2018 – Solved Question Paper | Managerial Economics | Previous Year – Masters of Commerce (M.Com) | Dibrugarh University

2018 – Solved Question Paper | Managerial Economics | Previous Year – Masters of Commerce (M.Com) | Dibrugarh University



Paper: 105

(Managerial Economics)

Full Marks – 80

Time – Three Hours

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

1(a) What do you mean by micro and macroeconomics approaches? Trace the importance of microeconomic analysis. What are its limitations?

-> Economics is divided into two different categories: microeconomics and macroeconomics. Microeconomics is the study of individuals and business decisions, while macroeconomics looks at the decisions of countries and governments.

While these two branches of economics appear to be different, they are actually interdependent and complement one another. Many overlapping issues exist between the two fields.


Microeconomics is the study of decisions made by people and businesses regarding the allocation of resources and prices of goods and services. It also takes into account taxes, regulations, and government legislation.

Microeconomics focuses on supply and demand and other forces that determine the price levels in the economy. It takes what is referred to as a bottom-up approach to analyzing the economy. In other words, microeconomics tries to understand human choices, decisions, and the allocation of resources.

Having said that, microeconomics does not try to answer or explain what forces should take place in a market. Rather, it tries to explain what happens when there are changes in certain conditions.

For example, microeconomics examines how a company could maximize its production and capacity so that it could lower prices and better compete in its industry. A lot of microeconomic information can be gleaned from the financial statements.

Microeconomics involves several key principles including (but not limited to):

  • Demand, Supply, and Equilibrium : Prices are determined by the theory of supply and demand. Under this theory, suppliers offer the same price demanded by consumers in a perfectly competitive market. This creates economic equilibrium.
  • Production Theory : This principle is the study of how goods and services are created or manufactured.
  • Costs of Production : According to this theory, the price of goods or services is determined by the cost of the resources used during production.
  • Labour Economics : This principle looks at workers and employers, and tries to understand the pattern of wages, employment, and income.

The rules in microeconomics flow from a set of compatible laws and theorems, rather than beginning with empirical study.


Macroeconomics , on the other hand, studies the behaviour of a country and how its policies affect the economy as a whole. It analyzes entire industries and economies, rather than individuals or specific companies, which is why it’s a top-down approach. It tries to answer questions like “What should the rate of inflation be?” or “What stimulates economic growth?”

Macroeconomics analyzes how an increase or decrease in net exports affects a nation’s capital account, or how GDP would be affected by the unemployment rate .

Macroeconomics focuses on aggregates and econometric correlations , which is why it is used by governments and their agencies to construct economic and fiscal policy. Investors of mutual funds or interest-rate-sensitive securities should keep an eye on monetary and fiscal policy. Outside of a few meaningful and measurable impacts, macroeconomics doesn’t offer much for specific investments.

John Maynard Keynes is often credited as the founder of macroeconomics, as he initiated the use of monetary aggregates to study broad phenomena. Some economists dispute his theory , while many of those who use it disagree on how to interpret it.

Microeconomics vs. Macroeconomics

1. Microeconomics studies individuals and business decisions, while macroeconomics analyzes the decisions made by countries and governments.

2. Microeconomics focuses on supply and demand, and other forces that determine price levels, making it a bottom-up approach. Macroeconomics takes a top-down approach and looks at the economy as a whole, trying to determine its course and nature.

3. Investors can use microeconomics in their investment decisions, while macroeconomics is an analytical tool mainly used to craft economic and fiscal policy.

Importance of microeconomics analysis:-

1. Functioning of an Economy:

Macroeconomic analysis is of paramount importance in getting us an idea of the functioning of an economic system.

It is very essential for a proper and accurate knowledge of the behaviour pattern of the aggregative variables as the description of a large and complex economic system is impossible in terms of numerous individual items.

2. Formulation of Economic Policies:

Macroeconomics is of great help in the formulation of economic policies. The days of ‘laissez faire’ are over and government intervention in economic matters is an accomplished fact. Governments deal not with individuals but with groups and masses of individuals, thereby establishing the importance of macroeconomic studies. For example, during depression, when the machines lie idle and men roam from pillar to post in search of employment, macroeconomics helps us to analyze the cause leading to depression and unemployment and to the adoption of suitable policies to cope with such a situation.

3. Understanding Macroeconomics:

The study of macroeconomics is essential for the proper understanding of microeconomics. No Microeconomic law could be framed without a prior study of the aggregates; for example, the theory of individual firm could not have been formulated with reference to the behaviour pattern of one single firm, howsoever representative it might have been; the theory was possible only after the behaviour pattern of several firms had been examined and analyzed, for example, the forest, though an aggregation of trees, does not exhibit the behaviour and characteristics of individual trees. Microeconomics has been, and to some extent, remains a jungle of special assumptions, special cases, unsatisfactory measurements and abstract theorising.

4. Understanding and Controlling Economic Fluctuations:

Economic fluctuations are a characteristic feature of the capitalist form of society. The theory of economic fluctuations can be understood and built up only with the help of macroeconomics, for here we have to take into consideration aggregate consumption, aggregate saving and investment in the economy. Thus, we are led to analyse the causes of fluctuations in income, output and employment, and make attempts to control them or at least to reduce their severity.

5. Inflation and Deflation:

Macroeconomic approach is of utmost importance to analyse and understand the effects of inflation and deflation. Different sections of society are affected differently as a result of changes in the value of money. Macroeconomic analysis enables us to take certain steps to counteract the adverse influences of inflation and deflation.

6. Study of National Income:

It is the study of macroeconomics which has brought forward the immense importance of the study of national income and social accounts. In micro-economy such a study was relegated to the background. It is the study of national income which enables us to know that three-fourth of the world is living in abject poverty. Without a study of national income, as a result of the development in macroeconomics, it was not possible to formulate correct economic policies.

7. Study of Economic Development:

As a result of advanced study in macroeconomics, it has become possible to give more attention to the problem of development of underdeveloped countries. Study of macroeconomics has revealed not only the glaring inequalities of wealth within an economy but has also shown the vast differences in the standards of living of the people in various countries necessitating the adoption of important steps to promote their economic welfare.

8. Performance of an Economy:

Macroeconomics helps us to understand and analyse the performance of an economy. It implies the result-oriented study of an economy—in terms of actual and factual achievements. Gross National Product (GNP) or National Income (NI) estimates are used to measure the performance of an economy over time by comparing the production of goods and services in one period with that of the other periods the composition of GNP gives information about the quantum of contribution of each sector of the economy to GNP.

9. Nature of Material Welfare:

Macroeconomics enables us to study the nature and size of the material welfare of the nations. The problem of measuring social welfare is not easy; even welfare economics does not help us. Those who are interested in the material and social welfare of all must study problems in their macroeconomic setting. This adds to the importance of macroeconomics because when the chief objective of the studies of economics is the welfare of entire society, economics becomes the study of macroeconomics.

Limitations of microeconomics:-

1. Excessive Generalisation:

Despite the immense importance of macroeconomics, there is the danger of excessive generalisation from individual experience to the system as a whole.

If an individual withdraws his deposits from the bank, there is no-harm in it, but if all the persons rushed to withdraw deposits, the bank would perhaps collapse.

2. Excessive Thinking in terms of Aggregates:

Again, macroeconomics suffers from excessive thinking in terms of aggregates, as it may not be always possible to have the homogeneous constituents. Prof. Boulding has pointed out that 2 apples + 3 apples = 5 apples is a meaningful aggregate ; 2 apples + 3 oranges = 5 fruits may be described as a fairly meaningful aggregate ; but 2 apples + 3 sky scrapers constitute a meaningless aggregate ; it is the last aggregate which brings forth the fallacy of excessive aggregative thinking.

3. Heterogeneous Elements:

It may, however, be remembered that macroeconomics deals with such aggregates as aggregate consumption, saving, investment and income, all composed of heterogeneous quantities. Money is the only measuring rod. But the value of money itself keeps on changing, rendering economic aggregates immeasurable and incomparable in real terms. As such, the sum or average of heterogeneous individual quantities loses their significance for accurate economic analysis and economic policy.

