Full Marks – 80
Time – Three Hours
The figures in the margin indicate full marks for the questions.
1(a)(i) What is equi-marginal principle? Illustrate how this principle is applied by business managers to allocate the resources. Under what conditions this principle can be applied?
-> This is one of the widely used concepts in managerial economics. This principle is also known the principle of maximum satisfaction. According to this principle, an input should be allocated in such a maimed that the value added by the last unit of input is same in all uses. This principle provides a base for maximum exploitation of all the inputs of a firm so as to maximise the profitability.
The equi-marginal principle can be applied in different areas of management. It is used in budgeting. The objective is to allocate resources where they are most productive. It can be used for eliminating waste in useless activities. It can be applied in any discussion of budgeting. The management can accept investments with high rates of return so as to ensure optimum allocation of capital resources. The equi-marginal principle can also be applied in multiple product pricing. A multi product firm will reach equilibrium when the marginal revenue obtained from a product is equal to that of another product or products. The equi-marginal principle may also be applied in allocating research expenditures.
This principle suggests that available resources (inputs) should be so allocated between the alternative options that the marginal productivity gains (MP) from the various activities are equalized.
The equi-marginal principle is an important idea in the economic subfield of managerial economics. It is otherwise known as the “equal marginal principle” or the “principle of maximum satisfaction.” The equi-marginal principle states that consumers choose combinations of various goods in order to achieve maximum total utility.
In other words, consumers will allocate spending their incomes across goods/services so that the marginal utility per dollar of expenditure on the final unit of each good purchased will be equal to all other goods purchased. It explains the way in which each consumer will spend portions of their income across a variety of different goods in such a way as to maximize their overall satisfaction.
(ii) Explain why scarcity is the fundamental economic problem.
-> All the problems which are associated with money are known as economic problem. It is also known as central, basic or fundamental economic problem. It state that there is scarcity that is, the availability of limited resources are not enough to satisfy the need want and demand of the society. So the question is that how to control and what to be produced, and how the capital and labour are utilized to remove this type of problems.
The problems of economics appear mostly with two problems:
1. Unlimited human wants
2. Limited resources.
Market system, also known as capitalism is a system of allocating resources based only on the interaction of market forces, such as supply and demand. It is a true market economy and free of government influence, collusion and other external interference. In this system, there are many advantages and disadvantages. One of the major advantages is that market system can adjust to change easily. If there is a demand for one thing, companies have the ability to change what they produce instead of having to go through too much government protocol first. One of the major disadvantages is that it doesn’t always provide the basic needs to everyone in the market. The weak, sick, disabled, and old sometimes have trouble providing for them and often slip into poverty. In term of having the scarcity, they have to solve this problem. What to produce? In market system, the firm will produce the product which has the highest demand compare to others. This can rise up their profit to the maximum. How to produce? In the market system, in order for them to maximize their profit, they have to maximize used up the resources. In solving this problem, the firm has to decide to use whether a production technique will be more or less capital-intensive. For whom to produce? If consumers are willing and able to pay a given price for a good or services, they can buy it. Consumers who are unable or unwilling to pay a given price for an item will not get one.
Command economy, known as planned economy is an economic system which the government control the economy. It is an economic system in which the central government makes all decisions on the production and consumption of goods and services. One of the advantages is that equality is focused on. The government tries to eliminate all private property and distribute its good equally. If it is done correctly, no one is in poverty and no one is wealthier than another. One of the disadvantages is there is very little freedom. The individual usually doesn’t have the opportunity to decide what they want to do for a career, and they have no control over the goods they receive. In this command economy, the central authority or agency draws up plans that establish what will be produced and when, sets production goals, and makes rules for distribution. The government will used more capital-intensive so it can create more jobs for the people around. All the goods and services are for everyone in the country because in command economy, everyone is treated as the same.
In other word, different economic systems have the different role or ways to rule the economy, but they advantages and also disadvantages at the same time. They also have their ways to overcome the scarcity by using the three basic economic problems; what to produce? How to produce? And for whom to produce?
The price elasticity of supply (Es) is defined similarly to the price elasticity of demand. It is to measure the responsiveness of the quantity supplies of a commodity to a change of its price. Supply elasticity are generally positive; this is because the law of supply states that when the price of the good increase, quantity supply of the good will also increase. The formula to calculate the price elasticity of supply (Es) is as follow:-
One of the determinants of price elasticity of supply is availability of raw materials. If stocks of raw materials and finished products are at a high level then a firm is able to respond to a change in demand quickly by supplying these stocks onto the market – supply will be elastic. Conversely when stocks are low, dwindling supplies force prices higher and unless stocks can be replenished, supply will be inelastic in response to a change in demand. For example, if the raw materials of producing papers: tree are running out of stock, the price of papers will increase and soon the quantity supplied will also increase.
Another determinant of price elasticity of supply is time period involved in the production process. Supply is more elastic, the longer the time period that a firm is allowed to adjust its production levels. In some agricultural markets for example, the momentary supply is fixed and is determined mainly by planting decisions made months before, and also climatic conditions, which affect the overall production yield.
The determinants of price elasticity of supply will affect the value of price elasticity of supply. The value of price elasticity can be categorized to 5 type; inelastic supply, elastic supply, unitary elastic, perfectly inelastic supply and also perfectly elastic supply.
(b) Critically examine the profit maximisation objective of a business firm. Explain why and how does the manager’s perused maximisation of firm’s growth rate as an alternative business objective.
-> Profit maximisation objective of a business firm:-
Traditional theory assumes profit maximisation as the sole objective of a business firm. In practice firms have been found to be pursuing objective other than profit maximisation.
Large firms pursue such goals as sales maximisation, revenue maximisation, a target profit, retaining market share, building up the net worth of the firm, etc.
However, traditional theory assumes full and perfect knowledge about current market conditions and the future developments in the business environment of the firm. The firm is thus supposed to be fully aware of its demand and cost functions in both short and long runs.
Briefly speaking, a complete certainty about the market conditions is assumed. On the contrary, it is widely recognized that the firm does not possess the perfect knowledge of their costs, revenue, and their environment. They operate in the world of uncertainty. Most price and output decisions are based on probabilities.
The marginal principle of equalizing MC and MR has been found to be absent in the decision-making process of the firms. Empirical studies of the pricing behaviour of the firms have shown that the marginal rule of pricing does not stand the test of empirical verification. Hall and Hitch have found, in their study of pricing practices of 38 firms, that the firms do not pursue the objective of profit maximisation and that they do not use the marginal principle of equalizing MR and MC in their price and output decisions.
Most firms aim at long-run profit maximisation. In the short-run, they set the price of their product on the basis of average cost principle, so as to cover AC = AVC + AFC and a normal margin of profit (usually 10 per cent). In a similar study, Gordon has found that there was marked deviation in the real business conditions from the assumptions of the traditional theory and that pricing practices were notably different from the marginal theory of pricing.
He has concluded that the real business world is much more complex than the one postulated by the theorists. Because of the extreme complexity of the real business world and the ever-changing conditions, the past experience of the business firms is of little use in forecasting demand, price and costs. The firms are not aware of their MR and MC. The average-cost-principle of pricing is widely used by the firms. Findings of many other studies of the pricing practices lend support to the view that there is little link between pricing theory and pricing practices.
The manager’s perused maximisation of firm’s growth rate as an alternative business objective:-
Some important alternative objectives of business firms are discussed below:
(i) Baumol’s Hypothesis of Sales Revenue Maximisation:
Prof. Baumol has postulated maximisation of sales revenue as an alternative to profit- maximisation objective.
The reason behind this objective is the dichotomy between ownership and management. This dichotomy gives managers an opportunity to set their goals other than profit maximisation which most owner-businessmen pursue.
Given the opportunity, managers choose to maximise their own utility function. According to Baumol, the most plausible factor in managers’ utility functions is maximisation of the sales revenue.
The factors which explain the pursuance of this goal by the managers are:
(i) Salary and other earnings of managers are more closely related to sales revenue than to profits,
(ii) Banks and financial corporation’s look at sales revenue while financing the corporation,
(iii) Trend in sale revenue is a readily available indicator of performance of the firm. It helps also in handling the personnel problem,
(iv) Increasing sales revenue enhances the prestige of managers while profit goes to the owners;
(v) Managers find profit maximisation a difficult objective to fulfil consistently over time and at the same level. Profits may fluctuate with changing conditions,
(vi) Growing sales strengthen competitive spirit of firm in the market and vice versa.
As empirical validity of sales maximisation objective is concerned, factual evidences are inconclusive. Most empirical works are in fact, based on inadequate data as requisite data are mostly not available. Even theoretically, if total cost function intersects the total revenue function (TR) before it reaches its climax, Baumol’s theory collapses. Besides, it is also argued that, in the long run, sales maximisation and profit maximisation objectives converge into one. For, in the long run, sales maximisation tends to yield only normal levels of profit which turns out to be the maximum under competitive conditions. Thus, profit maximisation is not incompatible with sales maximisation.
(ii) Marris’ Hypothesis of Maximisation of Firm’s Growth Rate:
Marris has suggested another alternative objective, i.e., maximisation of balanced growth rate of the firm. Marris recognizes the dichotomy between owners’ and managers’ interest. Accordingly, he assumes that owners and managers having their own utility functions to maximise. The managers’ utility function (Um) and owners’ utility function (U D) may be specified as
Um = f (salary, power, job security, prestige, status),
Uo = f (output, capital, market-share, profit, public esteem).
Owner’s utility function (U0) implies growth of demand for firm’s product and supply of capital. Therefore, maximisation of U G means maximisation of ‘demand for firm’s product’ or ‘growth of capital supply’. According to Marris, by maximising these variables, managers maximise both their own utility function and that of the owners.
The managers can do so because most of the variables (e.g., salaries, status, job security, power, etc.) appearing in their own utility function and those appearing in the utility function of the owners (e.g., profit, capital market share, etc.) are positively and strongly correlated with a single variable, i.e., size of firm. Maximisation of these variables depends on the maximisation of the growth rate of the firms. The managers therefore seek to maximise a steady growth rate.
