MANAGERIAL ECONOMICS

Unit I: Introduction to Managerial Economics: Definition, Nature, Scope,

Significance, MicroEconomics and Macro-Economics, Price and Value, Money,
Capital, Commodity, Satisfaction, Utility, Consumption, Production.

Unit II: Theory of Demand & Supply –Concept of Demand, Aggregate

Demand, Determinants of Demand, Demand Function, Law of Demand,
Elasticity of Demand, Demand Forecasting. Theories of Supply-Concept of
Supply, Aggregate Supply, Determinants of Supply, Supply function, Law of
Supply, Elasticity of Supply.

Unit III: Production &Cost Analysis: Concept of Cost, Different Types of Cost–
Fixed Cost, Variable Cost, Total Costs &Average Costs, Long-Run and Short-
Run Cost Curve, Cost Function, Law of Variable Proportions; Production,
Factors of Production, Cobb-Douglas Production Function. Law of Return to
scale.

Unit IV: Market Structure and pricing decisions : Types of Markets -monopoly,
monopolistic competition and oligopoly, Perfect Competition, Price and Output
determination in these types of market.

Unit V: National Income: Concept like GDP, GNP in National Income,

Measurement of National Income. Business Cycles, Fiscal Policy, Monetary
Policy, Inflation& Deflation.
 Unit I: Introduction to Managerial Economics

Introduction and Definition:

Managerial Economics is indeed an off-shoot of the Second World War. Before

the outbreak of this war, the study of economics was purely an academic
exercise, while business was a pure practice based on common practical sense
of human mind. The Second World War created a tremendous pressure on
scarce economic resources of the world. Thus, the need for optimum utilization
of resources intensified further, which ultimately gave birth to a new discipline
popularly known as Managerial Economics.

The present business world has become very dynamic, complex, uncertain and
risky. Therefore taking appropriate, correct and timely decision has become a
challenging and tedious task. The existence/ survival and growth of business
basically depends on such decisions. Undoubtedly, Managerial Economics is a
friend. philosopher and guide to the business leaders and managers. Further, the
growing complexity of decision-making process, the increasing use of economic
logic, concepts, theories and tools of economic analysis in the process of
decision-making and rapid increase in the demand for professionally trained
managerial man power increased the importance of the study of managerial
economics as a separate discipline of managerial curriculum. In this unit, we
would be studying the meaning, nature and scope of Managerial Economics and
its relationship with other branches of knowledge.

Managerial economics is a stream of management studies that emphasizes

primarily on solving business problems and decision-making by applying the
theories and principles of microeconomics and macroeconomics. It is a
specialized stream dealing with an organization‘s internal issues using various
economic tools. Economics is an indispensable part of any business. This single
concept derives all the business assumptions, forecasting, and investments.

Nature of Managerial Economics:

Managerial economics is a stream of management studies that emphasizes
primarily on solving business problems and decision-making by applying the
theories and principles of microeconomics and macroeconomics. It is a
specialized stream dealing with an organization‘s internal issues using various
economic tools. Economics is an indispensable part of any business. This single
concept derives all the business assumptions, forecasting, and investments.
• Art and Science: Management theory requires a lot of critical and logical
thinking and analytical skills to make decisions or solve problems. Many
economists also find it a source of research, saying it includes applying different
economic concepts, techniques, and methods to solve business problems.

• Microeconomics: Managers typically deal with the problems relevant to a

single entity rather than the economy as a whole. It is therefore considered an
integral part of microeconomics.

• Uses of Macro Economics: A corporation works in an external world, i.e., it

serves the consumer, which is an important part of the economy. For this
purpose, managers must evaluate the various macroeconomic factors such as
market dynamics, economic changes, government policies, etc., and their effect
on the company.

• Multidisciplinary: Managerial economics uses many tools and principles that

belong to different disciplines, such as accounting, finance, statistics,
mathematics, production, operational research, human resources, marketing, etc.

• Prescriptive or Normative Discipline: By introducing corrective steps

managerial economics aims at achieving the objective and solves specific issues
or problems.

• Management Oriented: This serves as an instrument in managers‘ hands to

deal effectively with business-related problems and uncertainties. This also
allows for setting priorities, formulating policies, and making successful
decisions.

• Pragmatic: The solution to day-to-day business challenges is realistic and

rational.

Different individuals take different views of the principles of managerial

economics. Others may concentrate more on customer service, while others may
prioritize efficient production.

Scope:
The definition of managerial economics is commonly used to deal with various
business problems within organizations. Both microeconomics and
macroeconomics have an equal effect on the organization and its work.

1. Demand Analysis and Forecasting

An economic organization is engaged in converting productive resources into
goods that can be sold in the market. A major part of this decision-making is
based on accurate estimates of demand. When future sales are forecast, the
management gets a better idea of when to produce and how much labor to
employ. This helps management maintain its market profit and strengthen the
customer base and profit base. Decision analysis also helps to understand
various factors affecting a company‘s growth. All this would not have been
possible if not for Managerial Economics.

2. Cost and Production analysis

While making a managerial decision, cost estimates are very important. All the
different factors that cause fluctuations in cost should be given due importance.
This is very important for planning purposes. This is also very difficult because
many cost fluctuating factors are uncontrollable or not known. Due to this
uncertainty of cost, managerial economics comes into the picture. If a company
can measure cost, it would help them make sound profit planning, pricing, and
cost control practices. The scope of managerial economics in cost and
production analysis extends to

Estimation of the cost in production

Recognizing the factors, which are causing costs to the firm

Suggests cost should reduce for making good profits

Production analysis deals with, Minimum cost that should be spent on raw
materials and maximum production should be obtained

3. Pricing decisions, policies, and practice

The scope of managerial economics is not just limited to making decisions. It

also helps in drafting policies. The price of the product/ service offered by the
company gives them profit and hence is considered to be the most important
field of managerial economics. If the company makes the correct price
decisions, it will be far more successful. The various factors that are dealt with
under this are market forms, pricing policies, pricing methods, differential
pricing, productive pricing, and price forecasting.

4. Profit Management
Most businesses start for the sole reason of earning maximum profit. But this is
always uncertain due to fluctuations in the market costs and revenues. The
world is not perfect, therefore profit analysis is a very difficult task. Profit
planning and measurement make up a large part of the scope of managerial
economics. A proper study of the nature and management of profit, profit
policies, and techniques of profit planning like break-even analysis has to be
done.

5. Capital Management

If you know the business, you know how troublesome and stressful investment
decisions are. Planning and controlling capital expenditure is very difficult as it
involves a large sum of money. Also, disposing of capital assets is complex and
requires time and labor. The main aspects to consider in capital management are
the cost of capital, rate of return, and selection of projects.

6. Analysis of Business Environment

The scope of managerial economics is not just limited to the operational issues
of a firm. Various environmental factors affect the performance of a business.
Therefore, it is very important to consider environmental factors while the
managers are in the process of decision making. If decisions are made without
considering environmental factors, it would prove very harmful for the
company. Therefore, the management must be aware of the economic
environment, especially those that affect the business climate. The factors that
affect the business climate most are the general trend in national income and
consumption expenditure, general price trends, trading relations with other
countries, trends in the world market, economic and business policies of the
government, and industrial relations.