4. Differences within Aggregates:

Under this approach one is likely to overlook the differences within aggregates. For example, during the first decade of planning in India (from 1951-1961) the national income increased by 42% ; this, however, doesn’t mean that the income of all the constituents, i.e., the wage earners or salaried persons increased by as much as that of entrepreneurs or businessmen. Hence, it takes no account of differences within aggregates.

5. Aggregates must be functionally related:

The aggregates forming the main body of macroeconomic theory must be significant and mutually consistent. In other words, these should be functionally related. For example, aggregate consumption and investment expenditures—which form part of the macroeconomic theory (Y = C + I) would have no importance, if they were not functionally related to the levels of income, interest and employment. If these composing aggregates are mutually inconsistent or are not functionally related, the study of macroeconomic theory will be of little use.

6. Limited Application:

Macroeconomics deals with positive economics in the sense of an analysis or how the aggregate theoretical models work—these are far removed from policy applications. These models explain the functioning of an economy and working of things in abstract and precise terms. Their abstraction and precision make such models unsuitable for use due to changes in significant variables from time to time and from one situation to another. But these limitations may be taken more in the nature of practical difficulties in formulating meaningful aggregates rather than factors invalidating the immense importance of macroeconomic analysis.

With the commencement of Keynes’ General Theory and his basic equation, Y = C + I; interest in the study of macroeconomics has deepened. Significant breakthroughs in the computation of national income accounts (the study of which forms the very basis of macroeconomics) prove it beyond doubt that the limitations of macroeconomic studies are not insurmountable.

(b) What is managerial economics? Discuss the salient features and significance of managerial economics .

-> Managerial Economics has emerged only recently. With the growing variability and unpredictability of the business environment, business managers have become increasingly concerned with finding rational and ways of adjusting to an exploiting environmental change.

The problems of the business world attracted the attentions of the academicians from 1950 onwards. Mana­gerial economics as a subject gained popularity in the USA after the publication of the book “Managerial Economics” by Joel Dean in 1951.

Managerial economics is a stream of management studies which emphasizes solving business problems and decision-making by applying the theories and principles of microeconomics and macroeconomics. It is a specialized stream dealing with the organization’s internal issues by using various economic theories.

Economics is an inevitable part of any business. All the business assumptions, forecasting and investments are based on this one single concept.

Subject Matter of Marginal Economics:

(i) Demand Analysis and Forecasting:

A firm is an economic organisation which transforms inputs into output that is to be sold in a market. Accurate estimation of demand, by analysing the forces acting on demand of the product pro­duced by the firm, forms the vital issue in taking effective decision at the firm level.

A major part of managerial decision making depends on accurate estimates of demand. When demand is estimated, the manager does not stop at the stage of assessing the current demand but estimates future demand as well. This is what is meant by demand forecasting.

This forecast can also serve as a guide to management for maintaining or strengthening market position and enlarging profit. Demand analysis helps in identifying the various factors influencing the demand for a firm’s product and thus provides guidelines to manipu­late demand. The main topics covered are: Demand Determinants, Demand Distinctions and Demand Forecasting.

(ii) Cost and Production Analysis:

Cost analysis is yet another function of managerial economics. In decision making, cost estimates are very essential. The factors causing variation in costs must be recognised and allowed for if management is to arrive at cost estimates which are significant for planning purposes.

The determinants of estimating costs, the relationship between cost and output, the forecast of cost and profit are very vital to a firm. An element of cost uncertainty exists because all the factors determining costs are not always known or controllable. Managerial economics touches these aspects of cost analysis as an effective knowledge and the application of which is corner stone for the success of a firm.

Production analysis frequently proceeds in physical terms. Inputs play a vital role in the econom­ics of production. The factors of production otherwise called inputs, may be combined in a particular way to yield the maximum output.

Alternatively, when the price of inputs shoots up, a firm is forced to work out a combination of inputs so as to ensure that this combination becomes the least cost combina­tion. The main topics covered under cost and production analysis are production function, least cost combination of factor inputs, factor productiveness, returns to scale, cost concepts and classification, cost-output relationship and linear programming.

(iii) Inventory Management:

An inventory refers to a stock of raw materials which a firm keeps. Now the problem is how much of the inventory is the ideal stock. If it is high, capital is unproductively tied up. If the level of inventory is low, production will be affected.

Therefore, managerial economics will use such methods as Eco­nomic Order Quantity (EOQ) approach, ABC analysis with a view to minimising the inventory cost. It also goes deeper into such aspects as motives of holding inventory, cost of holding inventory, inventory control, and main methods of inventory control and management.

(iv) Advertising:

To produce a commodity is one thing and to market it is another. Yet the message about the product should reach the consumer before he thinks of buying it. Therefore, advertising forms an inte­gral part of decision making and forward planning. Expenditure on advertising and related types of promotional activities is called selling costs by economists.

There are different methods for setting advertising budget: Percentage of Sales Approach, All You can Afford Approach, Competitive Parity Approach, Objective and Task Approach and Return on Investment Approach.

(v) Pricing Decision, Policies and Practices:

Pricing is very important area of managerial economics. The control functions of an enterprise are not only productions but pricing as well. When pricing a commodity, the cost of production has to be taken into account. Business decisions are greatly influenced by pervading market structure and the structure of markets that has been evolved by the nature of competition existing in the market.

Pricing is actually guided by consideration of cost plan pricing and the policies of public enterprises. The knowl­edge of the pricing of a product under conditions of oligopoly is also essential. The price system guides the manager to take valid and profitable decision.

(vi) Profit Management:

A business firm is an organisation designed to make profits. Profits are acid test of the individual firm’s performance. In appraising a company, we must first understand how profit arises. The concept of profit maximisation is very useful in selecting the alternatives in making a decision at the firm level.

Profit forecasting is an essential function of any management. It relates to projection of future earnings and involves the analysis of actual and expected behaviour of firms, the sales volume, prices and com­petitor’s strategies, etc. The main aspects covered under this area are the nature and measurement of profit, and profit policies of special significance to managerial decision making.

Managerial economics tries to find out the cause and effect relationship by factual study and logical reasoning. For example, the statement that profits are at a maximum when marginal revenue is equal to marginal cost, a substan­tial part of economic analysis of this deductive proposition attempts to reach specific conclusions about what should be done.

The logic of linear programming is deduction of mathematical form. In fine, managerial economics is a branch of normative economics that draws from descriptive economics and from well established deductive patterns of logic.

(vii) Capital Management:

Planning and control of capital expenditures is the basic executive function. The managerial prob­lem of planning and control of capital is examined from an economic stand point. The capital budgeting process takes different forms in different industries.

It involves the equi-marginal principle. The objec­tive is to assure the most profitable use of funds, which means that funds must not be applied when the managerial returns are less than in other uses. The main topics dealt with are: Cost of Capital, Rate of Return and Selection of Projects.

Thus we see that a firm has uncertainties to rock on with. Therefore, we can conclude that the subject matter of managerial economics consists of applying economic principles and concepts towards adjusting with these uncertainties of the firm.

In recent years, there is a trend towards integration of managerial economics and Operation Research. Hence, techniques such as linear Programming, Inventory Models, Waiting Line Models, Bidding Models, Theory of Games, etc. have also come to be regarded as part of managerial economics.

Features of Managerial economics:-

1. More Sophisticated and New Topic

Managerial Economics is a More sophisticated and new topic. So Managerial economics is a very refined topic compared to general economics .

It is sophisticated for these reasons that now currently its use in mathematical concepts and scientific instruments including computer etc.

Therefore , it was developed along with World War II so that’s a whole new topic and Pursuing developing scripture which is going through its early stages.

2. Practical utility

Managerial economics demonstrates the method of economic theory and analysis used in economic decision making and policy determiners.

Therefore , it is a tool of practical utility, not a principle.

3. Normative Economics or Determinant Nature

Managerial economics is not of the nature of descriptive economics but of the normative economics.

It coordinates economic theory and business practices and makes the right decision.

As the demand and decrease in the law of demand decreases and increases in demand. Managerial economics analyzing the good or bad results of the firm.

Thus , if you see correctly, managerial economics lives in a fixed nature.