Marris’s theory fails to deal satisfactorily with oligopolistic interdependence. Another shortcoming is that it ignores price determination which is the main concern of profit maximisation hypothesis. Marris’s model too does not seriously challenge the profit maximisation hypothesis.
(iii) Williamson’s Hypothesis of Maximisation of Managerial Utility Function:
Like Baumol and Marris, Willamson argues that managers have discretion to pursue objectives other than profit maximisation. The managers seek to maximise their own utility function subject to a minimum level of profit. Manager’s utility function (U) is expressed as:
U = f (S, M, ID)
where S = additional expenditure on staff
M = Managerial emoluments,
Id = Discretionary investments,
According to Williamson’s hypothesis, managers maximise their utility function subject a satisfactory profit. A minimum profit is necessary to satisfy the shareholders; otherwise manager’s job security is endangered. The utility functions which managers seek to maximize include both quantifiable variables like salary and slack earnings, and non-quantitative variable such as prestige, power, status, job security, professional excellence, etc.
The non-quantifiable variables are expressed, in order to make them operational, in terms of expense preference defined as ‘satisfaction derived out of certain types of expenditures’ (such as slack payments), and ready availability of funds for discretionary investment.
Thus, Williamson’s theory too suffers from certain weaknesses. His model fails to deal with problem of oligopolistic interdependence. It is said to hold only where rivalry is not strong. In case of strong rivalry, profit maximisation is claimed to be a more appropriate hypothesis. Thus, Williamson’s managerial utility function too does not offer a more satisfactory hypothesis than profit maximisation.
(iv) Cyert-March Hypothesis of Satisfying Behaviour:
Cyert-March hypothesis is an extension of Simon’s hypothesis of firms, ‘satisfying behaviour’. Simon had argued that the real business world is full of uncertainty; accurate and adequate data are not readily available; where data are available managers have little time and ability to process them; and managers work under a number of constraints.
Under such conditions it is not possible for the firms to act in terms of rationality postulated under profit maximisation hypothesis. Nor do the firms seek to maximise sales, growth or anything else. Instead they seek to achieve a ‘satisfactory profit,’ a ‘satisfactory growth’, and so on. This behaviour of firms is termed as ‘Satisfaction Behaviour’.
Cyert and March added that, apart from dealing with an uncertain business world, managers have to satisfy a variety of group of people-managerial staff, labour, shareholders, customers, financers, input suppliers, accountants, lawyers, authorities, etc. All these groups have their interest in the firms-often conflicting.
The managers’ responsibility is to satisfy them all. Thus, according to the “Behavioural Theory of Firms’, firm’s behaviour is ‘Satisfying Behaviour’. The underlying assumption of ‘Satisfying Behaviour’ of firms is that a firm is a coalition of different groups connected with various activities of the firms, e.g., shareholders, managers, workers, input supplier, customers, bankers, tax authorities, and so on. All these groups have some kind of expectations high and low- from the firm, and the firm seeks to satisfy all of them in one way or another by sacrificing some of its interest.
In order to reconcile between the conflicting interests and goals, managers form an aspiration level of the firm combining the following goals:
(a) Production goal,
(b) Sales and market share goals,
(c) Inventory goal, and
(d) Profit goal.
These goals and ‘aspiration level’ are set on the basis of the managers’ past experience and their assessment of the future market conditions. The ‘aspiration levels’ are modified and revised on the basis of achievements and changing business environment.
The behavioural theory has however been criticized on the following grounds:
First, though the behavioural theory deals realistically with the firm’s activity, it cannot explain the firm’s behaviour under dynamic conditions in the long run.
Secondly, it cannot be used to predict exactly the future course of firm’s activities. Thirdly, this theory does not deal with equilibrium of the industry. Fourthly, like other alternative hypotheses, this theory, too fails to deal with interdependence and interaction of the firms.
(v) Rothschild’s Hypothesis of Long-run Survival and Market Share Goals:
Another alternative objective of a firm – as an alternative to profit maximisation- was suggested by Rothschild. According to him, the primary goal of the firm is long-run survival. Some others have suggested that attainment and retention of a constant market share is the objective of the firms.
The managers therefore seek to secure their market share and long- run survival, the firms may seek to maximise their profit in the long-run, though it is not certain.
(vi) Entry-prevention and Risk-avoidance:
Yet another alternative objective of the firms suggested by some economists is to prevent entry of new firms into the industry.
The motive behind entry-prevention may be:
(a) Profit maximisation in the long run,
(b) Securing a constant market share, and
(c) Avoidance of risk caused by the unpredictable behaviour of the new firms.
The evidence of whether firms maximise profits in the long run is not conclusive. Some argue that where management is divorced from the ownership, the possibility of profit maximisation is reduced. Some argue that only profit-maximising firms can survive in the long run. They can achieve all other subsidiary goals easily if they can maximise their profits.
It is further argued that, prevention of entry may be the major objective in the pricing policy of the firm, particularly in case of limit pricing. But then, the motive behind entry- prevention is to secure a constant share in the market. Securing constant share, market share is compatible with profit maximisation.
2(a)(i) Why does the demand curve slope negatively? Explain the factors that can shift the demand curve.
-> The demand curve generally slopes downward from left to right. It has a negative slope because the two important variables price and quantity work in opposite direction. As the price of a commodity decreases, the quantity demanded increases over a specified period of time, and vice versa, other, things remaining constant.
The fundamental reasons for demand curve to slope downward are as follows:
(i) Law of diminishing marginal utility: The law of demand is based on the law of diminishing marginal utility . According to the cardinal utility approach, when a consumer purchases more units of a commodity, its marginal utility declines. The consumer, therefore, will purchase more units of that commodity only if its price falls. Thus a decrease in price brings about an increase, in demand. The demand curve, therefore, is downward sloping.
(ii) Income effect: Other things being equal, when the price of a commodity decreases, the real income or the purchasing power of the household increases. The consumer is now in a position to purchase more commodities with the same income. The demand for a commodity thus increases not only from the existing buyers but also from the new buyers who were earlier unable to purchase at higher price. When at a lower price, there is a greater demand for a commodity by the households, the
Demand curve is bound to slope downward from left to right.
(iii) Substitution effect: The demand curve slopes downward from left to right also because of the substitution effect. For instance, the price of meat falls and the prices of other substitutes say poultry and beef remain constant. Then the households would prefer to purchase meat because it is now relatively cheaper. The increase in demand with a fall in the price of meat will move the demand curve downward from left to right.
(iv) Entry of new buyers: When the price of a commodity falls, its demand not only increases from the old buyers but the new buyers also enter the market. The combined result of the income and substitution effect is that demand extends, ceteris paribus, as the .price falls. The demand curve slopes downward from left to right.
The factors that can shift the demand curve:-
1. Tastes and Preferences of the Consumers:
An important factor which determines the demand for a good is the tastes and preferences of the consumers for it. A good for which consumers’ tastes and preferences are greater, its demand would be large and its demand curve will therefore lie at a higher level. People’s tastes and preferences for various goods often change and as a result there is change in demand for them.
The changes in demand for various goods occur due to the changes in fashion and also due to the pressure of advertisements by the manufacturers and sellers of different products. On the contrary, when certain goods go out of fashion or people’s tastes and preferences no longer remain favourable to them, the demand for them decreases.
2. Income of the People:
The demand for goods also depends upon the incomes of the people. The greater the incomes of the people, the greater will be their demand for goods. In drawing the demand schedule or the demand curve for a good we take income of the people as given and constant. When as a result of the rise in the income of the people, the demand increases, the whole of the demand curve shifts upward and vice versa.
The greater income means the greater purchasing power. Therefore, when incomes of the people increase, they can afford to buy more. It is because of this reason that increase in income has a positive effect on the demand for a good.
When the incomes of the people fall, they would demand less of a good and as a result the demand curve will shift downward. For instance, as a result of economic growth in India the incomes of the people have greatly increased owing to the large investment expenditure on the development schemes by the Government and the private sector.
As a result of this increase in incomes, the demand for good grains and other consumer goods has greatly increased. Likewise, when because of drought in a year the agriculture production greatly falls, the incomes of the farmers decline. As a result of the decline in incomes of the farmers, they will demand less of the cotton cloth and other manufactured products.
3. Changes in Prices of the Related Goods:
The demand for a good is also affected by the prices of other goods, especially those which are related to it as substitutes or complements. When we draw the demand schedule or the demand curve for a good we take the prices of the related goods as remaining constant.
Therefore, when the prices of the related goods, substitutes or complements, change, the whole demand curve would change its position; it will shift upward or downward as the case may be. When the price of a substitute for a good falls, the demand for that good will decline and when the price of the substitute rises, the demand for that good will increase.
For example, when price of tea and incomes of the people remain the same but the price of coffee falls, the consumers would demand less of tea than before. Tea and coffee are very close substitutes. Therefore, when coffee becomes cheaper, the consumers substitute coffee for tea and as a result the demand for tea declines. The goods which are complementary with each other, the fall in the price of any of them would favourably affect the demand for the other.
For instance, if price of milk falls, the demand for sugar would also be favourably affected. When people would take more milk, the demand for sugar will also increase. Likewise, when the price of cars falls, the quantity demanded of them would increase which in turn will increase the demand for petrol.
4. Advertisement Expenditure:
Advertisement expenditure made by a firm to promote the sales of its product is an important factor determining demand for a product, especially of the product of the firm which gives advertisements. The purpose of advertisement is to influence the consumers in favour of a product. Advertisements are given in various media such as newspapers, radio, and television. Advertisements for goods are repeated several times so that consumers are convinced about their superior quality. When advertisements prove successful they cause an increase in the demand for the product.
5. The Number of Consumers in the Market:
The market demand for a good is obtained by adding up the individual demands of the present as well as prospective consumers of a good at various possible prices. The greater the number of consumers of a good, the greater the market demand for it.
Now, the question arises on what factors the number of consumers for a good depends. If the consumers substitute one good for another, then the number of consumers for the good which has been substituted by the other will decline and for the good which has been used in place of the others, the number of consumers will increase.
Besides, when the seller of a good succeeds in finding out new markets for his good and as a result the market for his good expands the number of consumers for that good will increase. Another important cause for the increase in the number of consumers is the growth in population. For instance, in India the demand for many essential goods, especially food grains, has increased because of the increase in the population of the country and the resultant increase in the number of consumers for them.