7. Allied disciplines

Most concepts and theories that help make business decisions are quantitative.
Hence, it is very important to use mathematical tools to determine the
relationship between economic variables. The mathematical linear programming
techniques are used by firms. This helps them maximize and minimize objective
functions. Similarly, many statistical and accounting principles are also being
used. So, all mathematical tools, statistical techniques, and accounting
principles that are used in analyzing business problems also come under the
scope of Managerial Economics.
Significance of Managerial Economic:

1. Business Planning : Managerial economics assists business organizations

in formulating plans and better decision making. It helps in analyzing the
demand and forecasting future business activities.
2. Cost Control: Controlling the cost is another important role played by
managerial economics. It properly analyses and decides production
activities and the cost associated with them. Managerial economics
ensure that all resources are efficiently utilized which reduces the overall
cost.
3. Price Determination: Setting the right price is one of the key decisions to
be taken by every business organization. Managerial economics supplies
all relevant data to managers for deciding the right prices for products.
4. Business Prediction: Managerial economics through the application of
various economic tools and theories helps managers in predicting various
future uncertainties. Timely detection of uncertainties helps in taking all
possible steps to avoid them.
5. Profit Planning And Control: Managerial economics enables
in planning and managing the profit of the business. It makes an accurate
estimate of all cost and revenue which helps in earning the desired profit.
6. Inventory Management: Proper management of inventory is a must for
ensuring the continuity of business activities. It helps in analyzing the
demand and accordingly, production activities are performed. Managers
can arrange and ensure that the proper quantity of inventory is always
available within the business organization.
7. Manages Capital: Managerial economics helps in taking all decisions
relating to the firm‘s capital. It properly analyses investment avenues
before investing any amount into it to ensure the profitability of an
investment.

Micro Economics and Macro-Economics:

Microeconomics is the study of decisions made by people and businesses
regarding the allocation of resources and prices of goods and services. The
government decides the regulation for taxes. Microeconomics focuses on the
supply that determines the price level of the economy.
It uses the bottom-up strategy to analyse the economy. In other words,
microeconomics tries to understand human‘s choices and allocation of
resources. It does not decide what are the changes taking place in the market,
instead, it explains why there are changes happening in the market.

The key role of microeconomics is to examine how a company could maximise

its production and capacity, so that it could lower the prices and compete in its
industry. A lot of microeconomics information can be obtained from the
financial statements.

The key factors of microeconomics are as follows:

1. Demand, supply, and equilibrium

2. Production theory
3. Costs of production
4. Labour economics

Examples: Individual demand, and price of a product.

Macroeconomics is a branch of economics that depicts a substantial picture. It

scrutinises itself with the economy at a massive scale, and several issues of an
economy are considered. The issues confronted by an economy and the
headway that it makes are measured and apprehended as a part and parcel
of macroeconomics.

Macroeconomics studies the association between various countries regarding

how the policies of one nation have an upshot on the other. It circumscribes
within its scope, analysing the success and failure of the government strategies.

In macroeconomics, we normally survey the association of the nation‘s total

manufacture and the degree of employment with certain features like cost
prices, wage rates, rates of interest, profits, etc., by concentrating on a single
imaginary good and what happens to it.

The important concepts covered under macroeconomics are as follows:

1. Capitalist nation
2. Investment expenditure
3. Revenue

Examples: Aggregate demand, and national income.

Price and Value:

The CBV Institute refers to the theoretical value (also called notional value) of a
business as the ―fair market value.‖ This is defined as ―the highest amount of
cash at which a business would change hands between a willing and able buyer
and seller, in an open and unrestricted market when neither is forced to buy or
sell and when both parties have reasonable knowledge of the facts.‖

In a commercial transaction, a product or service is exchanged for a price,

between the buyer and seller. So, we can say that price is the amount to be paid,
in order to get the product or service. There are many people who believe that
price, cost and value of a product or service are one and the same thing, but
there is nothing like that.

Cost is basically the aggregate monetary value of the inputs used in the
production of the goods or delivery of services. Conversely, Value of a product
or service is the utility or worth of the product or service for an individual.

Money:
Money, a commodity accepted by general consent as a medium of economic
exchange. It is the medium in which prices and values are expressed;
as currency, it circulates anonymously from person to person and country to
country, thus facilitating trade, and it is the principal measure of wealth.

Capital :

Capital is a broad term that can describe anything that confers value or benefit
to its owners, such as a factory and its machinery, intellectual property like
patents, or the financial assets of a business or an individual.

While money itself may be construed as capital, capital is more often associated
with cash that is being put to work for productive or investment purposes. In
general, capital is a critical component of running a business from day to day
and financing its future growth.

Business capital may derive from the operations of the business or be raised
from debt or equity financing. Common sources of capital include:

 Personal savings
 Friends and family
 Angel investors
 Venture capitalists (VC)
 Corporations
 Federal, state, or local governments
 Private loans
 Work or business operations
 Going public with an IPO
 Unit II: Theory of Demand & Supply

Concept of Demand:

Demand simply means a consumer‘s desire to buy goods and services without
any hesitation and pay the price for it. In simple words, demand is the number
of goods that the customers are ready and willing to buy at several prices during
a given time frame. Preferences and choices are the basics of demand, and can
be described in terms of the cost, benefits, profit, and other variables.
The amount of goods that the customers pick, modestly relies on the cost of the
commodity, the cost of other commodities, the customer‘s earnings, and his or
her tastes and proclivity. The amount of a commodity that a customer is ready
to purchase, is able to manage and afford at provided prices of goods, and
customer‘s tastes and preferences are known as demand for the commodity.

Aggregate Demand :
Aggregate demand, or market demand, is the demand from a group of people.
The five determinants of individual demand govern it. There‘s also a sixth: the
number of buyers in the market.

Aggregate demand can be measured for a country. It's the quantity of the goods
or services the country produces that the world's population demands. For that
reason, it is composed of the same five components that make up gross
domestic product:

 Consumer spending
 Business investment spending
 Government spending
 Exports
 Imports, which are subtracted from aggregate demand and GDP

Determinants of Demand :
There are many determinants of demand, but the top five determinants of
demand are as follows:

Product cost: Demand of the product changes as per the change in the price of
the commodity. People deciding to buy a product remain constant only if all the
factors related to it remain unchanged.
The income of the consumers: When the income increases, the number of goods
demanded also increases. Likewise, if the income decreases, the demand also
decreases.

Costs of related goods and services: For a complimentary product, an increase

in the cost of one commodity will decrease the demand for a complimentary
product. Example: An increase in the rate of bread will decrease the demand for
butter. Similarly, an increase in the rate of one commodity will generate the
demand for a substitute product to increase. Example: Increase in the cost of tea
will raise the demand for coffee and therefore, decrease the demand for tea.

Consumer expectation: High expectation of income or expectation in the

increase in price of a good also leads to an increase in demand. Similarly, low
expectation of income or low pricing of goods will decrease the demand.

Buyers in the market: If the number of buyers for a commodity are more or less,
then there will be a shift in demand.

Types of Demand
Few important different types of demand are as follows:

1. Price demand: It refers to various types of quantities of goods or

services that a customer will buy at a quoted price and given time,
considering the other things remain constant.
2. Income demand: It refers to various types of quantities of goods or
services that a customer will buy at different stages of income,
considering the other things remain constant.
3. Cross demand: This means that the product‘s demand does not depend
on its own cost but depends on the cost of the other related commodities.
4. Direct demand: When goods or services satisfy an individual‘s wants
directly, it is known as direct demand.
5. Derived demand or Indirect demand: The goods or services demanded
or needed for manufacturing the goods and satisfying the consumer
indirectly is known as derived demand.
6. Joint demand: To produce a product there are many things that are
related to each other, for example, to produce bread, we need services
like an oven, fuel, flour mill, and more. So, the demand for other
additional things to produce a product is known as joint demand.
 7. Composite demand: A composite demand can be described when goods
and services are utilised for more than one cause. Example: Coal

Demand Function:

Mathematically, a function is a symbolic representation of the relationship

between dependent and independent variables.