Because it cannot even tell that it is right that it can analyze them. And can present the data in front of you after all, you will take the right decision.

4. Helpful in Forecasting

One of the best key features of managerial economics. It is helpful in detecting prediction or forecasting.

This is very difficult for any business because what is going to happen with business in the future?

But the managerial economics can detect from different types of analytical data where the direction of the form shown in the future, where it goes, so it is quite helpful in forecasts.

5. Firm Theory/Economics of the firm

Now as we know the subject matter of managerial economics is related to the firm’s theory.

Therefore , the economic theory concept and analysis methods used in the firm’s theory.

So, it also uses them all in cost and advance analysis, demand and fulfilment analysis , production quantity and pricing and also for maximization of profits is remarkable.

Managerial Economics should be put together that uses the firm’s economics only to follow his principles.

6. Help of Macroeconomics

Managerial Economics uses macroeconomics components/factors elements of macroeconomics such as:-

1. business cycle ,

2. National income monetary,

3. foreign Trade Policy and

4. Price level fiscal policy.

Managerial economics also uses them.

Because what will happen with the firm in the future, or what events can happen who knows so to avoid them, macroeconomics is already used to determine policy and managerial economics.

7. Microeconomics

Managerial Economics is the nature of microeconomics .

Managerial Economics find the problems of individual firms, analyzing the events and actions related to it determine their policies, decides or makes plans. So it comes under microeconomics.

In essence , this is the main Feature of Managerial Economics. Because managerial economics does not analyze the entire economy.

Therefore, it only detects the analysis of a firm. So this is one of the best Features of Managerial Economics.

8. The Vital Part of the Firm

Managerial economics has become an important part of any firm because it is necessary for the firm.

It is useful for every firm, so it is an integral part of a firm.

9. Analysis and Cases

The purpose of managerial economics should be to show that and should provide the right direction using economic analysis to determine business policies.

Because managerial economics has the power, that analyses the business and provides the right direction.

Thus , now you can understand the features of Managerial Economics by knowing how managerial economics helps in benefiting any firm and how it handles a firm.

Significance of Managerial economics:-

Managerial economics can be characterized as the branch of economics which focuses on the appliance of microeconomics scrutiny and analysis for the aspect of decision-making in business. This branch of economics plays the role of mediator between the theories of economics and practical logics of economics. It is a discipline that amalgamates administrative practice with the theories of economics. This particular discipline provides impactful tools and approaches related to the making of managerial policy.

In today’s newfangled society, there is acceleration in the decision making related to business. Managerial economics offers numerous objectives in business decision-making. It is highly beneficial in making crucial decisions of business.

1. Helps in evaluating managerial policies – There are certain operational policies of company which yield no return or are not at all important in altering certain market conditions. It calls for timely evaluation of these policies so that there can be solutions for budding obstacles in the way of business decision-making. Managerial economics plays an active role in the evaluation and assessment of certain managerial policies.

2. Advantageous in business organization – Managerial economics is quite beneficial when it comes to organizing and managing the tasks, events related to the smooth functioning of business. It helps in taking the accurate decision related to the business organization.

3. Recognizes the economic strength and weakness – This significance of managerial economics is of utmost value as it defines the perks and pitfalls of the business economy. By exercising managerial economics the business managers can be sure of certain activities that could affect the growth of business.

4. Computing the economic relationship – There are certain business aspects like income, profit, acquisitions, loss, demand elasticity etc. The relationship and accord among these factors are estimated with the help of managerial economics.

5. Makes business planning much easier – The managerial economics is immense significant and essential in planning an appropriate prospect in order to achieve rewarding results and operations. This business planning plays an important role in connecting the tools of production and systems of operation. Through these benefits we can easily apprehend the importance of managerial economics.

6. Helps in managing the cost – Managerial economics offer a helping hand when it comes to deciding the correct and appropriate way for operating a business. All these decisions and arbitrations are possible when there is an active role and exercise of managerial economics which automatically affects the decisions related to cost control.

7. Systemization of business activities – There are several business activities that need to be coordinated and managed in a systematic manner. Managerial economics helps in coordination of activities related to business.

8. Resolves problem related to business taxation – Managerial economics proves to be the giant problem solving tool in various types of issues related to taxation in the business.

9. Helps in computing firm’s efficiency – Managerial economics help the business managers to measure the ability and efficiency of the firm.

2(b) Define demand forecasting. Discuss about the significance of demand forecasting. Also mention about the criteria of a good forecasting method.

-> 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.

Characteristics of Demand Forecasting:-

· Demand Forecasting is Always Wrong – It is important to understand that demand forecasts are always wrong. Even if the demand forecast is generated from demand forecasting software, you should expect to see some level of error within the forecasts. This is because year-to-year there will always be a variation in demand forecasts, no matter what company that you are. You have to take into account seasonality, macroeconomic factors, if you are running marketing campaigns, etc. All of these factors and more will greatly affect your demand and therefore leave you unable to accurately forecast what your demand will be.

· Long-Term Demand Forecast are Less Accurate – In correlation with demand forecasting being always wrong, long-term demand forecast are even less accurate than short-term forecast. This is because as you stretch your demand forecast further and further, the harder it is to accurately predict what it could be. Once again this is because of all of the factors associated with demand forecasting and any unforeseen events that may occur. Therefore, it is a must to attempt to only utilize short-term demand forecast and develop an idea of what demand may be.

· Aggregate Demand Forecast is More Accurate – Aggregate demand forecast take the cake when it pertains to accuracy. This is because aggregate demand planning tends to have a smaller standard deviation of error relative to the mean. Many large manufacturing facilities utilize aggregate demand forecasting and have seen a tremendous amount of efficiency improvement within their manufacturing operation. This form of software may be a bit more expensive than the others but is well worth the cost.

If you find that you are unable to purchase an expensive forecasting software, utilizing excel spreadsheets can be a great alternative option. If you find yourself utilizing ERP or MRP software, you may be seeking to locate another software that can fill in the gaps where these software’s lack in terms of efficiency. This is where many companies have found themselves utilizing Advanced Planning and Scheduling (APS) Software. Advanced Planning and Scheduling (APS) Software has become a necessity for manufacturing operations that are seeking to improve operational efficiency and overall reduce costs and waste within the production process. Advanced Planning and Scheduling (APS) Software is a must for manufacturers that want to maintain a competitive edge and improve their operation as a whole.

The criteria of a good forecasting method:-

Forecasting demand and revenues for new variants of existing products is difficult enough. But forecasting for radically innovative products in emerging new categories is an entirely different ball game. There are no past trends to reassuringly extrapolate into the future, just a ton of uncertainty about whether the latent demand that the marketing folk suggested to secure the R&D funding is real or not. And after so much investment, the board is sure that this is the product that is going to become the next cash cow. Sure, you could manage their expectations by reminding them that something like 80% of new products fail and name drop a few of the spectacular flops of Fortune 500 companies. But that would be career limiting. A better alternative is to take control of the situation and adopt some of the forecasting best practices approaches that others have found to work.

Step 1: Make it a collaborative effort

Identify a handful of key people from marketing, sales, operations, and relevant technical departments and form a working group. This core team will be responsible for developing and managing the reforecasting process through the launch period until demand planning becomes more predictable.

Step 2: Identify and agree upon the assumptions

Collectively review all the available qualitative and quantitative data from market research, market testing, and buyer surveys. Use the data to identify a set of assumptions that can form the basis of a forecasting model. Ideally this will include assumptions about:

· Number of consumers in the target market

· Proportion expected to buy the product

· Anticipated timing of their purchase

· Patterns of repeat purchasing and replacement purchasing

Be prepared to commission additional research or consult external industry experts to fill any important data gaps. And always let the working group use their collective judgment to identify a realistic range of values for each assumption.

Step 3: Build granular models

Not all consumers will purchase a new product at the same rate. Some may be prepared to queue all night around the block to get their hands on it, but others will want to wait for subsequent versions when any unforeseen bugs are fixed and prices are typically lower. So it is important to build a forecasting model that is sufficiently granular to reflect how and when different market segments in different geographies might purchase the product and at what price.