6. Consumers’ Expectations with Regard to Future Prices:
Another factor which influences the demand for goods is consumers’ expectations with regard to future prices of the goods. If due to some reason, consumers expect that in the near future prices of the goods would rise, then in the present they would demand greater quantities of the goods so that in the future they should not have to pay higher prices. Similarly, when the consumers expect that in the future the prices of goods will fall, then in the present they will postpone a part of the consumption of goods with the result that their present demand for goods will decrease.
(ii) Define market demand schedule with a hypothetical example. Mention the determinants of market demand.
-> Market Demand Schedule
It is a summation of the individual demand schedules and depicts the demand of different customers for a commodity in relation to its price. Let us study it with the help of an example.
Price per unit of commodity X
Quantity demanded by o consumer A (QA)
Quantity demanded by consumer B (QB)
Market Demand QA + QB
The above schedule shows the market demand for commodity X. When the price of the commodity is ₹100, customer A demands 50 units while the customer B demands 70 units.
Thus, the market demand is 120 units. Similarly, when its price is ₹500, Customer A demands 20 units while customer B demands 30 units.
Thus, its market demand decreases to 40 units. Thus, we can conclude that whether it is the individual demand or the market demand, the law of demand governs both of them.
Determinants of market demand:-
Market demand is aggregate of individual demand for a given product at a given time. Market demand depends upon the individual demand. Therefore, the factors influencing the individual demand also work as determinants of market demand. In addition to that some macroeconomic factors determined the market demand. Some of such determinants are stated below:-
1) With the increase in population, people naturally demand more goods.
2) Social customs and ceremonies are usually celebrated collectively as such involves extra expenditure creating more demand.
3) Tax rate also affect the market demand. High tax rate may result less demand and vice versa.
4) New inventions and innovation may also increase demand as customers have strong tendency to purchase new products.
5) Availability of cheaper credit in the economy also creates more demand for consumer durable goods.
6) An expansion or a contraction in the quantity of money supply in the economy also affects demand. When money supply increases the demand may increase because of more purchasing power in the hands of inhabitants.
7) Climate and weather condition also affect the market demand.
(iii) Distinguish between change in demand and change in the quantity demanded.
-> In economics the terms change in quantity demanded and change in demand are two different concepts.
Change in quantity demanded refers to change in the quantity purchased due to increase or decrease in the price of a product.
In such a case, it is incorrect to say increase or decrease in demand rather it is increase or decrease in the quantity demanded.
On the other hand, change in demand refers to increase or decrease in demand of a product due to various determinants of demand, while keeping price at constant.
Changes in quantity demanded can be measured by the movement of demand curve, while changes in demand are measured by shifts in demand curve. The terms, change in quantity demanded refers to expansion or contraction of demand, while change in demand means increase or decrease in demand.
1. Expansion and Contraction of Demand:
The variations in the quantities demanded of a product with change in its price, while other factors are at constant, are termed as expansion or contraction of demand. Expansion of demand refers to the period when quantity demanded is more because of the fall in prices of a product. However, contraction of demand takes place when the quantity demanded is less due to rise in the price o a product.
For example, consumers would reduce the consumption of milk in case the prices of milk increases and vice versa. Expansion and contraction are represented by the movement along the same demand curve. Movement from one point to another in a downward direction shows the expansion of demand, while an upward movement demonstrates the contraction of demand.
2. Increase and Decrease in Demand:
Increase and decrease in demand are referred to change in demand due to changes in various other factors such as change in income, distribution of income, change in consumer’s tastes and preferences, change in the price of related goods, while Price factor is kept constant Increase in demand refers to the rise in demand of a product at a given price.
On the other hand, decrease in demand refers to the fall in demand of a product at a given price. For example, essential goods, such as salt would be consumed in equal quantity, irrespective of increase or decrease in its price. Therefore, increase in demand implies that there is an increase in demand for a product at any price. Similarly, decrease in demand can also be referred as same quantity demanded at lower price, as the quantity demanded at higher price.
Increase and decrease in demand is represented as the shift in demand curve. In the graphical representation of demand curve, the shifting of demand is demonstrated as the movement from one demand curve to another demand curve. In case of increase in demand, the demand curve shifts to right, while in case of decrease in demand, it shifts to left of the original demand curve.
(b)(i) What is elasticity of demand? Illustrate different types of elasticity of demand with numerical example.
-> Demand extends or contracts respectively with a fall or rise in price. This quality of demand by virtue of which it changes (increases or decreases) when price changes (decreases or increases) is called Elasticity of Demand.
Elasticity means sensitiveness or responsiveness of demand to the change in price.
This change, sensitiveness or responsiveness, may be small or great. Take the case of salt. Even a big fall in its price may not induce an appreciable ex appreciable extension in its demand. On the other hand, a slight fall in the price of oranges may cause a considerable extension in their demand. That is why we say that the demand in the former case is ‘inelastic’ and in the latter case it is ‘elastic’.
The demand is elastic when with a small change in price there is a great change in demand; it is inelastic or less elastic when even a big change in price induces only a slight change in demand. In the words of Dr. Marshall, “The elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price.”But the demand cannot be perfectly ‘elastic’ or ‘inelastic’.
Completely elastic demand will mean that a slight fall (or rise) in the price of the commodity concerned induces an infinite extension (or contraction) in its demand. Completely inelastic demand will mean that any amount of fall (or rise) in the price of the commodity would not induce any extension (or contraction) in its demand. Both these conditions are unrealistic. That is why we say that elasticity of demand may be ‘more or less’, but it is seldom perfectly elastic or absolutely inelastic.
Types of Elasticity of Demand:
Elastic demand is the one when the response of demand is greater with a small proportionate change in the price. On the other hand, inelastic demand is the one when there is relatively a less change in the demand with a greater change in the price.
1. Perfectly Elastic Demand:
When a small change in price of a product causes a major change in its demand, it is said to be perfectly elastic demand. In perfectly elastic demand, a small rise in price results in fall in demand to zero, while a small fall in price causes increase in demand to infinity. In such a case, the demand is perfectly elastic or ep = 00.
The degree of elasticity of demand helps in defining the shape and slope of a demand curve. Therefore, the elasticity of demand can be determined by the slope of the demand curve. Flatter the slope of the demand curve, higher the elasticity of demand.
Though, perfectly elastic demand is a theoretical concept and cannot be applied in the real situation. However, it can be applied in cases, such as perfectly competitive market and homogeneity products. In such cases, the demand for a product of an organization is assumed to be perfectly elastic.
From an organization’s point of view, in a perfectly elastic demand situation, the organization can sell as much as much as it wants as consumers are ready to purchase a large quantity of product. However, a slight increase in price would stop the demand.
2. Perfectly Inelastic Demand:
A perfectly inelastic demand is one when there is no change produced in the demand of a product with change in its price. The numerical value for perfectly inelastic demand is zero (ep=0).
3. Relatively Elastic Demand:
Relatively elastic demand refers to the demand when the proportionate change produced in demand is greater than the proportionate change in price of a product. The numerical value of relatively elastic demand ranges between one to infinity.
Mathematically, relatively elastic demand is known as more than unit elastic demand (ep>1). For example, if the price of a product increases by 20% and the demand of the product decreases by 25%, then the demand would be relatively elastic.
4. Relatively Inelastic Demand:
Relatively inelastic demand is one when the percentage change produced in demand is less than the percentage change in the price of a product. For example, if the price of a product increases by 30% and the demand for the product decreases only by 10%, then the demand would be called relatively inelastic. The numerical value of relatively elastic demand ranges between zero to one (ep<1). Marshall has termed relatively inelastic demand as elasticity being less than unity.
(ii) How can ‘snob effect’ make the demand curve less elastic than otherwise?
-> The snob effect is a phenomenon described in microeconomics as a situation where the demand for a certain good by individuals of a higher income level is inversely related to its demand by those of a lower income level. The “snob effect” contrasts most other microeconomic models, in that the demand curve can have a positive slope, rather than the typical negatively sloped demand curve of normal goods .
This situation is derived by the desire to own unusual, expensive or unique goods . For consumers who want to use exclusive products, price is quality. These goods usually have a high economic value, but low practical value. The less of an item available, the higher its snob value. Examples of such items with general snob value are rare works of art , designer clothing , and sports cars .
In all these cases, one can debate whether they meet the snob value criterion, which in itself may vary from person to person. A person may reasonably claim to purchase a designer garment because of a certain threading technique, longevity, and fabric. While this is true in some cases, the desired effect can often be achieved by purchasing a less-expensive version from a reputable brand. Often these high-end items end up as closeout items in discount stores or online retailers where they may be offered at deep discounts from original price, bringing into question the true value of the product. Ultimately, wealthy consumers can be lured by superficial factors such as rarity, celebrity representation and brand prestige.
In case network externalities are negative, snob effect arises. Snob effect refers to the desire to possess a unique commodity having a prestige value. Snob effect works quite contrary to the bandwagon effect. The quantity demanded of a commodity having a snob value is greater, the smaller the number of people owning its.
Rare works of art, specially designed sport cars, specially designed clothing made to order, very expensive luxury cars. For example, the utility one gets from a very expensive luxury car is mainly due to the prestige and status value of it which results from the fact that only few others own it.
It is important to note that snob effect makes the demand curve less elastic. Thus at price Rs. 35 lakhs per luxury car, its quantity demand is 10 thousands. Now, if price is reduced to Rs. 15 lakhs per luxury car, its quantity demanded would increase to 50 thousands per year, and if snob effect was not present we had moved down more along the demand curve D 1. But in the presence of snob effect quantity demand increases from 10 thousand to only 30 thousand cars. Thus, in Figure 6.5 the snob effect has reduced the full effect of the fall in price so that net effect is the increase in quantity demanded from 10 thousand to 30 thousand units.
3(a) What is demand forecasting? Why is it done? Explain the uses and limitations of opinion-poll method of demand forecasting.
-> It is a technique for estimation of probable demand for a product or services in the future. It is based on the analysis of past demand for that product or service in the present market condition. Demand forecasting should be done on a scientific basis and facts and events related to forecasting should be considered.
