Full Marks – 80
Time – Three Hours
The figures in the margin indicate full marks for the questions.
1(a) Discuss Baumol’s Revenue Maximisation Theory emphasising upon its practical implications on managerial decision making.
-> Baumol’s Managerial Theory of Sales Revenue Maximization:-
I. Rationalisation of the Sales Maximisation Hypothesis:
Baumol offers several justifications of sales maximisation as a goal of the firm.
The separation of ownership from management, characteristic of the modern firm, gives discretion to the managers to pursue goals which maximise their own utility and deviate from profit maximisation, which is the desirable goal of owners.
Given this discretion, Baumol argues that sales maximisation seems the most plausible goal of managers. From his experience as a consultant to large firms Baumol found that managers are preoccupied with maximisation of the sales rather than profits. Several reasons seem to explain this attitude of the top management.
Firstly, there is evidence that salaries and other (slack) earnings of top managers are correlated more closely with sales than with profits.
Secondly, the banks and other financial institutions keep a close eye on the sales of firms and are more willing to finance firms with large and growing sales.
Thirdly, personnel problems are handled more satisfactorily when sales are growing. The employees at all levels can be given higher earnings and better terms of work in general. Declining sales, on the other hand, will make necessary the reduction of salaries and other payments and perhaps the lay-off of some employees. Such measures create dissatisfaction and uncertainty among personnel at all levels.
Fourthly, large sales, growing over time, give prestige to the managers, while large profits go into the pockets of shareholders.
Fifthly, managers prefer a steady performance with ‘satisfactory’ profits to spectacular profit maximisation projects. If they realize maximum high profits in one period, they might find themselves in trouble in other periods when profits are less than maximum.
Sixthly, large, growing sales strengthen the power to adopt competitive tactics, while a low or declining share of the market weakens the competitive position of the firm and its bargaining power vis-a-vis its rivals.
The desire for a steady performance with satisfactory profits, coupled with the separation of ownership and management, tend to make the managers reluctant to adopt promising projects which are risky. The top managers become to a certain extent risk- avoiders, and this attitude may act as a curb on economic growth. However, the desire for steady performance has a stabilizing effect on economic activity.
In general, large firms have research units which develop new ideas of products or techniques of production. The application of these projects is spread over time so as to avoid wide swings in the economic performance of the firm. Baumol seems to imply that the risk-avoidance and the desire for steady growth of the large corporations-secure ‘orderly markets’, in the sense that they have stabilizing effects on the economy.
II. Interdependence and Oligopolistic Behaviour:
Although Baumol recognises the interdependence of firms as the main feature of oligopolistic markets, he argues that in ‘day-to-day decision-making management often acts explicitly or implicitly on the premise that its decisions will produce no changes in the behaviour of those with whom they are competing . It is only when the firm makes ‘more radical decisions, such as the launching of a major advertising campaign or the introduction of a radically new line of products, that management usually does consider the probable competitive response. But often, even in fairly crucial decisions, and almost always in routine policy-making, only the most cursory attention is paid to competitive reactions’.
This attitude towards competitors attributed by Baumol to several reasons:
The complexity of the internal organisation of large firms renders decision-making a lengthy process: proposals originate from some sections, but final decisions are taken by top management after these proposals have passed through various levels of management and often from different departments. It is a characteristic inherent in the delegation of authority within the firm that each decision-maker will attempt to shift the responsibility on to others. Thus any reaction of competitors is bound to take place after ‘a considerable time lag’.
Large organisations work to a ‘blue-print’ which includes a variety of rules of thumb, which simplify complicated problems such as pricing, size of advertising expenditure, level of inventories. Prices are set by applying a standard mark-up to costs, advertising expenses are determined by setting aside a fixed percentage of total revenues, inventories are determined as a percentage of sales, and so on. Such rules of thumb clearly do not automatically take into account the actions of competitors, and the adaptation of the ‘blue-print’ of a firm to a new environment takes time.
The desire of top management for a ‘quiet life’ has led large enterprises to some tacit collusion firms depend on each other to behave in an ‘orderly’ way. They expect no ‘breach of etiquette’ in the established order in the industry as a whole. However, the above reasons do not imply that businessmen are completely indifferent to actions of competitors. In particular, being sales maximisers and growth seekers, they are very alert to any change in their share of the market. Top management will ignore competitors only to the extent that their actions do not encroach on the firm’s market and do not interfere with the desired rate of growth of the sales of the firm.
III. Baumol’s Static Models:
The basic assumptions of the static models:
1. The time-horizon of a firm is a single period.
2. During this period the firm attempts to maximise its total sales revenue (not physical volume of output) subject to a profit constraint. The firm in these models does not consider what will happen in subsequent periods as a result of the decisions taken in the current period.
3. The minimum profit constraint is exogenously determined by the demands and expectations of the shareholders, the banks and other financial institutions. The firm must realize a minimum level of profits to keep shareholders happy and avoid a fall of the prices of shares on the stock exchange. If profits are below this exogenously determined minimum acceptable level the managers run the risk of being dismissed, since shareholders may sell their shares and take-over raiders may be attracted by a fall of the prices of shares.
4. ‘Conventional’ cost and revenue functions are assumed. That is, Baumol accepts that cost curves are U-shaped and the demand curve of the firm is downward-sloping.
We will examine four models:
(1) A single-product model, without advertising.
(2) A single-product model, with advertising.
(3) A multiproduct model, without advertising.
(4) A multiproduct model, with selling activities.
Model 1: a single-product model, without advertising:
The total-cost and total-revenue curves under the above assumptions are shown in figure. Total sales revenue is at its maximum level at the highest point of the TR curve, where the price elasticity of demand is unity and the slope of this TR curve (the marginal revenue) is equal to zero.
Whether this maximum sales revenue will be realized or not depends on the level of the minimum acceptable level of profit which may act as a constraint to the activity of the firm. If the firm were a profit maximise, it would produce the level of output Xnm. However, in Baumol’s model the firm is sales maximise, but it must also earn a minimum level of profit acceptable to shareholders and to those who finance its operations.
If the minimum acceptable level of profit is Π1, the firm will produce the level of output XSm which maximises its sales revenue. With this level of output (XSm) the firm earns profits ΠSm, which are greater than the minimum required to keep the stockholders (and other interested parties) satisfied. Under these circumstances we say that the minimum profit constraint is not operative.
If the minimum acceptable profit is Π2, the firm will not be able to attain the maximum sales revenue because the profit constraint is operative, and the firm will produce Xs units of output, which are less than at the level XSm.
In summary… two types of equilibrium appear to be possible one in which the profit constraint provides no effective barrier to sales maximisation (XSm units of output with a minimum acceptable profit of Π 1), and one in which it does (XS units of output with a minimum acceptable profit of Π2)’. (W. J. Baumol, Business Behaviour, Value and Growth. The firm is assumed to be able to pursue an independent price policy, that is, to set its price so as to achieve its goal of sales maximisation (given the profit constraint) without being concerned about the reactions of competitors.
Model 2: A single-product model, with advertising:
The Assumptions of the Model:
As in the previous model the goal of the firm is sales revenue maximisation subject to a minimum profit constraint which is exogenously determined. The new element in this model is the introduction of advertising as a major instrument (policy variable) of the firm. Baumol argues that in the real world non-price competition is the typical form of competition in oligopolistic markets. The model presented by Baumol treats explicitly advertising, but other forms of non-price competition (product change, service, quality, etc.) may be analysed on similar lines.
The crucial assumption of the advertising model is that sales revenue increases with advertising expenditure (that is, ∂R/∂a > 0, where a = advertising expenditure). This implies that advertising will always shift the demand curve of the firm to the right and the firm will sell a larger quantity and earn a larger revenue. The price is assumed to remain constant. This, however, is a simplifying assumption which may be relaxed in a more general analysis.
Another simplifying assumption is that production costs are independent of advertising. Baumol recognizes that this is an unrealistic assumption, since with advertising the physical volume of output increases and the firm might move to a cost structure where production cost is different (increasing or decreasing). But he claims that this assumption is simplifying and can be relaxed without substantially altering the analysis. (In fact Baumol relaxes this assumption, as well as the assumption of constant price in the mathematical presentation of his model; see below.) From the above assumptions the following inferences can be drawn.
A firm in an oligopolistic market will prefer to increase its sales by advertising rather than by a cut in price. While an increase in physical volume induced by a price cut may or may not increase the sales revenue, depending on whether demand is elastic or inelastic, an increase in volume brought about by an increase in advertising will always increase sales revenue, since by assumption the marginal revenue of advertising is positive (∂R/∂a > 0).
With advertising introduced into the model, it is no longer possible to have an equilibrium where the profit constraint is not operative. While with price competition alone it is possible to reach an equilibrium (that is, maximise sales) where Π is not operative, with non-price competition such an unconstrained equilibrium is impossible. Unlike a price reduction, increased advertising always increases sales revenue.
Consequently it will always pay the sales maximiser to increase his advertising expenditure until he is stopped by the profit constraint. Consequently the minimum profit constraint is always operative when advertising (or any other form of non-price competition) is introduced in the model.
