2017

COMMERCE

Paper: 105

(Managerial Economics)

Full Marks – 80

Time – Three Hours

The figures in the margin indicate full marks for the questions.

1(a) “Profit maximisation remains the most important objective of business firms in spite of multiplicity of alternative business objectives suggested by the modern economics.” Comment.

-> Alternative Objectives of Business Firms

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 (U_m) and owners’ utility function (U _D) may be specified as

U_m = f (salary, power, job security, prestige, status),

U_o = 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, I_D)

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.

(b) What are the major areas of business decision making? How does economic theory contribute to managerial decision? Also discuss the importance of microeconomics in the decision making process.

-> 3 Major Areas of Decision-Making:-

1. Investment Decision:

It is the decision for creation of assets to earn income. Selec­tion of assets in which investment is to be made is the invest­ment decision. It has to be decided how the funds realized will be utilized on various investments.

Generally, the assets of a company are of two types — those which yield income spread­ing over a year or so and assets which are easily convertible into cash within a short time. The first type of investment deci­sion is capital budgeting and the second one is the working cap­ital management.

Capital budgeting is the allocation of funds on a new asset or reallocation of capital when an old asset becomes non-profitable. The worthiness of different investment proposals forms a vital part of capital budgeting exercise.

Risks of investment are there, so the management has to consider it with sufficient cau­tion and prudence. Capital budgeting decision has another im­portant aspect. It is to determine the norm or standard against which benefits are to be judged. This is known as cut-off rate, hurdle rate, minimum rate of return etc. This is actually cost of capital.

Working capital management relates to management of the cur­rent assets. To meet current obligations, sufficient working cap­ital may be necessary. This can be termed as liquidity. In case proper amount of working capital cannot be estimated, there may revenue lying idle or there may be dearth of capital.

Nei­ther is desirable. In case working capital remains in excess which could otherwise be utilized in the long term productive assets, profit earning would suffer a setback. The very significant point here to note is that in working capital management there is the trade-off between liquidity and profit­ability.

2. Financing Decision:

This decision relates to how, when and where funds are to be acquired to meet investment needs. It is related to the capital structure or financial leverage. This is debt-equity ratio. If more recourse is taken to debt capital, shareholders’ risk is lessened and the prospects of their dividend earning are reduced. So, in financing decision, the crucial point is the trade-off between returned risks.

The financing decision— unlike investment de­cision— relates to the determination of the capital structure — the proper balance between debt and equity.

Financing deci­sion has two important dimensions:

(1) Is there an optimum capital structure, and

(2) In what proportion should funds be raised to maximize the return to the shareholders? Once the best debt-equity mix is determined, the finance manager will be on the lookout for appropriate sources for raising loans and selling shares.

3. Dividend Decision:

The profit of a company can be dealt with in two alternative ways — to distribute them as dividends to shareholders or to retain them in the business. If sufficient dividend is not paid, shareholders will not be satisfied, the market value of shares will come down and there may be financial crisis.

If the profits, on the other hand, are distrib­uted to the maximum extent, the company will lose on impor­tant source of self financing. So a judicious decision is a must. There should be a good combination of distribution and reten­tion.

The dividend decision boils down to the determination of net profits to be paid out to shareholders as dividends. Here the management is to consider two major factors — preference of the shareholders and the investment opportunities in the com­pany.

The functions of financial management can be discussed from different angles but the fact remains that finance plays the piv­otal role in the whole organization. Whatever has to be done needs money and that money procurement is the financial man­ager’s function.

How to use the money, how much to use and where to use are also matters of consultation with the finance management. Even the top management personnel cannot by­pass the financial management to decide matters relating to fi­nance which is so vital to keep the organization in sound health.

Financial planning, investment of funds procured, financial con­trol and the future financial policy — all are within the preview of financial management.

Economics through, variously defined is essentially the study of logic, tools and techniques of making optimum use of the available resources to achieve the given ends. Economics thus provides analytical tool and technique that managers need to achieve the goals of the organization they manage.

Baumaol has pointed out there main contributions of economic theory to business.

First one of the most important! Unexpected End of Formula things which the economic theories can contribute to the management science is building analytical models which help to recognize the structure of managerial problems, eliminate the minor details which might obstruct decision making and help to concentrate on the main issue.

Secondly , Economic theory contributes to the business analysis & set of analytical methods which may not be applied directly to specific business problems, but they do entrance the analytical capabilities of the business analyst.

Thirdly , Economic theories offer clarity to the various concepts used in business analysis, which enables the managers to avoid conceptual pitfalls.

The areas of business issues to which economics theories can be directly applied may be broadly divided into two categories:-

Operational or internal issues and

Environmental or external issues

Operational problems are of internal nature. They include all those problems which arise within the business organization and fall within the preview and control of the management. Some of the basic internal issues are

Choice of business and the nature of product i.e. what to produce;

Choice of size of the firm i.e. how much to produce

Choice of technology i.e. choosing the factor contribution;

Choice of price i.e. how to price the common;

How to promote sales;

How to face price competition

How to decide on new investment;

How to manage profit and capital;

How to manage inventory i.e. stock of both finished goods and material.

The Microeconomic Theories which deals most of these questions include:-

Theory of demand.

Theory of production and production decisions.

Analysis of market structure and pricing theory.

Profit analysis and profit management.

Theory of capital and investment decision.

Environmental issues pertain to the general business environment in which a business operates. They are related to the overall economic, social and political atmosphere of the country. The factors which constitute economic environment of a country include the following factors:-

The type of economic system of the country

General trend in production, employment, income, price, savings and investment etc

Structure of the trends in the working of financial institutes e.g. banks, financial co-operations, insurance companies

Magnitudes of trends in foreign trend

Trends in labour and capital markets

Government’s economic policies e.g. Industrial policy, monetary policy, fiscal policy, price policy etc.

Social factors like the value system of the society, property rights, customs and habits

Social organizations like trade unions, customer’s co-operatives and producers union

The degree of openness of the economy and the influence MNCs

Importance of Microeconomics in Making Business Decision

Microeconomics is one of the most important parts of economics. It has both theoretical and practical importance. Different theories of microeconomics help in the study of various problems of microeconomics. The analysis of microeconomics has great importance in the fields such as production, pricing, social welfare, optimum allocation of resources etc. Microeconomics is also used in making business decision.