Therefore, in simple words, we can say that after gathering information about various aspect of the market and demand based on the past, an attempt may be made to estimate future demand. This concept is called forecasting of demand.
For example, suppose we sold 200, 250, 300 units of product X in the month of January, February, and March respectively. Now we can say that there will be a demand for 250 units approx. of product X in the month of April, if the market condition remains the same.
Demand plays a crucial role in the management of every business. It helps an organization to reduce risks involved in business activities and make important business decisions. Apart from this, demand forecasting provides an insight into the organization’s capital investment and expansion decisions.
i. Fulfilling objectives:
Implies that every business unit starts with certain pre-decided objectives. Demand forecasting helps in fulfilling these objectives. An organization estimates the current demand for its products and services in the market and move forward to achieve the set goals.
For example, an organization has set a target of selling 50, 000 units of its products. In such a case, the organization would perform demand forecasting for its products. If the demand for the organization’s products is low, the organization would take corrective actions, so that the set objective can be achieved.
ii. Preparing the budget:
Plays a crucial role in making budget by estimating costs and expected revenues. For instance, an organization has forecasted that the demand for its product, which is priced at Rs. 10, would be 10, 00, 00 units. In such a case, the total expected revenue would be 10* 100000 = Rs. 10, 00, 000. In this way, demand forecasting enables organizations to prepare their budget.
iii. Stabilizing employment and production:
Helps an organization to control its production and recruitment activities. Producing according to the forecasted demand of products helps in avoiding the wastage of the resources of an organization. This further helps an organization to hire human resource according to requirement. For example, if an organization expects a rise in the demand for its products, it may opt for extra labour to fulfil the increased demand.
iv. Expanding organizations:
Implies that demand forecasting helps in deciding about the expansion of the business of the organization. If the expected demand for products is higher, then the organization may plan to expand further. On the other hand, if the demand for products is expected to fall, the organization may cut down the investment in the business.
v. Taking Management Decisions:
Helps in making critical decisions, such as deciding the plant capacity, determining the requirement of raw material, and ensuring the availability of labour and capital.
vi. Evaluating Performance:
Helps in making corrections. For example, if the demand for an organization’s products is less, it may take corrective actions and improve the level of demand by enhancing the quality of its products or spending more on advertisements.
vii. Helping Government:
Enables the government to coordinate import and export activities and plan international trade.
Uses and limitations of opinion-poll method of demand forecasting:-
Demand forecasting is a difficult exercise. Making estimates for future under the changing conditions is a Herculean task. Consumers’ behaviour is the most unpredictable one because it is motivated and influenced by a multiplicity of forces. There is no easy method or a simple formula which enables the manager to predict the future.
Economists and statisticians have developed several methods of demand forecasting. Each of these methods has its relative advantages and disadvantages. Selection of the right method is essential to make demand forecasting accurate. In demand forecasting, a judicious combination of statistical skill and rational judgement is needed.
Mathematical and statistical techniques are essential in classifying relationships and providing techniques of analysis, but they are in no way an alternative for sound judgement. Sound judgement is a prime requisite for good forecast.
The judgment should be based upon facts and the personal bias of the forecaster should not prevail upon the facts. Therefore, a mid way should be followed between mathematical techniques and sound judgment or pure guess work.
1. Survey of Buyer’s-Intentions:
This is a short-term method of knowing and estimating customer’s demand. This is direct method of estimating demand of customers as to what they intend to buy for the forthcoming time—usually a year.
By this the burden of forecasting goes to the buyer. This method is useful for the producers who produce goods in bulk.
Still their estimates should not entirely depend upon it. This method does not hold good for household consumers because of their inability to foresee their choice when they see the alternatives. Besides the household consumers there are many which make this method costly and impracticable. It does not expose and measure the variables under management control.
2. Collective Opinion or Sales Force Competitive Method:
Under this method, the salesman is nearest persons to the customers and is able to judge, their minds and market. They better understand the reactions of the customers to the firm’s products and their sales trends. The estimates of the different salesmen are collected and estimates sales are predicted.
These estimates are revised from time to time with changes in sales price, product, designs, publicity programmes, and expected changes in competition, purchasing power, income distribution, employment and population. It makes use of collective wisdom of salesmen, departmental heads and top executives.
(1) It is simple, common sense method involving no mathematical calculations.
(2) It is based on the first-hand knowledge of salesman and the persons directly connected with sales.
(3) This method is particularly useful for sales of new product. It has the salesman’s judgment.
(1) It is a subjective approach.
(2) This method can be used only for short-term forecasting.
For long-term planning it is not useful.
3. Trend Projection or Time Trend of the Time Series:
This is the most popular method of analysing time series and is generally used to project the time trend of the time series. A trend line can be filled through the series in visual or statistical way by the method of least squares.
The analyst can make a plausible algebraic relation—may it be linear, a quadratic or logarithmic between sales on one hand and independent variable time on the other. The trend line is then projected into the future for purpose of extrapolation.
This method is most popular as it is simple and in-extensive and because of time series data often exhibits a persistent growth trend.
The basic assumption of this method is that the past rate of change of the variable under study will be continuing in future. This assumption gives good safe results till the time series exhibits a persistent tendency to move in the same direction.
When the burning point comes, the trend projection breaks down. Even though a forecaster could hope normally to be correct in most forecasts when the turning points are few and spaced at long intervals from each other.
In fact, the actual challenge of forecasting is in the prediction of turning points rather than in the trend projection. At such turning points the management will have to change and revise its sales and projection strategies most drastically.
There are four factors responsible for the characterization of time series.
1. Fluctuations and turning points.
2. Trend seasonal variations.
3. Cyclical fluctuations, and
4. Irregular or random forces.
The problem in forecasting is to separate and measure each of these factors.
This time series is expressed by the following equation:
O = TSCI
where, O = observed data
T = a secular tend
S = a seasonal factor
C = cyclical element
I = an irregular movement.
The usual practice is to calculate the trend first from the basic data. The trend values are then taken out from the observed data (TSCI /T). The next step is to reckon the seasonal index that is utilised to remove the seasonal effect (SCI/S).
It is fitted through chain to the remainder that also gives the irregular effect. This approach to the breaking up of time series data is an analytical device of usefulness for the knowledge of the nature of business fluctuations.
(a) Analysis of movements would be in the order of trend, seasonal variations and cyclical changes.
(b) The effects of every component are not dependent on any other components.
4. Executive Judgment Method:
Under this method opinions are sought from the executives of different discipline i.e., marketing, finance, production etc. and estimates for future demands are made. Thus, this is a process of combining, averaging or evaluating in some other way the opinions and views of the top executives.
The main advantages of this method are:
1. The forecasts can be made speedily by analysing the opinions and views of top executives. The techniques are quite easy and simple.
2. No need of elaborate statistics:
There is no need of collecting elaborate. Statistics for the forecasts hence it is not much expensive.
3. Only feasible method to follow:
In the absence of adequate data is it the only feasible method to be followed.
The chief dis-advantages of the of this method are:
(1) No factual basis of such forecast:
There is no factual basis of such forecasts, so the method is inferior to others.
(2) No accuracy:
Accuracy cannot be claimed under this method.
(3) Responsibility for the accuracy of data cannot be fixed on any one.
5. Economic Indicators:
This method has its base for demand forecasting on few economic indicators.
(a) Construction contracts:
For demand towards building materials sanctioned for Cement.
(b) Personal Income:
Towards demand of consumer goods.
(c) Agricultural Income:
Towards demand of agricultural imports instruments, fertilisers, manner etc.
(d) Automobiles Registration:
Towards demand of car parts and petrol. These and other economic indicators are given by specialised organisation. The analyst should establish relationship between the sale of the product and the economic indicators to project the correct sales and to measure as to what extent these indicators affect the sales. To establish relationship is not an easy task especially in case of New Product where there are no past records.
Following steps may be remembered:
(a) If there is any relationship between the demand for a product and certain economic indicator.
(b) Make the relationship by the method of least squares and derive the regression equation. Supposing the relationship is Linear the equation will be of the form y = α + bx. There can be curvilinear relationship also.
(c) Once the regression equation is obtained any value of X (economic indicator) can be applied to forecast the value of Y (demand).
(d) Past relationship may not recur. Therefore, need for value judgments are felt. Other new factors may also have to be taken into consideration.
The limitations of economic indicators are as follows:
(1) It is difficult to find out an appropriate economic indicator.
(2) For few products it is not good, as no past data are available.
(3) This method of forecasting is best suited where relationship of demand with a particular indicator is characterised by a Time Lag, such as construction contracts will give consequence to demand for building materials with some amount of Time Lag.
But where the demand does not lag behind the particular economic index, the utility is restricted because forecast may have to be based on projected economic index itself that may not result true.
6. Controlled Experiments:
Under this method, an effort is made to ascertain separately certain determinants of demand which can be maintained, e.g., price, advertising etc. and conducting the experiment, assuming etc., and conducting the experiment, assuming that the other factors remain constant.
Thus, the effect of demand determinants like price, advertisement packing etc., on sales can be assessed by either varying them over different markets or by varying them over different time periods in the same market.
Different prices would be associated with different sales on that basis the price, quantity relationship is estimated in the form of regression equation and used for forecasting purposes. It must be noted that the market divisions here must be homogeneous with regard to income, tastes etc.
Such experiments have been conducted widely in the USA and were successful. This is a new experiment. This is quite new and less applied.
The main reasons for non-application of this method so far as follows:
1. The method is expensive and time consuming.
2. It is risky because it may lead to un-favourable reactions on dealers, consumers and competitors.
3. It is not always easy to determine what conditions should be taken to be constant and what factors should be regarded as variable, so as to separate and measures their influence on demand.
4. It is hard to satisfy the homogeneity of market conditions. In-spite of these drawbacks, controlled experiments has sufficient potentialities to become a useful method for business research and analysis in future.
7. Expert’s Opinions:
Under this method expert’s opinions are sought from specialists in the field, outside the organisations or the organisation collects opinions from such specialists; views of expert’s published in the newspaper and journals for the trade, wholesalers and distributors for the company’s products, agencies and professional experts.