Step 4: Use flexible time periods

Sales over the first few days and weeks in the life of any new product need to be carefully monitored as they will quickly show how demand is likely to grow in the future. So although the sales and finance function may only be interested in monthly data, it pays to develop detailed daily forecasts for the first quarter against which to track actual sales.

Step 5: Generate a range of forecasts

Run through a number of iterations, changing various assumptions and probabilities in the model to generate a range of forecasts. This is easily done if a modeling solution that can be recalculated in real-time is deployed as internal experts and business leaders can generate and test alternative scenarios on the fly.

Step 6: Deliver the outputs that users need quickly

In new product launch planning , agreements may have been reached with a number of suppliers to deliver rapid replenishment designed to prevent stock outs in the most uncertain period immediately after the launch. However if reforecasting the exact replenishment needs of every distribution point in the supply chain involves multiple steps, much of that precious time will evaporate.

Building a fully integrated forecasting model that compares existing stock level and automatically generates a detailed replenishment report for every location as soon as any high level assumptions change precludes such delays and shortens the replenishment cycle.

Step 7: Combine different techniques

Bottom up modeling based on purchasing intentions is not the only method available for forecasting demand for new products. In some markets, such as technology and consumer electronics, products can go through an entire life cycle in a matter of months. Such narrow windows of opportunity make it vitally important to assess demand as accurately as possible. The most damaging situation is having a stock shortage while the product is still hot, leading disappointed consumers to purchase a competitor’s product.

These sectors make use of sophisticated modeling techniques developed by academics that use substitution and diffusion rates to forecast how rapidly new technologies replace older ones. Such methodologies might not be appropriate to many businesses, but the message is the same; combining different forecasting techniques gives more accurate results.

Step 8: Reality check the forecast

Whenever reliable data exists, always check the forecast against the sales evolution of comparable products to see if it is realistic. Similarly you should also estimate how your market share might evolve as new competitors came into this emerging category and how the total market might grow. Unless this macro overview is credible, be prepared to rework the assumptions behind the model.

Step 9: Reforecast, reforecast and reforecast some more

Diligently monitor sales and qualitative feedback such as product reviews, media mentions, and customer feedback, and agree with the members of the working group how the assumptions in the model might need to change. If it’s appropriate, reforecast daily.

Step 10: Be prepared to cut your losses

Finally, always have a contingency plan. A high proportion of new products fail and it is better to pull the plug on an ailing new product that is unlikely to achieve a viable level of profitability at the earliest opportunity. So quantify and agree what level of sales penetration constitutes failure well before the product launch. That way, the decision will be swift and the existing stock can be quickly and cost-efficiently depleted.

Forecasting demand for new products is not an exact science and relies on judgment rather than statistical techniques. Key to success are collaboration, using all the quantitative and qualitative data that is available and having a modelling solution that can quickly and easily be updated to generate detailed forecasts for all users across the business. The benefits can be impressive both in terms of reduced inventory costs and improved customer satisfaction, something that is vital for a new product to flourish.

3(a) Define monopoly. What are the sources of monopoly power? Discuss about the benefits of monopoly.

-> A market structure characterized by a single seller, selling a unique product in the market. In a monopoly market, the seller faces no competition, as he is the sole seller of goods with no close substitute.

In a monopoly market, factors like government license, ownership of resources, copyright and patent and high starting cost make an entity a single seller of goods. All these factors restrict the entry of other sellers in the market. Monopolies also possess some information that is not known to other sellers.

Characteristics associated with a monopoly market make the single seller the market controller as well as the price maker. He enjoys the power of setting the price for his goods.

Sources of Monopoly Power:

Monopoly power of a firm is its ability to set the price of its product above the marginal cost. We have also seen that, in equilibrium, p – MC/p is equal to 1/e. This gives us that the smaller the price-elasticity of demand for the product the larger would be the monopoly power of the firm.

The main source of monopoly power, therefore, is the elasticity of demand for the product concerned. Now, the elasticity of demand for a firm’s product is determined by three factors.

These are:

(i) Elasticity of market demand,

(ii) The number of firms in the market, and

(iii) The nature of interaction among the firms.

(i) The Elasticity of Market Demand:

In the case of pure monopoly, there is only one firm that produces the product. Here, there is no difference between the elasticity of the firm’s demand and the elasticity of market demand. There­fore, in this case, the firm’s degree of monopoly power is determined directly by the elasticity of market demand for his product.

However, pure monopoly is rare in the real world. Because, barring exceptions, every product has at least a few close substitutes. In other words, in the real world we often find that a close substitute product-group is produced by a number of firms.

These firms compete over selling their respective products. In the case of each such firm, the elasticity of market demand for the product-group, hereafter called the ‘product’, provides the bottom line for the elasticity of its demand curve.

For example, if at any particular price, the e of the market demand for the ‘product’ be e* = 1.5 (say), then the e for the product of every firm would be at least 1.5. That is, if a firm decreases (or increases) the price of its product by 1 per cent, then the demand for its product would increase (or decrease) by at least 1.5 per cent.

(ii) The Number of Firms:

However, e for the product of a firm belonging to the group of firms that produce the ‘product’, may very well be more than the e* (here 1.5)—how much more would, of course, depend on the number of firms that produce the ‘product’. Let us see why.

If one among several firms producing the ‘product’, say, firm A, reduces its price by 1 per cent, say, the prices of the other firms remaining unchanged, then the product of A would become relatively cheaper and some of the customers of the other firms would switch over to A.

In this case, demand for the product of A would not only increase, in the first instance, by 1.5 percent as given by the e* for the market demand for the product, but it would also increase somewhat more because of the ‘switch-over’ factor.

Similarly, if the price of the product of A increases by 1 percent, then its demand would decrease not only by 1.5 percent as given by e*, but it would also decrease somewhat more because of the ‘switch-over’ factor. For, now, the product of A would become relatively dearer and some of the customers of A would switch over to the close-substitute products of the group.

It is easy to understand from what we have said above that the larger the number of firms in the group, the more would be the strength of the ‘switch-over’ factor. That is, the larger the number of firms, the more would be the e for the product of A.

We may conclude then that the number of firms producing the ‘product’ is a determinant of the elasticity of demand for a firm’s product and the latter, in its turn, is a determinant of the degree of its monopoly power.

We may say then that the smaller (larger) the number of firms producing the close-substitute products, the smaller (larger) would be elasticity of demand for the product of a particular firm and the larger (smaller) would be the degree of its monopoly power (which is equal to 1/e)

We therefore have come, to an interesting conclusion that since in the case of pure mo­nopoly, the number of firms is only one, and since the e of the pure monopolist is equal to the bottom line e which is e*, the degree of monopoly power of a pure monopolist is the largest, i.e., it is larger than the monopoly power of a firm in a ‘non-pure’ monopolistic situation.

(iii) The Interaction among Firms:

If there are several firms producing the close-substitute products, called the ‘product’, then the monopoly power enjoyed by each of them would depend upon the interactions among them. If the firms compete aggressively, then they would undercut one another’s prices in order to increase their respective market shares.

Such aggressive competition among the firms may drive the prices of the products down nearly to the level of competitive price. In this case, p – MC would also be driven down and the degree of monopoly power of the firms would be relatively small.

On the other hand, the firms might decide not to compete among themselves, rather they might collude. In this case, collusion among the firms would restrict their outputs and increase their prices. So here they would have relatively high p – MC and the degree of their monopoly power would also be high.

Collusion may go to such a length that the firms may behave almost like one firm (giving rise to a multi-plant monopoly). In such a case, the degree of monopoly power would be the highest possible (approaching 1/e*).

We may conclude then that the monopoly power of a firm may arise from three sources.

These are:

(i) Elasticity of market demand for the product,

(ii) The number of firms, and

(iii) The nature of interaction among firms.

Benefits of Monopoly:-

Monopolies are generally considered to have several disadvantages (higher price, fewer incentives to be efficient etc). However, monopolies can also give benefits, such as – economies of scale, (lower average costs) and a greater ability to fund research and development. In certain circumstances, the advantages of monopolies can outweigh their costs.