The sales maximise will normally have higher advertising expenditures than a profit maximiser. In any case advertising cannot be less in a sales-maximising model. Baumol’s single-product model with advertising is shown in figure. Advertising outlay is measured on the horizontal axis and the advertising function is shown as a 45 line. Costs, total revenue and profits are measured on the vertical axis. Production costs are shown as being independent of the level of advertising (curve CC’). If these costs are added to the advertising cost line we obtain the total-cost curve (TC) as a function of advertising outlay. Subtracting the total cost from the total revenue at each level of output we obtain the total-profit curve Π.
The interrelationship between output and advertising and in particular the (assumed) positive marginal revenue of advertising permits us to see clearly that an unconstrained sales maximisation is (ordinarily) not possible. If price is such as to enable the firm to sell an output yielding profits above their minimum acceptable level, it will pay the firm to increase advertising and reach a higher level of sales revenue. The advertising outlay of the sales maximiser (0As) is higher than that of the profit maximiser (0AΠ), and the profit constraint (Π) is operative at equilibrium.
It should be stressed that the validity of this model rests on the crucial assumption that advertising always increases sales revenue. Baumol assumes that ∂R/∂a > 0, but does not establish the implied positive relation between total revenue and advertising. In particular Baumol does not examine explicitly the interrelationship between advertising, price, cost of production and level of output.
If total production costs are independent of advertising, (that is, production costs remain constant after advertising takes place) as Baumol assumes, this implies that total output X will remain constant after advertising has taken place; consequently an increase in sales revenue R, given X, can be attained only if P is raised. This case is in fact implied in figure 15.5, reproduced from Baumol’s book.
However, this is inconsistent with what Baumol states elsewhere (p. 60), that ‘unlike a price reduction a ceteris paribus rise in advertising expenditure involves no change in the market value of the item sold’. This statement implies clearly that advertising will not change the price. Hence Baumol implies that the increase in revenue will be attained from an increase in the volume X. But then production costs will increase, since MC is always positive.
In short, Baumol’s graphical representation of his model is inconsistent with his statements. In particular the price implications of a change in advertising are not obvious in Baumol’s analysis. Sandmeyer, Haveman and DeBartolo, and Kafoglis and Bushnell have highlighted this deficiency of Baumol’s model. They suggested that with advertising expenditures the TR curve will shift and in the new equilibrium revenue will be higher and advertising expenditure will be higher (consistent with Baumol).
However, output may be lower and price higher in the new equilibrium, depending on the shift and the elasticity of the demand curve following advertising, as well as on the cost conditions of the firm. This situation has not been explicitly envisaged by Baumol, whose model has been interpreted as implying that all ‘excess’ profit will be devoted to advertising and that, therefore, the increase in revenue will accrue from an increase in output resulting from the shift of the demand curve following advertising.
However, Baumol’s mathematical model allows for the possibility of a change in price as well as of advertising and output. Haveman and DeBartolo have presented a model which they call ‘generalized Baumol model’. In their model price, cost, output and advertising expenditure are all free to vary. We will first present graphically their model as modified by M. Kafoglis and R. Bushnell and by C. J. Hawkins. We will next present their model mathematically and will point out that actually their model is identical to Baumol’s mathematical presentation of his advertising model.
The cost curves. It is assumed that:
(a) Production costs vary proportionally with output. Thus the total production cost function is a straight (positively-sloping) line through the origin.
(b) Advertising expenditure may change but is independent of the level of output. Thus a given level of advertising is presented by a straight line parallel to the X-axis. Higher advertising levels are shown by parallel lines which are further away from the X-axis,
(c) The minimum profit constraint is exogenously determined and is denoted by a line parallel to the X-axis.
Model 3: Multiproduct firm, without advertising:
If we assume that the firm has a given amount of resources (and given costs C) and wants to allocate them among the various commodities it produces so as to maximise sales revenue, it will reach the same equilibrium solution as the profit maximise, that is, it will produce the same quantities of the various products as if it were a profit maximise. Formally, the condition for the equilibrium of the multiproduct firm (with given resources and costs) is
which reads the firm is in equilibrium when the ratio of the marginal revenue from any two commodities (i and j) is equal to the ratio of their marginal costs.
We may present the above solution graphically, assuming for simplicity that the firm produces two commodities, y and x. It involves the tools of the product transformation curve and of its revenue curves.
(b) Draw distinctive focus upon the scope of micro and macro economics in managerial decision making.
-> Managerial economics generally refers to the integration of economic theory with business practice. Economics provides tools managerial economics applies these tools to the management of business. In simple terms, managerial economics means the application of economic theory to the problem of management. Managerial economics may be viewed as economics applied to problem solving at the level of the firm.
It enables the business executive to assume and analyse things. Every firm tries to get satisfactory profit even though economics emphasises maximizing of profit. Hence, it becomes necessary to redesign economic ideas to the practical world. This function is being done by managerial economics.
Nature of Managerial Economics:
Managerial economics is a science applied to decision making. It bridges the gap between abstract theory and managerial practice. It concentrates more on the method of reasoning. In short, managerial economics is “Economics applied in decision making”.
Managerial economics is supposed to enrich the conceptual and technical skill of a manager. It is concerned with economic behaviour of the firm. It concentrates on the decision process, decision model and decision variables at the firm level. It is the application of economic analysis to evaluate business decisions.
The primary function of a manager in business organisation is decision making and forward planning under uncertain business conditions. Some of the important management decisions are production decision, inventory decision, cost decision, marketing decision, financial decision, personnel decision and miscellaneous decisions. One of the hallmarks of a good executive is the ability to take quick decision. He must have the clarity of goals, use all the information he can get, weigh pros and cons and make fast decisions.
The decisions are taken to achieve certain objectives. Objectives are the motivating factors in taking decision. Several acts are performed to attain the objectives quantitative techniques are also used in decision making. But it may be noted that acts and quantitative techniques alone will not produce desirable results. It is important to remember that other variables such as human and behavioural considerations, technological forces and environmental factors influence the choices and decisions made by managers.
Scope of Marginal Economics:
Managerial Economics is a developing subject. The scope of managerial economics refers to its area of study. Managerial economics has its roots in economic theory. The empirical nature of managerial economics makes its scope wider. Managerial economics provides management with strategic planning tools that can be used to get a clear perspective of the way the business world works and what can be done to maintain profitability in an ever changing environment.
Managerial economics refers to those aspects of economic theory and application which are directly relevant to the practice of management and the decision making process within the enterprise. Its scope does not extend to macro-economic theory and the economics of public policy which will also be of interest to the manager. While considering the scope of managerial economics we have to understand whether it is positive economics or normative economics.
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.
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.
Relation to Other Branches of Knowledge:
A useful method of throwing light on the nature and scope of managerial economics is to examine its relationship with other disciplines. To classify the scope of a field of study is to discuss its relation to other subjects. If we take the subject in isolation, our study would not be useful. Managerial economics has a close linkage with other disciplines and fields of study.
The subject has gained by the interaction with economics, mathematics and statistics and has drawn upon management theory and accounting concepts. The managerial economics integrates concepts and methods from these disciplines and bringing them to bear on managerial problems.
Managerial Economics and Economics:
Managerial Economics has been described as economics applied to decision making. It may be studied as a special branch of economics, bridging the gap between pure economic theory and managerial practice. Economics has two main branches—micro-economics and macro-economics.
‘Micro’ means small. It studies the behaviour of the individual units and small groups of such units. It is a study of particular firms, particular households, individual prices, wages, incomes, individual industries and particular commodities. Thus micro-economics gives a microscopic view of the economy.
The micro-economic analysis may be undertaken at three levels:
(i) The equalisation of individual consumers and produces;
(ii) The equalization of the single market;
(iii) The simultaneous equilibrium of all markets. The problems of scarcity and optimal or ideal allocation of resources are the central problem in micro-economics.
The roots of managerial economics spring from micro-economic theory. In price theory, demand concepts, elasticity of demand, marginal cost marginal revenue, the short and long runs and theories of market structure are sources of the elements of micro-economics which managerial economics draws upon. It also makes use of well known models in price theory such as the model for monopoly price, the kinked demand theory and the model of price discrimination.
To resolve the organisation’s internal issues arising in business operations, the various theories or principles of microeconomics applied are as follows:
1. Theory of Demand : The demand theory emphasises on the consumer’s behaviour towards a product or service. It takes into consideration the needs, wants, preferences and requirement of the consumers to enhance the production process.
2. Theory of Production and Production Decisions : This theory is majorly concerned with the volume of production, process, capital and labour required, cost involved, etc. It aims at maximising the output to meet the customer’s demand.
3. Pricing Theory and Analysis of Market Structure : It focuses on the price determination of a product keeping in mind the competitors, market conditions, cost of production, maximising sales volume, etc.
4. Profit Analysis and Management : The organisations work for a profit. Therefore they always aim at profit maximisation. It depends upon the market demand, cost of input, competition level, etc.
5. Theory of Capital and Investment Decisions : Capital is the most critical factor of business. This theory prevails the proper allocation of the organisation’s capital and making investments in profitable projects or venture to improve organisational efficiency.
‘Macro’ means large. It deals with the behaviour of the large aggregates in the economy. The large aggregates are total saving, total consumption, total income, total employment, general price level, wage level, cost structure, etc. Thus macro-economics is aggregative economics.
It examines the interrelations among the various aggregates, and causes of fluctuations in them. Problems of determination of total income, total employment and general price level are the central problems in macro-economics.