To understand the functioning of free economy

The economy without any interference of the government or any other sectors is known as free economy. In this type of economy, the consumers and producers are free to carry out their economic activities. In a free economy everyone has freedom regarding the consumption and production of goods and services, allocation of resources, modes of production and quantity of production. For the knowledge of this type of free economy to the businessmen microeconomics has a great importance.

To provide tools for economic policies

Microeconomics provides the essential tools for the formulation of economic policies of a country. For the formulation of economic policies, the economic activities of different sectors should be studied in depth. The information obtained from these studies will make it easier for a country to formulate its economic policies. Price or market mechanism is the main tool for this. For examples, in a mixed or capitalist economy the government will invest in specified public beneficial sectors. Price determination in these sectors in also done by the government. Price determined in this way will also affect in price determination of other goods and services. So microeconomics also helps in price determination and formulation of economic policies of these sorts. Thus microeconomics helps the business man in the price determination of goods and factors of production.

For efficient allocation of resources

“Human wants are unlimited but the resources are limited”. So microeconomics studies the efficient allocation of resources. Microeconomics helps in the proper allocation of resources in producing goods and services. It also helps in finding the quantity of goods to be produced, why to produce, for whom to produce and how to distribute the produced goods. In present world the main problem of every nation is the efficient allocation of resources among the competitive markets. In this way, microeconomics helps in proper allocation of resources and economic growth with stability.

For price determination

Different firms and industries produce different types of goods and services and microeconomics analysis is used for pricing of such goods and services because different problems are seen while pricing such goods. Microeconomics has great importance in the pricing of the products because it studies and identifies such problems. If any free economy, the pricing of the goods is done by the demand and supply of the goods. Since the pricing of goods is done by the competition in the market, the firms and industries need to take help of microeconomics while pricing their products.

To formulate the public policy for market mechanism

Microeconomics helps in formulating the public policy for market mechanism in any country. Analysis of perfect and imperfect competition markets is carried out with the help of microeconomics. Merits and demerits of these markets are studied in microeconomics. This helps the government and the entrepreneurs in selecting a better type of market system. In this way microeconomics explains economic efficiency of goods, services and resources in different market systems.

To achieve social welfare

Microeconomics in general explains the effects of taxation in social welfare. The tax system implemented in a country helps in redistribution of resources. It also finds out the tax system that reduces social welfare. Microeconomics helps in selecting the most suitable tax system in a country without affecting social welfare. It also analyses the problem of taxation which in turn helps in achieving maximum possible social and economic welfare.

To study the international trade

Microeconomics has importance in analyzing international trade surplus and deficit, balance and imbalance of payments and foreign exchange. It fixes the international trade surplus and deficit. The demand and supply of foreign currency plays a major role in the imbalance of payment. Surplus and deficit of international trade can be explained with the help of theory of demand, production possibility curve and indifference curves.

To develop and use of economic models

Microeconomics helps in analyzing real economic activities by forming simple and easy economic model and studying it.

2(a) How is market demand for a commodity derived? Derive the market demand curve by assuming three individual demand curves for a product. Explain the determinants of market demand.

-> Ordinarily by the word ‘demand’ we mean a desire or want for something. In economics, demand means much more than this.

Economists give a social meaning of the concept of demand which is as follows:

“Demand means effective desire or want for a commodity, which is backed by the ability (i.e., money or purchasing power) and willingness to pay for it.”

That is one should have the desire and capacity to buy a commodity and should be willing to pay its price to constitute effective demand for that commodity. For example—A pauper’s wish for a motor car will not constitute its potential market demand, as he has no ability to pay for it.

Similarly, a miser’s desire for the same, however rich he may be will not become an effective demand since he would not be willing to spend the money for the satisfaction of that desire.

Demand in economics, means effective demand for a commodity.

Although the behaviour of an individual in respect of selection and purchase of goods forms the basis of demand theory, the aggregate demand or market demand for a good is most important for its producer.

The aggre­gate quantity of a good that the buyers purchase or demand at a particular price and in a particu­lar period (e.g., in a day) is called the market demand for the good at the said price. Also, the curve that gives us the market demand for a good at any particular price is known as its market demand curve.

It is obvious from the definition of market demand that the horizontal or lateral summation of the individual demand curves for a good would give us its market demand curve. The market demand curve for a good would slope downward towards right, since, owing to the law of demand, the individual demand curves slope, in general, down­ward towards right (barring exceptions here and there).

In a broad sense, the concept of demand has two aspects:

(i) Direct Demand, and

(ii) Derived Demand.

Consumer’s demand is a direct demand as it directly gives satisfaction to the consumer. Consumption goods have direct demand. Producer’s demand for factor-inputs is a derived demand as it is derived from the demand for the final output. All capital goods have derived demand. For instance—The demand for a house for dwelling purpose is a direct demand, while the demands for bricks, cement or wood, mason, carpenter, architect etc. that are required to build the house are derived demands.

Further, consumer demand for a product may be viewed at two levels:

1. Individual demand, and

2. Market demand.

Individual demand:

Refers to the demand for a commodity from an individual. That quality of a commodity a consumer would buy at a given price during a given period of time is his individual demand for that particular commodity.

Market demand:

For a product on the other-hand refers to the total demand of all the individual buyers taken together. How much in quantity the consumers in general would buy at a given price during a given period of time constitutes the total market demand for the product.

Market demand is the sum of individual demands. It is derived by aggregating all individual buyers’ demands in the market. This demand is more important from the seller’s point of view. Sales depend on the market demand. Business policy and planning are based on the market demand. Prices are determined on the basis of market and not of just an individual demand for the product.

Kinds of Demand:

There are three kinds of demand:

1. Price demand,

2. Income demand, and

3. Cross demand.

1. Price Demand:

Price demand is that demand which refers to the various quantities of a commodity or service that a consumer would purchase at a given time in a market at various hypothetical prices. In this it is always assumed that other things such as consumer’s income, his tastes and prices of related goods remain unchanged.

This type of demand has been classified under three heads:

(a) Individual Demand:

Individual demand is the demand of an individual consumer.

(b) Industry Demand:

It is the aggregate demand of all the consumers combined for the commodity.

(c) Firm’s Demand or Individual Seller’s Demand:

This is the total demand for the product of an individual firm at various prices.

2. Income Demand:

This demand refers to the various quantities of goods which will be purchased by the consumer at various levels of income. In this, we start with this assumption that the price of the commodity as well as the price of related goods and the tastes and desire of the consumers do not change. The demand brings out the relationship between income and quantities demanded. This is helpful in preparing demand schedule.

