
customers and to extrapolate the results to a larger population. For example,
firms will often test a new consumer product in a geographically isolated "test
market" to establish its probable market share. This experience is then
extrapolated to the national market to plan the new product launch. Experimental
approaches are very useful and necessary for new products, but for existing
products that have an accumulated historical demand record it seems intuitive
that demand forecasts should somehow be based on this demand experience. For
most firms (with some very notable exceptions) the large majority of SKUs in the
product line have long demand histories.
3. Relational/Causal Approaches.The assumption behind a causal or relational
forecast is that, simply put, there is a reason why people buy our product. If we
can understand what that reason (or set of reasons) is, we can use that
understanding to develop a demand forecast. For example, if we sell umbrellas at
a sidewalk stand, we would probably notice that daily demand is strongly
correlated to the weather – we sell more umbrellas when it rains. Once we have
established this relationship, a good weather forecast will help us order enough
umbrellas to meet the expected demand.
4. "Time Series" Approaches. A time series procedure is fundamentally different
than the first three approaches we have discussed. In a pure time series
technique, no judgment or expertise or opinion is sought. We do not look for
"causes" or relationships or factors which somehow "drive" demand. We do not
test items or experiment with customers. By their nature, time series procedures
are applied to demand data that are longitudinal rather than cross-sectional. That
is, the demand data represent experience that is repeated over time rather than
across items or locations. The essence of the approach is to recognize (or assume)
that demand occurs over time in patterns that repeat themselves, at least
approximately. If we can describe these general patterns or tendencies, without
regard to their "causes", we can use this description to form the basis of a
forecast.
The demand analysis and the demand theory are of crucial importance to the business
enterprises. They are the source of many useful insights for business decision making. The
success or failure of business firms depend primarily on its ability to generate resources by
satisfying the demand of consumers. The firms unable to attract consumers are soon forced
out from the market.
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Chapter 11: Supply and its Analysis Managerial Economics
CHAPTER 11
SUPPLY and its ANALYSIS
Learning Objectives: In this chapter we will understand:

LO1: the concept of supply
LO2: the determinants of supply
LO3: concept of Law of supply
LO4: explanation of Supply curve
LO5: description of Shifts and movements along the supply curve
11.1. Understanding Supply:

In the previous unit, you have studied that a market is a place where buyers and sellers
are engaged in exchanging products at certain prices. The behavior of buyers is
understood with the help of the concept of demand. On the other hand, the behavior
of sellers is analyzed using the concept of supply.
Supply can be defined as the quantity of a product that a seller is willing to offer in
the market at a particular price within specific time. The supply of a product is
influenced by various determinants, such as price, cost of production, government
policies, and technology. It is governed by the law of supply, which states a direct
relationship between the supply and price of a product, while other factors remaining
the same. In simple words, the law of supply states that the supply of a product
increases with an increase in its price, while other factors at constant and vice versa.
In a market, the two forces demand and supply play a major role in influencing the
decisions of consumers and producers. The interaction between demand and supply
helps in determining the market equilibrium price of a product. Equilibrium price is a
price where the quantity demanded of a product by buyers is equal to the quantity
supplied by sellers. In simple terms, equilibrium price is a price when there is a balance
between market demand and supply. The equilibrium price of a product can change
due to various reasons, such as reduction in cost of production, fall in the price of
substitutes, and unfavorable climatic conditions. In this chapter, you will study the
concept of supply in detail. Moreover, you will study about market equilibrium price
at length.
11.1.1. Determinants of Supply
Supply does not remain constant all the time in the market. There are many
factors that influence the supply of a product. Generally, the supply of a
product depends on its price and cost of production. Thus, it can be said that
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Managerial Economics Chapter 11: Supply and its Analysis
supply is the function of price and cost of production. These factors that
influence the supply are called the determinants of supply.
a. Price of a product: The major determinant of the supply of a product is
its price. An increase in the price of a product increases its supply and vice
versa while other factors remain the same. Producers increase the supply
of the product at higher prices due to the expectation of receiving
increased profits. Thus, price and supply have a direct relationship.
b. Cost of production: It is the cost incurred on the manufacturing of goods
that are to be offered to consumers. Cost of production and supply are
inversely proportional to each other. This implies that suppliers do not
supply products in the market when the cost of manufacturing is more
than their market price. In this case, sellers would wait for a rise in price
in the future. The cost of production increases due to several factors, such
as loss of fertility of land; high wage rates of labour and increase in the
prices of raw material, transportation cost, and tax rate.
c. Natural conditions: The supply of certain products is directly influenced
by climatic conditions. For instance, the supply of agricultural products
increases when the monsoon comes well on time. On the contrary, the
supply of these products decreases at the time of drought. Some of the
crops are climate specific and their growth purely depends on climatic
conditions. For example, Kharif crops are well grown at the time of
summer, while Rabi crops are produced well in the winter season.
d. Transportation conditions: Better transport facilities result in an increase
in the supply of goods. Transport is always a constraint to the supply of
goods. This is because goods are not available on time due to poor
transport facilities. Therefore, even if the price of a product increases, the
supply would not increase.
e. Taxation policies: Government’s tax policies also act as a regulating force
in supply. If the rates of taxes levied on goods are high, the supply will
decrease. This is because high tax rates increase overall productions
costs, which will make it difficult for suppliers to offer products in the
market. Similarly, reduction in taxes on goods will lead to an increase in
their supply in the market.
f. Production techniques: The supply of goods also depends on the type of
techniques used for production. Obsolete techniques result in low
production, which further decreases the supply of goods. Over the years,
there has been tremendous improvement in production techniques,
which has led to increase in the supply of goods.
g. Factor prices and their availability: The production of goods is dependent
on the factors of production, such as raw material, machines and
equipment, and labour. An increase in the prices of the factors of
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production increases the cost of production. This will make difficult for
firms to supply large quantities in the market.
h. Price of related goods: The prices of substitutes and complementary
goods also influence the supply of a product to a large extent. For
example, if the price of tea increases, farmers would tend to grow more
tea than coffee. This would decrease the supply of tea in the market.
i. Industry structure: The supply of goods is also dependent on the
structure of the industry in which a firm is operating. If there is monopoly
in the industry, the manufacturer may restrict the supply of his/her goods
with an aim to raise the prices of goods and increase profits. On the other
hand, in case of a perfectly competitive market structure, there would be
a large of number of sellers in the market. Consequently, the supply of a
product would increase.
11.2. Law of Supply