These opinions and views are analysed and deductions are made there from to arrive at the figure of demand forecasts.
The advantages of this method are:
(1) Forecasts can be done easily and speedily.
(2) It is based on expert’s views and opinions hence estimates are nearly accurate.
(3) The method is suitable where past records of sales are not available.
(4) The method is economical because survey is done to collect the data. The expenses of seeking the opinions and views of experts are much less than the expenses of actual survey.
The important dis-advantages of this method are:
(1) Estimates for a market segment cannot be possible.
(2) The reliability of forecasting is always subjective because forecasting is not based on facts.
(b) Explain the advantages and disadvantages of estimating demand by
(i) Consumer surveys
-> The most efficient way to measure consumer survey is to develop customer satisfaction surveys with the help of a good survey software solution. An advanced survey software solution can manage multi-mode survey research methods – produce the same survey in different formats; including online surveys , mobile surveys , paper surveys , and more – depending on the best method to reach your target customer base. Customer satisfaction surveys are designed to give you anonymous and unambiguous insight into your customers’ thoughts and perceptions pertaining to your products, services, programs, and your organization as a whole. They can also provide valuable information leading to what needs to be changed in order to retain lasting customer relationships.
Consumer surveys are extremely advantageous to your organization. They do, however come with certain disadvantages, but those disadvantages should not discourage you from gathering valuable customer feedback.
Here are some of the advantages and disadvantages of implementing regularly administered consumer surveys into your business.
Advantages of Customer Satisfaction Surveys
- Up-to-date feedback: Gather current customer feedback on various aspects of your company. You can stay on top of customer trends through regularly scheduled online surveys or email surveys, and receive instant customer feedback. It is always useful to acquire insight into how your customers are currently reacting to all aspects of your business.
- Benchmark results: You can administer the same survey every so often to customers to gain continued insight into your customers. Surveys can have the same questions, which will allow you to compare data over time and benchmark survey data across previous years to determine if any changes need to be made.
- Show that you care: Customers like to be asked for their feedback. It gives the customer the perception that your company values them; is committed to keeping them as a long-term customer; and bases business decisions on their feedback.
Disadvantages of Customer Satisfaction Surveys
- Too many surveys, so little time: Your customers are bombarded with online surveys. Surveys may be simple to complete, however, some people simply don’t like to complete them. Sending surveys too often can irritate customers and lead to customer burnout. Customer burnout can result in low response rates or result in lower satisfaction scores, despite your reputation for providing excellent products or services.
- Privacy Issues: We live in a high-tech environment filled with daily doses of unwanted junk email, email solicitations, and sales calls. When taking an online survey or a phone survey (or any type of survey), it is hard for your customers to believe that they aren’t being tracked. Because of insecurities of releasing private information, customers today are hesitant in giving out information that may lead to more junk email and unwanted calls. Make certain to assure customers that the information they provide in response to your customer satisfaction surveys will not be used. Without this disclaimer, it may be difficult to receive a good response rate.
4(a) What is transfer pricing? What is its significance? Explain the process of determining the transfer price when the product has no external market.
-> Transfer pricing refers to the rules and methods for pricing transactions within and between enterprises under common ownership or control. Because of the potential for cross-border controlled transactions to distort taxable income, tax authorities in many countries can adjust intergroup transfer prices that differ from what would have been charged by unrelated enterprises dealing at arm’s length.
Aims & Objective of Transfer Pricing:
1. Transfer pricing minimizes the tax burden or arranging direction of cash flow:
Transfer price, as aforesaid, refers to the value attached to transfer of goods, services, and technology between related entities such as parent and subsidiary corporations and also between the parties which are controlled by a common entity. Its essence being that the pricing is not set by an independent transferor and transferee in an arm’s length transaction. Transaction between them is not governed by open market considerations.
2. Transfer pricing results in shifting profits:
Whatever the reason for fixing a transfer price which is not arm’s length, the result is the shift of profit. The effect is that the profit appropriately attributable to one jurisdiction is shifted to another jurisdiction. The main object is to avoid tax as also to withdraw profits leaving very little for the local participation to share. Other object is avoidance of foreign exchange restrictions.
3. Shifting of Profits- Tax avoiding not the only object:
Transfer between the enterprises under the same control and management, of goods, commodities, merchandise, raw material, stock, or services is made at a price which is not dictated by the market but controlled by such considerations such as:
• To reduce profits artificially so that tax effect is reduced in a specific country;
• To facilitate decentralization of production so that efforts are directed to concentrate profits in the State of production where there is no or least competition;
• To remit profits more than the ceilings imposed for repatriation;
• To use it as an effective tool to exploit the fluctuation in foreign exchange to advantage.
In financial sector, transfer pricing is the value placed on transfers within an organization, used as a means of allocating costs to various profit centers. Transfer pricing is used widely in multi-office banks and bank holding companies, serving these important functions: (i) price setting for services performed by business units; (ii) a means of evaluating financial performance by business units; and (iii) determining the contribution to net income by profit centres in the organization. The large size firms divide their operation very often into product divisions or subsidiaries. Growing firms add new divisions or departments to the existing ones. The firms then transfer some of their activities to other divisions. The goods and services produced by the new division are used by the parent organization. In other words, the parent division buys the product of its subsidiaries. Such firms face the problem of determining an appropriate price for the product transferred from one division or subsidiary to the other. Specifically, the problem is of determining the price of a product produced by one division of the same firm. This problem becomes much more difficult when each division has a separate profit function to maximize. Pricing of infra-firm ‘transfer product’ is referred to as ‘transfer pricing’. One of the most systematic treatments of the transfer pricing technique has been provided by Hirshleifer.
We will discuss here briefly his technique of transfer pricing.
(1) Market Prices
(2) Cost-Based Prices
(3) Negotiated Prices
(4) Dual Prices
(1) Market-Based Prices:
Market price refers to a price in an intermediate market between independent buyers and sellers. When there is a competitive external market for the transferred product, market prices work well as transfer prices. When transferred goods are recorded at market prices, divisional performance is more likely to represent the real economic contribution of the division to total company profits. If the goods cannot be bought from a division within the company, the intermediate product would have to be purchased at the current market price from the outside market. Divisional profits are therefore likely to be similar to the profits that would be calculated if the divisions were separate organizations.
Consequently, divisional profitability can be compared directly with the profitability of-similar companies operating in the same type of business. Managers of both buying and selling divisions are indifferent between trading with each other or with outsiders. No division can benefit at the expense of another division. In the market price situation, top management will not be tempted to intervene.
Market-based prices are based on opportunity costs concepts. The opportunity cost approach signals that the correct transfer price is the market price. Since the selling division can sell all that it produces at the market price, transferring internally at a lower price would make the division worse off.
Similarly the buying division can always acquire the intermediate goods at the market price, so it would be unwilling to pay more for internally transferred goods. Since the minimum transfer price for the selling division is the market price and the maximum price for the buying division is also the market price, the only possible transfer price is the market price.
The market price can be used to resolve conflicts among the buying and selling divisions. From the company viewpoint, market price is the optimal so long as the selling division is operating at full capacity. The market price does not allow any gains or losses in efficiency of the selling division. It saves administrative costs as the use of competitive market prices is free from any dispute, argument and bias.
Further, transfer prices based on market prices are consistent with the responsibility accounting concepts of profit centres and investment centres. In addition to encouraging division managers to focus on divisional profitability, market based transfer prices help to show the contribution of each division to overall company profit.
However, there are some problems using the market price approach:
Another problem with market prices can occur when a selling division is not operating at full capacity and cannot sell all its products. To illustrate this point, assume that material used by Division A in a company is being purchased from outside market at Rs 200 per unit.
The same materials are produced by Division B. If Division B is operating at full capacity, say of 50,000 units and can sell all its products to either Division A or to outside buyers, then the use of transfer price of Rs 200 per unit (market price) has no effect on Division B’s income or total company profit. Division B will earn revenue of Rs 200 per unit on all its production and sales, regardless of who buys its product and Division A will pay Rs 200 per unit, regardless of whether it purchases the materials from Division B or from an outside supplier. In this situation, the use of market price as the transfer price is appropriate.
However, if Division B is not operating at full capacity and unused capacity exists in that division, the use of market price may not lead to maximization of total company profit. To illustrate this point, assume that Division B has unused capacity of 30,000 units and it can continue to sell only 50,000 units to outside buyers.
In this situation, the transfer price should be set to motivate the manager of Division A to purchase from Division B if the variable cost per unit of product of Division B is less than the market price. If the variable costs are less than Rs 200 per unit but the transfer price is set equal to the market price of Rs 200, then the manager of Division A is indifferent as to whether materials are purchased from Division B or from outside suppliers, since the cost per unit to Division B would be the same, Rs 200.
Hilton sums up difficulty associated with general rule of transfer pricing in the following words:
(i) Defaulting in Measuring Opportunity Costs:
The general transfer-pricing rule will always promote goal-congruent decision making if the rule can be implemented. However, the rule is often difficult or impossible to implement due to the difficulty of measuring opportunity costs. Such a cost-measurement problem can arise for a number of reasons. One reason is that the external market may not be perfectly competitive. Under perfect competition, the market price does not depend on the quantity sold by anyone producer.
Under imperfect competition, a single producer or group of producers can affect the market price by varying the amount of product available in the market. In such cases, the external market price depends on the production decisions of the producer. This in turn means that the opportunity cost incurred by the company as a result of internal transfers depends on the quantity sold externally. These interactions may make it impossible to measure accurately the opportunity cost caused by a product transfer.
(ii) Nature of Transferred Goods:
Other reasons for difficulty in measuring the opportunity cost associated with a product transfer include uniqueness of the transferred goods or services, a need for the producing division to invest in special equipment in order to produce the transferred goods, and interdependencies among several transferred products or services. For example, the producing division may provide design services as well as production of the goods for a buying division. What is the opportunity cost associated with each of these related outputs of the producing division? In many such cases it is difficult to sort out the opportunity costs.
(iii) Distress Market Prices:
Occasionally an industry will experience a period of significant excess capacity and extremely low prices. For example, when gasoline prices soared due to a foreign oil embargo, the market prices for recreational vehicles and power boats fell temporarily to very low levels.