3. Cross Demand:

In this demand the quantities of goods which will be purchased with reference to changes in the price not of these goods but of other related goods. These goods are either substitutes or complementary goods. For example—A change in the price of tea will affect demands for coffee. Similarly, if the price of horses will become cheap demand for carriages may increase.

There are several factors that determine the demand for a product. These are:

1. Price of the Product: The price of a product is the most important determinant of market demand in the long-run and the only determinant in the short-run. As per the law of demand, the price of a product and its quantity demanded are inversely related, i.e. the quantity demanded increases when the price falls and decreases when the price raises, other things remaining the same.

Here, other things imply that the income of the consumer, the price of the substitute and complementary goods, tastes and preferences and the number of consumers, all remains constant. The price-demand relationship has more significance in the oligopolistic market structure in which the result of a price war among the firm and its rival decides the level of success of the firm.

2. Price of the Related Goods: The market demand for a commodity is also affected by the changes in the price of the related goods. The related goods may be the substitute or complementary goods. Two commodities are said to be a substitute for one another if they satisfy the same want of an individual and the change in the price of one commodity affects the demand for another in the same direction. Such as, tea and coffee, Maggie and Yippee, Pepsi and Coca-Cola are close substitutes for each other. The increase in the price of either commodity the demand for the other also increases and vice-versa.

A commodity is said to be a complement for another if the use of two goods goes together such that their demand changes (increases or decreases) simultaneously. For example, bread and butter, car and petrol, mattress and cot, etc. are complementary goods. The increase in the price of either commodity the demand for another decreases and vice-versa.

3. Consumer’s Income: The income is the basic determinant of the quantity demanded of a product as it decides the purchasing power of the consumers. Thus, people with higher disposable income spend a larger amount of income on consumer goods and services as compared to those with lower disposable income. Consumer goods and services can be grouped under four categories: essential goods, inferior goods, normal goods, and prestige or luxury goods. The relationship between the consumer’s income and these goods is explained below:

§ Essential Consumer Goods: The essential goods are the basic necessities of the life and are consumed by all the persons of the society. Such as food grains, salt, cooking oil, clothing, housing, etc., the demand for such commodities increases with the increase in consumer’s income but only up to a certain limit, although the total expenditure may increase with respect to the quality of goods consumed, other things remaining the same.

§ Inferior Goods: A commodity is deemed to be inferior if its demand decreases with the increases in the consumer’s income beyond a certain level of income and vice-versa. For example, Bajra, millet, bidi are the inferior goods.

§ Normal Goods: The normal goods are those goods whose demand increases with the increase in the consumer’s income, such as clothing, household furniture, automobiles, etc. It is to be noted that, demand for the normal goods increases rapidly with the increase in the consumer’s income but slows down with a further increase in the income.

§ Luxury Goods: The luxury goods are those goods which add to the prestige and pleasure of the consumer without enhancing the earnings. For example, jewellery, stone, gem, luxury cars, etc. The demand for such goods increases with the increase in the consumer’s income.

4. Consumers’ tastes and preferences: Consumer’s Tastes and preferences play a vital role in determining a demand for a product. Tastes and preferences often depend on the lifestyle, culture, social customs, hobbies, age and sex of the consumers and the religious sentiments attached to a commodity. The change in any of these factors results in the change in the consumer’s tastes and preferences, thereby resulting in either increase or decrease in the demand for a product.

5. Advertisement Expenditure: Advertisement is done to promote sales of a product. It helps in stimulating demand for a product in four ways; by informing the prospective consumers about the availability of a product, by showing its superiority over the competitor’s brand, by influencing the consumer’s choice against the rival product and by setting new fashion and changing tastes of the consumers. The effect of advertisement is said to be fruitful if it leads to the upward shift in the demand curve, i.e. the demand increases with the increase in the advertisement expenditure, other things remaining constant.

6. Consumers’ Expectations: In the short run, the consumer’s expectation with respect to the income, future prices of the product and its supply position plays a vital role in determining the demand for a commodity. If the consumer expects a high rise in the price of the commodity, shall purchase it today at a high current price so as to avoid the pinch of the high price in the future. On the contrary, if the prices are expected to fall in the future the consumer will postpone their purchase with a view to avail benefits of lower prices in the future, especially in case of nonessential goods.

Likewise, an expected increase in the income increases the demand for a product and vice-versa. Also, in the case of scarce goods, if its production is expected to fall short in the future, the consumer will buy it at current higher prices.

7. Demonstration Effect: Often, the new commodities or new models of an existing product are bought by the rich people. Some people buy goods due to their genuine need for them or have excess purchasing power. While some others do so because they want to exhibit their affluence. Once the commodity is in very much fashion, many households buy them not because they have a genuine need for them but their neighbours have purchased it. Thus, the purchase made by such people arises out of feelings as jealousy, equality in society, competition, social inferiority, status consciousness. The purchases made on the account of these factors results in the demonstration effect, also called as Bandwagon Effect.

8. Consumer-Credit Facility: The availability of credit to the consumer also determines the demand for a product. The credit extended by sellers, banks, friends, relatives or from other sources induces a consumer to buy more than what would have not been possible in the absence of the credit. Thus, the consumers with more borrowing capacity consumes more than the ones who borrow less.

9. Population of the Country: The population of the country also determines the total domestic demand for a product of mass consumption. For a given level of per capita income, tastes and preferences, price, income, etc., the larger the size of the population the larger the demand for a product and vice-versa .

10. Distribution of National Income: The national income is one of the basic determinants of the market demand for a product, such as the higher the national income, the higher the demand for all the normal goods. Apart from its level, the distribution pattern of the national income also determines the overall demand for a product. Such as, if the national income is unevenly distributed, i.e., the majority of the population falls under the low-income groups, then the market demand for the inferior goods will be more than the other category goods.

3. Answer any four of the following:

(a) Explain the scope of demand forecasting.

-> An organization faces several internal and external risks, such as high competition, failure of technology, labour unrest, inflation, recession, and change in government laws. Therefore, most of the business decisions of an organization are made under the conditions of risk and uncertainty. An organization can lessen the adverse effects of risks by determining the demand or sales prospects for its products and services in future. Demand forecasting is a systematic process that involves anticipating the demand for the product and services of an organization in future under a set of uncontrollable and competitive forces.