The law of supply explains the relationship between price and supply of a product.
According to the law, the quantity supplied increases with a rise in the price of a
product and vice versa while other factors are constant. The other factors may include
customer preferences, size of the market, size of population, etc. For example, in the
case of rise in a product’s price, sellers would prefer to increase the production of the
product to earn high profits, which would automatically lead to an increase in supply.
Similarly, if the price of the product decreases, the supplier would decrease the supply
of the product in the market as he/ she would wait for a rise in the price of the product
in the future. Thus, the law of supply states a direct relationship between the price of
a product and its supply. Therefore, both price and supply moves in the same
direction. To understand the law of supply, it is important to discuss the concepts of
demand schedule and demand curve.
11.2.1. Supply Schedule
Supply schedule can be defined as a tabular representation of the law of
supply. It represents the quantities of a product supplied by a supplier at
different prices and time periods, keeping all other factors constant. There
can be two types of supply schedules, namely individual supply schedule and
market supply schedule. These two types of supply schedules are explained
as follows:
a. Individual supply schedule: This schedule represents the quantities of a
product supplied by an individual firm or supplier at different prices
during a specific period of time, assuming other factors remain
unchanged.
b. Market supply schedule: This schedule represents the quantities of a
product supplied by all firms or suppliers in the market at different prices
during a specific period of time, while other factors are constant. In other
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words, market supply schedule can be defined as the summation of all

individual supply schedules.
11.2. 2. Supply Curve
The graphical representation of supply schedule is called supply curve. In a
graph, the price of a product is represented on Y-axis and quantity supplied is
represented on X-axis. Supply curve can be of two types, individual supply
curve and market supply curve. These two types of curves are explained as
follows:
Individual supply curve: It is the graphical representation of individual supply
schedule. The individual supply schedule of commodity A represented in the
following diagram.
25
20
15
10
0 10000 15000
Fig: 11. A: Individual Supply curve
The slope moving upwards to the right in individual supply curve shows the
direct relationship between supply and price, i.e. increase in supply along with
the rise in prices.
11.3. Supply Function

Supply function is the mathematical expression of law of supply. In other words,
supply function quantifies the relationship between quantity supplied and price of a
product, while keeping the other factors at constant. The law of supply expresses the
nature of relationship between quantity supplied and price of a product, while the
supply function measures that relationship. The supply function can be expressed as:
Qs = f (Pa ,Pb, Pc , T, Tp)
Where,
Qs = Supply
Pa = Price of the good supplied
Pb = Price of other goods
Pc = Price of factor input
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T = Technology
Tp = Time Period
According to supply function, the quantity supplied of a good (Qs ) varies with price
of that good (Pa ), the price of other goods (Pb), the price of factor input (Pc ),
technology used for production (T), and time period (Tp)
11.3.1. EXCEPTIONS TO LAW OF SUPPLY
According to the law of supply, if the price of a product rises, the supply of
the product also rises and vice versa. However, there are certain conditions
where the law of supply is not applicable. These conditions are known as
exceptions to the law of supply. In such cases, the supply of a product falls
with the increase in the price of a product at a particular point of time. For
example, there would be a decrease in the supply of labour in an organisation
when the rate of wages is high. The exception to the law of supply is
represented on the regressive supply curve or backward sloping curve. It is
also known as an exceptional supply curve. Some important exceptions to the
law of supply are described below.
a. Agricultural products: The law of exception is not applicable to
agricultural products. The production of these products is dependent on
so many factors which are uncontrollable, such as climate and availability
of fertile land. Thus, the production of agricultural products cannot be
increased beyond a limit. Therefore, even a rise in price cannot increase
the supply of these products beyond a limit.
b. Goods for auction: Auctions goods are offered for sale through bidding.
Auction can take place due to various reasons, for instance, a bank may
auction the assets of a customer in case of his failure in paying off the
debts over a period of time. Thus, supply of these goods cannot increase
or decrease beyond a limit. In case of these goods, a rise or fall in price
does not impact the supply.
c. Expectation of change in prices in the future: Law of supply is not
applicable under the circumstances when there is an expectation of
change in the prices of a product in the near future. For instance, if the
price of wheat rises and is expected to increase further in the next few
months, sellers may not increase supply and store huge quantities in the
hope of achieving profits at the time of a price rise.
d. Supply of labour: The law of supply fails in the case of labour. After a
certain point, the rise in wages does not increase the supply of labour. At
higher wages, labour prefers to work for lesser hours. This happens due
to change in preference of labour for leisure hours.
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11.4. Shifts and Movement along Supply Curve:

Change in quantity supplied can be measured by the movement of the supply curve,
while change in supply is measured by shifts in the supply curve. The terms, change in
quantity supplied refers to expansion or contraction of demand, while change in
supply means increase or decrease in demand. Let us discuss the expansion and
contraction of supply as well as increase and decrease in supply
EXPANSION AND CONTRACTION OF SUPPLY:
When there are large quantities of a good supplied at higher prices, it is known as
expansion or extension of supply. On the other hand, contraction of supply occurs
when smaller quantities of goods are supplied even at reduced prices. Following figure
shows the movement of the supply curve:
P2 A2
P1 A1
P3 A3
Q3 Q1 Q2
Fig: 11. B: Movement along the Supply curve
In the above figure, quantity supplied at price OP1 is OQ1. When the price rises to
OP2 , the quantity supplied also increases to OQ2 , which is shown by the upward
movement from A1 to A2 (it is pointed by the direction of the arrow between A1 to
A2 ). This upward movement is known as the expansion of supply. On the contrary, a
fall in price from OP1 to OP3 results in a decrease in supply from OQ1 to OQ2. This
movement from A1 to A3 shown by the arrow pointed downwards is known as the
contraction of supply. Thus, the movement from A1 to A3 is the representation of the
expansion and contraction of the quantity supplied
Increase and Decrease in Supply:
An increase in supply takes place when a supplier is willing to offer large quantities of
products in the market at the same price due to various reasons, such as improvement
in production techniques, fall in prices of factors of production, and reduction in taxes.
On the other hand, a decrease in supply occurs when a supplier is willing to offer small
quantities of products in the market at the same price due to increase in taxes, low
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agricultural production, high costs of labor, unfavorable weather conditions, etc. A

shift takes place in supply curve due to increase or decrease in supply, which is shown
in following figure.
S3
S1
P2
S
A3 A1 A2
P1
Q3 Q1 Q2
Fig: 11. C: Shift of the Supply Curve
In the above figure, an increase in supply in indicated by the shift of the supply curve
from S1 to S2. Because of an increase in supply, there is a shift at the given price OP,
from A1 on supply curve S1 to A2 on supply curve S2. At this point, large quantities
(i.e. Q2 instead of Q1) are offered at the given price OP. On the contrary, there is a
shift in the supply curve from S1 to S3 when there is a decrease in supply. The amount
supplied at OP is decreased from OQ1 to OQ3 due to a shift from A1 on supply curve
S1 to A3 on supply curve S3. However, a decrease in supply also occurs when
producers sell the same quantity at a higher price (which is shown in Figure 3.6) as
OQ1 is supplied at a higher price OP2.
This chapter gives an overview of supply of economic resources. Supply is a fundamental

concept in economics, any expansion or contraction of supply of resources will change the
cost of production which has an impact on total revenue of any business organization.
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Managerial Economics Chapter 12: Theory of Production
CHAPTER 12
THEORY OF PRODUCTION
Learning objectives: In this chapter we will understand:

LO1: the concept of production process
LO2: short run and long run production function
LO3: Three stages of production
LO4: concept of law of variable proportion
LO5: Returns to scale
12.1. Concept of Production process:

Production is a process of transforming tangible and intangible inputs into goods or
services. Raw materials, land, labour and capital are the tangible inputs, whereas
ideas, information and knowledge are the intangible inputs. These inputs are also
known as factors of production. For an organisation, the four major factors of
production are land, capital, labour and enterprise. An organisation needs to make an
optimum utilisation of these factors to achieve maximum output. The technical
relationship between the inputs and the output is expressed by production function.
It enables an organisation to achieve maximum output with the given combinations
of factors of production in a particular time period. The production function can be of
two types, namely, short-run production function and long-run production function.
In the short run change in production function is brought by changing only one factor
of production, while keeping the other factors constant. On the other hand, in the
long run, production function changes with changes in only two factors of production,
labour and capital, while other factors remain unchanged. The production laws
studied under these periods are law of diminishing returns and law of returns to scale.
In this unit, you will study about the concepts of production in short run and longrun,
in detail.
12.1. 1. Factors of Production
Factors of production are the inputs that are used for producing the final
output with the main aim of earning an economic profit. Land, labour, capital
and enterprise are the main factors of production. Each and every factor is
important and plays a distinctive role in the organisation. Let us learn these
factors of production in detail:
Land: Land is the gift of nature and includes the dry surface of the earth and
the natural resources on or under the earth’s surface, such as forests, rivers,
sunlight, etc. Land is utilised to produce income called rent. Land is available
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Chapter 12: Theory of Production Managerial Economics
in fixed quantity; thus, does not have a supply price. This implies that the
change in price of land does not affect its supply. The return for land is called
rent.
Labour: Labour is the physical and mental efforts of human beings that
undertake the production process. It includes unskilled, semi-skilled and
highly skilled labour. The supply of labour is affected by the change in its
prices. It increases with an increase in wages. The return for labour is called
wages and salary.
Capital: Capital is the wealth created by human beings. It is one of the
important factors of production of any kind of goods and services, as
production cannot take place without the involvement of capital. Capital is an
output of a production process that goes into another production process as
an input. It is divided into two parts, namely, physical capital and human
capital.
12.2. Production Function

Production function can be defined as a technological relationship between the
physical inputs and physical output of the organisation.
According to Stigler, “production function is the name given to the relationship
between the rates of input of productive services and the rate of output…”
According to Samuelson, “Production Function is the technological relationship,
which explains the quantity of production that can be produced by a certain group of
inputs. It is related with a given state of technological change.”
In the words of Watson, “The relation between a firm’s physical production (output)
and the material factors of production (input) is referred to as production function.”
Inputs include the factors of production, such as land, labour, capital, whereas
physical output includes quantities of finished products produced. The long-run
production function (Q) is usually expressed as follows:
Q= f (LB, L, K, M, T, t)
Where, LB= land and building
L = labour
K = capital
M = raw material
T = technology
t = time
Production function is based on the following assumptions:
 Production function is related to a specific time period.
 The state of technology is fixed during this period of time.
 The factors of production are divisible into the most viable units.
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 There are only two factors of production, labour and capital.

 Inelastic supply of factors in the short-run period.
The uses of production function are as follows:
 Helps in making short-term decisions, such as optimum level of output.
 Helps in making long-term decisions, such as deciding the production level.
 Helps in calculating the least cost combination of various factor inputs at a given
level of output.
 Gives logical reasons for making decisions. For example, if price of one input falls,
one can easily shift to other inputs.
Apart from the advantages, production function also suffers from some limitations,
which are given as follows:
 Restricts itself to the case of two inputs and one output.
 Assumes smooth and continuous curve, which is not possible in the real world, as
there are always discontinuities in production.
 Assumes technology as fixed, which is not possible in the real world.
 Assumes perfectly competitive market, which is rare in the real world.
12.2.1. Production in the Short Run
The two reference periods while learning the concept of production are short
run and long run. Let us learn the concept of short run period in this section.
The short run refers to a time period in which the supply of the inputs, such
as plant and machinery is fixed. Only the variable inputs, such as labour and
raw materials can be used to increase the production of the goods. In other
words, in the short run, change in production is brought by changing only one
variable, while other factors remain constant.
The short-run production function is given as:
Q = f(L, K)
where L=labour, which is variable
K= Capital, which is constant
The law of production studied under short-run production is called the law of
variable proportions or the law of diminishing marginal returns. For learning
the law of production under short run, it is necessary to study about total
product, average product and marginal product.
Total Product (TP): It can be defined as the total quantity of output produced
by an organisation for a given quantity of input. It is also known as total
physical product.
Average Product (AP): It refers to the ratio of the total product to the variable
input used for obtaining the total product. It is the product produced per unit
of variable input employed when fixed inputs are held constant. The average
product is calculated as:
Average Product = Total Product/ variable inputs employed
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Marginal Product (MP): Marginal product refers to the product obtained by

increasing one unit of input. In terms of labour, the change in total quantity
of product produced by including one more worker is termed as marginal
product of labour. Marginal product of labour (MPL) can be calculated with
the help of the following formula:
MPL = ΔQ/ ΔL
Where, ΔQ = Change in output
ΔQ = new product – old product
ΔL = new labour – old labour
12.3. Law of Diminishing Returns (Law of Variable Proportions)

According to G. Stigler, “As equal increments of one input are added; the inputs of
other productive services being held, constant, beyond a certain point the resulting
increments of the product will decrease, i.e., the marginal product will diminish.”
According to F. Benham, “As the proportion of one factor in a combination of factors
is increased, after a point, first the marginal and then the average product of that
factor will diminish.”
In the words of Alfred Marshall, “An increase in the Capital and Labour applied in the
cultivation of land causes, in general, less than proportionate increase in the amount
of produce raised unless it happens to coincide with an improvement in the art of
agriculture.” According to Richard A. Bilas, “If the input of one resource to other
resources is held constant, total product (output) will increase but beyond some
point, the resulting output increases will become smaller and smaller”. The law of
diminishing returns is an important concept of the economic theory. This law
examines the production function with one variable keeping the other factors
constant. It explains that when more and more units of a variable input are employed
at a given quantity of fixed inputs, the total output may initially increase at an
increasing rate and then at a constant rate, and then it will eventually increase at
diminishing rates. It implies that the total output initially increases with an increase in
variable input at a given quantity of fixed inputs, but it starts decreasing after a point
of time.
The main assumptions made under the law of diminishing returns are as follows:
 The state of technology is given and changed.
 The prices of the inputs are given.
 Labour is the variable input and capital is the constant input.
 Let us understand the law of diminishing returns with the help of an example.
Suppose an organisation has fixed amount of land (fixed factor) and workers
(variable factor) as the labour in the short-run production. For increasing the level
of production, it can hire more workers. In such a case, the production function
of the organisation would be as follows:
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Q = f (L), K
Q = Total Production
L = Labour
K = Capital (Constant)
No of Total Product Marginal Average Stage of

Workers(L) (TPL) Product (MPL) Product(APL) Production
1 80 80 80
Increasing
2 170 90 85
Return
3 270 100 90
4 368 98 92
5 430 62 86
Decreasing
6 480 50 80
Return
7 504 24 72
8 504 0 63
9 495 -9 55
Negative Return
10 470 -25 47
Table:11A: Law of variable Proportion
From above table, we can see that MP of labour rises till 3 units of labour. Beyond this
point, the MP of labour starts decreasing. After using the8 units of labour, the MP of
labour starts becoming negative.
Above table, the last column shows the three stages of production, which are
explained as follows:
 Stage I: Increasing returns: It refers to the stage of production in which the total
output increases initially with the increase in the number of labour. Table 7.2
shows the increase in the marginal product till the number of workers increased
to 3.
 Stage II: Diminishing returns: It refers to the stage of production in which the total
output increases, but marginal product starts declining with the increase in the
number of workers.
Above table shows the declining of marginal product as the number of workers
reaches 4.
 Stage III: Negative returns: It refers to the stage of production in which the total
product starts declining with an increase in the number of workers. As shown in
Table 7.2, the total output reaches to maximum level at the 8th worker. After that,
the total output starts declining. Marginal product becomes negative at this stage.
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Following chart shows the graphical representation of the three stages of production:
Fig: 12. A: Three Stages of production
From Figure 12.A, the following can be inferred:

Stage 1: MPL> APL
Stage 2: MPL< APL (both greater than zero)
Stage 3: MPL<0, APL > 0
12.4. Significance of Law of Diminishing Returns

The law of diminishing returns has a very wide application. Earlier, it was thought that
the law of diminishing returns can be applied only to the agriculture field. However,
now it is held that the law of diminishing returns can be applied in all the fields,
namely, agriculture, mining manufacturing, etc.
The validity of the law of diminishing returns is based upon the empirical evidence.
This can be explained by an instance. Suppose if there are no diminishing returns to
scale, the production in an economy can be increased by increasing the number of
labour and capital. The whole population can be fed by growing crops on tiny pieces
of land. As the demand increases with the increase in population, more labour and
capital can be used to increase the output. Thus, there would be no starvation and
recession. However, this is not true in the real world. Also, it is not possible to keep
pace with technology and capital with the increasing population. The law of
diminishing returns determines the optimum labour required to produce the
maximum output. In above chart, stages 1 and 3 depict the increasing and negative
returns, respectively. If an organisation is in stage 1 of the production, more increase
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in labour is required to increase the production. If an organisation is in stage 3, then

it needs to reduce the labour to reduce production. Thus, only stage 2 is important
that depicts the diminishing returns. This stage provides information about the
number of workers that needs to be employed for reaching the maximum level of
production. Thus, this stage is helpful in making important business decisions.
12.5. Production in the Long Run

Long run is the period in which the supply of labour and capital is elastic. It implies
that labour and capital are variable inputs. The long run production function can be
expressed as:
Q = f (L, K)
where
L= labour, which is variable
K=capital, which is variable
In the long run, inputs-output relations are studied by the laws of returns to scale.
These are long-run laws of production. The laws of returns to scale functional can be
explained with the help of the isoquant curve, which is discussed in the next section.
ISO QUANT CURVES
A technical relation that shows how inputs are converted into output is depicted by
an isoquant curve. It shows the optimum combinations of factor inputs with the help
of prices of factor inputs and their quantities that are used to produce the same
output. The term ISO implies equal and quant means quantity or output. For example,
for producing 100 calendars, 90 units of capital and 10 units of labour are used.
Isoquant curves are also called as equal product curves or production indifference
curves.
According to Ferguson, “An isoquant is a curve showing all possible combinations of
inputs physically capable of producing a given level of output.”
According to Peterson, “An isoquant curve may be defined as a curve showing the
possible combinations of two variable factors that can be used to produce the same
total product.”
The assumptions of an isoquant curve are as follows:
 There are only two factor inputs, labour and capital, to produce a particular
product.
 Capital, labour and goods are divisible in nature.
 Capital and labour are able to substitute each other up to a certain limit.
 Technology of production is given over a period of time.
 Factors of production are used with full efficiency.
Let us learn isoquant with the help of the following table.
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Following chart shows the different combination of capital and labour to produce
same level of output.
Fig. 12.B: Negatively sloped Isoquant
Some of the properties of the isoquant curves are as follows:

 Isoquant curves slope downwards: It implies that the slope of the isoquant curve
is negative. This is because when capital (K) is increased, the quantity of labour (L)
is reduced or vice versa, to keep the same level of output.
 Isoquant curves are convex to origin: It implies that factor inputs are not perfect
substitutes. This property shows the substitution of inputs and diminishing
marginal rate of technical substitution of isoquant. The marginal significance of
one input (capital) in terms of another input (labour) diminishes along with the
isoquant curve.
 Isoquant curves are convex to origin: It implies that factor inputs are not perfect
substitutes. This property shows the substitution of inputs and diminishing
marginal rate of technical substitution of isoquant. The marginal significance of
one input (capital) in terms of another input (labour) diminishes along with the
isoquant curve.
 Isoquant curves cannot intersect each other: An isoquant implies the different
levels of combination producing different levels of inputs. If the isoquants
intersect each other, it would imply that a single input combination can produce
two levels of output, which is not possible. The law of production would fail to be
applicable.
 The higher the isoquant the higher the output: It implies that the higher isoquant
represents higher output. The upper curve of the isoquant produces more output
than the curve beneath. This is because the larger combination of input results in
a larger output as compared to the curve that is beneath it.
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Returns to Scale:
Returns to scale implies the behaviour of output when all the factor inputs are
changed in the same proportion given the same technology. In other words, the law
of returns to scale explains the proportional change in output with respect to
proportional change in inputs.
The assumptions of returns to scale are as follows:
 The firm is using only two factors of production that are capital and labour.
 Labour and capital are combined in one fixed proportion.
 Prices of factors do not change.
 State of technology is fixed.
There are three aspects of the laws of returns:
 Increasing returns to scale
 Constant returns to scale
 Diminishing returns to scale
12.6. Returns to Scale

It is a situation in which output increase by a greater proportion than increase in factor
inputs. For example, to produce a particular product, if the quantity of inputs is
doubled and the increase in output is more than double, it is said to be an increasing
return to scale. When there is an increase in the scale of production, the average cost
per unit produced is lower. This is because at this stage an organization enjoys high
economies of scale. Following figure shows the increasing returns to scale:
Fig: 12.C: Increasing Returns to scale
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In the above figure movement from A to B shows that the amount of input is doubled.
When labour and capital are doubled from 2 to 4 units, output increases more than
double, that is, from 50 units to 120 units. This is increasing returns to scale, which
occurs because of economies of scale.
Constant Returns to Scale:
A constant return to scale implies the situation in which an increase in output is equal
to the increase in factor inputs. For example in the case of constant returns to scale,
when the inputs are doubled, the output is also doubled. Following figure shows the
constant returns to scale:
Fig: 12.D: Constant Returns to scale
In the above figure a movement from A to B shows that the amount of input is
doubled. When labour and capital are doubled from 2 to 4 units, output also doubles
from 50 units to 100 units. This is constant returns to scale.
Decreasing Returns to scale:
Diminishing returns to scale refers to a situation in which output increases in lesser
proportion than increase in factor inputs. For example, when capital and labour are
doubled, but the output generated is less than double, the returns to scale would be
termed as diminishing returns to scale. Following figure shows the diminishing returns
to scale:
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Fig: 12.E: Diminishing Returns to scale
In the above figure, a movement from A to B shows that the amount of input is
doubled. When labour and capital are doubled from 2 to 4 units, output increases less
than double that is from 50 units to 80 units. This is diminishing returns to scale.
Diminishing returns to scale is due to diseconomies of scale, which arises because of
the managerial inefficiency.
Product functions are used in managerial economics to determine the most efficient
combination of inputted resources needed to produce a desire amount of products. They're
not exact replications of real circumstances and aren't intended to be. Instead, they're
abstract models intended to focus on the problem of the efficient usage of resources available
to the business.
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Chapter 13: Market Structure Managerial Economics
CHAPTER 13
MARKET STRUCTURE
Learning Objectives: In this chapter we will understand

