03/05/2023

Economics For
1.4
Business Decisions

Module – 1 Introduction (8 hours)

Introduction to Managerial Economics; The roles of the firm and
the House hold Decision Making in the Household - Consumer
Choice. Theory of Demand; its Determination, Estimation and
Forecasting. Economic principles relevant to managerial decision
making. Opportunity cost, production possibility curve, concept
of increments and margin, discounting principle, Theory of
business firm.

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Meaning - Economics
Economics refers to choices or decisions made by
Individuals, Businesses, and Governments regarding
the production, distribution, and consumption of goods and
services.
It also studies their resource allocation for the same during
scarcity.
In short, it is a branch of social science dealing with the
interaction of people with value.

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Scarcity
• Scarcity implies the limited availability of resources, such as land,
capital, machinery, and labor.

• Economics examines effective resource utilization for the

production of commodities. Also, it investigates the role of
government incentives and policies in increasing production and
trade efficiency.

• It is Based on how people, entities, and nations interact to find ways

to meet increasing demands with scarce resources, it could be micro
and macroeconomics.

Definition
Dr. Alfred Marshall, one of the greatest economists of the
19th century, writes

“Economics is a study of man’s actions in the ordinary

business of life: it enquires how he gets his income and
how he uses it”.

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Businesses Decisions
• Businesses need to make crucial decisions on a day-to-day basis.
These decisions can be about an investment opportunity,
• A new product,
• A new competitor, or
• A company’s direction.
• For such important decisions, businesses need to rely on
experts. These experts come from the background of
Managerial Economics. They are the experts who provide
monetary value to the different opportunities and then
urge the company to proceed.

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Microeconomics

• The study of an individual consumer or a firm is called

microeconomics.
• Microeconomics deals with behavior and problems of
single individual and of micro organization.
• It is concerned with the application of the concepts such as
price theory, Law of Demand and theories of market structure
and so on.

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Macroeconomics
• The study of ‘aggregate’ or total level of economic activity in a
country is called macroeconomics.
• It studies the flow of economics resources or factors of production
(such as land, labor, capital, organization and technology) from the
resource owner to the business firms and then from the business firms
to the households.
• It is concerned with the level of employment in the economy.
• It discusses aggregate consumption, aggregate investment, price level,
and payment, theories of employment, and so on.

Managerial Economics
• Managerial Economics can be defined as amalgamation
(combination or mix) of economic theory with business practices so as
to ease decision-making and future planning by management.
• Managerial Economics assists the managers of a firm in a rational
solution of obstacles faced in the firm’s activities.
• It makes use of economic theory and concepts.
• It helps in formulating logical managerial decisions.

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• Managerial Economics is a science dealing with

effective use of scarce resources.

• It guides the managers in taking decisions relating to the

firm’s customers, competitors, suppliers as well as relating
to the internal functioning of a firm.

• It makes use of statistical and analytical tools to assess

economic theories in solving practical business problems.

• Study of Managerial Economics helps in enhancement of

analytical skills, assists in rational configuration as well as solution of
problems.

• While Micro Economics is the study of decisions made regarding

the allocation of resources and prices of goods and services.

• Macro Economics is the field of economics that studies the

behavior of the economy as a whole (i.e. entire Industries and
Economies).

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• The use of Managerial Economics is not limited to profit-making

firms and organizations. But it can also be used to help in decision-
making process of non-profit organizations (Hospitals, Educational
Institutions, etc).
• It enables optimum utilization of scarce resources in such
organizations as well as helps in achieving the goals in most efficient
manner.
• Managerial Economics is of great help in
• Price Analysis
• Production Analysis
• Capital Budgeting
• Risk Analysis and
• Determination of Demand.

• Managerial economics uses both Economic theory as well

as Econometrics for rational managerial decision making.
• Econometrics is defined as use of statistical tools for assessing
economic theories by empirically measuring relationship between
economic variables.
• It uses factual data for solution of economic problems.

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• Managerial Economics is associated with the economic theory which

constitutes “Theory of Firm”.
• Theory of firm states that the primary aim of the firm is to maximize
wealth.
• Decision making in managerial economics generally involves
• Establishment of firm’s objectives
• Identification of problems involved in achievement of those objectives
• Development of various alternative solutions
• Selection of best alternative and
• Finally implementation of the decision.