Scope of demand forecasting:-

The scope of demand forecasting depends upon the purpose for which it has been undertaken. In short run forecast, usually the seasonal pattern of probable changes is given prime importance. This forecast helps in making sales policy and also scheduling output so that the risk of overstocking and shortage need not face. These forecasts also help a concern to arrive at suitable selling price and also to take steps for modification of advertisement and other selling techniques.

Long term forecasts are basically helpful in planning for a new unit or expansion of an existing unit. When new production capacity is installing the flexibility and availability has to ensure for taking care of expected change in production. After taking decision regarding process and equipment, the firm can plan for personnel recruitment, other inputs to procedure etc. Long term sales forecasts quite essential to assess the long term financial requirement as raising fund requires sufficient time. Long term sales forecasts helps in assessing manpower requirement for any possible change in output level. On the basis of future requirement of manpower training and developmental programme for human resource can be arranged well ahead because organising training takes some time. Demand forecast of a particular product may also provide a guideline for demand forecasts of related goods. At micro level, demand forecasts may also help the govt. in determining the size of input to meet any probable deficit n domestic supply and supply and also in promoting export if there is any surplus. Thus, we have seen that demand forecasting not only helps the industry but also useful to the Govt.

(b) Discuss four objectives of demand forecasting.

-> Demand forecasting is absolutely essential within supply chain management. Without adequate demand forecasting or planning, you will find that your inventory and stock falls short and could cost you a substantial amount of money over time. The entire concept behind demand forecasting is to ensure that you are fulfilling orders on time in the most efficient method/way possible.

This is why you need to ensure that you understand the characteristics and methods associated with proper demand forecasting and locate a method that enables your company to meet demand in an efficient and on-time manner. Therefore, within this blog, we are going to discuss the characteristics of demand forecasting in supply chain management and how it may pertain to your manufacturing operation.

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.

(c) Discuss the sample survey and test marketing techniques of demand forecasting.

-> 1. Executive Opinion/Judgment Method:

This is a traditionally used method. One or more top executives, including general manager, marketing manager, other departmental heads, sales officers, and some others, forecast the future demand based on their personal knowledge and experience.

They may talk to customers, dealers and other relevant sources; refer to published reports and other sources; or may consult experts for estimating company sales volume in a given period. They may discuss jointly and pool their knowledge and experience to arrive at the round estimate of sales. Forecasting by executive opinion alone is risky. This method lacks scientific validity. The estimate may be subjective or biased.

Merits:

i. The estimates tend to be more balanced as various executives are involved.

ii. Sales forecasting is more accurate and reliable because the executives are well aware of company’s strengths and weaknesses.

iii. It promotes cooperation and integration among the executives of various departments. They strive to meet the estimate they proposed.

Demerits:

i. Lack of time and knowledge to perform the task of forecasting is the prime problem.

ii. It may deteriorate relations due to possible conflicts or lack of consensus.

iii. Each department has its priorities, principles, and theories to work. So, result may be polarized.

iv. Prejudice, bias, and personal philosophy always affect the final estimate to a great extent.

2. Survey of Buyers’ Intentions Method:

It is also known as consumers’ expectations or opinions survey. It is commonly used method for sales forecasting. A sale is the result of consumer intention to buy the product. Many companies conduct periodical survey of consumers’ buying interest to know when and how much they will buy.

A sample of potential consumers is surveyed to know how much of the stated product they would buy at a given price during a specified future time period. Some firms maintains a permanent sample of buyers known as the panel to collect needed data on a regular basis.

Merits:

i. More reliable and relevant information can be collected.

ii. This method is more suitable for industrial products.

iii. It is highly effective for short-run sales forecasting.

iv. This method is proved effective when consumers state their intention clearly and adhere to it.

Demerits:

i. It is applicable only for short-run forecasting.

ii. It is expensive method and needs a lot of preparations. Also, it needs a large amount of time.

iii. Consumers may not express their intention clearly, or may not behave as per intention expressed.

iv. In case of highly scattered large number of consumers, it is not applicable.

v. Poor response rate is the major problem in our country. They do not respond to the questions asked and/or do not return questionnaire fully completed.

vi. Purchase intention is subject to change as per social and economic circumstances. One cannot expect consistent intention over time.

vii. Selection of the sample of potential buyers is difficult task as who, how many, and from which places respondents should be selected. Limitations of sampling become the limitation of the method.

It is especially more effective when:

(1) There are relatively few buyers,

(2) Buyers are willing to express buying intentions reliably,

(3) Company has enough time and money to spend, and

(4) There is high probability that stated intention would result into actual purchase.

3. Composite of Sales Force Opinion Method:

Sometimes, it is called sales force estimate method. Company can ask, either all or some of salesmen, to estimate demand for a given time. Each sales representative estimates how much each current and prospective customer will buy the company’s product. They are offered certain incentives to encourage them better estimate.

Here, for estimating the future demand, the company’s sales force opinions are taken as a base. Since salesmen have direct and close contact with customers, competitors, dealers, and overall market environment, they can provide more reliable estimates of the future sales.

However, company must be careful to avoid over optimistic or over-pessimistic opinions of salesmen. Their opinions should not be followed directly without investigating the market facts.

Merits:

i. Salesmen have better insight into the recent market trend than any other groups. So, more accurate estimate is possible.

ii. It motivates and encourages salesmen as their opinions are considered by the company.

iii. It is suitable to all products and firms.

iv. No need to spend extra. Only limited incentives are sufficient to get desired results.

v. It is a speedy method to estimate sales.

vi. They can provide estimate in terms of products, territory, and customers.

vii. They struggle to fulfill the estimate they have given. High degree of commitment prevails.

Demerits:

i. Salesman may not have time. Their regular work may suffer.

ii. Lack of experience and expertise to perform such task.

iii. Reliability is a question. There is possibility of manipulation of estimates.

iv. The future sales are affected by a large number of factors. Sales people may not be aware of them. Therefore, the sales estimates given by sales force may be less reliable.

v. For their protection, they may underestimate sales.

4. Expert opinion method:

Company can also take assistance of experts to obtain forecasts. The experts include dealers, suppliers, distributors, consultants, and trade associations. These experts supply their estimate individually or jointly in form of the pooled individual estimate.

Along with the estimates, they also underline certain assumptions. Company contacts them periodically or occasionally for their opinions regarding level of company sales in the future. Some companies buy economic and industry forecasts from well-known economic firms.

Even, they can employ or undergo contract with economists or experts on a professional basis for the purpose. The experts, taking into account strengths of company’s strategies and market situations, exert their sales estimate for a give time period. The expert opinions on sales estimates and assumptions are accepted directly or they are reviewed further.