LO1: the concept of market
LO2: the types of Market and its characteristics
LO3: Profit maximization condition in short run and Long run
13.1. Introduction
The market structure in which an organisation operates also plays an important role
its decisions making related to pricing, quantity demanded, profit maximization, etc.
Market is often referred to a physical location where exchange of goods and services
takes place between buyers and sellers at a specific price. In economics, it cannot be
restricted to a physical place, rather has a broader meaning. Thus, in economics,
market is a set of buyers and sellers who may be geographically separated from each
other, but are still able to make successful transactions through various means of
communication. A market is characterized by various features, such as the nature of
competition, quantity of products demanded, price of the product and availability of
substitutes.
To understand the structure of the market, the most important factor analysed is
competition in the market. Based on this factor, market structure is classified into
three categories, namely, a purely competitive market, perfectly competitive market,
and imperfectly competitive market. A purely competitive market is characterized by
a large number of independent sellers and buyers dealing with standardized products.
A perfectly competitive market is a wider term and constitutes a large number of
buyers and sellers engaged in transaction of the homogenous products. On the
contrary, in an imperfectly competitive market, buyers and sellers deal in
differentiated products, and sellers have the power of influencing the market price of
products. An organisation operating in any kind of market structure has only one aim,
i.e. profit maximization, whereby the organisation decides the level of output and
price to maximize the profits in the short run and long run. In this chapter, you will
study about the concept of market structure and how organisations operate under
different structures.
As discussed, market is a system under which buyers and sellers interact to set a price
and quantity of a product for making transactions. However, all markets are not
similar as they consist of different types of buyers and sellers. Thus, markets must be
classified on the basis of certain factors as shown in following figure.
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Managerial Economics Chapter 13: Market Structure
Let us discuss these bases in detail. Geographical area: The geographical area of a
market is dependent upon the region where buyers and sellers are dispersed. The
geographical area can be as small as a neighborhood market where one goes to buy
groceries, or as large as the oil market. Thus, on the basis of geographical area,
markets can be classified into local markets, national markets and international
markets. Local market is the place where both the demand and supply of a product
are limited to a small area, such as fruit market and vegetable market. When the place
where both demand and supply of a product cover the entire country, it is called
national market, such as sugar market in India. When both demand and supply of a
product cover different countries across the world, it is called international market.
For example, metals like silver and gold have an international market. Competition: A
state wherein large number of sellers exist offering similar products is known as
competition. Competition provides a firm base for the classification of the market. On
the basis of competition, markets are classified as perfect markets and imperfect
markets. A perfect market exists when both the buyers and sellers have complete
knowledge about the prices of products prevailing in the market. Thus, the price of a
product is same all over the market. On the contrary, an imperfect market exists when
the price of a product is different all over the market. This is because, buyers and
sellers are not aware about the prices of the products.
13.2. Types of Market structure

Market structure can be defined as a group of industries characterised by number of
buyers and sellers in the market, level and type of competition, degree of
differentiation in products and entry and exit of organisations from the market. The
study of market structure helps organisations in understanding the functioning of
different firms under different circumstances. Based on the study, organisations can
make effective business decisions. There are mainly four types of market structures,
as shown following figure.
13.2.1. Perfect Competition
A perfect competition is an extension of pure market subject to wider scope.
According to Robinson perfect competition can be defined as, “When the
number of firms being large, so that a change in the output of any of them
has a negligible effect upon the total output of the commodity, the
commodity is perfectly homogeneous in the sense that the buyers are alike in
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respect of their preferences (or indifference) between one firm and its rivals,
then the competition is perfect, and the elasticity of demand for the individual
firm is infinite.” Some other important definitions of perfect competition are:
In the words of Spencer, “Perfect competition is the name given to an industry
or to a market characterised by a large number of buyers and sellers all
engaged in the purchase and sale of a homogeneous commodity, with perfect
knowledge of market price and quantities, no discrimination and perfect
mobility of resources.” According to Bilas, “The perfect competition is
characterised by the presence of many firms. They all sell identical products.
The seller is a price taker, not price maker.” In the words of Prof. Leftwitch,
“Perfect competition is a market in which there are many firms selling
identical products with no firm large enough relative to the entire market to
be able to influence the market price.” Thus, from the above discussion it can
be concluded that perfect competition is a market where various firms selling
identical products exist along with a large number of buyers who are well
aware of the prices. However, the existence of perfect competition is not
possible in the real world. The main characteristics of perfect competition are
shown in following figure.
Let us discuss these characteristics in detail.

 Large number of buyers and sellers: In perfect competition, a large number
of buyers and sellers exist. However, the high population of buyers and sellers
fails to affect the prices, and the output produced by a seller or purchases
made by a buyer are very less in comparison to the total output or total
purchase in an economy. ‰
 Homogenous product: Another important characteristic of perfect
competition is the existence of homogenous product for buying and selling.
This makes it possible for buyers to choose the product from any seller in the
market. Due to the presence of large number of sellers, the market price
remains same throughout the market.
 Ease of entry and exit from the market: In perfect competition, there are
hardly any barriers, such as government regulations and policies, to enter or
exit the market. Consequently, firms find it easy to enter the markets as all
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the organisations earn normal profits. Similarly, organisations also easily exit
the market as they are not bound by any rules and regulations. ‰
 Perfect knowledge: In the perfectly competitive scenario, both buyers and
sellers are completely aware of the product price prevailing in the market.
Thus, no seller would try to sell the product at a higher price. However, this
also leaves no scope for bargaining for buyers too. ‰ No transportation costs:
In perfect competition, the existence of the same price is because of zero
transportation costs. Due to the absence of transportation costs, there is no
scope of price variation in all sectors of the market.
13.2.2. Imperfect Competition:
It is a competitive market where a large number of sellers are engaged in
selling heterogeneous (dissimilar) goods as opposed to the perfectly
competitive market. The concept of imperfect competition was first explained
by an English economist, Joan Robinson. Under imperfect competition, both
buyers and sellers are unaware of the prices. Therefore, producers can
influence the price of the product they are offering for sale. Imperfect
competition can be classified into three categories, such as Monopoly,
Monopolistic competition and oligopoly.
13.2.2.1. Monopolistic Competition:
It is a type of imperfect competition, wherein a large number of sellers are
engaged in offering heterogeneous products for sale to buyers. The term
monopolistic competition was givenby Prof. Edward H. Chamberlin of Harvard
University in 1933 in his book, Theory of Monopolistic Competition.
Monopolistic competition is the most realistic situation that exists in the
market. In the words of J.S. Bains, “Monopolistic competition is a market
structure where there are a large number of small sellers, selling
differentiated, but close substitute products.” Another definition of
monopolistic competition was provided by Baumol, who defined
monopolistic competition as, “The market structure in which the sellers do
have a monopoly (they are the only sellers) of their own product, and they
are also subject to substantial competitive pressures from sellers of substitute
products.” Thus, monopolistic competition can be defined as a competitive
scenario wherein close substitutes are offered to consumers in the market.
For example, there is variety of shoes offered by different organisations, such
as Nike, Woodland, Puma, Reebok and Addidas. The conditions of
monopolistic competition resemble with that of perfect competition.
However, the main difference between the two is that the products sold in
monopolistic competitive markets are not perfect substitute of each other
and differ from each other in one aspect or the other. Some important
characteristics of monopolistic competition are:
 Large number of sellers and buyers: The presence of large number of sellers
offering different products to equal number of buyers is a primary
characteristic of monopolistic competition. ‰
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 Product differentiation: Another important characteristic of monopolistic