1. Research and development. Monopolies can make supernormal profit, which can be used to fund high-cost capital investment spending. Successful research can be used for improved products and lower costs in the long term. This is important for industries like telecommunications, aeroplane manufacture and pharmaceuticals. Without monopoly power that a patent gives, there may be less development of medical drugs. In developing drugs, there is a high risk of failure; monopoly profits give a firm greater confidence to take risks and fund research which may prove futile.

2. Economies of scale Increased output will lead to a decrease in average costs of production. These can be passed on to consumers in the form of lower prices. See: Economies of Scale this is important for industries with high fixed costs, such as tap water and steel production.

3. International competitiveness . A domestic firm may have monopoly power in the domestic country but face effective competition in global markets. E.g. British Steel has a domestic monopoly but faces competition globally. With markets increasingly globalised, it may be necessary for a firm to have a domestic monopoly in order to be competitive internationally

4. Monopolies can be successful firms . A firm may become a monopoly through being efficient and dynamic. A monopoly is thus a sign of success, not inefficiency. For example – Google has gained monopoly power through being regarded as the best firm for search engines. Apple has a degree of monopoly power through successful innovation and being regarded as the best producer of digital goods.

5. Monopoly regulation . One possibility is for a firm to have a monopoly situation, but the government sets up a regulator to prevent the excesses of monopoly power. For example, utilities like water and gas are natural monopolies so it makes sense to have one provider. The regulator can limit price increases and ensure standards of service are met. In theory, this enables the best of both worlds – the monopoly firm can benefit from economies of scale, but the consumer is protected from monopoly prices. However, it depends on the quality of regulation. There is a danger of regulatory capture and the regulator allowing the firm to be too profitable.

6. Subsidise loss-making services . Another potential advantage of a monopoly is that they can use their supernormal profit to subsidise socially useful but loss-making services. For example, a train company can use its monopoly power to set high prices on peak services, but this allows the firm to subsidise unprofitable late-running services on Sat night, which is useful for people going out for the night.

7. Avoid the duplication of services . In some areas, the most efficient number of firms is one. For example, if a city deregulates its bus travel, then rival bus companies may compete for profitable peak-hour services. This may lead to increased congestion as several buses turn up at once. It is more efficient to have a monopoly and avoid this inefficient duplication of services.

(b) What are the objectives of pricing policy? Explain the method of cost plus pricing. What are its limitations?

-> Objectives of Pricing policy:-

(i) Achieving a Target Return on Investments:

This is the most important objective which every concern wants to achieve. The objective is to achieve a certain rate of return on investments and frame the pricing policy in order to achieve that rate. Sometimes, it is observed that the actual profit rates may be more than the target return. This is because the targets already fixed are low and new opportunities and demand of the product exceeding the return rate already fixed.

(ii) Price Stability:

This is another important objective of an enterprise. Stability of prices over a period reflects the efficiency of a concern. But in practice, on account of changing costs from time to time, price stability cannot be achieved. In the market where there are few sellers, every seller wants to maintain stability in prices. Price is set by one producer and others follow him. He acts as a leader in price fixation.

(iii) Achieving Market Share:

Market share refers to the share of the company in the total sales of the product in the market. Some of the concerns when introduce their product in the competitive market want to achieve a certain share in the market in the initial stages. In the long run the concern may aim at achieving a sizeable portion of the market by selling its products at lower prices.

The main objective of achieving larger share in the market is to enjoy more reputation and goodwill among the people. The other consideration of widening the markets by lowering prices is to eliminate competitors from the market.

It has been observed that companies may not like to increase the size of their share on account of fear of Govt, intervention and control. General Motors, America, capturing about 50% of the automobile market, passed through this situation. Some companies like General Electric and Johns-Mauville preferred to have relatively small market say 20% rather than 50%.

(iv) Prevention of Competition:

Modern industrial set up is confronted with cut throat competition. Pricing can be used as one of the effective means to fight against the competition and business rivalries. Lesser prices are charged by some firms to keep their competitors out of the market. But a firm cannot afford to charge fewer prices over a long period of time.

(v) Increased Profits:

Maximisation of profits is one of the main objectives of a business enterprise. A firm can adopt such a price policy which ensures larger profits. However, such enterprises are also expected to discharge certain social obligations also.

Method of cost plus pricing:-

Cost-based Pricing:

Cost-based pricing refers to a pricing method in which some percentage of desired profit margins is added to the cost of the product to obtain the final price. In other words, cost-based pricing can be defined as a pricing method in which a certain percentage of the total cost of production is added to the cost of the product to determine its selling price. Cost-based pricing can be of two types, namely, cost-plus pricing and markup pricing.

These two types of cost-based pricing are as follows:

i. Cost-plus Pricing:

Refers to the simplest method of determining the price of a product. In cost-plus pricing method, a fixed percentage, also called mark-up percentage, of the total cost (as a profit) is added to the total cost to set the price. For example, XYZ organization bears the total cost of Rs.100 per unit for producing a product. It adds Rs. 50 per unit to the price of product as’ profit. In such a case, the final price of a product of the organization would be Rs. 150.

Cost-plus pricing is also known as average cost pricing. This is the most commonly used method in manufacturing organizations.

In economics, the general formula given for setting price in case of cost-plus pricing is as follows:

P = AVC + AVC (M)

AVC= Average Variable Cost

M = Mark-up percentage

AVC (m) = Gross profit margin

Mark-up percentage (M) is fixed in which AFC and net profit margin (NPM) are covered.

AVC (m) = AFC+ NPM

ii. For determining average variable cost, the first step is to fix prices. This is done by estimating the volume of the output for a given period of time. The planned output or normal level of production is taken into account to estimate the output.

The second step is to calculate Total Variable Cost (TVC) of the output. TVC includes direct costs, such as cost incurred in labor, electricity, and transportation. Once TVC is calculated, AVC is obtained by dividing TVC by output, Q. [AVC= TVC/Q]. The price is then fixed by adding the mark-up of some percentage of AVC to the profit [P = AVC + AVC (m)].

iii. The advantages of cost-plus pricing method are as follows:

a. Requires minimum information

b. Involves simplicity of calculation

c. Insures sellers against the unexpected changes in costs

The disadvantages of cost-plus pricing method are as follows:

a. Ignores price strategies of competitors

b. Ignores the role of customers

iv. Markup Pricing:

Refers to a pricing method in which the fixed amount or the percentage of cost of the product is added to product’s price to get the selling price of the product. Markup pricing is more common in retailing in which a retailer sells the product to earn profit. For example, if a retailer has taken a product from the wholesaler for Rs. 100, then he/she might add up a markup of Rs. 20 to gain profit.

It is mostly expressed by the following formulae:

a. Markup as the percentage of cost= (Markup/Cost) *100

b. Markup as the percentage of selling price= (Markup/ Selling Price)*100

c. For example, the product is sold for Rs. 500 whose cost was Rs. 400. The mark up as a percentage to cost is equal to (100/400)*100 =25. The mark up as a percentage of the selling price equals (100/500)*100= 20.

Demand-based Pricing:

Demand-based pricing refers to a pricing method in which the price of a product is finalized according to its demand. If the demand of a product is more, an organization prefers to set high prices for products to gain profit; whereas, if the demand of a product is less, the low prices are charged to attract the customers.

The success of demand-based pricing depends on the ability of marketers to analyze the demand. This type of pricing can be seen in the hospitality and travel industries. For instance, airlines during the period of low demand charge fewer rates as compared to the period of high demand. Demand-based pricing helps the organization to earn more profit if the customers accept the product at the price more than its cost.

Competition-based Pricing:

Competition-based pricing refers to a method in which an organization considers the prices of competitors’ products to set the prices of its own products. The organization may charge higher, lower, or equal prices as compared to the prices of its competitors.

The aviation industry is the best example of competition-based pricing where airlines charge the same or fewer prices for same routes as charged by their competitors. In addition, the introductory prices charged by publishing organizations for textbooks are determined according to the competitors’ prices.