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Difference Between Managerial Economics

and Economics
Basis of
Managerial Economics Economics
Difference
It is the study of proper allocation of resources in a It is the study of allocation of resources in a society
Meaning
particular firm as a whole.
Presence of The proper application of economic principles to the
The body of the principles are being dealt itself.
Principle problems of the firm.
Nature It is individualistic. It is comprehensive.
Type of
It is micro-economic in character. It is both macro and micro-economic in character.
Economics
Deals in It deals only with a firm. It deals with a firm and its Industry.
Scope It is narrow in scope. It is wider in scope.
The modification and enlargement of models is done by
adopting and revaluating of economics models to match It speculates economic relationships and builds
Type of Work
specific conditions and to help in the process of problem- simplified economic models.
solving.
Variables such objectives of the firm, multi-product nature
Factors Used of manufacture, constraints on resource availability, Theoretical assumptions are used only.
environmental aspects, legal constraints, etc., are utilized.

Household
Concept of Household
• Households are the main sector for the consumption of an economy.
• The primary economic function of households is to supply domestic firms with needed
factors of production - land, human capital, real capital and enterprise. The factors are
supplied by factor owners in return for a reward.
• Land is supplied by landowners,
• Human capital by labour,
• Real capital by capital owners (capitalists) and
• Enterprise is provided by entrepreneurs
• Entrepreneurs combine the other three factors, and bear the risks associated with production.
• It purchases all the final goods and services produced by the firms from the markets
directly. Hence, they supply different factor services to the economy and on the other
hand they create demand for the final goods and services from the market.

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Role of the Household in Economy

The roles and importance of households for building an economy are
immense. Some of the performances of household are described
below:
• Act as a Producer
• Act as a Consumer
• Act as aTax-Payer
• Act as a Professional
• Act as a Saver

Act as a Producer
• There are several families in India who are the owners of several small
production units.
• These households act as entrepreneurs or producers of different goods and
services.
• They form the enterprises which are basically semi-corporate in nature.

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Act as a Consumer
• The households are the final consumers of goods and services produced by
the firms.
• They create demand in the market and according to their tastes and
preferences.
• The firms produced and supplied goods in the market, as per their
demand.
• Therefore, households determine the production line of a country.

Act as a Tax-Payer
• Households are the main sources of the government tax-revenue.
• They are the main tax-payer.
• A household pays
• Income tax
• Wealth tax
• Estate duty
• Gift tax, etc, as direct taxes to the state.
• Similarly, a household pays several indirect taxes to the government like
• GST, customs duty, etc.
• All these tax revenues are collected for the welfare and
development of the economy.

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Act as a Professional
• All types of professional services like Doctor, Teacher, Lawyer, Engineer., etc.,
come from households.
• Their activities are very much required for the country to enhance economic
development.
• These professional services increase the living standard of the people.

Act as a Saver Income

• After consumption is saving.
• Hence households earn income after giving several services to the economy.
• The portion of their income left after the consumption, is saved in the
banks or financial institutions.
• These savings are considered as one of the main source of capital
formation in India.

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Economic Principles Relevant to

Managerial Decision Making

Opportunity Cost
Concept of Incremental
Principle
Principle
Concept of Marginal
Concept of Discounting
Principle
Principle
Concept of Time
Concept of Equi-Marginal
Perspective Principle
Principle
Concept of Scarcity
Principle of Risk and
Principle
Uncertainty

Opportunity Cost Principle

• The interest earned on the funds that had been employed in other
ventures is the opportunity cost of the funds employed in one’s own
business.
• The time given by an entrepreneur to himself is the opportunity cost of
time.
• The opportunity cost of holding Rs.1,000/- as cash for one year is 8%
rate of interest, if the person has invested the money in mutual funds.
Therefore the determination of sacrifices is known as opportunity
cost. Opportunity cost will be zero, if there are no sacrifices.

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Concept of Incremental Principle

• Incremental cost and Revenue : The changes in a particular
decision like price, product, procedure, investment, etc. which results into
the change in total cost and revenue of a product.
A decision is profitable if, the following factors:
•The increase in revenue is more than the increase in cost.
•The increment in other costs is comparatively less than the reduction in some of the cost.
•The fall in other resources is comparatively less than the rise in some of the resources.
• It helps in reducing the cost without reduction in the revenue.
The basic motive of every businessman is to earn profit. It clearly states
that higher the risk more is the profit.

Concept of Marginal Principle

• If the resources are scarce then the manager has to be very careful
about the full utilization of each and every additional unit of
resources (inputs).

• Example: a consumer is willing to pay $5 for an ice cream, so the marginal benefit
of consuming the ice cream is $5. However, the consumer may be substantially less
willing to purchase additional ice cream at that price – only a $2 expenditure will
tempt the person to buy another one.