Let us assume that the quantity demanded of a commodity X is Dx, which

depends only on its price Px, while other factors are constant. It can be
mathematically represented as:

Dx = f (Px)

However, the quantitative relationship between Dx and Px is expressed as:

Dx = a – bPx

Where a (intercept) and b (relationship between Dx and Px) are constants.

Law of Demand:

The law of demand governs the relationship between the quantity demanded
and the price. This economic principle describes something you already
intuitively know. If the price increases, people buy less. The reverse is also true.
If the price drops, people buy more.

But the price is not the only determining factor. The law of demand is only true
if all other determinants don't change.

Elasticity of Demand :

Demand elasticity means how much more, or less, demand changes when the
price does. It's specifically measured as a ratio. It's the percentage change of the
quantity demanded divided by the percentage change in price.

There are three levels of demand elasticity:

Unit elastic is when demand changes by the exact same percentage as the price
does.

Elastic is when demand changes by a greater percentage than the price does.
Inelastic is when demand changes by a smaller percentage than the price does.

Demand Forecasting:

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

It is a technique for estimation of probable demand for a product or services in

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

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

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

Theories of Supply -

Concept of Supply:
Supply refers to the amount of a good or service that the producers/providers
are willing and able to offer to the market at various prices during a period
of time. There are two important aspects of supply:

 Supply refers to what is offered for sale and not what is finally sold.
 Supply is a flow. Hence, it is a certain quantity per day or week or month,
etc.

Determinants of Supply:

While the price is an important aspect for determining the willingness and
desire to part with goods/services, many other factors determine the supply of
a product or service as discussed below:

Price of the Good/ Service

The most obvious one of the determinants of supply is the price of the
product/service. With all other parameters being equal, the supply of a product
increases if its relative price is higher. The reason is simple. A firm provides
goods or services to earn profits and if the prices rise, the profit rises too.

Price of Related Goods

Let‘s say that the price of wheat rises. Hence, it becomes more profitable for
firms to supply wheat as compared to corn or soya bean. Hence, the supply of
wheat will rise, whereas the supply of corn and soya bean will experience a fall.

Hence, we can say that if the price of related goods rises, then the firm increases
the supply of the goods having a higher price. This leads to a drop in the supply
of the goods having a lower price.

Price of the Factors of Production

Production of a good involves many costs. If there is a rise in the price of a

particular factor of production, then the cost of making goods that use a great
deal of that factors experiences a huge increase. The cost of production of goods
that use relatively smaller amounts of the said factor increases marginally.

For example, a rise in the cost of land will have a large effect on the cost of
producing wheat and a small effect on the cost of producing automobiles.

Therefore, the change in the price of one factor of production causes changes in
the relative profitability of different lines of production. This causes producers
to shift from one line to another, leading to a change in the supply of goods.

State of Technology

Technological innovations and inventions tend to make it possible to produce

better quality and/or quantity of goods using the same resources. Therefore, the
state of technology can increase or decrease the supply of certain goods.

Government Policy

Commodity taxes like excise duty, import duties, GST, etc. have a huge impact
on the cost of production. These taxes can raise overall costs. Hence, the supply
of goods that are impacted by these taxes increases only when the price
increases. On the other hand, subsidies reduce the cost of production and
usually lead to an increase in supply.
Aggregate Supply:

Aggregate supply is the total value of goods or services in a market, sector or

economy. Aggregate supply is used to show the amount of goods that can be
produced at different price levels in a given time period – usually one year.

Aggregate supply is the total quantity of output firms will produce and sell—in
other words, the real GDP.

The upward-sloping aggregate supply curve—also known as the short run

aggregate supply curve—shows the positive relationship between price level
and real GDP in the short run.

The aggregate supply curve slopes up because when the price level for outputs
increases while the price level of inputs remains fixed, the opportunity for
additional profits encourages more production.

Potential GDP, or full-employment GDP, is the maximum quantity that an

economy can produce given full employment of its existing levels of labor,
physical capital, technology, and institutions.

Aggregate demand is the amount of total spending on domestic goods and

services in an economy.

Supply function:

A supply function is a tool used by economists to measure the relationship

between price and quantity of goods supplied. The supply function describes the
effect that changes in one variable have on another. Supply function can be
described with three variables: Price, Quantity Supplied, and Marginal Cost.
The supply function is also known as Supply Curve. The Supply Curve is a
graphical representation of the Law of Supply. It shows the relationship
between price and quantity supplied at a given point in time. The curve slopes
upward because as price increases, producers are able to sell more units of the
good or service. The marginal cost curve intersects the supply curve at the
equilibrium point. This is where quantity supplied equals quantity demanded.
The marginal cost curve measures the change in total costs associated with
producing one more unit of output. At the equilibrium point, marginal cost is
equal to price.

1. Supply function is an integral part of microeconomics, which deals with

the behavior and decision-making process of individuals and firms in
 society. The supply function is used to measure price elasticity demand
for goods & services. The concept helps economists predict how much
quantity will be produced by producers when prices change.
2. Supply function is also used in macroeconomics, which deals with the
performance, structure, and behavior of an economy as a whole. Supply
functions help policymakers understand how shocks to the economy
(such as changes in tax rates or government spending) will impact things
like employment levels and inflation.
3. Supply function is used in business, to help managers understand how
costs and prices impact their production levels. The supply curve can be
helpful in forecasting future sales and making pricing decisions.
4. Supply function is also used in agricultural economics, which deals with
land usage and food production. Supply functions can help assess how
policies impact the price of crops or livestock over time.
5. Supply function is also used in natural sciences, for example, to
determine the effect of temperature changes on tiny organisms or
chemicals. Supply functions can help scientists understand how
biological specimens react when they are exposed to new conditions such
as heat or cold.

Law of Supply:
The law of supply is a fundamental concept in microeconomics that governs
supply at a given price. The law of supply states that when the market price of a
good increases, suppliers will increase the supply of that good. And when the
price decreases, the quantity they will supply decreases.

When employing the law of supply concept, economists assume that only the
price changes and all other variables that can affect supply (like consumer
mindset or materials cost) remain constant. On a graph with quantity (the
dependent variable) on the horizontal axis and price (the independent variable)
on the vertical axis, the law of supply forms an upward slope, called a supply
curve, which shows the relationship between the cost of a product and the
quantity that suppliers can (or will) supply.

Law of supply states that other factors remaining constant, price and quantity
supplied of a good are directly related to each other. In other words, when the
price paid by buyers for a good rises, then suppliers increase the supply of that
good in the market.
Description: Law of supply depicts the producer behavior at the time of changes
in the prices of goods and services. When the price of a good rises, the supplier
increases the supply in order to earn a profit because of higher prices.

The above diagram shows the supply curve that is upward sloping (positive
relation between the price and the quantity supplied). When the price of the
good was at P3, suppliers were supplying Q3 quantity. As the price starts rising,
the quantity supplied also starts rising.

Elasticity of Supply:

The price elasticity of supply is a measure of the degree of responsiveness of the

quantity supplied to the change in the price of a given commodity. It is an
important parameter in determining how the supply of a particular product is
affected by fluctuations in its market price. It also gives an idea about the profit
that could be made by selling that product at its price difference. In this article,
we will discuss the elasticity of the supply formula, different types of elasticity
of supply, the supply curve characteristics, and many more.

The price elasticity of supply refers to the response to a change in a good or

service's price by the supply of that good or service. According to basic
economic theory, the supply of goods decreases when its price increases.