Macro-economies are also related to managerial economics. The environment, in which a business operates, fluctuations in national income, changes in fiscal and monetary measures and variations in the level of business activity have relevance to business decisions. The understanding of the overall operation of the economic system is very useful to the managerial economist in the formulation of his policies.
The chief contribution of macro-economics is in the area of forecasting. The post-Keynesian aggregative theory has direct implications for forecasting general business conditions. Since the prospects of an individual firm often depend greatly on business in general, for-casts of an individual firm depend on general business forecasts, which make use of models derived from theory. The most widely used model in modern forecasting is the gross national product model.
Any organisation is much affected by the environment it operates in. The business environment can be classified as follows:
1. Economic Environment : The economic conditions of a country, GDP, economic policies, etc. indirectly impact the business and its operations.
2. Social Environment : The society in which the organisation functions also affects it like employment conditions, trade unions, consumer cooperatives, etc.
3. Political Environment : The political structure of a country, whether authoritarian or democratic; political stability; and attitude towards the private sector, influence organizational growth and development.
Techniques or Methods of Managerial Economics:
6 most important methods used by managerial economics to explain and solve business problems of a firm:
(i) Scientific Method:
Scientific method is a branch of study which is concerned with observed facts systematically classified and which includes trustworthy method for the discovery of truths. It refers to a procedure or mode of investigation by which scientific and systematic knowledge is acquired.
The method of enquiry is a very important aspect of science, perhaps this is the most significant feature. Scientific method alone can bring about confidence in the validity of conclusions. It concentrates on controlled experiments and investigates the behaviour of preconceived elements in a highly simplified environment.
The experimental method may be usefully applied to those aspects of managerial behaviour which call for accurate and logical thinking. The experimental methods are of limited use to managerial economics. A managerial economist cannot apply experimental methods to the same extent and in the same way as a physicist can in physical sciences.
We usually adopt an inductive as well as deductive approach in any analysis of managerial behaviour. The deductive method begins with postulates and hypotheses which are arbitrary. For the rationalists, there stands at the head of the system, a set of self-evident propositions and it is from these that other propositions (theorems) are derived by the process of reasoning.
At the other end are inductions (empiricists) who believe that science must construct its axioms from the same data and particularly by ascending continually and gradually till it finally arrives at the most general axioms.
It is often asked what the method of science is, whether induction or deduction? The proper answer to this is, both. Both the methods are interdependent and hold an equally important place in any scientific analysis.
(ii) The Statistical Method:
Statistical methods are a mechanical process especially designed to facilitate the condensation and analysis of the large body of quantitative data. The aim of statistical method is to facilitate comparison, study relationships between the two phenomena and to interpret the complicated data for the purpose of analysis.
Many a time comparison has to be made between the changes and results which are due to changes in time, frequency of occurrence, and many other factors. Statistical methods are used for such comparison among past, present and future estimates.
For example, such methods as extrapolation can be applied for the purpose of making future forecast about the trends of say, demand and supply of a particular commodity. The statistical method of drawing inference is mathematical in nature. It not only establishes causal connection between two variables but also tries to establish a mathematical relationship between them.
Statistical approach is a quantitative micro-approach. Certain important correlation and association of attributes can be found with the help of statistics. It is useful for the study of management, economics, etc. and it is very helpful to bankers, state, planners, speculators, researchers, etc.
Though statistical methods are the handmaid of managerial economics, they should be used with care. The most significant peculiarity of the statistical method is that it helps us to seek regularities or patterns in economic data and permits us to arrive at generalizations that cannot be reached by any other method.
(iii) Method of Intellectual Experiment:
The fundamental problem in managerial economics is to find out the nature of any relationship between different variables such as cost, price and output. The real world is also invariably complex. It is influenced by many factors such as physical, social, temperamental and psychological. It is difficult to locate any order, sequence or law in such a confused and complex structure. In this context, it is essential for the managerial economist to engage in model building.
At times, to analyse behaviour we use models. A model is an abstraction from reality. A model may be in the form of diagram, a verbal description or a mathematical description. It can be classified into three categories such as iconic, analogue and symbolic.
Managerial economics may be viewed as economics applied to problem solving at the level of the firm. The problems relate to choices and allocation of resources is faced by managers all the time. Managerial economics is more concrete and situational and mainly concerned with purposefully managed process of allocation. For this purpose the managerial economist can and does use an abstract model of the enterprise.
Models are approximate representations of reality. They help us in understanding the underlying forces of the complex world of reality through approximation. Model building is more useful in managerial economics, as it helps us to know the actual socio-economic relationship prevailing in a firm.
Firms have only limited resources at their disposal which they must utilise to make profit. The managers of these firms must make judgements about the disposition of their resources and decide which priorities among the various competing claims they have upon them. Models can guide business executives to predict the future consequences.
(iv) The Method of Simulation:
It is an extension of the intellectual experiment. This method has gained popularity with the development of electronic computers, calculators and other similar equipment and internet services. We can programme a complex system of relationship with the help of this method. Computer is not only used for scientific or mathematical applications, it may also be used for some business applications, document generations and graphical solutions. Computer is a fast electronic calculating machine capable of absorbing, processing, integrating, relating and producing the resultant output information within a short span of time.
A manager has to take numerous decisions in the management of business which may be minor or major, simple or complex. They have to ensure that once the decision is taken, it is to be implemented within the minimum time and cost. The electronic gadgets will enable the manager to understand business problems in a better perspective and increase his ability to solve the business problems facing him in the management of business.
(v) The Historical Method:
Past knowledge is considered to be a pre-requisite for present knowledge. This is the main argument for the adoption of historical method in the present day managerial economics. In order to discover some basis for business activity, the method becomes generic in character.
The main objective of this method is to apply mind in the matter of various business problems by discovering the past trend regarding facts, events and attitudes and by demarcating the lines of development of thought and action. If we have an idea of the past events, we can understand the current economic problems much better. The wisdom of a particular economic policy is an inevitable product of its past.
The historical method requires experience not only in collecting data but also in finding out their relations and significance in the particular context. The managerial economist must take up the analytical view in order to get perfect control over facts and the synthetic view of facts.
He should be able to find out the relations between events and events and between events and environment. It is necessary to make an objective approach both in discovering facts and interpreting them. But in order to be objective, the approach must be based on relevant, adequate and reliable data.
For applying historical method, the managerial economist should be familiar with the general field of his topic and be clear with regard to his own objective. A good deal of imagination is required to apply the historical method.
(vi) The Descriptive Method:
The descriptive method is simple and easily applicable to various business problems, particularly in developing countries. It is a fact finding approach related mainly to the present and abstract generalisations through the cross sectional study of the present situation.
This method is mainly concerned with the collection of data. To some extent, the descriptive method is also concerned with the interpretation of data. In order to apply the descriptive method, the data should be accurate and objective and if possible quantifiable.
Since the descriptive method wants to relate causality of the collected facts, it is necessary for it to make comparisons between one situation with the other and among different aspects of the same situation. Thus, situational comparability is an essential element of this method.
This method is used to describe the organisation and functioning of institutions and the policies which have economic significance. To analyse the impact of the organisational structure in the working of business enterprises, it is widely used by the managerial economist.
The best descriptive studies are observational in nature. This method provides the empirical and logical basis for drawing conclusions and gaining knowledge. Thus it enables the managerial economists to describe or present the picture of a phenomenon or phenomena under investigation.
Role of Managerial Economics in Business Development:
Decision making is an integral part of today’s business management. Making a decision is one of the most difficult tasks faced by a professional manager. A manager has to take several decisions in the management of business. The life of a manager is filled with making decisions alter decisions.
Decision making is a process and a decision is the product of such a process. Managerial decisions are based on the flow of information. Decision making is both a managerial function and an organisational process. Managerial function is exercised through decision making.
The purpose of decision making as well as planning is to direct human behaviour and effort towards a future goal or objective. It is organisational in that many decisions transcend the individual manager and become the product of groups, teams, committees, etc.
Once the decision is taken it is implemented within the minimum time and cost. A study of the principles of business decisions will enable managers to understand business problems in a better perspective and increase their ability to solve business problems facing them in the management of business.
Executives make many types of decisions connected with the business such as production, inventory, cost, marketing, pricing, investment and personnel. In the long-run, application of principles of business decisions will result in successful outcomes. A good decision is one that is based on logic, considers all available data and possible alternatives and applies the quantitative approach.
Organisational decisions are those which the executive makes in his personal capacity as a manager. They include the adoption of the strategies, the framing of objectives and the approval of plans. These decisions can be delegated to the organisational members so that decisions could be implemented with their support. These decisions aim at achieving the best interests of the organisation. The basic decisions are those which are more important, they involve long-range commitment and heavy expenditure of funds.
A high degree of importance is attached to them. A serious mistake will endanger the company s existence. The selection of a location, selection of a product line, and decision relating to manage the business are all basic decisions. They are considered basic because they affect the whole organisation.
Some of the important types of business decisions are given below:
(i) Production Decisions:
Production is an economic activity which supplies goods and services for sale in a market to satisfy consumer wants thereby profit maximisation is made possible. The business executive has to make the rational allocation of available resources at his disposal. He may face problems relating to best combination of the factors to gain maximum profit or how to use different machine hours for maximum production advantage, etc.