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Example: Should a store-owner keep his shop

open one hour longer?
• We must compare the marginal benefit with the
marginal cost
• Benefit = the extra bonus that results from the small
change
• Cost = the additional costs associated with the small
change

Difference between Marginal and

Incremental Concept
Basis of
Marginal Concept Incremental Concept
Difference
Marginal concept focuses on the function
Incremental concept considers more than
of single variable or it considers
Meaning one independent variable. It is multi-variable
independent variable.
function.
Example:Revenue depends upon Output.
Nature It is more specific in nature. It is general in nature.
Interrelation
All marginal concepts are some how All incremental concepts are not essentially
between each
incremental concepts. marginal.
other
Expressed in It is expressed in terms of unit change. It is expressed in terms of bulk change.

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Concept of Discounting Principle

• The origin of this principle is the valuation of the money received at
different point of time.
• Various transactions which involve making or receiving cash
payments at numerous future dates uses the discounting principle.

• Example: When a buyer takes home loan from any bank then he promise to make
monthly payments for twenty years. When a person injured in an automobile accident
then he accepts a settlement of Rs.4,000/- per month as compensation for the
damage from the insurance company for the life time.

• The concept of time value of money explains that the money which is received
at different future dates will not be same today.
• After one year the value of Rs.1,000/- is not equal to Rs.1,000/-, but
less than that. But it is required to know that how much money today is
equal to 1,000/- of one year hence. The rate of interest is required to find
out this.
• So, we will discount 1,000 at that rate of interest to ascertain the value
of 1,000 one year hence or two years hence.
• This discounting principle is:
FV=PV (1+r) n

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Concept of Time Perspective Principle

• A business firm should take any decision only after considering the effects of
decisions on costs and revenues in short-run and long-run.
• It is required that the proper balance should be maintained between the
short-run and long- run effects. Hence, it is very important to give proper
consideration to the time perspective.
• For example, ABC is a firm engaged in continuous production of X
commodities (long run). In the production process, it is having daily an ideal
time (free time) for few hours. In that ideal time, firm can take an order for
manufacturing other similar goods instead of wasting time.

Concept of Equi-Marginal Principle

• According to this principle, an input should be allocated in a way that the
value added by the last unit is the same in all cases. This generalization is
called the equi - marginal principle.

• Let us consider that a firm is involved in three activities such as A, B and C

activity. All the activities require the services of labour and the firm should
allocate the available labour in such a way that the value of Marginal
Product of labour is equal in all the three activities.

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VMPLa = VMPLb= VMPLc

Where,
• VMP =Value of Marginal Product
• L = Labour
• a, b, c = Activities i.e., the value of the marginal product of labour employed in a is equal to the value of the
marginal product of the labour employed in b and so on.

• For example: if in activity 'A', the value of marginal product of labour is 30 while
that in activity 'B', it is 40. Hence, it is profitable to shift labour from activity 'A' to
activity 'B', thereby expanding activity 'B' and reducing activity 'A'. When the value of
marginal product is equal in all the activities then the optimum condition will be
achieved.

Concept of Scarcity Principle

• 'Excess demand' of any commodity or service is referred to as scarcity.
• If demand (requirement) for anything exceeds its supply (availability) then it is
called scarce.
• Amount of demand in relation to supply determines the scarcity and hence it is
called relative concept. The scarcity requires managerial attention because it lies at
the root of any problem.
For example:
• Scarcity of jobs is known as unemployment.
• Scarcity of goods is known as inflation.
• Unsold stock of inventory is essentially the scarcity of buyers.
• Under-utilised capacity at the plant level may be primarily due to scarcity of power or other
supporting facilities.

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Principle of Risk and Uncertainty

• The risk and uncertainty are the important conditions which are faced by the managers
at the time of taking various kinds of decisions. The businessmen for taking better
decision should understand these conditions properly.
• Risk
• Risk refers to the possibility of the amount of uncertainty in the business. In other words, the
reduction in the number of possible outcome to various alternative course of action is termed as
risk.
• Uncertainty
• It refers to a situation where the various alternatives are present and among that the specific
outcome is determined. The possibilities of happening and non-happening of the resultant outcome
cannot be predicted.

Production Possibility Curve

• A production possibilities curve measures the maximum
output of two goods using a fixed amount of input.
• The input is any combination of the four Factors of
Production: natural resources (including land), labor,
capital goods, and entrepreneurship.