Similarly, one can also study the price elasticity of demand. This illustrates how
easily the demand for a product can change based on changes in price. Price
changes fairly rapidly if the price of a product changes. This is known as price
elasticity of demand.

Price Elasticity of Supply Formula

After having understood the elasticity of supply definition in economics, we
now move to the elasticity of supply formula which is based on its definition.

ES=%ΔP%ΔQ =%Δ %Δ

Here,
ES
denotes the elasticity of supply which is equal to the percentage change in
quantity supplied divided by the percentage change in the price of the
commodity.

Since producers compete for profits in a free market, profits are never constant
over time or across different goods. Entrepreneurs, therefore, shift resources and
labor efforts towards products that are more profitable and away from those that
are less profitable.

The law of supply refers to the tendency for price and quantity to be related. For
instance, assume that consumers demand more oranges and fewer apples. More
dollars are bidding for oranges, but fewer for apples, resulting in higher orange
prices.

5 Types of Elasticity of Supply

Price elasticity of supply is of 5 types; perfectly elastic, more than unit elastic,
unit elastic supply, less than unit elastic, and perfectly inelastic. Read below to
know them in more detail.
1. Perfectly Elastic Supply: A commodity becomes perfectly elastic when
its elasticity of supply is infinite. This means that even for a slight
increase in price, the supply becomes infinite. For a perfectly elastic
supply, the percentage change in the price is zero for any change in the
quantity supplied.
2. More than Unit Elastic Supply: When the percentage change in the
supply is greater than the percentage change in price, then the commodity
has the price elasticity of supply greater than 1.
3. Unit Elastic Supply: A product is said to have a unit elastic supply when
the change in its quantity supplied is proportionate or equal to the change
in its price. The elasticity of supply, in this case, is equal to 1.
4. Less than Unit Elastic Supply: When the change in the supply of a
commodity is lesser as compared to the change in its price, we can say
 that it has a relatively less elastic supply. In such a case, the price
elasticity of supply is less than 1.
5. Perfectly Inelastic Supply: Product supply is said to be perfectly inelastic
when the percentage change in the quantity supplied is zero irrespective
of the change in its price. This type of price elasticity of supply applies to
exclusive items. For example, a designer gown styled by a famous
personality.
 Unit III: Production & Cost Analysis

Concept of Cost :
The concept of cost is a key concept in Economics. It refers to the amount of
payment made to acquire any goods and services. In a simpler way, the concept
of cost is a financial valuation of resources, materials, risks, time and utilities
consumed to purchase goods and services. From an economist's point of view,
the cost of manufacturing any goods and services is often said to be the concept
of opportunity cost.
With heightened competition in today's world, companies are urged to make
maximum profits. The company's decision to maximize earnings relies on the
behavior of its costs and revenues. Besides the concept of opportunity cost,
there are several other concepts of cost namely fixed costs, explicit costs, social
costs, implicit costs, social costs, and replacement costs.

Different Types of Cost –

Fixed Cost :

Fixed costs are those which do not change with the volume of output. The
business incurs them regardless of their level of production. Examples of these
include payment of rent, taxes, interest on a loan, etc.

Variable Cost :
These costs will vary depending upon the output that the business generates.
Less production will cost fewer expenses, and vice versa, the business will pay
more when its production is greater. Expenses on the purchase of raw material
and payment of wages are examples of variable costs.

Total Costs & Average Costs:

Total cost is an economic measure that sums all expenses paid to produce a
product, purchase an investment, or acquire a piece of equipment including not
only the initial cash outlay but also the opportunity cost of their choices. The
meaning of this term varies slightly depending on the content. For example,
when using it to define production costs, it measures the total fixed, variable,
and overhead expenses associated with producing a good. This is a fundamental
concept for business owners and executives because it allows them to track the
combined costs of their operations. It allows the individuals to make pricing and
revenue decisions based on whether total costs are increasing or decreasing.
Furthermore, interested individuals can dig into the total cost numbers to
separate them into fixed costs and variable costs, and adjust operations
accordingly to lower overall costs of production. Management also uses this
idea when contemplating capital expenditures..

Average Cost, also called average total cost (ATC), is the cost per output unit.
We can calculate the average cost by dividing the total cost by the total output
quantity.

Average Cost equals the per-unit cost of production which is calculated by

dividing the total cost by the total output.

Total cost means the sum of all costs, including the fixed and variable costs.
Therefore, Average Cost is also often called the total cost per unit or the
average total cost.

Long-Run and Short-Run Cost Curve :

In the diagram (Fig. 23.6), SAC,, SAC,, and SAC, are the short-run cost curves
corresponding to the different scales of operations. In each case, the firm in
question will be producing the desired output at the lowest cost. For example,
OM‖‘ output is produced at PM‖‘ in the scale of operations represented by the
curve SAC OM will be produced on SAC, and so on.

It should be clearly understood that only in the long-run can the scale of
operations be altered; in the short-run, it will be fixed, and the average cost of
output above or below the optimum level will necessarily rise along the short-
run cost curve in question, whether it be SAC,, SAC 2 and SAC3. A long-run
average cost will show what the long-run cost of producing each output will be.
It will be seen, in the Fig. 23.6 that the short-run average cost curve SAC, has a
lower minimum point than either the curves SAC, and SAC3. The optimum
output of the firm is obtained at OM.
The long-run average cost curve LAC is a tangent to all the short-run cost
curves SAC, SAC2 and SAC. The LAC curve will, therefore, be U-shaped like
the short-run cost curves, but its U-shape will be less pronounced than that of
the short-run cost curves. It will be flatter. That is why the long-run cost curve
is called an ‗Envelope‘, because it envelops all the short-run cost curves.

We may repeat that, in the short-run, a firm will adjust output to demand by
varying the variable factors. If all the factors of production can be used in
varying proportions, it means that the scale of operations of the firm can be
changed. Each time, the scale of operations is changed, a new short-run cost
curve will have to be drawn for the firm such as SAC‘, SAC‖ and SAC‖ in the
next diagram.

To begin with, let us suppose that the firm has the short-run cost curve SAC ―.
,In this case, the optimum output will be OM‘. Now, if it is desired to increase
the output to OM‖ in the short-run, it can be obtained at the average cost M‖L‖
along the short-run cost curve SAC‖, because in the short-run, the scale of
operations is fixed. But, in the long run, a new and bigger plant can be built on
which OM ‖ is the optimum output. That is, the firm has now a short-run
average cost curve SAC ―‗, and by increasing the scale of its operations, the
firm can produce the OM‖ output at a cost of M ―L‖ ‗ instead of M ―L‖

Thus, it will be seen that, at any scale of operations in the short-run, a firm will
have regions of rising and falling costs. But, in the long-run, the firm can
produce on a completely different cost curves to the left (i.e., SAC‘) or right
(i.e., SAC‖‘) of the original cost curve (i.e., SAC‖). For each different scale
represented by a different short-run cost curve, there will be an output where the
average cost is the minimum. This is the optimum output.
Cost Function:

A cost function is a function of input prices and output quantity whose value is
the cost of making that output given those input prices, often applied through
the use of the cost curve by companies to minimize cost and maximize
production efficiency. There are a variety of different applications to this cost
curve which include the evaluation of marginal costs and sunk costs.

In economics, the cost function is primarily used by businesses to determine

which investments to make with capital used in the short and long term.

The relationship between output and costs is expressed in terms of cost

function. By incorporating prices of inputs into the production function, one
obtains the cost function since cost function is derived from production
function. However, the nature of cost function depends on the time horizon. In
microeconomic theory, we deal with short run and long run time.

Law of Variable Proportions:

The law of variable Proportion is considered an important theory in Economics.