(ii) Inventory Decision:
Inventory refers to the quantity of goods, raw material or other resources that are idle at any given point of time held by the firm. The decision to hold inventories to meet demand is quite important for a firm and in certain situation the level of inventories serves as a guide to plan production and is therefore, a strategic management variable. Large inventory of raw materials, intermediate goods and finished goods means blocking of capital.
(iii) Cost Decisions:
The competitive ability of the firm depends upon the ability to produce the commodity at the minimum cost. Hence, cost structure, reduction of cost and cost control has come to occupy important places in business decisions. In the absence of cost control, profits would come down due to increasing cost.
Business decisions about the future require the businessmen to choose among alternatives, and to do this, it is necessary to know the costs involved. Cost information about the resources is very essential for business decision making.
(iv) Marketing Decisions:
Within market planning, the marketing executive must make decisions on target market, market positioning, product development, pricing channels of distribution, physical distribution, communication and promotion. A businessman has to take mainly two different but interrelated decisions in marketing.
They are the sales decision and purchase decision. Sales decision is concerned with how much to produce and sell for maximising profit. The purchase decision is concerned with the objective of acquiring these resources at the lowest possible prices so as to maximise profit. Here the executive’s basic skill lies in influencing the level, timing, and composition of demand for a product, service, organisation, place, person or idea.
(v) Investment Decision:
The problems of risks and imperfect foresight are very crucial for the investment decision. In real business situation, there is seldom an investment which does not involve uncertainties. Investment decision covers issues like the decisions regarding the amount of money for capital investment, the source of financing this investment, allocation of this investment among different projects over time. These decisions are of immense significance for ensuring the growth of an enterprise on sound lines. Hence, decisions on investment are to be taken with utmost caution and care by the executive.
(vi) Personnel Decision:
An organisation requires the services of a large number of personnel. These personnel occupy various positions. Each position of the organisation has certain specific contributions to achieve organisational objectives. Personnel decisions cover the areas of manpower planning, recruitment, selection, training and development, performance appraisal, promotion, transfer, etc. Business executives should take personnel decisions as an essential element.
2(a) Enlist and explain the determinants of individual demand.
-> Determinants of individual demand:-
The demand of a product is influenced by a number of factors.
An organization should properly understand the relationship between the demand and its each determinant to analyze and estimate the individual and market demand of a product.
The demand for a product is influenced by various factors, such as price, consumer’s income, and growth of population.
For example, the demand for apparel changes with change in fashion and tastes and preferences of consumers. The extent to which these factors influence demand depends on the nature of a product.
An organization, while analyzing the effect of one particular determinant on demand, needs to assume other determinants to be constant. This is due to the fact that if all the determinants are allowed to differ simultaneously, then it would be difficult to estimate the extent of change in demand.
Following are the determinants of demand for a product:
i. Price of a Product or Service:
Affects the demand of a product to a large extent. There is an inverse relationship between the price of a product and quantity demanded. The demand for a product decreases with increase in its price, while other factors are constant, and vice versa.
For example, consumers prefer to purchase a product in a large quantity when the price of the product is less. The price-demand relationship marks a significant contribution in oligopolistic market where the success of an organization depends on the result of price war between the organization and its competitors.
Constitutes one of the important determinants of demand. The income of a consumer affects his/her purchasing power, which, in turn, influences the demand for a product. Increase in the income of a consumer would automatically increase the demand for products by him/her, while other factors are at constant, and vice versa.
For example, if the salary of Mr. X increases, then he may increase the pocket money of his children and buy luxury items for his family. This would increase the demand of different products from a single family. The income-demand relationship can be analyzed by grouping goods into four categories, namely, essential consumer goods, inferior goods, normal goods, and luxury goods.
The relationship between the income of a consumer and each of these goods is explained as follows:
a. Essential or Basic Consumer Goods:
Refer to goods that are consumed by all the people in the society. For example, food grains, soaps, oil, cooking fuel, and clothes. The quantity demanded for basic consumer goods increases with increase in the income of a consumer, but up to a fixed limit, while other factors are constant.
b. Normal Goods:
Refer to goods whose demand increases with increase in the consumer’s income. For example, goods, such as clothing, vehicles, and food items, are demanded in relatively increasing quantity with increase in consumer’s income. The demand for normal goods varies due to .different rate of increase in consumers’ income.
c. Inferior Goods:
Refer to goods whose demand decreases with increase in the income of consumers. For example, a consumer would prefer to purchase wheat and rice instead of millet and cooking gas instead of kerosene, with increase in his/her income. In such a case, millet and kerosene are inferior goods for the consumer.
However, these two goods can be normal goods for people having lower level of income. Therefore, we can say that goods are not always inferior or normal; it is the level of income of consumers and their perception about the need of goods.
d. Luxury Goods:
Refer to goods whose demand increases with increase in consumer’s income. Luxury goods are used for the pleasure and esteem of consumers. For example, expensive jewellery items, luxury cars, antique paintings and wines, and air travelling.
iii. Tastes and Preferences of Consumers:
Play a major role in influencing the individual and market demand of a product. The tastes and preferences of consumers are affected due to various factors, such as life styles, customs, common habits, and change in fashion, standard of living, religious values, age, and sex.
A change in any of these factors leads to change in the tastes and preferences of consumers. Consequently, consumers reduce the consumption of old products and add new products for their consumption. For example, if there is change in fashion, consumers would prefer new and advanced products over old- fashioned products, provided differences in prices are proportionate to their income.
Apart from this, demand is also influenced by the habits of consumers. For instance, most of the South Indians are non-vegetarian; therefore, the demand for non- vegetarian products is higher in Southern India. In addition, sex ratio has a relative impact on the demand for many products.
For instance, if females are large in number as compared to males in a particular area, then the demand for feminine products, such as make-up kits and cosmetics, would be high in that area.
iv. Price of Related Goods:
Refer to the fact that the demand for a specific product is influenced by the price of related goods to a greater extent.
Related goods can be of two types, namely, substitutes and complementary goods, which are explained as follows:
Refer to goods that satisfy the same need of consumers but at a different price. For example, tea and coffee, jowar and bajra, and groundnut oil and sunflower oil are substitute to each other. The increase in the price of a good results in increase in the demand of its substitute with low price. Therefore, consumers usually prefer to purchase a substitute, if the price of a particular good gets increased.
b. Complementary Goods:
Refer to goods that are consumed simultaneously or in combination. In other words, complementary goods are consumed together. For example, pen and ink, car and petrol, and tea and sugar are used together. Therefore, the demand for complementary goods changes simultaneously. The complementary goods are inversely related to each other. For example, increase in the prices of petrol would decrease the demand of cars.
v. Expectations of Consumers:
Imply that expectations of consumers about future changes in the price of a product affect the demand for that product in the short run. For example, if consumers expect that the prices of petrol would rise in the next week, then the demand of petrol would increase in the present.
On the other hand, consumers would delay the purchase of products whose prices are expected to be decreased in future, especially in case of non-essential products. Apart from this, if consumers anticipate an increase in their income, this would result in increase in demand for certain products. Moreover, the scarcity of specific products in future would also lead to increase in their demand in present.
vi. Effect of Advertisements:
Refers to one of the important factors of determining the demand for a product. Effective advertisements are helpful in many ways, such as catching the attention of consumers, informing them about the availability of a product, demonstrating the features of the product to potential consumers, and persuading them to purchase the product. Consumers are highly sensitive about advertisements as sometimes they get attached to advertisements endorsed by their favorite celebrities. This results in the increase demand for a product.
vii. Distribution of Income in the Society:
Influences the demand for a product in the market to a large extent. If income is equally distributed among people in the society, the demand for products would be higher than in case of unequal distribution of income. However, the distribution of income in the society varies widely.
This leads to the high or low consumption of a product by different segments of the society. For example, the high income segment of the society would prefer luxury goods, while the low income segment would prefer necessary goods. In such a scenario, demand for luxury goods would increase in the high income segment, whereas demand for necessity goods would increase in the low income segment.
viii. Growth of Population:
Acts as a crucial factor that affect the market demand of a product. If the number of consumers increases in the market, the consumption capacity of consumers would also increase. Therefore, high growth of population would result in the increase in the demand for different products.
ix. Government Policy:
Refers to one of the major factors that affect the demand for a product. For example, if a product has high tax rate, this would increase the price of the product. This would result in the decrease in demand for a product. Similarly, the credit policies of a country also induce the demand for a product. For example, if sufficient amount of credit is available to consumers, this would increase the demand for products.
x. Climatic Conditions:
Affect the demand of a product to a greater extent. For example, the demand of ice-creams and cold drinks increases in summer, while tea and coffee are preferred in winter. Some products have a stronger demand in hilly areas than in plains. Therefore, individuals demand different products in different climatic conditions.
(b) Write short notes on:
(i) Demand Elasticity
-> Demand extends or contracts respectively with a fall or rise in price. This quality of demand by virtue of which it changes (increases or decreases) when price changes (decreases or increases) is called Elasticity of Demand.
“The elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price”. – Dr. Marshall.
Elasticity means sensitiveness or responsiveness of demand to the change in price.
This change, sensitiveness or responsiveness, may be small or great. Take the case of salt. Even a big fall in its price may not induce an appreciable ex appreciable extension in its demand. On the other hand, a slight fall in the price of oranges may cause a considerable extension in their demand. That is why we say that the demand in the former case is ‘inelastic’ and in the latter case it is ‘elastic’.