Merits:

i. Less expensive and speedy estimates can be obtained.

ii. Balanced estimate is possible as more experts are involved.

iii. Pooled knowledge can be used. Experts of various fields contribute to sales forecasting.

iv. It is the only option when the past sales data are not available.

v. Estimates tend to be more neutral as experts are external to organisation.

Demerits:

i. It is not a scientific method. Personal value, experience, and attitudes play vital role.

ii. It is based on opinions, and therefore, reliability is always doubtful.

iii. It is difficult to fix responsibility of the final estimates as many experts contribute to forecasting.

iv. It is not possible to get sales estimates in terms of products, customers, or territories.

v. Possibility of prejudice or bias cannot be ignored.

vi. All opinions, right or wrong, may be given equal importance.

(d) Mention the difference between forecasting a new product and an established product.

-> The definition of a new product can vary. It may be an entirely new product which has been launched, a variation of an existing product, a change in the pricing scheme of an existing product, or even an existing product entering a new market.

Judgmental forecasting is usually the only available method for new product forecasting, as historical data are unavailable. The approaches we have already outlined (Delphi, forecasting by analogy and scenario forecasting) are all applicable when forecasting the demand for a new product.

Other methods which are more specific to the situation are also available. We briefly describe three such methods which are commonly applied in practice. These methods are less structured than those already discussed, and are likely to lead to more biased forecasts as a result.

Sales force composite

In this approach, forecasts for each outlet/branch/store of a company are generated by salespeople, and are then aggregated. This usually involves sales managers forecasting the demand for the outlet they manage. Salespeople are usually closest to the interaction between customers and products, and often develop an intuition about customer purchasing intentions. They bring this valuable experience and expertise to the forecast.

However, having salespeople generate forecasts violates the key principle of segregating forecasters and users, which can create biases in many directions. It is common for the performance of a salesperson to be evaluated against the sales forecasts or expectations set beforehand. In this case, the salesperson acting as a forecaster may introduce some self-serving bias by generating low forecasts. On the other hand, one can imagine an enthusiastic salesperson, full of optimism, generating high forecasts.

Moreover a successful salesperson is not necessarily a successful nor well-informed forecaster. A large proportion of salespeople will have no or limited formal training in forecasting. Finally, salespeople will feel customer displeasure at first hand if, for example, the product runs out or is not introduced in their store. Such interactions will cloud their judgement.

Executive opinion

In contrast to the sales force composite, this approach involves staff at the top of the managerial structure generating aggregate forecasts. Such forecasts are usually generated in a group meeting, where executives contribute information from their own area of the company. Having executives from different functional areas of the company promotes great skill and knowledge diversity in the group.

This process carries all of the advantages and disadvantages of a group meeting setting which we discussed earlier. In this setting, it is important to justify and document the forecasting process. That is, executives need to be held accountable in order to reduce the biases generated by the group meeting setting. There may also be scope to apply variations to a Delphi approach in this setting; for example, the estimate-talk-estimate process described earlier.

Customer intentions

Customer intentions can be used to forecast the demand for a new product or for a variation on an existing product. Questionnaires are filled in by customers on their intentions to buy the product. A structured questionnaire is used, asking customers to rate the likelihood of them purchasing the product on a scale; for example, highly likely, likely, possible, unlikely, highly unlikely.

Survey design challenges, such as collecting a representative sample, applying a time- and cost-effective method, and dealing with non-responses, need to be addressed. ⁹

Furthermore, in this survey setting we must keep in mind the relationship between purchase intention and purchase behaviour. Customers do not always do what they say they will. Many studies have found a positive correlation between purchase intentions and purchase behaviour; however, the strength of these correlations varies substantially. The factors driving this variation include the timings of data collection and product launch, the definition of “new” for the product, and the type of industry. Behavioural theory tells us that intentions predict behaviour if the intentions are measured just before the behaviour. The time between intention and behaviour will vary depending on whether it is a completely new product or a variation on an existing product. Also, the correlation between intention and behaviour is found to be stronger for variations on existing and familiar products than for completely new products.

Whichever method of new product forecasting is used, it is important to thoroughly document the forecasts made, and the reasoning behind them, in order to be able to evaluate them when data become available.

(e) Mention the criteria for the choice of a good forecasting method.

-> The criteria of a good demand forecasting method in economics:

1. Accuracy:

Accuracy denotes near to actual demand. A firm should forecast its demand very close to the actual market demand so that required quantities could be made available for the market. Inaccurate forecast may cost huge to the firm. It may create over or under production. Forecast should be explicit. For example, there would be an increase in sales in the next year than the current is not a good forecast but there would be an increase in sales by 20% in the next year is an accurate forecast.

2. Longevity or Durability:

Demand forecast generally takes huge time, money and planning. Since a forecast takes a lot of time and money, it should be usable for longer span of time or multiple years. A forecast for short span of time may not be effective for the organization.

3. Flexibility or Scale-ability

A demand forecast should be flexible and adaptable to any kind of changes. Now a day there is a rapid change in the tastes and preferences of consumers. This affects the demand for different products up to a great extent. Therefore, the demand forecasts made by a firm should be able to reflect those changes accordingly. Apart from this, a business firm, while making forecasts, should consider various business risks that may take place in the future.

4. Acceptability and Simplicity:

Acceptability is one of the most important criterions of a good demand forecasting method. That means a forecast should be acceptable to all. It should also be as simple as possible. A business firm should forecast its market demand by using simple and easy methods so that the organizations do not face any complexities. However, some companies generally prefer advanced statistical methods, which may prove difficult and complex.

5. Availability:

A good a good demand forecasting method should have adequate and up-to-date data available. The forecasts should be done in timely manner so that necessary arrangements could be made related to the market demand. Data should be available to the decision makers at all time.

6. Plausibility and Possibility:

It denotes that the demand forecasts should be reasonable, so that they are easily understood by individuals who will use it. Again, it should have the quality of application in the changing business conditions.

7. Economy:

A good demand forecast ing method should have a relationship with costs and benefits. It should be economically effective. The forecasting should be made in such a way that the costs do not exceed the benefits that will be derived from it. Costs should be less and benefits should be high.

8. Yielding quick results:

A good demand forecast ing method should yield quick result rather than taking longer period to respond. It should match with the changing business environment.

9) Maintenance of timeliness:

It should take care of timelines. Data should be available to users as and when requires so that decision making does not hamper.