competition is product differentiation; wherein products that are sold in the
market vary in style, quality standards, trademarks and brands. This helps
buyers in differentiating among the available products in more than one way.
However, under monopolistic competition, products are close substitutes of
each other. ‰
 Ease of entry and exit: Similar to perfect competition, under monopolistic
competition, organisations are free to enter or exit the market due to the
limited number of restrictions imposed by the government. ‰
 Restricted mobility: Dissimilar to perfect competition, the factors of
production are not perfectly mobile in monopolistic competition. This is due
to organisation’s willingness to pay heavy transportation costs to move the
factors of production or goods and services. This results in difference in the
prices of products of organisations. ‰
 Price control policy: Under monopolistic competition, organisations do not
have much control over the price of the product. If the prices of products are
higher, then the buyers would switch to other sellers due to close
substitutability of products. Therefore, the price policy of competitors greatly
influences the price policy of an organisation.
13.2.2.2 Oligopoly:
Oligopoly is a type of imperfect competition, wherein there are few sellers
dealing either in homogenous or differentiated products. The term oligopoly
has been derived from the two Greek words, oligoi means few and poly means
control. Thus, it means the control of the few organisations in the market. For
example, oligopoly in India exists in the aviation industry where there are just
few players, such as Kingfisher, Air India, Spice Jet, Indigo, etc. All these
airlines depend on each other for setting their pricing policies. This is because
the prices are affected by the prices of the competitors’ products. Some of
the popular definitions of oligopoly are as follows: In the words of Prof.
George J. Stigler, “Oligopoly is a market situation in which a firm determines
its marketing policies on the basis of expected behavior of close competitors.”
According to Prof. Stoneur and Hague, “Oligopoly is different from a
monopoly on one hand, in which there is a single seller. On the other hand, it
differs from perfect competition and monopolistic competition also in which
there are a large number of sellers. In other words, while describing the
concept of oligopoly, we include the concept of a small group of firms.”
According to Prof. Leftwitch, “Oligopoly is a market situation in which there
are a small number of sellers, and activities of every seller are important for
others.” In oligopoly market structure, the interdependency of organizations
may either lead to conflicts or cooperation among sellers. Let us discuss the
characteristics of oligopoly in detail, as follows: ‰ Existence of few sellers:
One of the primary features of oligopoly is the existence of a few sellers who
dominate the entire industry and influence the prices of each other, greatly.
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In addition, the number of buyers is also large. Moreover, in oligopoly, there

are a large number of buyers. ‰ Identical or differentiated products: An
important characteristic of oligopoly is the production of identical products
or differentiated products. This implies that organizations may either produce
homogenous products, such as cement, asphalt, concrete and bricks, or
differentiated products, such as an automobile. If organizations produce
homogenous products, it is said to be pure oligopoly. ‰ Impediments in
entry: Another important characteristic of oligopolistic competition is that
organizations cannot easily enter the market; nor can they make an exit from
the market. The reasons for difficult entry in the market are various legal,
social and technological barriers. This also implies that the existing
organizations have a complete control over the market. ‰ Enhanced role of
government: Under oligopolistic market structure, the government has a
greater role as it acts as a guard to anti-competitive behaviors of oligopolists.
It is often observed that oligopolists may engage in the illegal practice of
collusion, where they together make production and pricing decisions.
Oligopolists may start acting as a single organization and further increase
prices and profits. Thus in such an environment, the government requires to
keep a watch on such activities to curb the illegal practices. ‰ Mutual
interdependence: Under oligopoly market structure, mutual
interdependence refers to the influence that organizations create on each
other’s decisions, such as pricing and output decisions. In oligopoly, a few
numbers of sellers compete with each other. Therefore, the sale of an
organization is dependent on its own price of products, as well as the price of
its competitor’s products. Thus, in oligopoly, no organization can make an
independent decision. ‰ Existence of price rigidity: Under oligopolistic
market, organizations do not prefer to change the prices of their products as
this can adversely affect the profits of the organization. For instance, if an
organization reduces its price, its competitors may reduce the prices too,
which would bring a reduction in the profits of the organization. On the other
hand, the increase in prices by an organization will lead to loss of buyers.
13.2.2.2.1. The Cartel Model of Oilgopoly:
The cartel model can be defined as a special case of oligopoly in which rival
firms in an industry come together as a cartel to create formal agreements to
make decisions to attain high profits. The formation of a cartel is more
applicable to oligopoly where there are a small number of firms.
Organisations that form cartel come to an agreement on issues, such as price
fixing, total industry output, market share, the allocation of customers, the
allocation of territories, bid rigging, establishment of common sales agencies
and the division of profits. In a cartel, all the firms sell at the same price, and
each organisation set its individual production volume for sale, so that the
marginal cost of operation remains same. The most important example of an
effective cartel is the Organization of Petroleum Exporting Countries (OPEC),
which was formed at the Baghdad Conference on 10–14 September, 1960.
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The aim of the OPEC is to coordinate the policies of oil producing countries in
a way that the member states receive a steady income. The member states
also collude to influence the prices of oil all over the world. Presently, there
are 12 member countries in OPEC cartel.
13.2.2.3. Monopoly:
Monopoly can be defined as a market structure, wherein a single producer or
seller has a control on the entire market. The term monopoly has been
derived from a Greek word Monopolian, which means a single seller. Thus, in
monopoly, a single seller deals in the products that have no close substitutes
in the market. Some of the definitions of monopoly are: In the words of Prof.
Chamberlain, “Monopoly refers to the control over supply.” According to
Prof. Thomas, “Broadly, the term monopoly is used to cover any effective
price control, whether of supply or demand of services or goods; narrowly it
is used to mean a combination of manufacturers or merchants to control the
supply price of commodities or services.”
In the words of Robert Triffin, “Monopoly is a market situation in which the
firm is independent of price changes in the product of each and every other
firm.” Thus by studying the abovementioned definitions, we can conclude
that the demand, supply and prices of a product are controlled by a single
seller in monopoly. Therefore, the slope of the demand curve moves
downward towards the right. A common example of a monopoly is Indian
Railways, which has control of railroad transportation. Some important
characteristics of monopoly are described as follows: ‰
 Existence of a single seller: Under monopoly market structure, there is always
a single seller producing large quantities of the products. Due to availability
of only one seller, buyers are forced to purchase from the only seller. This
results in total control on the supply of products by the seller in the market.
Moreover, the seller has complete power to decide the price of products. ‰
 Absence of substitutes: Another important characteristic of monopoly is the
absence of substitutes of the products in the market. In addition,
differentiated products are absent in the case of monopoly market. ‰
 Barriers to entry: The reason behind the existence of monopoly is the various
barriers that restrict the entry of new organisations in the market. These
barriers can be in the form of exclusive resource ownership, copyrights, high
initial investment and other restrictions by the government. Some of the
barriers that limit the entry of new organisations are: •
 Restrictions imposed by the government. For example, electricity in India is
considered as an old monopoly. •
 Control over resources required for production of other goods. For example,
Japan is considered to have a monopoly over electronic products. •
 Technological efficiencies resulting in economies of scale. ‰
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 Limited information: Under monopoly, information cannot be disseminated