The demand is elastic when with a small change in price there is a great change in demand; it is inelastic or less elastic when even a big change in price induces only a slight change in demand. In the words of Dr. Marshall, “The elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price.”But the demand cannot be perfectly ‘elastic’ or ‘inelastic’.
Completely elastic demand will mean that a slight fall (or rise) in the price of the commodity concerned induces an infinite extension (or contraction) in its demand. Completely inelastic demand will mean that any amount of fall (or rise) in the price of the commodity would not induce any extension (or contraction) in its demand. Both these conditions are unrealistic. That is why we say that elasticity of demand may be ‘more or less’, but it is seldom perfectly elastic or absolutely inelastic.
Factors Determining Elasticity of Demand:
There are various factors on which elasticity of demand depends:
(a) Nature of the Commodity:
In the first place, it depends on the nature of the commodity. Commodities which are supposed to be essential or critical to our daily lives must have an inelastic demand, since price change of these items does not bring about a greater change in quantity demanded.
But, luxury goods have an elastic demand. Demand for these good can be quickly reduced when their prices rise. When their prices fall, consumers demand these goods in larger quantities. However, whether a particular commodity is a necessary or a luxury depends on income, tastes and preferences of the consumer.
A particular good may be necessary to someone having an inelastic demand. Same commodity may be elastic to another consumer. For instance, owning a TV may be a luxury item to a low income person. But the same may be bought as an essential item by a rich person.
(b) Availability of Substitutes:
Secondly, commodities having large number of substitutes must have an elastic demand. Some products, such as Horlicks, Complain, Viva, Maltova, Milo, etc., have quite a large number of close substitutes. A change in the price of, say, Horlicks—the prices of other substitutes remaining constant—will lead a consumer to substitute one beverage for another.
If the price of Horlicks goes down, buyers will demand more of it and less of its substitutes. Conversely, demand is fairly inelastic in the case of those commodities which do not have a large number of substitutes.
(c) Extent of Uses:
Thirdly, there are some commodities which can be used for a variety of purposes. For example, electricity. If price per unit of electricity consumed falls, people will reduce their consumption of its substitutes (e.g., coal, gas, etc.) and increase the consumption of electricity.
Coefficient of price elasticity of demand in this case must be greater than one. On the other hand, when a commodity is used only for one or two purposes, a price change will have less effect on its quantity demanded and, therefore, demand will be inelastic.
(d) Habit Good:
Fourthly, there are some commodities consumed out of habits and conventions— they have an elastic demand. Even in the face of rising prices of those commodities or falling income, people will consume those (such as, cigarette).
For this reason, price elasticity as well as income elasticity of demand for this type of commodity is inelastic. Further, gold ornaments are used in the marriage ceremony rather out of convention, though gold prices are rising. When gold is used in this way, its demand becomes inelastic.
(e) Time Dimension:
Fifthly, shorter the time, lower will be the elasticity of demand. This is because in the short run satisfactory substitutes of a product may not be available. Thus, demand for a product in the short run usually becomes inelastic. Such a commodity will be elastic in the long run when close substitutes may be produced.
Thus, the response of quantity demanded to a change in price will tend to be greater (smaller), the longer (shorter) the time-span considered. In the long run, there is enough time for adjustments to be made following a change in price.
(f) The Importance of being Unimportant:
Sixthly, people often pay little attention to the price of a product if it constitutes a relatively small part in their budget. For example, if the fire of railway ticket of a tourist who travels by rail once in a year is increased form Rs. 125 to Rs. 135, then he may not postpone his journey. This means he is unresponsive to such price hike and his demand is inelastic. This is called ‘the importance of being unimportant’.
Finally, durable commodities have an elastic demand. If the price of these goods rises, people will spend less on these goods. On the other hand, following a fall in the price of durable commodities (e.g., refrigerator), people demand more of them. In the case of non-durable commodities, demand is elastic.
Importance of the Concept of Elasticity of Demand:
The concept of elasticity of demand has both theoretical and practical value.
(a) Price Determination:
Use of the concept of elasticity of demand is required in the price determination of a commodity under different market conditions. Under perfect competition, in the short run in which supply is absolutely inelastic price depends upon the elasticity of demand.
If demand suddenly falls—supply remaining fixed—prices will fall, and, if demand suddenly rises, prices will rise as output cannot be increased. Again, the stability of prices also depends on the elasticity of demand and elasticity of supply. If either the demand or the supply is elastic, fluctuations in prices will be within narrow limits.
Further, if the demand for an agricultural commodity is inelastic, increased production may spell disaster to the economic condition of farmers. So the government can adopt measures to save the plight of the farmers.
A monopoly seller must have a knowledge relating to the elasticity of demand for his product while determining the price of his commodity.
A monopolist will produce a commodity in the range of his demand curve where demand is said to be elastic. He will never produce in the range of the demand curve where demand is inelastic. Obviously, price determination of the monopoly product will be governed by the elasticity of demand.
(b) Wage Determination:
The concept of elasticity of demand is employed in wage determination. Wages, in modern days, are determined through the process of collective bargaining. Trade union will be successful in raising the wage rate provided labour demand is deemed to be inelastic. This is because of the fact that the degree of substitution between labour and other labour substituting inputs is less.
Trade union becomes cautious in demanding higher wage rates when the demand for labour is said to be elastic. Under the circumstance, the employer may be forced to employ more machines (assumed to be a cheaper input) than labour.
Anyway, this concept may be employed in analysing the problems connected with changes in the conditions of supply. Economists are interested in knowing the effect on employment in the software industry following a rise in the wages of workers engaged in this industry
(c) Policy Determination:
The concept of elasticity of demand is of great importance to a finance minister. While imposing tax or rising the existing tax rates, the finance minister must have sufficient knowledge of the elasticity of demand for the taxed commodity.
If the demand for the product is inelastic, the purpose of the tax—say revenue-earning—will be served. That is why taxes are mostly imposed or rates of taxes are raised in the case of commodities having inelastic demand.
Again, the concept may be used in the determination of incidence of a tax. It is easier to shift the burden of taxes on to the consumers if the product demand is assumed to be inelastic. Further, whether exportable or importable be taxed or not, the concept of elasticity may be of great use.
(d) Exchange Rate Determination:
In international trade too, the concept may be employed. For instance, as far as exchange rate (i.e., the rate at which one currency is exchanged for another currency) determination is concerned, the concept of elasticity of demand is of great importance.
The concept of elasticity of demand is used to justify whether devaluation of a currency is a right step in curbing balance of payment problems of a country. Devaluation is expected to correct the balance of payments disequilibrium if the sum of the elasticity’s of demand for export and import exceeds unity.
In international trade theory, within the limits set by the comparative costs, the terms of trade also depends on the elasticity of demand of each country for the goods of other countries.
In fine, elasticity of demand is a concept which has much applicability as far as business decision-making is concerned and is, therefore, of much importance in modern economics. In fact, most businessmen should try to form as precise an idea of elasticity as possible.
The concept of elasticity of demand is useful in business decision-making because “it is a convenient shorthand way of expressing the effects of price change on demand for a commodity and as such it is relevant to price fixing.”
(ii) Demand Schedule
-> A demand schedule is a chart that shows the number of goods or services demanded at specific prices. In other words, it’s a table that shows the relationship between the price of goods and the amount of goods consumers are willing and able to pay for them at that price.
Schedule is based on the demand curve that illustrates inverse relationship between quantities demanded and price. As the price of good increases, the quantity demanded decreases.
The table simply takes the plotted points on the demand curve and puts them on a table. In an effort to plan production processes, management can look at the schedule and figure out how many units consumers will demand based on the price.
They can also use this schedule to maximize profits by pricing goods or services according to their demand elasticity . In other words, they might be able to maximize profits by selling fewer high priced goods than many more low priced goods.
It is a statement in the form of a table that shows the different quantities in demand at different prices. There are two types of Demand Schedules:
1. Individual Demand Schedule
2. Market Demand Schedule
Individual Demand Schedule
It is a demanding schedule that depicts the demand of an individual customer for a commodity in relation to its price. Let us study it with the help of an example.
Price per unit of commodity X (Px)
Quantity demanded of commodity X (Dx)
The above schedule depicts the individual demand schedule. We can see that when the price of the commodity is ₹100, its demand is 50 units. Similarly, when its price is ₹500, its demand decreases to 10 units.
Thus, we can conclude that as the price falls the demand increases and as the price raises the demand decreases. Hence, there exists an inverse relationship between the price and quantity demanded.
Individual Demand Curve
It is a graphical representation of the individual demand schedule. The X-axis represents the demand and Y-axis represents the price of a commodity.
The above demand curve shows the demand for Gasoline. When the price of gasoline is $3.5 per litre, its demand is 50 litres and when the price is $0.5 per litre, its demand is250 litres.
Market Demand Schedule
It is a summation of the individual demand schedules and depicts the demand of different customers for a commodity in relation to its price. Let us study it with the help of an example.
Price per unit of commodity X
Quantity demanded by consumer A (QA)
Quantity demanded by consumer B (QB)
Market Demand QA + QB
The above schedule shows the market demand for commodity X. When the price of the commodity is ₹100, customer A demands 50 units while the customer B demands 70 units.
Thus, the market demand is 120 units. Similarly, when its price is ₹500, Customer A demands 20 units while customer B demands 30 units.