4 (b)(i) Explain the degrees of price discrimination.

-> Price discrimination is a strategy that consists of a business or seller charging a different price to various customers for the same product or service? It is one of the competitive practices used by larger, established businesses in an attempt to profit from differences in supply and demand from consumers.

A company can enhance its profits by charging each customer the maximum amount he is willing to pay, eliminating consumer surplus, but it is often a challenge to determine what that exact price is for every buyer. For price discrimination to succeed, businesses must understand their customer base and its needs, and there must be familiarity with the various types of price discrimination used in economics. The most common types of price discrimination are first, second, and third-degree discrimination.

First-Degree Price Discrimination

In an ideal business world, companies would be able to eliminate all consumer surpluses through first-degree price discrimination. This type of pricing strategy takes place when businesses can accurately determine what each customer is willing to pay for a specific product or service and selling that good or service for that exact price.

In some industries, such as used car or truck sales, an expectation to negotiate final purchase price is part of the buying process. The company selling the used car can gather information through data mining relating to each buyer’s past purchase habits, income, budget, and maximum available output to determine what to charge for each car sold. This pricing strategy is time-consuming and difficult to perfect for most businesses, but it allows the seller to capture the highest amount of available profit for each sale.

Second-Degree Price Discrimination

In second-degree price discrimination, the ability to gather information on every potential buyer is not present. Instead, companies price products or services differently based on the preferences of various groups of consumers.

Most often, businesses apply second-degree price discrimination through quantity discounts ; customers who buy in bulk receive special offers not granted to those who buy a single product. This type of pricing strategy is used most often in warehouse retailers, such as Sam’s Club or Costco ( COST ), but it can also be seen in companies that offer loyalty or rewards cards to frequent customers.

Second-degree price discrimination does not altogether eliminate consumer surplus, but it does allow a company to increase its profit margin on a subset of its consumer base.

Third-Degree Price Discrimination

Third-degree price discrimination occurs when companies price products and services differently based on the unique demographics of subsets of its consumer base, such as students, military personnel, or seniors.

Companies can understand the broad characteristics of consumers more easily than the buying preferences of individual buyers. Third-degree price discrimination provides a way to reduce consumer surplus by catering to the price elasticity of demand of specific consumer subsets.

This type of pricing strategy is often seen in movie theatre ticket sales, admission prices to amusement parks, or restaurant offers. Consumer groups that may otherwise not be able or willing to purchase a product due to their lower income are captured by this pricing strategy, increasing company profits.

(ii) Discuss the factors under which price discrimination is possible.

-> When a firm charges different prices for the same good or service to different consumers, even though there is no difference in the cost to the firm of supplying these consumers, the firm is engaging in price discrimination. Except for a few situations of price discrimination that have been declared illegal, such as manufacturers selling their goods to distributors at different prices when there are no differences in cost, price discrimination is generally legal.

The potential for price discrimination exists in all market structures except perfect competition. As long as a firm faces a downward-sloping demand curve and thus has some degree of monopoly power, it may be able to engage in price discrimination. But monopoly power alone is not enough to allow a firm to price discriminates.

Factors under which price discrimination is possible:-

(1) Market Imperfections:

Price discrimination is possible when there is some degree of market imperfection. The individual seller is able to divide and keep his market into separate parts only if it is imperfect. Customers do not move readily from one market to the other because of ignorance or inertia.

(2) Agreement among Rival Sellers:

Price discrimination also takes place when the seller of a commodity is a monopolist or when rivals enter into an agreement for the sale of the product at different prices to different customers. This is usually possible in the sale of direct services. A single surgeon may charge a high fee for an operation from a rich patient and relatively low fee from a poor patient.

In place where a number of surgeons and physicians practice, they charge their fees according to the income of the patients. The rate of fee is fixed for each category of patient. Lawyers charge from their clients in proportion to the degree of risk or amount of money involved in a law suit. Price discrimination is possible in the case of services because there is no possibility of resale.

(3) Geographical or Tariff Barriers:

Discrimination may occur on geographical grounds. The monopolist may discriminate between home and foreign buyers by selling at a lower price in the foreign market than in the domestic market. This type of discrimination is known as “dumping”. It can only be successful if the commodities sold abroad can be prevented from being returned to the home country by tariff restrictions.

Sometimes transport costs are so high that they act as a safeguard against the return of dumped goods. Geographical discrimination satisfies Pigou’s first condition for discrimination ‘when no unit of the commodity sold in one market can be transferred to another.’

(4) Differentiated Products:

Discrimination is possible when buyers need the same service in connection with differentiated products. Railways charge different rates for the transport of coal and copper. For they know that it is physically impossible for a copper merchant to convert copper into coal for the purpose of transporting it cheaper.

This satisfies Pigou’s second condition that ‘no unit of demand proper to one market can be transferred to another.’ It also applies to discrimination based on age, sex, status and income of buyers of services. For instance, a rich man cannot become poor for the sake of getting cheap medical facilities.

(5) Ignorance of Buyers:

Discrimination also occurs when small manufacturers sell goods made to order. They charge different rates to different buyers depending upon the intensity of their demand for the product. Shoe makers charge a high price for the same variety from those customers who want them earlier than others. For the same variety of shoes, different buyers are also charged different prices because individual buyers are not in a position to know the price being charged to others.

(6) Artificial Differences between Goods:

A monopolist may create artificial differences by presenting the same commodity in different quantities. He may present it under different names and labels, one for the rich and snobbish buyers and the other for the ordinary. Thus he may charge different prices for substantially the same product. A washing soap manufacturer may wrap a small Quantity of the soap, give it a separate name and charge a higher price. He may sell it at Rs 17 per kg. As against Rs 16 for the unwrapped soap.

(7) Differences in Demand:

For price discrimination, the demand in the separate markets must be considerably different. Different prices can be charged in separate markets based on differences of elasticity of demand. Low price is charged where demand is more elastic and high price in the market with the less elastic demand.

5(a) Define Inflation. Discuss the demand side and supply side cause inflation. How can demand-pull inflation are controlled.

-> Inflation and unemployment are the two most talked-about words in the contemporary society.

These two are the big problems that plague all the economies.

Almost everyone is sure that he knows what inflation exactly is, but it remains a source of great deal of confu­sion because it is difficult to define it unam­biguously.