Under such extreme conditions, basing transfer prices on market prices can lead to decisions that are not in the best interests of the overall company. Basing transfer prices on artificially low distress market prices could lead the producing division to sell or close the productive resources devoted to producing the product for transfer. Under distress market prices, the producing division manager might prefer to move the division into a more profitable product line.
While such a decision might improve the division’s profit in the short run, it could be contrary to the best interests of the company overall. It might be better for the company as a whole to avoid divesting itself of any productive resources and to ride out the period of market distress. To encourage an autonomous division manager to act in this fashion, some companies set the transfer price equal to the long-run average external market price, rather than the current (possibly depressed) market price.
(2) Cost Based Prices:
When external markets do not exist or are not available to the company or when information about external market prices is not readily available, companies may decide to use some forms of cost-based transfer pricing system.
Cost-based transfer prices may be in different forms such as variable cost, actual full cost, full cost plus profit margin, standard full cost.
(a) Variable Cost:
Variable cost-based pricing approach is useful when the selling division is operating below capacity. The manager of the selling division will generally not like this transfer price because it yields no profit to that division. In this pricing system, only variable production costs are transferred. These costs are direct materials, direct labour and variable factory overhead.
Variable cost has the major advantage of encouraging maximum profits for the entire firm. By passing only variable costs alone to the next division, production and pricing decisions are based on cost- volume-profit relationships for the firm as a whole. The obvious problem is that selling division is left holding all its fixed costs and operating expenses. That division is now a loss division, nowhere near a profit centre.
(b) Actual Full Cost:
In actual full cost approach, transfer price is based on the total product cost per unit which will include direct materials, direct labour and factory overhead. When full cost is used for transfer pricing, the selling division cannot realize a profit on the goods transferred. This may be disincentive to the selling division. Further, full cost transfer pricing can provide perverse incentives and distort performance measures. A full cost transfer price would have shutdown the chances of any negotiation between divisions about selling at transfer prices.
(c) Full Cost plus Profit Margin:
Full cost plus mark up (or profit margin) overcomes the weaknesses of full cost basis transfer pricing system. The full cost plus price include the allowed cost of the item plus a mark up or other profit allowance. With such a system, the selling division obtains a profit contribution on units transferred and hence, benefits if performance is measured on the basis of divisional operating profits. However, the manager of the buying division would naturally object that his costs (and hence reported performance) are adversely affected.
The basic question in full cost plus mark up is ‘what should be the percentage of mark up.’ It can be suggested that the mark up percentage should cover operating expenses and provide a target return on sales or assets.
(d) Standard Costs:
In actual cost approaches, there is a problem of measuring cost. Actual cost does not provide any incentive to the selling division to control cost. All product costs are transferred to the buying division. While transferring actual costs any variances or inefficiencies in the selling division are passed along to the buying division.
The problem of isolating the variances that have been transferred to subsequent buyer division becomes extremely complex. To promote responsibility in the selling division and to isolate variances within divisions, standard costs are usually used as a basis for transfer pricing in cost-based systems.
Whether transferring at differential costs or full costs, standard costs, where available, are often used as the basis for the transfer. This encourages efficiency in the selling division because inefficiencies are not passed onto the buying division. Otherwise, the selling division can transfer cost inefficiencies to the buying division. Use of standard cost reduces risk to the buyer. The buyer knows that standard costs will be transferred and avoids being charged with suppliers’ cost overruns.
(3) Negotiated Prices:
Negotiated prices are generally preferred as a middle solution between market prices and cost- based prices. Under negotiated prices, the managers involved act much the same as the managers of independent companies. Negotiation strategies may be similar to those employed when trading with outside markets. If both divisions are free to deal either with each other or in the external market, the negotiated price will likely be close to the external market price. If all of a selling division’s output cannot be sold in the external market (that is, a portion must be sold to the buying division), the negotiated price will likely be less than the market price and the total margin will be shared by the divisions.
The conditions under which a negotiated transfer price will be successful include:
1. Some Form of Outside Market for the Intermediate Product:
This avoids a bilateral monopoly situation in which the final price could vary over too large a range, depending on the strength and skill of each negotiator.
2. Sharing of all Market Information Among the Negotiators:
This should enable the negotiated price to be close to the opportunity cost of one or preferably both divisions.
3. Freedom to Buy or Sell Outside:
This provides the necessary discipline to the bargaining process.
4. Support and Occasional Involvement of Top Management:
The parties must be urged to settle most disputes By themselves, otherwise the benefits of decentralization will be lost. Top management must be available to mediate the occasional unresolvable dispute or to intervene when it sees that the bargaining process is clearly leading to suboptimal decisions. But such involvement must be done with restraint and tact if it is not to undermine the negotiating process.
Negotiated price avoids mistrusts, bad feelings and undesirable bargaining interests among divisional managers. Also, it provides an opportunity to achieve the objectives of goal congruence, autonomy and accurate performance evaluation. The overall company is beneficiary if selling and buying divisions can agree upon some mutually transfer prices. Negotiated transfer price is considered as a vital integrating tool among divisions of a company which is necessary to achieve goal congruence.
If negotiations help ensure goal congruence, top management has little temptation to intervene between divisions. The agreed prices also can be used for performance measurement without creating any friction. The use of negotiated prices is consistent with the concept of decentralized decision-making in the divisionalised firms.
However, negotiated prices have the following disadvantages:
(1) A great deal of management effort, time and resources can be consumed in the negotiating process.
(2) The final emerging negotiated price may depend more on the divisional manager’s ability and skill to negotiate than on the other factors. Thus, performance measures will be distorted leading to incorrect evaluation of divisional performance.
(3) One divisional manager having some private information may take advantage of another divisional manager.
(4) It is time-consuming for the managers involved.
(5) It leads to conflicts between divisions.
(6) It may lead to a suboptimal level of output if the negotiated price is above the opportunity cost of supplying the transferred goods.
(4) Dual Prices:
Under dual prices of transfer pricing, selling division sells the transferred goods at a (i) market or negotiated market price or (ii) cost plus some profit margin. But the transfer price for the buying division is a cost-based amount (preferably the variable costs of the selling division). The difference in transfer prices for the two divisions could be accounted for by special centralized account. This system would preserve cost data for subsequent buyer departments, and would encourage internal transfers by providing a profit on such transfers for the selling divisions.
Dual prices give motivation and incentive to selling divisions as goods are transferred at market price and this arrangement provides a minimal cost to the buying division as well. Market price can be considered as the most appropriate base for the selling division. Thus dual pricing-system has the function of motivating both the selling division and buying division to make decisions that are consistent with the overall goals of decentralization—goal congruence, accurate performance measurement, autonomy, adequate motivation to divisional manager.
(b) Highlight the salient features of monopolistic competition. Illustrate how a monopolistically competitive firm determine price and output in both short-run and long-run.
-> Salient features of monopolistic competition:-
1. Large Number of Buyers and Sellers:
There are large number of firms but not as large as under perfect competition.
That means each firm can control its price-output policy to some extent. It is assumed that any price-output policy of a firm will not get reaction from other firms that means each firm follows the independent price policy.
If a firm reduces its price, the gains in sales will be slightly spread over many of its rivals so that the extent to which each of the rival firms suffers will be very small. Thus these rival firms will have no reason to react.
2. Free Entry and Exit of Firms:
Like perfect competition, under monopolistic competition also, the firms can enter or exit freely. The firms will enter when the existing firms are making super-normal profits. With the entry of new firms, the supply would increase which would reduce the price and hence the existing firms will be left only with normal profits. Similarly, if the existing firms are sustaining losses, some of the marginal firms will exit. It will reduce the supply due to which price would rise and the existing firms will be left only with normal profit.
3. Product Differentiation:
Another feature of the monopolistic competition is the product differentiation. Product differentiation refers to a situation when the buyers of the product differentiate the product with other. Basically, the products of different firms are not altogether different; they are slightly different from others. Although each firm producing differentiated product has the monopoly of its own product, yet he has to face the competition. This product differentiation may be real or imaginary. Real differences are like design, material used, skill etc. whereas imaginary differences are through advertising, trade mark and so on.
4. Selling Cost:
Another feature of the monopolistic competition is that every firm tries to promote its product by different types of expenditures. Advertisement is the most important constituent of the selling cost which affects demand as well as cost of the product. The main purpose of the monopolist is to earn maximum profits; therefore, he adjusts this type of expenditure accordingly.
5. Lack of Perfect Knowledge:
The buyers and sellers do not have perfect knowledge of the market. There are innumerable products each being a close substitute of the other. The buyers do not know about all these products, their qualities and prices.
Therefore, so many buyers purchase a product out of a few varieties which are offered for sale near the home. Sometimes a buyer knows about a particular commodity where it is available at low price. But he is unable to go there due to lack of time or he is too lethargic to go or he is unable to find proper conveyance. Likewise, the seller does not know the exact preference of buyers and is, therefore, unable to get advantage out of the situation.
6. Less Mobility:
Under monopolistic competition both the factors of production as well as goods and services are not perfectly mobile.
7. More Elastic Demand:
Under monopolistic competition, demand curve is more elastic. In order to sell more, the firms must reduce its price.
Monopolistically competitive firm determine price and output in both short-run and long-run:-
Under monopolistic competition, organizations need to make optimum adjustments in the prices and output sold to attain equilibrium.
Apart from this, under monopolistic competition, organizations also need to pay attention toward the design of the product and the way the product is promoted in the market.
Moreover, an organization under monopolistic competition is not only required to study its individual equilibrium, but group equilibrium of all organizations existing in the market. Let us first understand individual equilibrium of an organization under monopolistic competition.
As we know every seller, irrespective of the market structure, is willing to maximize his/her profits. In monopolistic competition, profits are maximized at a point where marginal revenue is equal to marginal cost. The price determined at this point is known as equilibrium price and the output produced at this point is called equilibrium output.
If the marginal revenue of a seller is greater than marginal cost, he/she may plan to expand his/her output. On the other hand, if marginal revenue is lesser than marginal cost, it would be profitable for the seller to reduce his/her output to the level where marginal revenue is equal to marginal cost.