Thus, its market demand decreases to 40 units. Thus, we can conclude that whether it is the individual demand or the market demand, the law of demand governs both of them.
Market Demand Curve
It is a graphical representation of the market demand schedule. The X-axis represents the market demand in units and Y-axis represents the price of a commodity.
3(b) Explain any two qualitative methods of Demand Forecasting?
-> The main challenge to forecast demand is to select an effective technique.
There is no particular method that enables organizations to anticipate risks and uncertainties in future. Generally, there are two approaches to demand forecasting.
The first approach involves forecasting demand by collecting information regarding the buying behaviour of consumers from experts or through conducting surveys. On the other hand, the second method is to forecast demand by using the past data through statistical techniques.
Thus, we can say that the techniques of demand forecasting are divided into survey methods and statistical methods. The survey method is generally for short-term forecasting, whereas statistical methods are used to forecast demand in the long run.
Two qualitative methods of Demand Forecasting are:-
Survey method is one of the most common and direct methods of forecasting demand in the short term. This method encompasses the future purchase plans of consumers and their intentions. In this method, an organization conducts surveys with consumers to determine the demand for their existing products and services and anticipate the future demand accordingly.
The survey method undertakes three exercises-
i. Experts’ Opinion Poll:
Refers to a method in which experts are requested to provide their opinion about the product. Generally, in an organization, sales representatives act as experts who can assess the demand for the product in different areas, regions, or cities.
Sales representatives are in close touch with consumers; therefore, they are well aware of the consumers’ future purchase plans, their reactions to market change, and their perceptions for other competing products. They provide an approximate estimate of the demand for the organization’s products. This method is quite simple and less expensive.
However, it has its own limitations, which are discussed as follows:
a. Provides estimates that are dependent on the market skills of experts and their experience. These skills differ from individual to individual. In this way, making exact demand forecasts becomes difficult.
b. Involves subjective judgment of the assessor, which may lead to over or under-estimation.
c. Depends on data provided by sales representatives who may have inadequate information about the market.
d. Ignores factors, such as change in Gross National Product, availability of credit, and future prospects of the industry, which may prove helpful in demand forecasting.
ii. Delphi Method:
Refers to a group decision-making technique of forecasting demand. In this method, questions are individually asked from a group of experts to obtain their opinions on demand for products in future. These questions are repeatedly asked until a consensus is obtained.
In addition, in this method, each expert is provided information regarding the estimates made by other experts in the group, so that he/she can revise his/her estimates with respect to others’ estimates. In this way, the forecasts are cross checked among experts to reach more accurate decision making.
Ever expert is allowed to react or provide suggestions on others’ estimates. However, the names of experts are kept anonymous while exchanging estimates among experts to facilitate fair judgment and reduce halo effect.
The main advantage of this method is that it is time and cost effective as a number of experts are approached in a short time without spending on other resources. However, this method may lead to subjective decision making.
iii. Market Experiment Method:
Involves collecting necessary information regarding the current and future demand for a product. This method carries out the studies and experiments on consumer behaviour under actual market conditions. In this method, some areas of markets are selected with similar features, such as population, income levels, cultural background, and tastes of consumers.
The market experiments are carried out with the help of changing prices and expenditure, so that the resultant changes in the demand are recorded. These results help in forecasting future demand.
There are various limitations of this method, which are as follows:
a. Refers to an expensive method; therefore, it may not be affordable by small-scale organizations
b. Affects the results of experiments due to various social-economic conditions, such as strikes, political instability, natural calamities
Statistical methods are complex set of methods of demand forecasting. These methods are used to forecast demand in the long term. In this method, demand is forecasted on the basis of historical data and cross-sectional data.
Historical data refers to the past data obtained from various sources, such as previous years’ balance sheets and market survey reports. On the other hand, cross-sectional data is collected by conducting interviews with individuals and performing market surveys. Unlike survey methods, statistical methods are cost effective and reliable as the element of subjectivity is minimum in these methods.
i) Trend Projection Method
Trend projection or least square method is the classical method of business forecasting. In this method, a large amount of reliable data is required for forecasting demand. In addition, this method assumes that the factors, such as sales and demand, responsible for past trends would remain the same in future.
In this method, sales forecasts are made through analysis of past data taken from previous year’s books of accounts. In case of new organizations, sales data is taken from organizations already existing in the same industry. This method uses time-series data on sales for forecasting the demand of a product.
Table-1 shows the time-series data of XYZ Organization:
i. Graphical Method:
Helps in forecasting the future sales of an organization with the help of a graph. The sales data is plotted on a graph and a line is drawn on plotted points.
Let us learn this through a graph shown in figure:-
ii. Fitting Trend Method:
Implies a least square method in which a trend line (curve) is fitted to the time-series data of sales with the help of statistical techniques.
In this method, there are two types of trends taken into account, which are explained as follows:
a. Linear Trend:
Implies a trend in which sales show a rising trend.
In linear trend, following straight line trend equation is fitted:
S = A+BT
S= annual sales
T=time (in years)
A and B are constant
B gives the measure of annual increase in sales
b. Exponential Trend:
Implies a trend in which sales increase over the past years at an increasing rate or constant rate.
The appropriate trend equation used is as follows:
Y = aTb
Y= annual sales
T= time in years
a and b are constant
Converting this into logarithm, the equation would be:
Log Y = Log a + b Log T
The main advantage of this method is that it is simple to use. Moreover, the data requirement of this method is very limited (as only sales data is required), thus it is inexpensive method.
However, this method also suffers from certain limitations, which are as follows:
1. Assumes that the past rate of changes in variables will remain same in future too, which is not applicable in the practical situations.
2. Fails to be applied for short-term estimates and where trend is cyclical with lot of fluctuations
3. Fails to measure relationship between dependent and independent variables.
iii. Box-Jenkins Method:
Refers to a method that is used only for short-term predictions. This method forecasts demand only with stationary time-series data that does not reveal the long-term trend. It is used in those situations where time series data depicts monthly or seasonal variations with some degrees of regularity. For instance, this method can be used for estimating the sales forecasts of woollen clothes during the winter season.
4(b) Cite suitable examples, from the real markets, to explain the methods of price discrimination popularly in practice.
-> In a competitive market, price discrimination occurs when identical goods and services are sold at different prices by the same provider. In pure price discrimination, the seller will charge the buyer the absolute maximum price that he is willing to pay. Companies use price discrimination in order to make the most revenue possible from every customer. This allows the producer to capture more of the total surplus by selling to consumers at prices closer to their maximum willingness to pay.
An example of price discrimination would be the cost of movie tickets. Prices at one theater are different for children, adults, and seniors. The prices of each ticket can also vary based on the day and chosen show time. Ticket prices also vary depending on the portion of the country as well.
Industries use price discrimination as a way to increase revenue. It is possible for some industries to offer retailers different prices based solely on the volume of products purchased. Price discrimination can also be based on age, location, desire for the product, and customer wage.
Forms of Price Discrimination
There are a variety of ways in which industries legally use price discrimination. It is not important that pricing information be restricted, or that the price discriminated groups be unaware that others are being charged different prices:
1. Coupons: coupons are used in retail as a way to distinguish customers by their reserve price. The assumption is that individuals who collect coupons are more sensitive to a higher price than those who don’t. By offering coupons, a producer can charge a higher price to price-insensitive customers and provide a discount to price-sensitive individuals.
2. Premium pricing: premium products are priced at a level that is well beyond their marginal cost. For example, a regular cup of coffee might be priced at $1, while a premium coffee is $2.50.
3. Discounts based on occupation: many businesses offer reduced prices to active military members. This can increase sales to the target group and provide positive publicity for the business which leads to increased sales. Less publicized discounts are also offered to off duty service workers such as police.
4. Retail incentives: retail incentives are used to increase market share or revenues. They include rebates, bulk and quantity pricing, seasonal discounts
5. Gender based discounts: gender based discounts are offered in some countries including the United States. Examples include free drinks at bars for women on “Ladies Night,” men often receive lower prices at the dry cleaners and hair salons than women because women clothes and hair generally take more time to work with. In contrast, men usually have higher car insurance rates than women based on the likelihood of being in an accident based on their age.
6. Financial aid: financial aid is offered to college students based on either the student and/or the parent’s economic situation.
7. Haggling: haggling is a form of price negotiation that requires knowledge and confidence from the customer.
Industries that Use Price Discrimination
The airline industry uses price discrimination regularly when they sell travel tickets simultaneously to different market segments. Price discrimination is evident within individual airlines, but also in the industry as a whole. Tickets vary based on the location within the plane, the time and day of the flight, the time of year, and what city the aircraft is traveling to. Prices can vary greatly within an airline and also among airlines. Customers must search for the best priced ticket based on their needs. Airlines do offer other forms of price discrimination including discounts, vouchers, and member perks for individuals with membership cards.
The pharmaceutical industry experiences international price discrimination. Drug manufacturers charge more for drugs in wealthier countries than in poor ones. For example, the United States has the highest drug prices in the world. On average, Europeans pay 56% less than Americans do for the same prescription medications. However, in many countries with lower drug costs, the difference in price is absorbed into the taxes which results in lower average salaries when compared to those in the United States.
Academic textbooks are another industry known for price discrimination. Textbooks in the United States are more expensive than they are overseas. Because most of the textbooks are published in the United States, it is obvious that transportation costs do not raise the price of the books. In the United States price discrimination on textbooks is due to copyright protection laws. Also, in the United States textbooks are mandatory where as in other countries they are viewed as optional study aids.