Inflation is often defined in terms of its supposed causes. Inflation exists when money supply exceeds available goods and services. Or inflation is attributed to budget deficit financing. A deficit budget may be financed by the additional money creation. But the situation of monetary expansion or budget deficit may not cause price level to rise. Hence the difficulty of defining ‘inflation’.

Inflation may be defined as ‘a sustained upward trend in the general level of prices’ and not the price of only one or two goods. G. Ackley defined inflation as ‘a persistent and appreciable rise in the general level or aver­age of prices’. In other words, inflation is a state of rising prices, but not high prices.

It is not high prices but rising price level that con­stitute inflation. It constitutes, thus, an over­all increase in price level. It can, thus, be viewed as the devaluing of the worth of money. In other words, inflation reduces the purchasing power of money. A unit of money now buys less. Inflation can also be seen as a recurring phenomenon.

While measuring inflation, we take into ac­count a large number of goods and services used by the people of a country and then cal­culate average increase in the prices of those goods and services over a period of time. A small rise in prices or a sudden rise in prices is not inflation since they may reflect the short term workings of the market.

As the nature of inflation is not uniform in an economy for all the time, it is wise to distin­guish between different types of inflation. Such analysis is useful to study the distribu­tional and other effects of inflation as well as to recommend anti-inflationary policies. Infla­tion may be caused by a variety of factors. Its intensity or pace may be different at different times. It may also be classified in accordance with the reactions of the government toward inflation.

Demand-pull inflation

Demand pull inflation occurs when aggregate demand is growing at an unsustainable rate leading to increased pressure on scarce resources and a positive output gap

When there is excess demand, producers can raise their prices and achieve bigger profit margins

Demand-pull inflation becomes a threat when an economy has experienced a boom with GDP rising faster than the long-run trend growth of potential GDP

Demand-pull inflation is likely when there is full employment of resources and SRAS is inelastic.

When the supply of money in the economy increases, people have more money available which in turn increases their purchasing power. As a result of which, demand for goods and services increases. In response to rising demand, instead of increasing supply of goods and services, prices are increased which causes reduction in demand but at the same time increase in the profits of the sellers.

Example: – A seller selling a good for Rs 2 earns profit of Rs1000 by selling 500units of that good. Experiencing the rising demand for good, he increases its price to Rs 4, as a result the demand falls and now he sells only 300 units of good but still witnesses an increase in profit to Rs 1200.

The most effective way to reduce the demand-pull inflation is by reducing the supply of money in the economy through monetary policy which will reduce the purchasing power of the people and hence the demand will fall further reducing the prices of goods and services. Now, after getting a clear understanding of demand side of inflation or Demand-pull inflation, the next we come up with is Supply side of inflation or Cost-push inflation.

A depreciation of the exchange rate increases the price of imports and reduces the foreign price of a country’s exports. If consumers buy fewer imports, while exports grow, AD in will rise – and there may be a multiplier effect on the level of demand and output

Higher demand from a fiscal stimulus e.g. lower direct or indirect taxes or higher government spending. If direct taxes are reduced, consumers have more disposable income causing demand to rise. Higher government spending and increased borrowing creates extra demand in the circular flow

Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand – for example in raising demand for loans or in leading to house price inflation. Monetarist economists believe that inflation is caused by “too much money chasing too few goods” and that governments can lose control of inflation if they allow the financial system to expand the money supply too quickly.

Fast growth in other countries – providing a boost to UK exports overseas. Export sales provide an extra flow of income and spending into the UK circular flow – so what is happening to the economic cycles of other countries definitely affects the UK.

Cost-push inflation

The rise in the prices which is caused due to reduction in the supply of goods and services in the economy is called supply side of inflation which is also known as Cost-Push Inflation

Cost-push inflation occurs when firms respond to rising costs by increasing prices in order to protect their profit margins. As the name suggests, when the cost of production of a good or service increases, it becomes expensive for the producers to produce goods and services and as a result they transfer this burden of rise in the cost of production to the customers by increasing the prices of goods and services. Thus, causing inflation.

Causes of Cost-Push Inflation

The various causes which lead to cost-push inflation are-

Increase in the prices of raw materials.

Increase in taxes like VAT and excise duties.

Increasing the amount of wages and salaries to workers.

There are many reasons why costs might rise:

Component costs: e.g. an increase in the prices of raw materials and other components. This might be because of a rise in commodity prices such as oil, copper and agricultural products used in food processing. A recent example has been a surge in the world price of wheat.

Rising labour costs – caused by wage increases, which are greater than improvements in productivity. Wage costs often rise when unemployment is low because skilled workers become scarce and this can drive pay levels higher. Wages might increase when people expect higher inflation so they ask for more pay in order to protect their real incomes. Trade unions may use their bargaining power to bid for and achieve increasing wages; this could be a cause of cost-push inflation

Expectations of inflation are important in shaping what actually happens to inflation. When people see prices are rising for everyday items they get concerned about the effects of inflation on their real standard of living. One of the dangers of a pick-up in inflation is what the Bank of England calls “second-round effects” i.e. an initial rise in prices triggers a burst of higher pay claims as workers look to protect their way of life. This is also known as a “wage-price effect”

Higher indirect taxes – for example a rise in the duty on alcohol, fuels and cigarettes, or a rise in Value Added Tax. Depending on the price elasticity of demand and supply for their products, suppliers may choose to pass on the burden of the tax onto consumers.

A fall in the exchange rate – this can cause cost push inflation because it leads to an increase in the prices of imported products such as essential raw materials, components and finished products

Monopoly employers/profit-push inflation – where dominants firms in a market use their market power (at whatever level of demand) to increase prices well above costs.

Demand-pull inflation is controlled:-

Demand Pull Inflation involves inflation rising as real Gross Domestic Product rises and unemployment falls, as the economy moves along the Phillips Curve . Demand Pull Inflation is commonly described as “too much money chasing too few goods”.

More accurately, it should be described as involving “too much money spent chasing too few goods,” since only money that is spent on goods and services can cause inflation. This rise in price level is not expected to happen unless the economy is already at a full-employment level. The term demand-pull inflation is mostly associated with Keynesian economics.

For example, if aggregate demand is rising at 3%, but the productive capacity is only rising at 2%. Thus, firms will see that demand is outstripping supply and will respond by increasing prices. As firms produce more, they will hire more workers. This hiring spree will cause a fall in unemployment. This increased demand for workers puts upward pressure on wages, leading to wage-push inflation. Finally, higher wages increase the disposable income of employees, leading to a rise in consumer spending.