It is called a law that when the value of one production element is increased,
while all other factors are kept unchanged, it will lead to a decrease in the
product output of that item.

The law of variable proportion is also known as the Law of Equality. When the
dynamic factor becomes higher, it can lead to a negative value of the third party
product.

The law of variable proportion can be understood as follows.

If the dynamic factor rises while all other factors are kept constant, the product
price will initially increase at an increasing rate, the next level will decrease
with the decrease and eventually there will be a decrease in production.
Production :

Since the primary purpose of economic activity is to produce utility for

individuals, we count as production during a time period all activity which
either creates utility during the period or which increases ability of the society
to create utility in the future.

Business firms are important components (units) of the economic system.

They are artificial entities created by individuals for the purpose of organising
and facilitating production. The essential characteristics of the business firm is
that it purchases factors of production such as land, labour, capital, intermediate
goods, and raw material from households and other business firms and
transforms those resources into different goods or services which it sells to its
customers, other business firms and various units of the government as also to
foreign countries.

Definition of Production:

According to Bates and Parkinson:

―Production is the organised activity of transforming resources into finished

products in the form of goods and services; the objective of production is to
satisfy the demand for such transformed resources‖.

Factors of Production :

Production of a commodity or service requires the use of certain resources or

factors of production. Since most of the resources necessary to carry on
production are scarce relative to demand for them they are called economic
resources.Resources, which we shall call factors of production, are combined in
various ways, by firms or enterprises, to produce an annual flow of goods and
services.
(1) Land and Natural Resources:

In economics the term land is used in a broad sense to refer to all natural
resources or gifts of nature. As the Penguin Dictionary of Economics has put
it: ―Land in economics is taken to mean not simply that part of the earth‘s
surface not covered by water, but also all the free gifts of nature‘s such as
minerals, soil fertility, as also the resources of sea. Land provides both space
and specific resources‖.

From the above definition, it is quite clear that land includes farming and
building land, forests, and mineral deposits. Fisheries, rivers, lakes, etc. all those
natural resources (or gifts of nature) which help us (the members of the society)
to produce useful goods and services. In other words, land includes not only the
land surface, but also the fish in the sea, the heat of the sun that helps to dry
grapes and change them into resins, the rain that helps farmers to grow crops,
the mineral wealth below the surface of the earth and so on.

(2) Labour:

Like land, labour is also a primary factor of production. The distinctive feature
of the factor of production, called labour, is that it provides a human service. It
refers to human effect of any kind—physical and mental— which is directed to
the production of goods and services. ‗Labour‘ is the collective name given to
the productive services embodied in human physical effort, skill, intellectual
powers, etc.

(3) Capital:

Capital, the third agent or factor is the result of past labour and it is used to
produce more goods. Capital has, therefore, been defined as ‗produced means of
production.‘ It is a man-made resource. In a board sense, any product of labour-
and-land which is reserved for use in future production is capital.

To put it more clearly, capital is that part of wealth which is not used for the
purpose of consumption but is utilised in the process of production. Tools and
machinery, bullocks and ploughs, seeds and fertilizers, etc. are examples of
capital. We have already identified certain things described as capital in our
discussion on producers‘ goods.

(4) Enterprise (Organisation):

Organisation, as a factor of production, refers to the task of bringing land,

labour and capital together. It involves the establishment of co-ordination and
co-operation among these factors. The person in charge of organisation is
known as an organiser or an entrepreneur. So, the entrepreneur is the person
who takes the charge of supervising the organisation of production and of
framing the necessary policy regarding business.

Cobb-Douglas Production Function :

The Cobb-Douglas production function is based on the empirical study of the

American manufacturing industry made by Paul H. Douglas and C.W. Cobb. It
is a linear homogeneous production function of degree one which takes into
account two inputs, labour and capital, for the entire output of the
.manufacturing industry.

Q = ALa Cβ

where Q is output and L and С are inputs of labour and capital respectively. A, a
and β are positive parameters where = a > O, β > O.
The equation tells that output depends directly on L and C, and that part of
output which cannot be explained by L and С is explained by A which is the
‗residual‘, often called technical change.

The production function solved by Cobb-Douglas had 1/4 contribution of

capital to the increase in manufacturing industry and 3/4 of labour so that the C-
D production function is

Law of Return to scale

The term returns to scale refers to the changes in output as all factors change by
the same proportion.‖ Koutsoyiannis ―

Returns to scale relates to the behaviour of total output as all inputs are varied
and is a long run concept‖. Leibhafsky

Returns to scale are of the following three types:

1. Increasing Returns to scale.

2. Constant Returns to Scale

3. Diminishing Returns to Scale

Explanation:

In the long run, output can be increased by increasing all factors in the same
proportion. Generally, laws of returns to scale refer to an increase in output due
to increase in all factors in the same proportion. Such an increase is called
returns to scale.

Suppose, initially production function is as follows:

P = f (L, K)

Now, if both the factors of production i.e., labour and capital are increased in
same proportion i.e., x, product function will be rewritten as.
The above stated table explains the following three stages of returns to scale:

1. Increasing Returns to Scale:

Increasing returns to scale or diminishing cost refers to a situation when all

factors of production are increased, output increases at a higher rate. It means if
all inputs are doubled, output will also increase at the faster rate than double.
Hence, it is said to be increasing returns to scale. This increase is due to many
reasons like division external economies of scale. Increasing returns to scale can
be illustrated with the help of a diagram 8.
In figure 8, OX axis represents increase in labour and capital while OY axis
shows increase in output. When labour and capital increases from Q to Q1,
output also increases from P to P1 which is higher than the factors of production
i.e. labour and capital.

2. Diminishing Returns to Scale:

Diminishing returns or increasing costs refer to that production situation, where

if all the factors of production are increased in a given proportion, output
increases in a smaller proportion. It means, if inputs are doubled, output will be
less than doubled. If 20 percent increase in labour and capital is followed by 10
percent increase in output, then it is an instance of diminishing returns to scale.

The main cause of the operation of diminishing returns to scale is that internal
and external economies are less than internal and external diseconomies. It is
clear from diagram 9.
In this diagram 9, diminishing returns to scale has been shown. On OX axis,
labour and capital are given while on OY axis, output. When factors of
production increase from Q to Q1 (more quantity) but as a result increase in
output, i.e. P to P1 is less. We see that increase in factors of production is more
and increase in production is comparatively less, thus diminishing returns to
scale apply.

3. Constant Returns to Scale:

Constant returns to scale or constant cost refers to the production situation in

which output increases exactly in the same proportion in which factors of
production are increased. In simple terms, if factors of production are doubled
output will also be doubled.

In this case internal and external economies are exactly equal to internal and
external diseconomies. This situation arises when after reaching a certain level
of production, economies of scale are balanced by diseconomies of scale. This
is known as homogeneous production function. Cobb-Douglas linear
homogenous production function is a good example of this kind. This is shown
in diagram 10. In figure 10, we see that increase in factors of production i.e.
labour and capital are equal to the proportion of output increase. Therefore, the
result is constant returns to scale.
 Unit IV: Market Structure and pricing decisions

Types of Markets -monopoly, monopolistic competition and oligopoly,

Perfect Competition:
A variety of market structures will characterize an economy. Such market
structures essentially refer to the degree of competition in a market.
There are other determinants of market structures such as the nature of the
goods and products, the number of sellers, number of consumers, the nature of
the product or service, economies of scale etc. We will discuss the four basic
types of market structures in any economy.
One thing to remember is that not all these types of market structures actually
exist. Some of them are just theoretical concepts. But they help us understand
the principles behind the classification of market structures.