Equilibrium in Short Run:
The short-run equilibrium of a monopolistic competitive organization is the same as that of an organization under monopoly. In the short run, an organization under monopolistic competition attains its equilibrium where marginal revenue equals marginal cost and sets its price according to its demand curve. This implies that in the short run, profits are maximized when MR=MC.
Equilibrium in Long Run:
In the preceding sections, we have discussed that in the short run, organizations can earn supernormal profits. However, in the long run, there is a gradual decrease in the profits of organizations. This is because in the long run, several new organizations enter the market due to freedom of entry and exit under monopolistic competition.
When these new organizations start production the supply would increase and the prices would fall. This would automatically increase the level of competition in the market. Consequently, AR curve shifts from right to left and supernormal profits are replaced with normal profits.
In the long run, the AR curve is more elastic than that of in the short run. This is because of an increase in the number of substitute products in the long- run. The long-run equilibrium of monopolistically competitive organizations is achieved when average revenue is equal to average cost. In such a case, organizations receive normal profits.
5(a)(i) Explain the features of business cycles. Which phase of the business cycle is the most fearsome phase for the business firms and why?
-> The business cycle is the natural expansion and contraction of the production and output of goods and services that happens over a period of time. It can be said to be the economic rise and fall of a firm in the economy .
It is most importantly a tool to understand the economic conditions of the firm and the economy in general. The firm can use this analysis to make necessary changes to their policies.
One thing to understand that business cycles are a natural phenomenon that occurs over time. Every firm will go through the cycles. No firm can have a constant growth or decline over its life cycle. There are always ups and downs in the economic activities of the firm.
1] Occur Periodically
As we saw, these phases occur from time to time. However they do not occur in for specific times, their time periods will vary according to the industries and the economic conditions. Their duration may vary from anywhere between two to ten or even twelve years.
Even the intensity of the phases will be different. For example, the firm may see tremendous growth followed by a shallow short-lived depression phase.
2] They are Synchronic
Another one of the features of business cycles is that they are synchronic. Business cycles are not limited to one firm or one industry. They originate in the free economy and are pervasive in nature.
A disturbance in one industry quickly spreads to all the other industries and finally affects the economy as a whole. For example, a recession in the steel industry will set off a chain reaction until there is a recession in the entire economy.
3] All Sectors are affected
All major sectors of the economy will face the adverse effects of a business cycle. Some industries like the capital goods industry, consumer goods industry may be disproportionately affected.
4] Complex Phenomenon
Business cycles are a very complex and dynamic phenomenon. They do not have any uniformity. There are no set causes for business cycles as well. So it is nearly impossible to predict or prepare for these business cycles.
5] Affect all Departments
Trade cycles are not only limited to the output of goods and services. It has an effect on all other variables as well such as employment, the rate of interest, price levels, investment activity etc.
6] International in Character
Trade cycles are contagious. They do not limit themselves to one country or one economy. Once they start in one country they will spread to other countries and economies via trade relations and international trade practices.
We have an actual example of this when the Great Depression of 1929 in the USA, later on, had an adverse effect on the entire global economy. So in an integrated global economy like todays the effects of a trade cycle spread far and wide.
Phases of the business cycle are the most fearsome phase for the business firms:-
1. Slump or Depression:
This is the most critical and fearful stage of a trade cycle. Harberler has described depression as “a state of affairs in which real income consumed or volume of production per head and the rate of employment are falling and are sub-normal in the sense that there are idle resources and unused capacity, especially unused labour.”
A slump or depression shows itself first in a substantial decline in general output and employment.
The decline in economic activity is not, of course, uniform. Contraction in output might be much more in manufacturing such as machinery and equipment, mining, construction and transport than in retail trade or agriculture.
While output and employment tend to fall fast during the slump, prices and wages continue to decline. This is really agonizing experience for both the producers and the workers. Prices decline because of the expectations of producers in general that these would continue to fall in spite of all governmental efforts.
While the producers try to dispose of their stocks at the current market prices, the consumers tend to postpone their purchases in the hope that the prices would fall further and they would be able to benefit from it.
Scared by the general slump in the economy, the financial institutions press the producing firms to return their advances according to the contract. This forces the producers to meet their contractual obligations through unintended sales of their inventories in a market where prices are already declining.
This deepens the depression further. Most firms reduce their output and as such are forced to lay-off workers. As unemployment increases, the wages tend to fall under its pressure.
However, the fall in wages is less than the fall in prices. This is because workers’ unions strongly oppose wage reductions. The rate of fall in prices of agricultural raw materials is generally more than chat of manufactured goods.
This is because the producers are not prepared to lift off the supplies of the raw materials which cause a sharper fall in their prices than the prices of manufactures. The wholesale prices fall faster than the retail prices. These sudden changes in the relative price structure of the economy cause dislocations in production and exchange.
Depression or slump leads to redistribution of the national income. Profits and wages fall faster relatively to rent and other fixed incomes. Incomes of shareholders go down fast. This reduces the deposits with banks and other financial institutions.
They, in turn, follow the policy of credit contraction. While producers are reluctant to borrow because of dull trade conditions, the financial institutions are hesitant in lending for fresh investments. This causes the depression to persist for a longer period than it would have lasted on its own.
Recovery shows the upturn of the output and employment of the economy from the state of depression. Recovery is most probably the result of the fresh demand for plant and equipment arising from the consumer goods industries which had been postponing this investment during depression.
The capital goods have a limited life. They wear out completely after some time and need replacement. This replacement demand starts the recovery process.
Although prices remain more or less stable, wages and other incomes show a noticeable rise. Profits and hence dividends start rising which spurs the producers to float fresh investment proposals in the stock market. Since incomes rise, consumer spending also rises to encourage increased production. Soon the other business activity also picks up.
The appearance of new demand for capital goods, existence of low interest rates, willingness of financial institutions to extend credit and optimistic expectations of the investors about the future, all generate a favourable climate for new investment. The stock exchanges bear out the signs of recovery in the form of rising dividends and bullish share markets.
It must be pointed out here that a non-intervention policy from the government fails to start the recovery phase. Recover)’ is a slow and halting process. The government has to pursue stabilisation policies and show special initiatives in dispelling the pessimistic mood of the investors. The economic system, left to it is likely to stagnate in the state of depression for an intolerably long period for the working class.
3. Boom or Prosperity:
During the recovery phase, rise in output and incomes of the people induces substantial increase in aggregate spending. This has a multiplier effect. As effective demand increases, income rises faster than before. The whole process becomes self-reinforcing.
The cumulative process of rising investment and employment forges ahead. As investors become more confident, expanding productive activity takes the economy to a boom or prosperity phase.
According to Haberler, prosperity is “a state of affairs in which the real income consumed, real income produced and the level of employment are high or rising, and there are no idle resources or unemployed workers or very few of cither”. This means that the ideals of full employment of the labour force and full utilisation of productive capacity are realized in the prosperity phase. There is a state of exuberance and enthusiasm in the business community.
Industrial and commercial activity, both speculative and non-speculative, shows remarkable expansion. Construction activity gets a big boost. Share markets reflect the general state of exuberating of the investors. Share markets give handsome gains to investors which encourages accumulation of inventories of durable capital goods.
Financial institutions tend to expand credit as the interest rates and discount rates go up. Thus, everyone seems to be happy during the state of prosperity which ultimately, of course, proves to be short-lived.
The end to prosperity phase comes because of certain tendencies in the private-enterprise economy prevalent during the boom conditions.
Firstly, as prices rise, wages tend to lag behind. As a result, purchasing power of workers, who form a majority of the people, tends to lag behind the supply of consumer goods.
Secondly, expansion of production is hampered by shortages of some inputs and bottlenecks in production.
Thirdly, excessive demand for labour and materials pushes up both the factor and the product prices but in a disproportionate fashion.
Fourthly, the non-availability of credit beyond a particular rate of expansion might also act as a serious break on prosperity. Financial institutions including banks cannot expand credit beyond a limit put by their reserve requirements. As this limit is reached, they start recovering their loans. Shortages of finance crop up.
Firms are forced to liquidate their stocks when most firms try to sell their output at the same time, the price level starts falling. When some firms get involved in losses in this way a wave of pessimism runs through the share markets.
Production schedules by firms are curtailed, workers are laid off and outstanding orders for raw materials are cancelled. In this way the wave of pessimism gets transmitted to other sectors of the economy. The whole economic system thereby runs into a crisis. Thus the next stage of the trade cycle, called recession of deflation starts.
When sure signs of recession appear on the stock and financial markets, over- pessimism, nervousness and fear born out of uncertainty overtake the businessmen. In this atmosphere, new projects are shelved. Even the projects in hand may be abandoned. Some firms go sick. Others simply go bankrupt. All this hastens the process of economic contraction.
The fall in the purchasing power of the general public reduces demand for consumer goods which aggravates the slackening demand for machines and equipment. Construction activity falls significantly. The business world goes panicky.
(ii) How can monetary changes cause cyclical fluctuations?
-> In the long term, we cannot influence growth potential or prosperity by means of monetary policy – not even in Norway. But we can influence the fluctuations in the economy, the short-term cyclical movements. Norges Bank also takes into account that monetary policy should not cause unreasonably sharp fluctuations in output by setting a relatively long-term horizon for the attainment of the inflation target, and allowing deviations in the intervening period.
It would probably be possible by a very aggressive use of instruments to force inflation back to the target within a time frame of 3-4 quarters – perhaps even less if the foreign exchange channel is strong. This would cause very pronounced fluctuations in the real economy, however.
In this sense, variations in output enter our “loss function”. The thinking that follows from the theoretical research is to a large degree present in the actual setting of interest rates. For practical purposes, we, and other central banks with inflation targeting, make estimates of future price inflation. Our instruments are oriented in such a way that there are prospects of attaining the inflation target two years ahead. The theoretical literature has given us useful knowledge as to how far forward in time this horizon should be set. The result of using too short a horizon will be considerable sinstability in output and in nominal and real interest rates.
From our point of view, it is very positive that substantial resources are being invested in theoretical and empirical research in this area. Norges Bank will seek to contribute to this work and to the public debate. We must also be willing to consider adjusting the manner in which we carry out our analyses and communicate monetary policy as new knowledge becomes available.