1. Consumption

If there is a sharp increase in consumption and investment along with extremely positive businesses atmosphere, then there will be a rise in Aggregate Demand.

2. Exchange Rate

A depreciation of the exchange rate increases the price of imports and reduces the price of a country’s exports. Consumers will buy fewer imports, while exports grow. There will be an increase in Aggregate Demand.

3. Government Spending

An enormous increase in government spending will drive up Aggregate Demand.

4. Expectations

The expectation that inflation will rise often leads to a rise in inflation. Workers and firms will raise their prices to ‘catch up’ to inflation.

5. Monetary Growth

If there is excessive monetary growth – when they are too much money in the system chasing too few goods? The ‘price’ of goodwill thus increases.

(b) What is Business cycle? Explain the features of business cycle. Discuss the measures that can control business cycles.

-> The period of high income, output and employment has been called the period of expansion, upswing or prosperity, and the period of low income, output and employment has been described as contraction, recession, downswing or depression.

The economic history of the free market capitalist countries has shown that the period of economic prosperity or expansion alternates with the period of contraction or recession.

These alternating periods of expansion and contraction in economic activity has been called business cycles. They are also known as trade cycles. J.M. Keynes writes, “A trade cycle is composed of periods of good trade characterized by rising prices and low unemployment percentages with periods of bad trade characterized by falling prices and high unemployment percentages.”

A noteworthy feature about these fluctuations in economic activity is that they are recurrent and have been occurring periodically in a more or less regular fashion. Therefore, these fluctuations have been called business cycles. It may be noted that calling these fluctuations as ‘cycles’ means they are periodic and occur regularly, though perfect regularity has not been observed.

The duration of a business cycle has not been of the same length; it has varied from a minimum of two years to a maximum of ten to twelve years, though in the past it was often assumed that fluctuations of output and other economic indicators around the trend showed repetitive and regular pattern of alternating periods of expansion and contraction.

However, actually there has been no clear evidence of very regular cycles of the same definite duration. Some business cycles have been very short lasting for only two to three years, while others have lasted for several years. Further, in some cycles there have been large swings away from trend and in others these swings have been of moderate nature.

A significant point worth noting about business cycles is that they have been very costly in the economic sense of the word. During a period of recession or depression many workers lose their jobs and as a result large-scale unemployment, which causes loss of output that could have been produced with full employment of resources, come to prevail in the economy.

Besides, during depression many businessmen go bankrupt and suffer huge losses. Depression causes a lot of human sufferings and lowers the levels of living of the people. Fluctuations in economic activity create a lot of uncertainty in the economy which causes anxiety to the individuals about their future income and employment opportunities and involve a great risk for long-run investment in projects. Even boom when it is accompanied by inflation has its social costs. Inflation erodes the real incomes of the people and makes life miserable for the poor people. Inflation distorts allocation of resources by drawing away scarce resources from productive uses to unproductive ones. Inflation redistributes income in favour of the richer sections and also when inflation rate is high, it impedes economic growth.

Features of Business cycle:-

a) Fluctuations in business cycle are wave like observed by the economists.

b) The fluctuations are recurring in nature.

c) These fluctuations are repeated at irregular interval in other words boom and through do not occur at regular intervals.

d) The changes or fluctuations are found in aggregate of various economic variables not in any single firm or industry. It connotes changes in overall economic environment affecting all the economic entities.

e) The economic variables move in the same time in the same direction but not at the same rate.

f) Business cycles are not to be confused with the seasonal fluctuations and secular trends.

g) The effects of fluctuation are cumulative.

The measures that can control business cycles:-

1. Monetary Policy

2. Fiscal Policy

3. State Control of Private Investment

4. International Measures to Control of Business Cycle Fluctuation

5. Reorganization of Economic System

1. Monetary Policy A Control of Business Cycle

Monetary policy as measure to control business cycle fluctuation refers to all those measures which are taken with a view to control money and credit supply in the country. When we are in the state of full employment and we are facing inflation, a deflationary policy may be adopted. The central bank can reduced the quantity of money in circulation. The bank can adopt different measures for this purpose, like increase in the bank rate, selling of securities in the market, increasing the reserve ratio of the member banks etc.

On the other hand, in case of deflation the central bank can adopt inflationary monetary policy by lowering the bank rates or purchase of securities. Monetary policy has achieved a very limited success in the past, because central bank has not full power over the supply of money and credit in the country. Moreover, the quantity of money has failed during the world depression of 1930s.

2. Fiscal Policy Measure to Control of Business Cycle Fluctuation

Fiscal policy as measure to control business cycle fluctuation nowadays is considered to be a powerful anti-cycle weapon in the hands of the government. Fiscal policy involves the process of shaping the public finance (income and expenditure) with a view of reduce fluctuations in the business cycle and attainment of full employment without inflation.

In case of inflation the governments reduces the public work programs, imposing heavy taxes on business profits to discourage private investment, reduces purchasers power, taking loans from the people, prepares surplus budget to reduce public debt. All these fiscal measures greatly help in reducing the inflationary trend in the economy.

If the economy facing depression, the government increases it expenditure on public works programs like construction of new canals, new roads, buildings etc. Increase in government expenditure, income, employment, profit and consumption of the people. In order to encourage private investment the government reduces taxes on profit. The government also prepares deficit budget and the deficit is met by loans. All these fiscal measures to control business cycle sets in upswing in the economy.

3. State Control of Private Investment

Some economists have suggested that if a government takes control of private investment is a tool to control of business cycle fluctuations can be controlled within the limits. The other economists, who disagree with the above view state that if a government takes control of private investment, private investment will be discouraged. Low investment will reduce employment and income. J.M Keynes is of the view that if we adopt the middle way we can get control of business cycle fluctuation.

4. International Measures Control of Business Cycle

Today, every country has trade relations with the rest of the world. If there is inflation or deflation in one country, it can be easily carried to other countries. The example of great depression can be given. Business cycle is an internationaal phenomenon and it should be tackled on international level. Different measures to control business cycle fluctuations have been suggested by some well-known economists these are:

§ Control of International Production

§ International Bill Stock Control

§ International Investment Control

5. Reorganization of Economic System

Some economists suggest that there should be complete reorganization of the whole economic system to control of business cycle fluctuation. The capitalistic system of production should be replaced by the socialistic system of production. In socialistic economy, there are few chances of cyclic fluctuations. In 1930, when all capitalist countries of the world were suffering from depression, it was only socialist countries which were free from such crisis.