Types of Market Structure :

The four different types of market structure are discussed below:

1. Perfect Competition Market Structure: In a perfectly competitive
market, the forces of supply and demand determine the number of goods
and services produced as well as market prices set by the companies in
the market.
2. Monopolistic Competition Market Structure: Unlike perfect
competition, monopolistic competition does not assume the lowest
possible cost of production. That little difference in the definition leaves
room for huge differences in how the companies operate in the market.
The companies under a monopolistic competition structure sell very
similar products with slight differences they use as the basis of their
marketing and advertising.
 3. Monopoly Competition Market Structure: Monopolies and completely
competitive markets sit at either end of market structure extremes.
However, both minimize cost and maximize profit. Where there are many
competitors in perfect competition, in monopolistic markets, there's just
one supplier. High barriers to entry into the monopoly market leave a
"mono-" or lone company standing so there is no price competition. The
supplier is the price-maker, setting a price that increases profits.
4. Oligopoly Competition Market structure: Not all companies aim to sit
as a single building in a city. Oligopolies have companies that
collaborate, or work together, to limit competition and dominate a
different market or industry. The companies under oligopoly market
structures can be small or large. However, the most powerful firms often
have patents, finance, physical resources which control over raw
materials that create barriers to entry for new firms.

Characteristics of Types of Market Structure :

The different characteristics of four types of market structure are as follows:
Perfect Competition
 Under perfect competition, there are a large number of buyers and sellers
in the market.
 Uner competition, the firms have no control over the price. They have to
sell the products at a price predetermined by the industry.
 Under perfect competition, firms are free to exit and enter the market at
any point in time. This means that there is no obstruction for a new firm
to produce a similar product produced by the existing firms in the market
 Under perfect competition, firms can't charge high prices as both sellers
and buyers have perfect knowledge about the goods and their prices.
 Under perfect competition, The products offered by different firms are
homogeneous. This implies that buyers do not have any basis to prefer
the goods of one seller over the goods of another seller. The goods are
similar in terms of quality, size, packing, etc.

Perfect Competition Examples

 Foreign exchange markets.
 Agricultural markets.
 Internet-related industries.
Monopoly Competition
 Under Monopoly competition, there is only one firm producing the
product. Being a single firm, there is complete control over the supply
and price of the product.
 There is no substitute for the products produced by monopolistic firms.
 Under Monopoly competition, there is a strong barrier for the other firms
to enter the market. Also, once a monopoly firm starts producing the
product, no other firms produce the same.
 Being a single seller of the product, the monopolistic firm has full control
over the price of the product.
 The monopolist firm can sell different quantities of a similar product to a
consumer at different prices or the same quantity to different consumers
at different prices by judging the standard of living of the consumer.

Monopoly Competition Examples

 Microsoft and Windows
 DeBeers and diamonds
 Your local natural gas company.

Monopolistic Competition
 Under monopolistic competition, a large number of firms sell closely
related products.
 Product Differentiation is an important characteristic of Monopolistic
Competition. This differentiation could be based on quality, packaging,
color, etc. For example, you must have seen different brands of
shampoos. Even if they look different and have different fragrances, the
product has the same use.
 Under monopolistic competition, firms spend large amounts of money on
advertisements of their product to attract more and more customers.
Every firm tries to promote its product through an advertisement for
which it bears some extra cost over and above its cost of production.
 Under Monopolistic Competition, firms compete with each other without
changing prices. They may initiate different program schemes, gift
schemes, or promotional schemes Thus, firms compete in every possible
way to attract a large number of customers and gain maximum possible
market share.
Monopolistic Competition Examples
 Restaurants
 Hairdressers
 Clothing
 TV programs

Oligopoly Competition
 In the oligopoly market, once prices of the products are fixed by the firms
it is normally not changeable. Hence, the price of the products is rigid.
 As there are very few firms in the oligopoly market, there is a tendency
among them to collaborate to avoid competition. They secretly meet each
other to negotiate price and quantity. The aim behind this is to maximize
profit.
 In the oligopoly market, selling costs such as advertisement, promotion,
sales, etc to sell the product are determined by the firms.
 Interdependence is an important feature of the oligopoly market. As the
number of firms in this market is few, any strategy regarding the change
in price, output, or quality of a product depends on the rival‘s reaction to
its success. Thus, the success of a price reduction policy by one company)
will depend on the reaction of its rival. For example, if the company
decides to lower the price per bottle from Rs 12 to Rs 10, the effect of
this step on demand for Pepsi will depend on the counter-strategy of the
other company i.e. Coke. If Coke decides to lower the price from Rs 12
per bottle to Rs. 8 per bottle, demand for Pepsi may decrease even below
its initial level.

Oligopoly Competition Examples

 Steel industry
 Aluminum
 Film
 Television
 Cell phone
 Gas
Price and Output determination in these types of market :

Determinants of Price Under Perfect Competition

Market price is determined by the equilibrium between demand and supply in a
market period or very short run. The market period is a period in which the
maximum that can be supplied is limited by the existing stock. The market
period is so short that more cannot be produced in response to increased
demand. The firms can sell only what they have already produced. This market
period may be an hour, a day or a few days or even a few weeks depending
upon the nature of the product.
Market Price of a Perishable Commodity
In the case of perishable commodity like fish, the supply is limited by the
available quantity on that day. It cannot be stored for the next market period and
therefore the whole of it must be sold away on the same day whatever the price
may be.
Market Price of Non-Perishable and Reproducible Goods
In case of non-perishable but reproducible goods, some of the goods can be
preserved or kept back from the market and carried over to the next market
period. There will then be two critical price levels.
The first, if price is very high the seller will be prepared to sell the whole stock.
The second level is set by a low price at which the seller would not sell any
amount in the present market period, but will hold back the whole stock for
some better time. The price below which the seller will refuse to sell is called
the Reserve Price.
Monopolistic Competition
Monopolistic competition is a form of market structure in which a large number
of independent firms are supplying products that are slightly differentiated from
the point of view of buyers. Thus, the products of the competing firms are close
but not perfect substitutes because buyers do not regard them as identical. This
situation arises when the same commodity is being sold under different brand
names, each brand being slightly different from the others.
For example − Lux, Liril, Dove, etc.
Each firm is therefore the sole producer of a particular brand or ―product‖. It is
monopolist as far as a particular brand is concerned. However, since the various
brands are close substitutes, a large number of ―monopoly‖ producers of these
brands are involved in a keen competition with one another. This type of market
structure, where there is competition among a large number of ―monopolists‖ is
called monopolistic competition.
In addition to product differentiation, the other three basic characteristics of
monopolistic competition are −
 There are large number of independent sellers and buyers in the market.
 The relative market shares of all sellers are insignificant and more or less
equal. That is, seller-concentration in the market is almost non-existent.
 There are neither any legal nor any economic barriers against the entry of
new firms into the market. New firms are free to enter the market and
existing firms are free to leave the market.
 In other words, product differentiation is the only characteristic that
distinguishes monopolistic competition from perfect competition.
Monopoly
Monopoly is said to exist when one firm is the sole producer or seller of a
product which has no close substitutes. According to this definition, there must
be a single producer or seller of a product. If there are many producers
producing a product, either perfect competition or monopolistic competition
will prevail depending upon whether the product is homogeneous or
differentiated.
On the other hand, when there are few producers, oligopoly is said to exist. A
second condition which is essential for a firm to be called monopolist is that no
close substitutes for the product of that firm should be available.
From above it follows that for the monopoly to exist, following things are
essential −
 One and only one firm produces and sells a particular commodity or a
service.
 There are no rivals or direct competitors of the firm.
 No other seller can enter the market for whatever reasons legal, technical,
or economic.
 Monopolist is a price maker. He tries to take the best of whatever demand
and cost conditions exist without the fear of new firms entering to
compete away his profits.
The concept of market power applies to an individual enterprise or to a group of
enterprises acting collectively. For the individual firm, it expresses the extent to
which the firm has discretion over the price that it charges. The baseline of zero
market power is set by the individual firm that produces and sells a
homogeneous product alongside many other similar firms that all sell the same
product.
Since all of the firms sell the identical product, the individual sellers are not
distinctive. Buyers care solely about finding the seller with the lowest price.
In this context of ―perfect competition‖, all firms sell at an identical price that is
equal to their marginal costs and no individual firm possess any market power.
If any firm were to raise its price slightly above the market-determined price, it
would lose all of its customers and if a firm were to reduce its price slightly
below the market price, it would be swamped with customers who switch from
the other firms.
Accordingly, the standard definition for market power is to define it as the
divergence between price and marginal cost, expressed relative to price. In
Mathematical terms we may define it as −
L = (P − MC) / P