Price discrimination exists within a market when the sales of identical goods or services are sold at different prices by the same provider. The goal of price discrimination is for the seller to make the most profit possible. Although the cost of producing the products is the same, the seller has the ability to increase the price based on location, consumer financial status, product demand, etc.
Price Discrimination Criteria
Within commerce there are specific criteria that must be met in order for price discrimination to occur:
· The firm must have market power.
· The firm must be able to recognize differences in demand.
· The firm must have the ability to prevent arbitration, or resale of the product.
Types of Price Discrimination
In commerce there are three types of price discrimination that exist. The exact price discrimination method that is used depends on the factors within the particular market.
- First degree price discrimination: the monopoly seller of a good or service must know the absolute maximum price that every consumer is willing to pay and can charge each customer that exact amount. This allows the seller to obtain the highest revenue possible.
- Second degree price discrimination: the price of a good or service varies according to the quantity demanded. Larger quantities are available at a lower price (higher discounts are given to consumers who buy a good in bulk quantities).
- Third degree price discrimination: the price varies according to consumer attributes such as age, sex, location, and economic status.
Examples of Price Discrimination
There are industries that conduct a substantial portion of their business using price discrimination:
- Travel industry: airlines and other travel companies use differentiated pricing often. Travel products and services are marketed to specific social segments. Airlines usually assign specific capacity to various booking classes. Also, prices fluctuate based on time of travel (time of day, day of the week, time of year). Prices fluctuate between companies as well as within each company.
- Pharmaceutical industry: price discrimination is common in the pharmaceutical industry. Drug-makers charge more for drugs in wealthier countries. For example, drug prices in the United States are some of the highest in the world. Europeans, on average, pay only 56% of what Americans pay for the same prescription drugs.
- Textbooks (physical ones, not your Boundless one!): price discrimination is also prevalent within the publishing industry. Textbooks are much higher in the United States despite the fact that they are produced in the country. Copyright protection laws increase the price of textbooks. Also, textbooks are mandatory in the United States while schools in other countries see them as study aids.
Price discrimination is prevalent in varying degrees throughout most markets. Methods of price discrimination include:
- Coupons: coupons are used to distinguish consumers by their reserve price. Companies increase the price of a good and individuals who are not price sensitive will pay the higher price. Coupons allow price sensitive consumers to receive a discount. At the same time the seller is still making increased revenue.
- Age discounts: age discounts are a form of price discrimination where the price of a good or admission to an event is based on age. Age discounts are usually broken down by child, student, adult, and senior. In some cases, children under a certain age are given free admission or eat for free. Examples of places where age discounts are given include restaurants, movies, and other forms of entertainment.
- Occupational discounts: price discrimination is present when individuals receive certain discounts based on their occupation. An example is when active military members receive discounts.
- Retail incentives: this includes rebates, discount coupons, bulk and quantity pricing, seasonal discounts, and frequent buyer discounts.
- Gender based prices: in certain markets prices are set based on gender. For example, a Ladies Night at a bar is a form of price discrimination.
5(a) Project a real business case to discuss the various phases of the Business Cycle, emphasising upon the factors responsible for each of the phases.
-> The period of high income, output and employment has been called the period of expansion, upswing or prosperity, and the period of low income, output and employment has been described as contraction, recession, downswing or depression.
The economic history of the free market capitalist countries has shown that the period of economic prosperity or expansion alternates with the period of contraction or recession.
These alternating periods of expansion and contraction in economic activity has been called business cycles. They are also known as trade cycles. J.M. Keynes writes, “A trade cycle is composed of periods of good trade characterized by rising prices and low unemployment percentages with periods of bad trade characterized by falling prices and high unemployment percentages.”
A noteworthy feature about these fluctuations in economic activity is that they are recurrent and have been occurring periodically in a more or less regular fashion. Therefore, these fluctuations have been called business cycles. It may be noted that calling these fluctuations as ‘cycles’ means they are periodic and occur regularly, though perfect regularity has not been observed.
The duration of a business cycle has not been of the same length; it has varied from a minimum of two years to a maximum of ten to twelve years, though in the past it was often assumed that fluctuations of output and other economic indicators around the trend showed repetitive and regular pattern of alternating periods of expansion and contraction.
However, actually there has been no clear evidence of very regular cycles of the same definite duration. Some business cycles have been very short lasting for only two to three years, while others have lasted for several years. Further, in some cycles there have been large swings away from trend and in others these swings have been of moderate nature.
A significant point worth noting about business cycles is that they have been very costly in the economic sense of the word. During a period of recession or depression many workers lose their jobs and as a result large-scale unemployment, which causes loss of output that could have been produced with full employment of resources, come to prevail in the economy.
Besides, during depression many businessmen go bankrupt and suffer huge losses. Depression causes a lot of human sufferings and lowers the levels of living of the people. Fluctuations in economic activity create a lot of uncertainty in the economy which causes anxiety to the individuals about their future income and employment opportunities and involve a great risk for long-run investment in projects. Even boom when it is accompanied by inflation has its social costs. Inflation erodes the real incomes of the people and makes life miserable for the poor people. Inflation distorts allocation of resources by drawing away scarce resources from productive uses to unproductive ones. Inflation redistributes income in favor of the richer sections and also when inflation rate is high, it impedes economic growth.
Phases of Business cycle:-
There are basically two important phases in a business cycle that are prosperity and depression. The other phases that are expansion, peak, trough and recovery are intermediary phases.
The graphical representation of different phases of a business cycle:
As shown in figure, the steady growth line represents the growth of economy when there are no business cycles. On the other hand, the line of cycle shows the business cycles that move up and down the steady growth line. The different phases of a business cycle are explained below.
The line of cycle that moves above the steady growth line represents the expansion phase of a business cycle. In the expansion phase, there is an increase in various economic factors, such as production, employment, output, wages, profits, demand and supply of products, and sales.
In addition, in the expansion phase, the prices of factor of production and output increases simultaneously. In this phase, debtors are generally in good financial condition to repay their debts; therefore, creditors lend money at higher interest rates. This leads to an increase in the flow of money.
In expansion phase, due to increase in investment opportunities, idle funds of organizations or individuals are utilized for various investment purposes. Therefore, in such a case, the cash inflow and outflow of businesses are equal. This expansion continues till the economic conditions are favourable.
The growth in the expansion phase eventually slows down and reaches to its peak. This phase is known as peak phase. In other words, peak phase refers to the phase in which the increase in growth rate of business cycle achieves its maximum limit. In peak phase, the economic factors, such as production, profit, sales, and employment, are higher, but do not increase further. In peak phase, there is a gradual decrease in the demand of various products due to increase in the prices of input.
The increase in the prices of input leads to an increase in the prices of final products, while the income of individuals remains constant. This also leads consumers to restructure their monthly budget. As a result, the demand for products, such as jewellery, homes, automobiles, refrigerators and other durables, starts falling.
As discussed earlier, in peak phase, there is a gradual decrease in the demand of various products due to increase in the prices of input. When the decline in the demand of products becomes rapid and steady, the recession phase takes place.
In recession phase, all the economic factors, such as production, prices, saving and investment, starts decreasing. Generally, producers are unaware of decrease in the demand of products and they continue to produce goods and services. In such a case, the supply of products exceeds the demand.
Over the time, producers realize the surplus of supply when the cost of manufacturing of a product is more than profit generated. This condition firstly experienced by few industries and slowly spread to all industries.
This situation is firstly considered as a small fluctuation in the market, but as the problem exists for a longer duration, producers start noticing it. Consequently, producers avoid any type of further investment in factor of production, such as labour, machinery, and furniture. This leads to the reduction in the prices of factor, which results in the decline of demand of inputs as well as output.
During the trough phase, the economic activities of a country decline below the normal level. In this phase, the growth rate of an economy becomes negative. In addition, in trough phase, there is a rapid decline in national income and expenditure.
In this phase, it becomes difficult for debtors to pay off their debts. As a result, the rate of interest decreases; therefore, banks do not prefer to lend money. Consequently, banks face the situation of increase in their cash balances.
Apart from this, the level of economic output of a country becomes low and unemployment becomes high. In addition, in trough phase, investors do not invest in stock markets. In trough phase, many weak organizations leave industries or rather dissolve. At this point, an economy reaches to the lowest level of shrinking.
As discussed above, in trough phase, an economy reaches to the lowest level of shrinking. This lowest level is the limit to which an economy shrinks. Once the economy touches the lowest level, it happens to be the end of negativism and beginning of positivism.
This leads to reversal of the process of business cycle. As a result, individuals and organizations start developing a positive attitude toward the various economic factors, such as investment, employment, and production. This process of reversal starts from the labour market.
Consequently, organizations discontinue lying off individuals and start hiring but in limited number. At this stage, wages provided by organizations to individuals is less as compared to their skills and abilities. This marks the beginning of the recovery phase.
In recovery phase, consumers increase their rate of consumption, as they assume that there would be no further reduction in the prices of products. As a result, the demand for consumer products increases.
In addition in recovery phase, bankers start utilizing their accumulated cash balances by declining the lending rate and increasing investment in various securities and bonds. Similarly, adopting a positive approach other private investors also start investing in the stock market As a result, security prices increase and rate of interest decreases.