Let us now look at the concrete objectives of Norwegian monetary policy. A year and a half ago, the Starting and the Government adopted new guidelines for economic policy. According to its mandate, Norges Bank shall orient monetary policy towards maintaining low and stable inflation.
The first paragraph presents an objective. The last paragraph states more specifically what Norges Bank is to do.
The first sentence in the mandate refers to the value of the krone. Stability in the internal value of the krone implies that inflation must be low and stable. It is also a necessary precondition for stability in financial and property markets.
The regulation also states that monetary policy shall be aimed at stability in the international value of the krone. The krone exchange rate fluctuates from day to day, from week to week, and from month to month. We have free international trade and free capital movements. We do not have the instruments for fine-tuning the exchange rate. In Norges Bank’s submission of 27 March 2001 to the Ministry of Finance on the new guidelines for economic policy, we indicated that when monetary policy is aimed at low and stable inflation, this is the best contribution monetary policy can make to stability in the krone exchange rate over time.
The interest rate affects price inflation through a number of channels, including the krone exchange rate. A stronger krone curbs inflation. If we take steps to counteract an appreciation of the krone when there are pressures in the economy, we reduce the possibility of keeping inflation at bay and there is a greater risk of pronounced fluctuations in the economy. Maintaining stability in the internal value of the krone must thus take precedence. As long as other countries pursue a policy of low and stable inflation, stability in the international value of the krone is dependent on low and stable inflation in Norway
The implementation of monetary policy is delegated to Norges Bank. This implies that Norges Bank sets the interest rate on the basis of our understanding of the regulation, as indicated in the Bank’s submission to the Ministry of Finance in March last year. Our interpretation places emphasis on the Government’s rationale behind the regulation, on the objective as formulated in the first paragraph and on our knowledge about the relationships between the interest rate, the krone exchange rate, output, employment and inflation.
The operational objective of monetary policy is low and stable inflation. The inflation target is set at 2½ per cent. A monetary stance resulting in high and varying inflation would have led to wider swings in output and employment. It would also have been a recipe for turbulence in the foreign exchange markets. There is therefore a close link between the third paragraph of the regulation – the inflation target – and the first paragraph concerning stabilising economic developments and exchange rate expectations.
Monetary policy affects the economy with considerable and variable lags. The current level of inflation does not provide an adequate basis for determining the level at which interest rates should be set today. Our analyses indicate that a substantial share of the effects of an interest rate change will occur within two years. Two years is thus a reasonable time horizon for attaining the inflation target, and also makes it possible to avoid unnecessary output and employment variability. See also the formulation of the regulation about contributing to stable developments in output and employment. If we should attempt to attain the inflation target in the very short term, by lowering the key rate and thereby contributing to a depreciation of the krone and higher price inflation, we would very probably be compelled to raise the interest rate even more a year from now in order to attain the inflation target than we did the last time we raised interest rates. Such a short-term policy would have contributed to greater demand and output instability. With the relatively long time horizon that has been chosen, monetary policy can contribute to stable developments in output and employment.
However, situations may arise where more than two years or less than two years are required to attain the inflation target. This will depend on what disturbances the economy is exposed to. Norges Bank will communicate such a change in the time horizon.
(b) Explain how the instruments of monetary and fiscal policies are manipulated to control cyclical fluctuations.
-> Monetary policies- Macroeconomic policy has come to play a very vital role as a policy instrument in a modern welfare state.
It aims at bringing about the desired charges in income and employment in the economy.
Maintaining price stability, providing full employment, rapid economic growth, maintaining exchange rates are amongst the important social and economic objectives of the state.
In order to attain these objectives the governments adopt suitable macroeconomic policies.
The use of macroeconomic policy for promoting economic growth with stability and social justice involves the framing of appropriate economic policies which also aim at reducing income and wealth inequalities in the economic system.
As a matter of fact, the objectives of such a macroeconomic policy are many and varied, important ingredients of a macroeconomic policy for rapid economic growth with stability are the monetary, fiscal, income and other measures. All these are used as complementary policy instruments in a macroeconomic policy to attain the social and economic objectives.
At measures at full employment aim at maintaining aggregate demand at a level sufficient to ensure full employment. In order to achieve and maintain full employment, expenditures on consumption and investment have to be maintained at sufficiently high levels.
The simple income equation Y = C + I, given by Keynes, underlines even the most tough employment policy. Adequate expenditure to maintain full employment can be ensured only if we can stimulate either consumption or investment expenditure or both to the required level, choice depending on cyclical or secular nature of the unemployment in question.
Consumption function being stable in the short-run, efforts has to be made to promote investment to counteract trade cycles or cyclical fluctuations. In the long-run, however, consumption expenditures have to be manipulated.
It is clear, therefore, that for continuous full employment monetary expenditures on both consumption and investment must be stimulated and kept under control for as excess of these expenditures leads to inflation and a deficiency to depression. We take up the monetary measures here: Monetary policy seeks to influence the rate of aggregate spending by varying the degree of liquidity of various constituents of the economy including banks, firms, business houses and households.
Monetary policy raises the level of expenditure by increasing the amount of cash and other liquid assets (e.g., short and long-term government securities) at the disposal of the community and by making borrowing conditions easier through lower rates of interest. Again, monetary policy seeks to restrict aggregate spending in the country by reducing the total amount of liquid assets with the community and by making borrowing more costly and difficult. Therefore, whether the central bank will follow a ‘cheap money policy’ or a ‘tight money policy’ depends on the economic conditions prevailing in the economy.
Instruments of Monetary Policy:
Monetary policy refers to measures designed to influence the cost and availability of money for the purpose of influencing the working of the economy. In other words, monetary policy consists of all those measures which help the central banking authorities of a country to manipulate the various instruments of credit control.
The instruments of monetary policy are the same as instruments of credit control at the disposal of a central bank, like the bank rate, open market operations, changes in reserve requirements usually referred to as quantitative credit controls.
Second category consists of consumer credit control, margin requirements, etc., known as qualitative controls. The quantitative instruments are so called because they regulate the total quantity of money and qualitative because they are employed to limit the amount of money available for certain specific purposes even though plenty of money may be available for other purposes.
It is argued that the MEC and other psychological factors rather than the rate of interest affect the amount and direction of investment in periods of inflation and deflation. Further, to the extent that investment is made possible by the retained profits of business enterprises, it may be decided irrespective of the considerations of the rate of interest. R.P. defines monetary policy as, “the management of the expansion and contraction of the volume of money in circulation for the explicit purpose of attaining a specific objective such as full employment.”
According to G.K. Shaw, “By monetary policy we mean any conscious action undertaken by the monetary authorities to change the quantity, availability or cost (interest) of money” H.G. Johnson defines monetary policy as a policy of central bank’s control of the supply of money for achieving the objectives of general macroeconomic policy.
Thus, policy of handling control of credit is called monetary policy; it is so called because it is the policy adopted by the central bank, the final monetary authority. Broadly speaking, monetary policy can be conceived to embrace all measures undertaken by a government to affect the expenditure or use of money by the public, whereas in the narrow sense it refers to the regulation of the supply of money (currency and bank deposits) through discretionary actions of the central banking authorities.
According to Friedman the most important development in the post-war years in the field of policy has been a shift from credit policy to monetary policy. This distinction though highly important yet remained neglected. By Credit Policy we mean the effect of the actions of the monetary authorities on rates of interest, terms of lending and conditions in the credit markets. By monetary policy we mean the effect of the action of monetary authorities on the stock of money—on the number of pieces of paper in people’s pockets or the quantity of deposits on the books of banks.
This distinction between credit policy and monetary policy is of fundamental importance for the policy-makers in every country because monetary policy is and must be much more a matter of opportunities, of day-do-day adjustment, of meeting the particular problems of our time. Friedman laments the fact that those who are entrusted with the task of laying down monetary policy (for USA) are still wedded to old theories prevalent 20 years ago.
Fiscal Policy- Fiscal policy has a number of objectives depending upon the circumstances in a country.
Important objectives of fiscal policy are:
1. Optimum allocation of economic resources. The aim is that fiscal policy should be so framed as to increase the efficiency of productive resources.
To ensure this, the government should spend on those public works which give the maximum employment.
2. Fiscal policy should aim at equitable distribution of wealth and income. It means that fiscal policy should be so designed as to bring about reasonable equality of incomes among different groups by transferring wealth from the rich to the poor.
3. Another objective of fiscal policy is to maintain price stability. Deflation leads to a sharp decline in business activity. On the other extreme, inflation may hit the fixed income classes hard while benefiting speculators and traders. Fiscal policy has to be such as will maintain a reasonably stable price level thereby benefiting all sections of society.
4. the most important objective of fiscal policy is the achievement and maintenance of full employment because through it most other objectives are automatically achieved. Fiscal policy aimed at full employment envisages the direction of tax structure, not with a view to raising revenue but with a view to noticing the effects with specific kinds of taxes have on consumption, saving and investment.
The problem is determination of the volume and direction of government spending not only to provide certain services but also to fit public expenditure into the general pattern of total spending currently taking place in the economy.
These objectives are not always compatible, particularly those of price stability and full employment. The objective of equitable distribution of income might come in conflict with the objectives of economic efficiency and economic growth. Fiscal policy can be geared to transfer wealth from the rich to the poor through taxation with a view to bringing about a redistribution of income. But the transfer of income from the rich to the poor will adversely affect savings and capital formation. Thus, equity and growth objectives conflict.
Instruments of Fiscal Policy:
The tools of fiscal policy are taxes, expenditure, public debt and a nation’s budget. They consist of changes in government revenues or rates of the tax structure so as to encourage or restrict private expenditures on consumption and investment.
Public expenditures include normal government expenditures, capital expenditures on public works, relief expenditures, and subsidies of various types, transfer payments and social security benefits.
Government expenditures are income-creating while taxes are primarily income-reducing. Management of public debt in most countries has also become an important tool of fiscal policy. It aims at influencing aggregate spending through changes in the holding of liquid assets.
During inflation, fiscal policy aims at controlling excessive aggregate spending, while during depression it aims at making up the deficiency in effective demand for raising the economy from the depths of depression. The following considerations may be noted in the adoption of proper policy instruments.