Oligopoly
In an oligopolistic market there are small number of firms so that sellers are
conscious of their interdependence. The competition is not perfect, yet the
rivalry among firms is high. Given that there are large number of possible
reactions of competitors, the behavior of firms may assume various forms. Thus
there are various models of oligopolistic behavior, each based on different
reactions patterns of rivals.
Oligopoly is a situation in which only a few firms are competing in the market
for a particular commodity. The distinguishing characteristics of oligopoly are
such that neither the theory of monopolistic competition nor the theory of
monopoly can explain the behavior of an oligopolistic firm.
Two of the main characteristics of Oligopoly are briefly explained below −
 Under oligopoly the number of competing firms being small, each firm
controls an important proportion of the total supply. Consequently, the
effect of a change in the price or output of one firm upon the sales of its
rival firms is noticeable and not insignificant. When any firm takes an
action its rivals will in all probability react to it. The behavior of
oligopolistic firms is interdependent and not independent or atomistic as
is the case under perfect or monopolistic competition.
 Under oligopoly new entry is difficult. It is neither free nor barred. Hence
the condition of entry becomes an important factor determining the price
or output decisions of oligopolistic firms and preventing or limiting entry
of an important objective.
For Example − Aircraft manufacturing, in some countries: wireless
communication, media, and banking.
 Unit V: National Income

Concept like GDP, GNP in National Income :

The National Income is the total amount of income accruing to a country

from economic activities in a years time. It includes payments made to all
resources either in the form of wages, interest, rent, and profits.

The progress of a country can be determined by the growth of the national income
of the country

National Income Definition

There are two National Income Definition

 Traditional Definition
 Modern Definition
Traditional Definition
According to Marshall: ―The labor and capital of a country acting on its natural
resources produce annually a certain net aggregate of commodities, material and
immaterial including services of all kinds. This is the true net annual income or
revenue of the country or national dividend.‖

The definition as laid down by Marshall is being criticized on the following

grounds.

Due to the varied category of goods and services, a correct estimation is very
difficult.

There is a chance of double counting, hence National Income cannot be estimated

correctly.

For example, a product runs in the supply from the producer to distributor
to wholesaler to retailer and then to the ultimate consumer. If on every movement
commodity is taken into consideration then the value of National Income
increases.Also, one other reason is that there are products which are produced but
not marketed.
For example, In an agriculture-oriented country like India, there are commodities
which though produced but are kept for self-consumption or exchanged with other
commodities. Thus there can be an underestimation of National Income.

Simon Kuznets defines national income as ―the net output of commodities and
services flowing during the year from the country‘s productive system in the
hands of the ultimate consumers.‖

Following are the Modern National Income definition

 GDP
 GNP
Gross Domestic Product :
The total value of goods produced and services rendered within a country during a
year is its Gross Domestic Product.

Further, GDP is calculated at market price and is defined as GDP at market prices.
Different constituents of GDP are:

1. Wages and salaries

2. Rent
3. Interest
4. Undistributed profits
5. Mixed-income
6. Direct taxes
7. Dividend
8. Depreciation
Gross National Product :
For calculation of GNP, we need to collect and assess the data from all productive
activities, such as agricultural produce, wood, minerals, commodities, the
contributions to production by transport, communications, insurance companies,
professions such (as lawyers, doctors, teachers, etc). at market prices.
It also includes net income arising in a country from abroad. Four main
constituents of GNP are:

1. Consumer goods and services

2. Gross private domestic income
3. Goods produced or services rendered
4. Income arising from abroad.
GDP and GNP on the basis of Market Price and Factor Cost

a) Market Price
The Actual transacted price including indirect taxes such as GST, Customs duty
etc. Such taxes tend to raise the prices of goods and services in the economy.

b) Factor Cost
It Includes the cost of factors of production e.g. interest on capital, wages to labor,
rent for land profit to the stakeholders. Thus services provided by service
providers and goods sold by the producer is equal to revenue price.

Alternatively,

Revenue Price (or Factor Cost) = Market Price (net of) Net Indirect Taxes

Net Indirect Taxes = Indirect Taxes Net of Subsidies received

Hence,

Factor Cost shall be equal to

(Market Price) LESS (Indirect Taxes ADD Subsidies)

Net Domestic Product

The net output of the country‘s economy during a year is its NDP. During the year
a country‘s capital assets are subject to wear and tear due to its use or can become
obsolete.
Hence, we deduct a percentage of such investment from the GDP to arrive at
NDP.

So NDP=GDP at factor cost LESS Depreciation.

The Accumulation of all factors of income earned by residents of a country and

includes income earned from the county as well as from abroad.

Thus, National Income at Factor Cost shall be equal to

NNP at Market Price LESS (Indirect Taxes ADD Subsidies)

Measurement of National Income. :

There are three ways of measuring the National Income of a country. They are
from the income side, the output side and the expenditure side. Thus, we can
classify these perspectives into the following methods of measurement of National
Income.

Methods of Measuring National Income

 Product Method
 Income Method
 Expenditure Method

1. Product Method

Under this method, we add the values of output produced or services rendered by
the different sectors of the economy during the year in order to calculate the
National Income.

In this method, we include only the value added by each firm in

the production process in the output figure.

Hence, we use the value-added method. The value-added output of all the sectors
of the economy is the GNP at factor cost.
However, this method is unscientific as it adds the value of only those goods and
services that are sold in the market or are available for sale in the market

2. Income Method

Under this method, we add all the incomes from employment and ownership of
assets before taxation received from all the production activities in an economy.

Thus, it is also the Factor Income method. We also need to add the
undistributed profits of the private sector and the trading surplus of the public
sector corporations.

However, we need to exclude items not arising from productive activities such as
sickness benefits, interest on the national debt, etc.

3. Expenditure Method

This method measures the total domestic expenditure of the economy. It consists
of two elements, viz. Consumption expenditure and Investment expenditure.

Consumption expenditure includes consumption expenditure of the household

sector on goods and services and consumption outlays of the business sector and
public authorities.

Investment expenditure refers to the expenditure on the making of fixed capital

such as Plant and Machinery, buildings, etc.

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

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

Stages of the Business Cycle :

In the diagram above, the straight line in the middle is the steady growth line.
The business cycle moves about the line. Below is a more detailed description
of each stage in the business cycle:

1. Expansion

The first stage in the business cycle is expansion. In this stage, there is an
increase in positive economic indicators such as employment, income, output,
wages, profits, demand, and supply of goods and services. Debtors are generally
paying their debts on time, the velocity of the money supply is high, and
investment is high. This process continues as long as economic conditions are
favorable for expansion.