Other Pricing Methods:

In addition to the pricing methods, there are other methods that are discussed as follows:

i. Value Pricing:

Implies a method in which an organization tries to win loyal customers by charging low prices for their high- quality products. The organization aims to become a low cost producer without sacrificing the quality. It can deliver high- quality products at low prices by improving its research and development process. Value pricing is also called value-optimized pricing.

ii. Target Return Pricing:

Helps in achieving the required rate of return on investment done for a product. In other words, the price of a product is fixed on the basis of expected profit.

iii. Going Rate Pricing:

Implies a method in which an organization sets the price of a product according to the prevailing price trends in the market. Thus, the pricing strategy adopted by the organization can be same or similar to other organizations. However, in this type of pricing, the prices set by the market leaders are followed by all the organizations in the industry.

iv. Transfer Pricing:

Involves selling of goods and services within the departments of the organization. It is done to manage the profit and loss ratios of different departments within the organization. One department of an organization can sell its products to other departments at low prices. Sometimes, transfer pricing is used to show higher profits in the organization by showing fake sales of products within departments.

Limitations of Cost plus pricing:-

1. Ignores competition – A company may set a product price based on the cost plus formula and then be surprised when it finds that competitors are charging substantially different prices. This has a huge impact on the market share and profits that a company can expect to achieve. The company either ends up pricing too low and giving away potential profits, or pricing too high and achieving minor revenues .

2. Product cost overruns – Under this method, the engineering department has no incentive to prudently design a product that has the appropriate feature set and design characteristics for its target market. Instead, the department simply designs what it wants and launches the product.

3. Contract cost overruns – From the perspective of any government entity that hires a supplier under a cost plus pricing arrangement, the supplier has no incentive to curtail its expenditures – on the contrary, it will likely include as many costs as possible in the contract so that it can be reimbursed. Thus, a contractual arrangement should include cost-reduction incentives for the supplier.

4. Ignores replacement costs – The method is based on historical costs , which may have subsequently changed. The most immediate replacement cost is more representative of the costs incurred by the entity.

4(a) What is inflation ? Discuss about the impact of inflation on

– Different types of income groups

– Social-political environment.

-> 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.

Impact of inflation on different types of income groups:-

The impact of inflation is felt unevenly by the different groups of individuals within the national economy—some groups of people gain by making big fortune and some others lose.

We may now explain in detail the effects of inflation on different groups of people:

(a) Creditors and debtors:

During inflation creditors lose because they receive in effect less in goods and services than if they had received the repayments during a period of low prices. Debtors, on other hand, as a group gain during inflation, since they repay their debts in currency that has lost its value (i.e., the same currency unit will now buy less goods and services).

(b) Producers and workers:

Producers gain because they get higher prices and thus more profits from the sale of their products. As the rise in prices is usually higher than the increase in costs, producers can earn more during inflation. But, workers lose as they find a fall in their real wages as their money wages do not usually rise proportionately with the increase in prices. They, as a class, however, gain because they get more employment during inflation.

(c) Fixed income-earners:

Fixed income-earners like the salaried people, rent-earners, landlords, pensioners, etc., suffer greatly because inflation reduces the value of their earnings.

(d) Investors:

The investors in equity shares gain as they get dividends at higher rates because of larger corporate profits and as they find the value of their shareholdings appreciated. But the bondholders lose as they get a fixed interest the real value of which has already fallen.

(e) Traders, speculators, businesspeople and black-marketers:

They gain because they make more profits from the persistent rise in prices.

(f) Farmers:

Farmers also gain because the rise in the prices of agricultural products is usually higher than the increase in the prices of other goods. Thus, inflation brings a shift in the pattern of distribution of income and wealth in the country, usually making the rich richer and the poor poorer. Thus during inflation there is more and more inequality in the distribution of income.

Impact of inflation on Social-political environment:-

Inflation is generally termed as “increase in prices and fall in the purchasing value of money.”

However, this increase in price part is something the result of fall in purchasing value of money, which in-turn is an outcome of many fundamental factors, namely GDP, employment, trade relations, geo-political pressure in the economy etc.

Coming to the point, Inflation does cut the value of money and that’s the main economic effect of it which majority of central-bankers rush to control.

While higher inflation is too harmful to the economy, too low a level of inflation may not heat up the economy to the level desirable for full employment.

Hence, you need a moderate level of inflation to sustain the economy and that moderate level could be known after years of study.

In case of social impact, price-rise may hurt more to the middle and lower sections of the society than the rest and their life sometimes become too tough to live.

(b) Explain the following-

(i) Innovation theory of business cycle

-> The innovation theory of a trade cycle is propounded by J.A. Schumpeter. He regards innovations as the originating cause of trade cycles. The term “innovation” should not be confused with inventions. Inventions, in ordinary parlance, are discoveries of scientific novelties. Innovation is the application of such inventions to actual production (i.e., exploiting them).

It is innovations that are subject to cyclical fluctuations, not inventions. Innovation, thus, in economics means the commercial application of inventions like new techniques of production, new methods of organisation, novel products, etc.

Schumpeter regards trade cycles as the offspring of economic progress in a capitalist society. Cyclical fluctuations are inherent in the economic process of industrial production. When there are internal changes taking place on account of innovation, the development process begins.

Schumpeter classifies innovation into five categories as follows:-

(i) Introduction of new type of goods.

(ii) Introduction of new methods of production.

(iii) Opening of new markets.

(iv) Discovering of new sources of raw materials.

(v) Change in the organisation of an industry, like the creation of a monopoly, trust, or cartel or breaking up of a monopoly, cartel, etc.

Innovation, however, does not arise spontaneously. It must be actively promoted by some agency in the economic system. Such an agent, according to Schumpeter, is an “entrepreneur”, entrepreneurs are innovators.

To carry cut his innovative function, the entrepreneur needs two things. First, he must have the technical knowledge to produce new products or new services. Second, since the introduction of innovation presupposes the diversion of the means of production from the existing to new channels, the entrepreneur must also possess the power of disposal over the factors of production.

The necessary command over the productive factor is provided by the monetary factor in the form of credit. The entrepreneur secures funds for his project not from saving out of his own income but from the crediting bank system.

Thus, money capital and bank credit play a significant role in the Schumpeterian theory. According to Schumpeter, credit is important only in so far as the innovation is concerned in the context of a progressing economy, and only if the innovator requires credit to carry on his function, i.e., innovative activity. In the absence of innovation, in a circular flow of money economy, where Say’s Law of Market operates into, no credit is required.

The strategic factors in the Schumpeterian theory are:

(i) Innovations

(ii) Entrepreneurs.

Innovations brought about by entrepreneurs disturb the circular flow of stationary economy, so the development is a dynamic, discontinuous, cyclical process.

Schumpeter attributes the swarm-like appearance of entrepreneurs to the cyclical nature of economic progress. In his view, the cyclical upswing starts when entrepreneurs start investing in the commercial applications of their innovative ideas.

This may start gradually when a few leading entrepreneurs with drive come into the field But once these few innovators have demonstrated the profitability of their ventures, others will imitate and follow suit. With a few leaders smoothening the path, the original innovators are soon followed by a swarm-like appearance of entrepreneurial activity.

Schumpeter assumes that innovating activity is helped by the banking systems’ readiness to give credit. The “swarm-like” appearance of entrepreneurial activity naturally raises the volume of investment which in turn raises income, employment and output. Thus, the prosperity phase gathers momentum and the economy moves up, away from the neighbourhood of equilibrium.

In short, the clustering of innovations creates a discontinuous disturbance in the economy. It will lead to an overwhelming outflow of new products when all these innovations are beginning to have their full effect. When the market is flooded with new products, their prices fall and profit margins decline. On the other hand, the credit-financed innovations bid up the factor prices and so the costs of production rise.

New innovations will now cease. Hence prosperity will end and recession begins. At this stage, credit deflation also ensues with the persistent tendency of new firms to utilise the sales receipts of their new products to repay their bank loans. This tends to put the old firms in a difficult position of readjustment and adaptation.

For, when credit deflation sets in, the flow of money stream into the economy will slacken hence the demand for revenues of the old firms, making their position still more awkward; so the recession is aggravated further. Schumpeter describes this process as “auto-deflation” implying thereby that commercial banks play only a passive role in the process.