in the market and is restricted to the organisation and its employees. Such
information is not easily available to public or other organisations. This type
of information generally comes in the form of patents, copyrights or
trademarks.
 Price Discrimination under Monopoly: It is generally observed that different
prices are charged from various users by a monopolist to achieve more
profits. This policy of charging different prices by a monopolist is known as
price discrimination. Some other important definitions of price discrimination
are:
In the words of J.S. Bains, “Price discrimination refers strictly to the practice
of a seller to charge different prices from different buyers for the same
goods.” According to Dooley, “Discriminatory monopoly means charging
different rates from customers for the same goods or services.” According to
Mrs. Joan Robisnon, “The act of selling the same article produced under single
control at a different price is known as price discrimination.” Thus, by studying
the abovementioned definitions, it can be concluded that price discrimination
is charging different prices from buyers by monopolists.
Price discrimination can be classified into three types, as shown in following
figure.
Let us discuss these types of price discrimination in detail. ‰

 Geographical price discrimination: In this type of price discrimination, a
monopolist charges different prices for the products in different areas.
Generally, if the demand of a product is inelastic in an area, the monopolist
charges higher price and vice versa. For example, rice is sold at different prices
by Food Corporation of India in Kashmir and Himachal Pradesh. ‰
 Personal price discrimination: In this type of price discrimination, a
monopolist charges different prices from different users or buyers. Personal
price discrimination occurs mainly due to ignorance among buyers related to
the prices of the products. For example, a grocery seller may charge different
prices for similar vegetables from different customers depending on the
negotiation power of customers. If a customer is aware of the prices and is
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able to bargain, the seller may become willing to sell the product at a lower
price. On the other hand, the seller may sell the same product at a higher
price if the customer is ignorant and unaware of prevailing prices in the
market.
 Utility based price discrimination: In this type of price discrimination, the
seller charges different prices from buyers in accordance with the use of the
products. For example, the price of electricity differs on the basis of
consumption, i.e., rate per unit for commercial use is higher than that for the
domestic use.
Market structure refers to the nature and degree of competition in the market for goods and
services. This chapter gives an overview of different kinds of market exist in the country. We
have also discussed about the pros and cons of the types of market. Next chapter will give an
idea about how the market economy will fail to exist.
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Managerial Economics Chapter 14: Market Failure
CHAPTER 14
MARKET FAILURE
Learning Objectives: In this chapter we will

LO1: understand about the meaning of market failure
LO2: know the causes of market failure
LO3: importance of market regulation
LO4: Price regulation and firms behaviour
14.1. What is market failure?

In the previous chapter, you have studied about the concept of market and different
types of market structures. As studied, market comprises various factors, such as
buyers, sellers, commodities and resources. The success of the market is mainly
dependent on the effective allocation of resources. However, there are situations
when markets fail to allocate these resources efficiently, which is also known as
market failure.
Market failure occurs when there is an imbalance in the quantity of a product
demanded and supplied, which leads to an inefficient allocation of resources. These
failures can occur due to a variety of reasons, such as existence of externalities, public
goods and incomplete information. The occurrence of market failure is more likely to
be in imperfect competition, due to existence of market power of organisations. Thus,
these organisations can influence the prices to increase their profits, resulting in total
failure of markets.
In order to prevent the market failures, the government intervention is required. The
government adopts various measures to keep the law of demand and supply
functioning. One such measure is price regulations (price ceiling, price floor, price cap,
etc.), whereby government intends to regulate the prices in the market. These
regulations impact the efficiencies of various organisations operating under them,
thereby affecting their profits.
14.2. Meaning of Market failure:

Market failure can be defined as a situation where the quantity of a product
demanded by consumers is not equal to the quantity supplied by suppliers. It occurs
mainly due to inefficient allocation of goods and services in the free market. In such a
situation, the social costs incurred in the production of goods are not minimised,
resulting in wastage of resources. Thus, equilibrium between supply and demand of
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Chapter 14: Market Failure Managerial Economics
the product is not reached. Let us understand the concept of market failure with the
help of an example.
It is known that wages are defined in accordance with the minimum wage laws.
Therefore, wage rates are established at the going market clearing wage to raise
market wages. On this, critics argue that employers prefer to employ less minimum
wage employees at a higher wage cost. Consequently, more minimum-wage workers
remain unemployed, thereby resulting in market failure due to high social costs.
Thus in simple words, market failure can be referred to as imperfections occurring in
exchange of products and services between buyers and sellers; thereby preventing
efficient allocation of scarce resources in the market. Market failures are corrected by
governmental interventions only.
14.2.1. Causes of market failures:
Market failures are not attributed to a single factor. There are various causes
that can result in market failures. However, there are four most important
causes of market failures, as listed in following:
i. Externalities
ii. Public goods
iii. Asymmetric information
iv. Imperfect competition
i. Externalities: These can be defined as an impact of production and
consumption of products affecting the third-party (one who is neither
a consumer, nor the producer of the product). Externalities can be
either positive or negative.
Positive externality can be defined as the positive impact of the
consumption of a product on the third-party. For example, increase
in education of individuals can result in an increase in productivity,
fall in unemployment and a higher political participation in the
country. Positive externality is also known as an external benefit.
Negative externality can be defined as the negative impact of the
consumption of a product on the third-party. In this case, social cost
of an activity exceeds the private cost. Example of negative
externality is noise pollution due to various sources, which can be
mentally and psychologically disruptive for the nearby people.
Negative externalities are also known as an external cost.
ii. Public goods: These are the goods that are characterised by non-
excludability and non-rivalry. By non-excludability, it means that a
good that benefits an individual can be used by others too to derive
the same benefits. Non-rivalry implies that the enjoyment of using a
product does not reduce the satisfaction of those who have been
using it from a certain time. An example of a public good is the
defence system, as it provides protection to all the individuals of a
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nation. The problem with these goods is that they can be used by
everyone after made available making it impossible to regain the
costs of provision by extracting payment from users resulting in
market failures.
iii. Asymmetric information: It deals with the study of decisions in
transactions, wherein one party has access to more or better in-
formation than others. Due to absence of the same information to all
the participants, individuals or organizations are unable to make the
right decisions. This results in an imbalance of power in transactions
that can lead to market failure. Due to information asymmetry, the
following two problems occur:
Adverse selection: This implies taking the advantage of asymmetric
information before transaction. For example, a person may be more
eager to purchase life insurance due to health problems than,
someone who is healthy.
Moral hazards: This implies taking the advantage of asymmetric
information after transaction. For example, if someone has car
insurance he may commit theft by getting his car stolen to reap the
benefits of the insurance.
iv. Imperfect market conditions: Market failure is also caused due to
imperfect market conditions, such as monopoly (existence of a single
supplier in the market) and oligopoly (existence of few firms that
control the market). In imperfect market structure, organisations
have market power to influenceprices. This can result in inefficiencies
due to the following:
a. Existing firms have the power to raise prices to increase their
profits while the demand remains the same.
b. Various barriers to entry by other firms restrict competition in the
market.
c. To prevent market failures due to the presence of market power,
government interventions are required to correct the market
operations or set prices at a competitive level.
14.3. Price Regulation:

Price regulations are governmental measures dictating the quantities of a commodity
to be sold at specified price both in the retail marketplace and at other stages in the
production process. These regulations act as control measures or emergency
economic measures in the case of imperfect competition to prevent probable market
failures. For example, in monopolies, sellers have complete market power of
controlling the pricing decisions and setting prices higher than in competitive markets.
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Chapter 14: Market Failure Managerial Economics
In such a case, demand for the product does not lower down, which can lead to
market failure. Thus, the government is required to intervene in the scenario to
prevent market failures. By using price regulations, the government not only controls
the functioning of the market, rather protects consumer welfare.
Price Regulation and Firm Behavior:
As discussed in the previous section, there are basically two types of price regulation
used by the government, which are price ceiling and price floor. These price regulatory
mechanisms have an impact on a firm’s behaviour as price regulations affect the
efficiency (profits) of the firm. In this section, you will study the effect of price ceiling
and price floor on the firm’s efficiency. Price ceiling and firm efficiency: The most
common regulatory system under the price ceiling is the price cap regulation. A price
cap regulation is used to set a maximum allowed price for a specific product. Price cap
regulation has a direct impact on the firm’s efficiency. Let us understand this with the
help of an example. Consider a gas distributor that sells LPG to local consumers. The
firm can be regulated using the two policies. The firm may either operate under a
regulatory system that limits profits to a set level (assuming the limit at ` 20 lakh).
Alternatively, the firm may operate under price cap regulation, where it can set the
price of LPG at a cap of 5 cents per megajoule (Mj). At this price, the firm can sell
1,00,000 Mj resulting in a profit of ` 30 lakh. Firm profits are computed as revenue less
costs of production. The costs of production would include billing and servicing
customers, routine and emergency maintenance, cost of wholesale gas, etc. If the
costs of retailing and distributing 1,00,000 Mj of gas are ` 10 lakh, then the firm would
earn a profit of ` 20 lakh under the price cap regulation. In other words, the firm makes
identical profits under either of the two regulatory systems with identical levels of
output and costs of production. However, if the owners of the firm using the profit
limiting regulatory system reduce the costs of production, then the increase in profit
would need to be offset by using other measures, such as lowering the price of LPG.
Therefore, there is a little incentive for the firm to operate efficiently under profit
regulation system. On the other hand, if the firm follows the price cap regulation, any
reduction in the costs of production can be retained by the firm. If the owners reduce
the costs of producing 1,00,000Mj of LPG to ` 8 lakh (from ` 10 lakh), then the entire `
2 lakh is retained as the increased profits. As the firm retains the benefits of cost
reductions under price cap regulation, the price cap regulatory system provides
dominant eficiency incentives to the firm. However, price ceiling imposed on
suppliers as a government’s intervention may sometimes lead to the shortage of
goods. Generally, the government apply price ceilings on the sale of petroleum by
various private organisations such as Reliance Petroleum Limited. Any supplier
charging more than this maximum price would be guilty of fraud. This may often lead
to the shortage of petroleum in the market. Assume that the equilibrium price is ` 70
per gallon of petrol. The maximum price set by the government is ` 67.50 per gallon.
At the price of ` 67.50 per gallon, the quantity demanded is 10 million gallons per week
and the quantity supplied is 5 million gallons per week. Thus, there is a shortage of 5
million gallons per week.
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14.4. Price floor and firm efficiency:

Price floor is a price regulation system where a minimum price is determined for
selling a firm’s product. A price floor encourages firms to increase their output beyond
the consumers’ demand. The government purchases the surplus, which is equal to the
quantity supplied minus the quantity demanded, at the floor price. As a result, the
marginal cost of production exceeds the marginal profits of the firm resulting in a
deadweight loss for the firm. Therefore, price floor results in a decline in the efficiency
of the firm.
Market efficiency is the property of society maximizes the benefits it achieves from the use of
its scarce resources. When the production is efficient, the economy will obtain all it can from
the scarce resources that is available and there is no way to produce more than a good without
producing less of other goods. Market failure is a circumstance which a market will overlook
its own fails to allocate resources efficiently.
BIBS 181

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Managerial

Chapter No Chapter Name Page No

5 Interest Rates ....................................................................................63

6 Monetary Policy ................................................................................78

7 Fiscal Policy .......................................................................................91

8 Business Cycles ...............................................................................106

9 Foreign Exchange market and International trade .........................116

10 Demand and its analysis .................................................................131

11 Supply and its analysis ....................................................................150

12 Theory of production ......................................................................157

13 Market structures ...........................................................................168

Learning Objectives: In this chapter we will:

1.1. What is Economics?

1.1.1. Nature of Economics:

Nature of economics refers to whether economics is a science or art or both, and if it

• We have often stated that Economics is a social science.

• price, demand, supply, money supply, production, national income,

• Various branches of Economics, like consumption, production, distribution,

economical as well as socio-economical problem. When economic laws are tested

Economics as a positive science—

• A positive science is that science in which analysis is confined to cause and

• Positive economics is concerned with the facts about the economy.

• It studies the economic phenomena as they exist.

• It generalizes their relationship by formulating economic theories and makes

Economics as a normative science—

The above fact can be described by the following example:

1.1.2. Economics and the other branches of social sciences:

Economics as a branch of social science is interrelated with the other sub-disciplines

Economics and Sociology

Economics and Politics:

Economics and History

Economics, mathematics and statistics

store information, to identify trends, to attribute value, and mathematics to calculate

Economics is a social science

1.2 Economic resources

thus increase wages – as we’ll see later in the course.

3. Capital: Capital includes man-made items such as buildings, machinery, and

4. Entrepreneurship: The last resource is entrepreneurship, which combines the

Effective allocation and management of economic resources is an essential task

1.2.1 Economic Efficiency

1.3. Three major Economic systems:

Merits of market economy:

Demerits of market economy:

Demerits of Planned economy:

it is even allowed. Any private business would constantly be under the

Demerits of Mixed Economy:

Planned or Command Free market or Laissez Fair

Cuba, North Korea, Singapore, USA, Hong

1.4. Different branches of Economics:

Fig. 1.A: Subject matter of Economics

1.4.2. Significance of Microeconomics in Business Decision Making

d) Theory of general price level

Table 1. B: Five differences between micro and macroeconomics:

Deals with Individual economic variables Aggregate economic variables

Business Applied to operational or internal

Covers various issues like demand,

Helpful in determining the prices of a Maintains stability in the general

It has been analysed that 'Fallacy of

1.4.4 Micro and Macroeconomic factors affect economic environment:

way or the other, in order to sustain the businesses. And so there is an

2.1. Understanding the concept of national income:

The concept of national income has three interpretations. It represents total

In India national income measures are published by Central Statistical

2.2. How does income flow within the entire economy?