Price mechanism plays a very important role in the recovery phase of economy. As discussed earlier, during recession the rate at which the price of factor of production falls is greater than the rate of reduction in the prices of final products.
Therefore producers are always able to earn a certain amount of profit, which increases at trough stage. The increase in profit also continues in the recovery phase. Apart from this, in recovery phase, some of the depreciated capital goods are replaced by producers and some are maintained by them. As a result, investment and employment by organizations increases. As this process gains momentum an economy again enters into the phase of expansion. Thus, a business cycle gets completed.
The trade cycle has the following attributes:
(i) Depression lasts longer than prosperity,
(ii) The process of revival starts gradually,
(iii) Prosperity phase is characterized by extreme activity in the business world,
(iv) The phase of prosperity comes to an end abruptly.
(b) Highlight the determinants or causes of Demand Pull Inflation and suggest measures to overcome the same.
-> Demand-pull inflation is a specific phenomenon, and it typically refers to an effect not just impacting individual goods and services or markets, but entire economies.
This concept was originally developed as part of Keynesian economics, a set of economic theories developed by John Maynard Keynes during the early half of the 20th century. Much of his economic ideas set out to understand the Great Depression and was built around the goal of encouraging peak economic performance by influencing consumer demand for goods and services.
Demand-pull inflation usually results from a drastically increased demand for a product. This phenomenon, however, does not arise out of thin air.
There are five main causes why this type of inflation occurs.
1. Economic Growth
When an economy is thriving, people and businesses tend to feel more confident in spending their money. They are secure in the idea that they will continue to be employed or even have a higher salary in the future, meaning that they are less inclined to save and more likely to borrow money. When this happens, general demand rises and many businesses may have trouble keeping pace with the increased demand.
2. Surge in Exports
Exchange rate depreciation can drive aggregate demand and create demand-pull inflation by encouraging a high level of exports. Typically when this happens people in a country buy fewer imports while at the same time exports from their country increase.
3. Government Spending
When the government begins spending on large-scale projects, this often drives prices up. This is because substantial projects funded by massive amounts of capital that governments provide creates more demand overall. Fiscal policies that drive demand can also create demand-pull inflation.
4. Inflation Forecasts
When economists, the government, or major media outlets forecast inflation, this can unintentionally cause demand-pull inflation through a couple of avenues. First, some companies may raise their prices pre-emptively to meet the expected inflation. Second, some consumers may make major purchases pre-emptively to avoid paying higher prices later. This can create greater demand and result in demand-pull inflation.
5. Exorbitant Supply of Money
All governments must occasionally create more currency, but when a government prints too much money, this can create demand-pull inflation. In this case, the popular definition of demand-pull inflation — “too much money chasing too few goods” — applies quite literally. Some nations’ governments have done this to the detriment of their economies, rendering their currency virtually worthless.
Examples of Demand-Pull Inflation
Demand-pull inflation is easiest to understand when you translate these ideas into everyday scenarios.
One needs to look no further than Zimbabwe for a prime example. The country experienced a 79.6 billion percent inflation rate from the late 1990s, peaking in late 2008 at a 98% daily inflation rate. While there was a tapestry of reasons behind Zimbabwe’s hyperinflation, many of the key sources stem from the causes detailed above. The country was printing money at an extraordinary rate to fund government wars, projects, and salaries. In tandem, there was a shortage of goods across the nation and, to make matters worse, the country had already been hit by an ongoing food shortage. In some ways, demand was already significantly higher than supply, and the addition of printing exorbitant amounts of money only made matters worse. Additionally, the country had been experiencing high inflation rates for decades, creating the expectation of inflation among consumers. The hyper-inflation resulted in the almost complete halt of normal economic activity in the country. Zimbabwe’s economy is still in recovery.
Measures to overcome Demand Pull Inflation:-
Some of the important measures to control inflation are as follows:
1. Monetary Measures
2. Fiscal Measures
3. Other Measures.
Inflation is caused by the failure of aggregate supply to equal the increase in aggregate demand. Inflation can, therefore, be controlled by increasing the supplies of goods and services and reducing money incomes in order to control aggregate demand.
The various methods are usually grouped under three heads: monetary measures, fiscal measures and other measures.
1. Monetary Measures:
Monetary measures aim at reducing money incomes.
(a) Credit Control:
One of the important monetary measures is monetary policy. The central bank of the country adopts a number of methods to control the quantity and quality of credit. For this purpose, it raises the bank rates, sells securities in the open market, raises the reserve ratio, and adopts a number of selective credit control measures, such as raising margin requirements and regulating consumer credit. Monetary policy may not be effective in controlling inflation, if inflation is due to cost-push factors. Monetary policy can only be helpful in controlling inflation due to demand-pull factors.
(b) Demonetisation of Currency:
However, one of the monetary measures is to demonetize currency of higher denominations. Such a measures is usually adopted when there is abundance of black money in the country.
(c) Issue of New Currency:
The most extreme monetary measure is the issue of new currency in place of the old currency. Under this system, one new note is exchanged for a number of notes of the old currency. The value of bank deposits is also fixed accordingly. Such a measure is adopted when there is an excessive issue of notes and there is hyperinflation in the country. It is a very effective measure. But is inequitable for its hurts the small depositors the most.
2. Fiscal Measures:
Monetary policy alone is incapable of controlling inflation. It should, therefore, be supplemented by fiscal measures. Fiscal measures are highly effective for controlling government expenditure, personal consumption expenditure, and private and public investment.
The principal fiscal measures are the following:
(a) Reduction in Unnecessary Expenditure:
The government should reduce unnecessary expenditure on non-development activities in order to curb inflation. This will also put a check on private expenditure which is dependent upon government demand for goods and services. But it is not easy to cut government expenditure. Though this measure is always welcome but it becomes difficult to distinguish between essential and non-essential expenditure. Therefore, this measure should be supplemented by taxation.
(b) Increase in Taxes:
To cut personal consumption expenditure, the rates of personal, corporate and commodity taxes should be raised and even new taxes should be levied, but the rates of taxes should not be so high as to discourage saving, investment and production. Rather, the tax system should provide larger incentives to those who save, invest and produce more.
Further, to bring more revenue into the tax-net, the government should penalise the tax evaders by imposing heavy fines. Such measures are bound to be effective in controlling inflation. To increase the supply of goods within the country, the government should reduce import duties and increase export duties.
(c) Increase in Savings:
Another measure is to increase savings on the part of the people. This will tend to reduce disposable income with the people, and hence personal consumption expenditure. But due to the rising cost of living, people are not in a position to save much voluntarily.
Keynes, therefore, advocated compulsory savings or what he called ‘deferred payment’ where the saver gets his money back after some years. For this purpose, the government should float public loans carrying high rates of interest, start saving schemes with prize money, or lottery for long periods, etc. It should also introduce compulsory provident fund, provident fund-cum-pension schemes, etc. All such measures increase savings and are likely to be effective in controlling inflation.
(d) Surplus Budgets:
An important measure is to adopt anti-inflationary budgetary policy. For this purpose, the government should give up deficit financing and instead have surplus budgets. It means collecting more in revenues and spending less.
(e) Public Debt:
At the same time, it should stop repayment of public debt and postpone it to some future date till inflationary pressures are controlled within the economy. Instead, the government should borrow more to reduce money supply with the public.
Like monetary measures, fiscal measures alone cannot help in controlling inflation. They should be supplemented by monetary, non-monetary and non-fiscal measures.
3. Other Measures:
The other types of measures are those which aim at increasing aggregate supply and reducing aggregate demand directly.
(a) To Increase Production:
The following measures should be adopted to increase production:
(i) One of the foremost measures to control inflation is to increase the production of essential consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.
(ii) If there is need, raw materials for such products may be imported on preferential basis to increase the production of essential commodities,
(iii) Efforts should also be made to increase productivity. For this purpose, industrial peace should be maintained through agreements with trade unions, binding them not to resort to strikes for some time,
(iv) The policy of rationalization of industries should be adopted as a long-term measure. Rationalization increases productivity and production of industries through the use of brain, brawn and bullion,
(v) All possible help in the form of latest technology, raw materials, financial help, subsidies, etc. should be provided to different consumer goods sectors to increase production.
(b) Rational Wage Policy:
Another important measure is to adopt a rational wage and income policy. Under hyperinflation, there is a wage-price spiral. To control this, the government should freeze wages, incomes, profits, dividends, bonus, etc.
But such a drastic measure can only be adopted for a short period as it is likely to antagonize both workers and industrialists. Therefore, the best course is to link increase in wages to increase in productivity. This will have a dual effect. It will control wages and at the same time increase productivity, and hence raise production of goods in the economy.
(c) Price Control:
Price control and rationing is another measure of direct control to check inflation. Price control means fixing an upper limit for the prices of essential consumer goods. They are the maximum prices fixed by law and anybody charging more than these prices is punished by law. But it is difficult to administer price control.
Rationing aims at distributing consumption of scarce goods so as to make them available to a large number of consumers. It is applied to essential consumer goods such as wheat, rice, sugar, kerosene oil, etc. It is meant to stabilize the prices of necessaries and assure distributive justice. But it is very inconvenient for consumers because it leads to queues, artificial shortages, corruption and black marketing. Keynes did not favour rationing for it “involves a great deal of waste, both of resources and of employment.”