The recession in the economic system is caused by the stoppage of innovations and the slackening of entrepreneurial activity. He stresses that innovations halt not because there is lack of inventions, but because the economic environment is not favourable for further innovation.

When there is overproduction in the prosperity period, general prices decline, reducing the profit margins. The disappearance of profit margins of new investment makes innovations financially unattractive.

Further, during an economic crisis, expectations are dampened under conditions of uncertainty. Since the clustering of innovations in the prosperity period had led the economy to a very dis-equilibrated state, all values and estimates in the system change now. This makes the accurate planning of new investments extremely difficult. So, the economic situation so developed acts as a deterrent to the planning and formation of new enterprises.

However, Schumpeter’s theory of trade cycles is imperfect.

It suffers from many drawbacks such as:

(i) His theory is highly institutional: it requires the existence of a typical institutional framework of society for its validity. He considers entrepreneurs as mere innovators. Further, he overemphasises the role of the entrepreneur, thereby creating a very strong personal element in the path of industrial progress.

(ii) Schumpeter attributes trade cycles to the phenomenon of innovations only. But, the trade cycle being a complex phenomenon cannot be attributed to a single factor alone.

(iii) Schumpeter unrealistically assumes that innovations are financed solely by means of bank credit. They must be financed out of voluntary savings. Moreover, major innovations generally require long-term credit, whereas the banking system usually grants only short-term loans.

(b)(ii) Depression phase of business cycle

-> The term depression usually means an economic downturn that is longer lasting and more severe than the more frequently occurring recessions. Sometimes, to define the term more formally, a depression is said to begin when GDP declines more than 10% from the most recent economic peak. By this criterion, the last two real depressions in the United States occurred in these periods:

§ From 1929 to 1933—the Great Depression—when the US GDP nearly 33% and unemployment rose to 25%.

§ In 1937-38, where GDP declined by more than 18%, and unemployment reached 19%.

By contrast, US GDP declined at most 5% in the severe recession of 1973-75.

In general, periods of economic depression are manifest substantially reduced GDP, as well as severely high rates of unemployment, foreclosures, business closures, as well as significantly reduced wholesale and retail sales activity.

A depression is a severe and prolonged downturn in economic activity. In economics, a depression is commonly defined as an extremerecession that lasts three or more years or leads to a decline in real gross domestic product (GDP) of at least 10 percent.

In times of depression, consumer confidence and investments decrease, causing the economy to shut down. Economic factors that characterize a depression include:

Ø Substantial increases in unemployment

Ø A drop in available credit

Ø Diminishing output

Ø Bankruptcies

Ø Sovereign debt defaults

Ø Reduced trade and commerce

Ø Sustained volatility in currency values

Depression (also known as trough) is an economics term referring to the stage of business cycle in which a regional or world economy operates at its lowest level. Depression is one of the four stages of a business cycle. It is preceded by recession stage and succeeded by recovery stage.

Depression is characterized by low trade and commerce, high rate of unemployment, decline in real GDP, low incomes and investment, sovereign debt defaults, reduced credit availability, bankruptcies including bank failures. In some depressions, price deflation may also be observed.

There are no well-defined boundaries of depression in time. Some economists consider depression simply an extreme form of recession. However, in context of business cycle, these are two different stages. Recession morphs into depression and depression then morphs into expansion (or recovery) stage. In some cases, depression is limited to a region and in other cases it occurs worldwide.


Ø Notable examples of economic depression are the Great Depression (1929-1930) and the Long Depression (1876-1896) (formerly known as the Great Depression)

Ø There have been numerous other economic depressions which were either small in magnitude or were limited to few nations. For example, Soviet Russia was hit by very severe depression in 1990s. 2010s depression in Greece is one of the most recent examples.

Ø A depression is a severe and prolonged downturn in economic activity characterized by a sharp fall in employment and production.

Ø Depressions are much more severe and prolonged than recessions. In general, they are identified as either lasting more than three years or resulting in a decline of real gross domestic product (GDP) of at least 10 percent.

Ø The U.S. economy has experienced many recessions but just one major economic depression: The Great Depression of the 1930s.

5. Write short notes on:-

(a) Fiscal policy

-> 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.

(b) Characteristics of perfect competition.

-> A Perfect Competition market is that type of market in which the number of buyers and sellers is very large; all are engaged in buying and selling a homogeneous product without any artificial restrictions and possessing perfect knowledge of the market at a time.

In other words it can be said—”A market is said to be perfect when all the potential buyers and sellers are promptly aware of the prices at which the transaction take place. Under such conditions the price of the commodity will tend to be equal everywhere.”

In this connection Mrs. Joan Robinson has said —”Perfect Competition prevails when the demand for the output of each producer is perfectly elastic.”

According to Boulding—”A Perfect Competition market may be defined as a large number of buyers and sellers all engaged in the purchase and sale of identically similar commodities, who are in close contact with one another and who buy and sell freely among themselves.”

Characteristics of Perfect Competition:

The following characteristics are essential for the existence of Perfect Competition:

1. Large Number of Buyers and Sellers:

The first condition is that the number of buyers and sellers must be so large that none of them individually is in a position to influence the price and output of the industry as a whole. In the market the position of a purchaser or a seller is just like a drop of water in an ocean.

2. Homogeneity of the Product:

Each firm should produce and sell a homogeneous product so that no buyer has any preference for the product of any individual seller over others. If goods will be homogeneous then price will also be uniform everywhere.

3. Free Entry and Exit of Firms:

The firm should be free to enter or leave the firm. If there is hope of profit the firm will enter in business and if there is profitability of loss, the firm will leave the business.

4. Perfect Knowledge of the Market:

Buyers and sellers must possess complete knowledge about the prices at which goods are being bought and sold and of the prices at which others are prepared to buy and sell. This will help in having uniformity in prices.

5. Perfect Mobility of the Factors of Production and Goods:

There should be perfect mobility of goods and factors between industries. Goods should be free to move to those places where they can fetch the highest price.

6. Absence of Price Control:

There should be complete openness in buying and selling of goods. Here prices are liable to change freely in response to demand and supply conditions.

7. Perfect Competition among Buyers and Sellers:

In this purchasers and sellers have got complete freedom for bargaining, no restrictions in charging more or demanding less, competition feeling must be present there.

8. Absence of Transport Cost:

There must be absence of transport cost. In having less or negligible transport cost will help complete market in maintaining uniformity in price.

9. One Price of the Commodity:

There is always one price of the commodity available in the market.

10. Independent Relationship between Buyers and Sellers:

There should not be any attachment between sellers and purchasers in the market. Here, the seller should not show pick and choose method in accepting the price of the commodity. If we will see from the close we will find that in real life “Perfect Competition is a pure myth.”

(c) Market economy and invisible hands.

-> Market economy– A market economy is a system where the laws of supply and demand direct the production of goods and services. Supply includes natural resources , capital, and labour. Demand includes purchases by consumers, businesses, and the government.

Businesses sell their wares at the highest price consumers will pay. At the same time, shoppers look for the lowest prices for the goods and services they want. Workers bid their services at the highest possible wages that their skills allow. Employers seek to get the best employees at the lowest possible price.

Capitalism requires a market economy to set prices and distribute goods and services. Socialism and communism need a command economy to create a central plan that guides economic decisions. Market economies evolve from traditional economies. Most societies in the modern world have elements of all three types of economies. That makes them mixed economies . Characteristics of a Market Economy

The following six characteristics define a market economy.1

1. Private Property . Most goods and services are privately-owned. The owners can make legally-binding contracts to buy, sell, or lease their property. Their assets give them the right to profit from ownership. There are some assets U.S. law excludes. Since 1865, you cannot legally buy and sell human beings. That includes you, your body, and your body parts.

2. Freedom of Choice . Owners are free to produce, sell, and purchase goods and services in a competitive market. They only have two constraints. First is the price at which they are willing to buy or sell. Second is the amount of capital they have.

3. Motive of Self-Interest . Everyone sells their wares to the highest bidder while negotiating the lowest price for their purchases. Although the reason is selfish, it benefits the economy over the long run. This auction system sets prices for goods and services that reflect their market value. It gives an accurate picture of supply and demand at any given moment.