2. Peak

The economy then reaches a saturation point, or peak, which is the second stage
of the business cycle. The maximum limit of growth is attained. The economic
indicators do not grow further and are at their highest. Prices are at their peak.
This stage marks the reversal point in the trend of economic growth. Consumers
tend to restructure their budgets at this point.

3. Recession

The recession is the stage that follows the peak phase. The demand for goods
and services starts declining rapidly and steadily in this phase. Producers do not
notice the decrease in demand instantly and go on producing, which creates a
situation of excess supply in the market. Prices tend to fall. All positive
economic indicators such as income, output, wages, etc., consequently start to
fall.

4. Depression

There is a commensurate rise in unemployment. The growth in the economy

continues to decline, and as this falls below the steady growth line, the stage is
called a depression.
5. Trough

In the depression stage, the economy‘s growth rate becomes negative. There is
further decline until the prices of factors, as well as the demand and supply of
goods and services, contract to reach their lowest point. The economy
eventually reaches the trough. It is the negative saturation point for an economy.
There is extensive depletion of national income and expenditure.

6. Recovery

After the trough, the economy moves to the stage of recovery. In this phase,
there is a turnaround in the economy, and it begins to recover from the negative
growth rate. Demand starts to pick up due to low prices and, consequently,
supply begins to increase. The population develops a positive attitude towards
investment and employment and production starts increasing.

Employment begins to rise and, due to accumulated cash balances with the
bankers, lending also shows positive signals. In this phase, depreciated capital is
replaced, leading to new investments in the production process. Recovery
continues until the economy returns to steady growth levels.

Fiscal Policy:

Fiscal policy is the governmental decision to increase or decrease taxation and

spending.

Fiscal policy and monetary policy are often used together to influence the
economy.

Fiscal policy can affect a company‘s growth, hiring ability and taxes.

Fiscal policy is based on the theories of British economist John Maynard

Keynes, which hold that increasing or decreasing revenue (taxes) and
expenditure (spending) levels influence inflation, employment and the flow of
money through the economic system. Fiscal policy is often used in combination
with monetary policy, which, in the United States, is set by the Federal Reserve
to influence the direction of the economy.

Fiscal policy is paramount to successful economic management since taxes,

spending, inflation and employment all factor into gross domestic product
(GDP). This figure details the value of goods and services produced by a nation
within a year.
Monetary Policy:

Monetary policy is a set of tools used by a nation's central bank to control the
overall money supply and promote economic growth and employ strategies
such as revising interest rates and changing bank reserve requirements.

Monetary policy is the control of the quantity of money available in

an economy and the channels by which new money is supplied.

Economic statistics such as gross domestic product (GDP), the rate of inflation,
and industry and sector-specific growth rates influence monetary policy
strategy.

 Monetary policy is a set of actions to control a nation's overall money

supply and achieve economic growth.
 Monetary policy strategies include revising interest rates and changing
bank reserve requirements.
 Monetary policy is commonly classified as either expansionary or
contractionary.
 The Federal Reserve commonly uses three strategies for monetary policy
including reserve requirements, the discount rate, and open market
operations.
Types of Monetary Policy
Monetary policies are seen as either expansionary or contractionary depending
on the level of growth or stagnation within the economy.

Contractionary
A contractionary policy increases interest rates and limits the outstanding
money supply to slow growth and decrease inflation, where the prices of goods
and services in an economy rise and reduce the purchasing power of money.

Expansionary
During times of slowdown or a recession, an expansionary policy grows
economic activity. By lowering interest rates, saving becomes less attractive,
and consumer spending and borrowing increase.

Goals of Monetary Policy

Inflation
Contractionary monetary policy is used to target a high level of inflation and
reduce the level of money circulating in the economy.
Unemployment
An expansionary monetary policy decreases unemployment as a higher money
supply and attractive interest rates stimulate business activities and expansion
of the job market.

Exchange Rates
The exchange rates between domestic and foreign currencies can be affected by
monetary policy. With an increase in the money supply, the domestic currency
becomes cheaper than its foreign exchange.

Inflation & Deflation:

Inflation is the rate at which the prices for goods and services increase. Inflation
often affects the buying capacity of consumers. Most Central banks try to limit
inflation in order to keep their respective economies functioning efficiently.
There are certain advantages as well as disadvantages to inflation. Inflation
refers to the increase in the prices of the goods and services of daily use, such as
food, housing, clothing, transport, recreation, consumer staples, etc. Inflation is
measured by taking into consideration the average price change in a basket of
commodities and services over a period of time.

Inflation is a general rise in the price level in the economy.

These goods and services include:

 Essential goods (such as food items, hygiene products, housing supplies,

clothing, etc.).
 Housing and cars.
 Rental services (car, accommodation, etc.).
 Luxury goods.

These are only a few examples, there are a lot more. Try to think about the
items you consume daily and occasionally and they should probably be on this
list.

There are two types of inflation:

 Demand-pull inflation: this is when inflation is caused by

excessive aggregate demand. This means that the aggregate demand is
rapidly increasing, faster than the long-run aggregate supply of the
economy, creating inflation.
 Cost-push inflation: this is when inflation arises due to issues in the
supply-side of the economy. It can occur due to the increased union
power in the wage bargaining process, or through an increase in either
 commodity or energy prices. This usually causes the short-run aggregate
supply to shift to the left due to increased costs of production, creating
inflation.

Causes of inflation:

The two main types of inflation (demand-pull and cost-push) are caused by
different factors that affect the economy.

Demand-pull inflation
 The main cause of demand-pull inflation is an increase in aggregate
demand. The prices of products and services will increase to stimulate
firms to produce more output in response to growing demand.
 The positive output gap is another cause of demand-pull inflation. It
means that the growth rate of the economy is above the trend growth rate,
which leads to higher inflation.

Cost-push inflation
 This type of inflation is caused by the growing monopoly power of trade
unions. As unions become more powerful they demand higher wages,
which raises the cost of labour, thereby raising the costs of production for
a firm.
 Additionally, cost-push inflation can be caused by the increased
commodity or energy prices, which raises the overall cost of production
causing the short-run aggregate supply to shift to the left.

Deflation is a general decline in prices for goods and services, typically

associated with a contraction in the supply of money and credit in the economy.
During deflation, the purchasing power of currency rises over time.

 Deflation is the general decline of the price level of goods and services.
 Deflation is usually associated with a contraction in the supply of money
and credit, but prices can also fall due to increased productivity and
technological improvements.
 Whether the economy, price level, and money supply are deflating or
inflating changes the appeal of different investment options.

Deflation causes the nominal costs of capital, labor, goods, and services to fall,
though their relative prices may be unchanged. Deflation has been a popular
concern among economists for decades. On its face, deflation benefits
 consumers because they can purchase more goods and services with the same
nominal income over time.

There are two big causes of deflation: a decrease in demand or growth in

supply. Each is tied back to the fundamental economic relationship between
supply and demand. A decline in aggregate demand leads to a fall in the price of
goods and services if supply does not change.

A drop in aggregate demand may be triggered by:

 Monetary policy: Rising interest rates may lead people to save their cash
instead of spending it and may discourage borrowing. Less spending means less
demand for goods and services.
 Declining confidence: Adverse economic events—such as a global pandemic—
may lead to a decrease in overall demand. If people are worried about the
economy or unemployment, they may spend less so they can save more.
Higher aggregate supply means that producers may have to lower their prices
due to increased competition. This boost in aggregate supply may stem from a
drop in production costs: If it costs less to produce goods, companies can make
more of them for the same price. This can result in more supply than demand
and lower prices.