4. Competition . The force of competitive pressure keeps prices low. It also ensures that society provides goods and services most efficiently. As soon as demand increases for a particular item, prices rise thanks to the law of demand . Competitors see they can enhance their profit by producing it, adding to supply. That lowers prices to a level where only the best competitors remain. This competitive pressure also applies to workers and consumers. Employees vie with each other for the highest-paying jobs. Buyers compete for the best product at the lowest price. There are three strategies that work to maintain a competitive advantage .

5. System of Markets and Prices . A market economy relies on an efficient market in which to sell goods and services. That’s where all buyers and sellers have equal access to the same information. Price changes are pure reflections of the laws of supply and demand. There are five determinants of demand .

6. Limited Government . The role of government is to ensure that the markets are open and working. For example, it is in charge of national defence to protect the markets. It also makes sure that everyone has equal access to the markets. The government penalizes monopolies that restrict competition. It makes sure no one is manipulating the markets and that everyone has equal access to information.

Four Advantages of a Market Economy

Since a market economy allows the free interplay of supply and demand, it ensures that the most desired goods and services are produced. Consumers are willing to pay the highest price for the things they want the most. Businesses will only create those things that return a profit.

Second, goods and services are produced in the most efficient way possible. The most productive companies will earn more than less productive ones.

Third, it rewards innovation. Creative new products will meet the needs of consumers in better ways that existing goods and services. These cutting-edge technologies will spread to other competitors so they, too, can be more profitable. This illustrates why Silicon Valley is America’s innovative advantage.

Fourth, the most successful businesses invest in other top-notch companies. That gives them a leg up and leads to increased quality of production.

The Disadvantages of a Market Economy

The key mechanism of a market economy is competition. As a result, it has no system to care for those who are at an inherent competitive disadvantage. That includes the elderly, children, and people with mental or physical disabilities.

Second, the caretakers of those people are at a disadvantage. Their energies and skills go toward caretaking, not competing. Many of these people might become contributors to the economy’s overall comparative advantage if they weren’t caretakers.

That leads to the third disadvantage. The human resources of society may not be optimized. For example, a child who might otherwise discover the cure for cancer might instead work at McDonald’s to support her low-income family.

Fourth, society reflects the values of the winners in the market economy. A market economy may produce private jets for some while others starve and are homeless. A society based on a pure market economy must decide whether it’s in its larger self-interest to care for the vulnerable.

Invisible hands- The invisible hand describes the unintended social benefits of an individual’s self-interested actions, a concept that was first introduced by Adam Smith in The Theory of Moral Sentiments , written in 1759, invoking it in reference to income distribution.

By the time he wrote The Wealth of Nations in 1776, Smith had studied the economic models of the French Physiocrats for many years, and in this work the invisible hand is more directly linked to production, to the employment of capital in support of domestic industry. The only use of “invisible hand” found in The Wealth of Nations is in Book IV, Chapter II, “Of Restraints upon the Importation from foreign Countries of such Goods as can be produced at Home.” The exact phrase is used just three times in Smith’s writings .

Smith may have come up with the two meanings of the phrase from Richard Cantillon who developed both economic applications in his model of the isolated estate.

The idea of trade and market exchange automatically channelling self-interest toward socially desirable ends is a central justification for the laissez-faire economic philosophy, which lies behind neoclassical economics . In this sense, the central disagreement between economic ideologies can be viewed as a disagreement about how powerful the “invisible hand” is. In alternative models, forces which were nascent during Smith’s lifetime, such as large-scale industry, finance , and advertising, reduce its effectiveness.

Interpretations of the term have been generalized beyond the usage by Smith

The unobservable market force that helps the demand and supply of goods in a free market to reach equilibrium automatically is the invisible hand.

The phrase invisible hand was introduced by Adam Smith in his book ‘The Wealth of Nations’. He assumed that an economy can work well in a free market scenario where everyone will work for his/her own interest.

He explained that an economy will comparatively work and function well if the government will leave people alone to buy and sell freely among them. He suggested that if people were allowed to trade freely, self interested traders present in the market would compete with each other, leading markets towards the positive output with the help of an invisible hand.

In a free market scenario where there are no regulations or restrictions imposed by the government, if someone charges less, the customer will buy from him. Therefore, you have to lower your price or offer something better than your competitor. Whenever enough people demand something, it will be supplied by the market and everyone will be happy. The seller end up getting the price and the buyer will get better goods at the desired price.

(d) Distinction among plant, firm and industry.

-> Plant

A plant in terms of business is a particular facility that is used to manufacture a product or produce the substance etc in question for a company or business. A plant will usually have a plant manager whom is responsible for the manufacturing process to run smoothly. They implement the most effective system for producing the product in a comfortable and steady manner. They also are responsible for overseeing and organizing meetings as well as goals that the company is aiming for in terms of production.


A firm refers to a group or organization that focuses on producing goods and services to trade or to sell to consumers. A firm is another name for business so while the plant is a specific facility, a firm is the business that needs to the facility to produce their goods. The majority of firms are privately owned and are created to produce mass profit however; there are a number of non-profit organizations.


An industry is used to refer to the wider spectrum in the sense that it is a certain part of the economy that contains a number of firms. For example, one particular industry is the beauty industry. Therefore, the beauty industry will have a number of various firms such as L’Oreal or Revlon, and they in turn will have plant facilities that are used to create their products.

(e) Forms of price discrimination.

-> Price discrimination refers to the charging of different prices by the monopolist for the same product.

The difference in the product may be on the basis of brand, wrapper etc. This policy of the monopolist is called price discrimination.

Types of Discriminating Monopoly:

Price discrimination is of following three types:

1. Personal Price Discrimination:

Personal price discrimination refers to the charging of different prices from different customers for the same product. For example, a doctor charges different fees for the same operation from rich and poor patients.

2. Geographical Price Discrimination:

Under geographical price discrimination, the monopolist charges different prices in different markets for the same product. It also includes dumping where a producer may sell the same commodity at one price at home and at the other price abroad.

3. Price Discrimination according to Use:

When the monopolist charges different prices for the different uses of the same commodity is called the price discrimination according to use.

Conditions for Price Discrimination:

For price discrimination to exist, it requires the basic conditions.

These are:

1. Difference in Elasticity of Demand:

Price discrimination is possible only when elasticity of demand will be different in different markets. The monopolist will fix higher price where demand is inelastic and low price where the demand will be elastic. In this way, he will be able to increase his total revenue.

2. Market Imperfections:

Generally, price discrimination is possible only when there is some degree of market imperfections. The individual seller is able to divide his market into separate parts only if it is imperfect.

3. Differentiated Product:

Price discrimination is possible when buyers need the same service in connection with differentiated products. For example, railways charges different rates for the transport of coal and copper.

4. Legal Sanction:

In some cases price discrimination is legally sanctioned. As, Electricity Board charges lowest for electricity for domestic use and highest for commercial houses.

5. Monopoly Existence:

Price discrimination is also called discrimination monopoly. It is evident that price discrimination is possible only under conditions of monopoly.

Degree of Price Discrimination:

Prof. A.C. Pigou has given the following three degrees of discriminating monopoly:

1. Price Discrimination of First Degree:

Price discrimination of first degree is said to exist when the monopolist is able to sell each separate unit of his product at different prices. It is also known as the perfect price discrimination. In case of first degree price discrimination, a seller charges a price equal to what the consumer is willing to pay. It means the seller leaves no consumer’s surplus with the consumer. Apart from above, under perfect price discrimination the demand curve of the buyer, like under simple monopoly, becomes the marginal revenue curve of the seller.

2. Price Discrimination of Second Degree:

In the price discrimination of second degree buyers are divided into different groups and from different groups a different price is charged which is the lowest demand price of that group. This type of price discrimination would occur if each individual buyer had a perfectly in- elastic demand curve for good below and above a certain price.

3. Price Discrimination of Third Degree:

Price discrimination of third degree is said to exist when the seller divides his buyers into two or more than two sub markets and from each group a different price is charged. The price charged in each sub-market depends on the output sold in that sub-market along with demand conditions of that sub-market. In the real world, it is the third degree price discrimination which exists.

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