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• In Economics, the production possibilities curve is a visualization

that demonstrates the most efficient production of a pair of goods.
Each point on the curve shows how much of each good will be
produced when resources shift to making more of one good and less of
another.
• The production possibilities curve measures the trade-off
between producing one good versus another.
• Alternate name:Transformation curve

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• Say an economy produces 20,000

oranges and 120,000 apples. On the
chart, that's point B. If it wants to
produce more oranges, it must produce
fewer apples. On the chart, Point C shows
that if it produces 35,000 oranges, it
can only produce 85,000 apples.

• By describing this trade-off, the curve

demonstrates the concept of
opportunity cost. Making more of one
good will cost society the opportunity
of making more of the other good.

How the Production Possibilities Curve

Affects the Economy
• The curve does not tell decision-makers how much of each good the
economy should produce; it only tells them how much of each good
they must give up if they are to produce more of the other good.
• It is up to them to decide where the sweet spot is.
• In a market economy, the law of demand determines how much of
each good to produce. In a command economy, planners decide the
most efficient point on the curve. They are likely to consider how best
to use labor so there is full employment.

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Theory / Objectives of Business

Firm

Profit Maximization
Sales Maximization

Wealth Maximization
Managerial utility Maximization

Satisfactory level of profits

Economist theory of the firm

Cyert and March’s Behaviour

Other theory / Objectives of a
Theory
firm

Profit maximisation
• Profit maximisation is a process in business firms undergo to ensure the
best output and price levels are achieved in order to maximise its returns.
• In business, profit maximisation is a good at the same time it can be a bad
• For example, lower-quality materials and labour are used or if the business decides
to raise the prices for executing projects, all in pursuit of profit maximisation.
• Advantages Disadvantages
• Economic survival
• ‘Profit’ definition is unclear
• Measurement standard
• Social and economic welfare • Time value of money is ignored
• Attention not paid to risk
• Ignores quality

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Sales Maximization
• It is achieved when a
business sells as much of a
product or service as possible
without making a loss,
meaning the average revenue
of a product or service is the
same as its average cost to
produce it.

The wealth will be maximized if this criterion is followed in

making financial decisions:
• TimeValue of Money
• Risk and Return
• Select Discount Rate
• Cash Flows
• EconomicWelfare
• Increase MarketValue

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Topics Profit Maximization Wealth Maximization

Wealth maximization means maximizing
Profit maximization means
Definition the net present value or a wealth of a course
maximizing the profit of the firm.
of action to shareholders.
Subject Matter To increase profit volume. To increase wealth, not profit.
Risk The risk would not be considered. The risk would be considered.
TimeValue Time value is not considered. Time value is considered.
Inflation Inflation would not be evaluated. Inflation would be evaluated.
Welfare Social welfare is not considered. Social welfare is considered.
Keeps interested Only the owners. All the interested parties
Indicator It indicates increasing EPS. It indicates an increasing share price.

Maximum Growth Rate

Economic
Objectives
Desire for Liquidity

Survival
Other theory /
Objectives of Building-up Public
a firm Confidence for the product

Non-Economic Welfare
Objectives
Sound Business Practices

Progressive Management

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References:
• https://www.mbaknol.com/managerial-economics/introduction-to-managerial-economics/
• https://www.cheggindia.com/career-guidance/managerial-economics-principals-types-and-scope/
• https://www.superprof.co.in/blog/top-economists/
• https://www.superprof.co.in/blog/most-influential-economists/
• https://www.jaborejob.com/top-10-economists-of-india-you-must-know/
• https://www.wallstreetmojo.com/economics/
• https://www.managementstudyguide.com/principles-managerial-economics.htm
• https://youtu.be/QvOOnPLzc_U

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Economics For
1.4
Business Decisions

MODULE 2: DEMAND ANALYSIS & CONSUMER

EQUILIBRIUM 10 Hours
Demand theory and analysis, Elasticity of Demand and its role
in Managerial decision making, Demand forecasting, Techniques
of Demand forecasting. Consumers Equilibrium: Cardinal
utility approach, Indifference curve approach, Theory of
revealed preference, Consumer surplus.

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Concept of Demand

• Demand analysis is the process of understanding the

customer demand for a product or service in a target market.
• Companies use demand analysis techniques to determine if
they can successfully enter a market and generate expected
profits to expand their business operations.

Meaning of Demand
• The Demand refers to a consumer’s willingness for such quantity of goods and
services and ability to pay for same at various price trade within a period of
time.
• For example: if a person in feeling hungry but he does not have money
to pay for it, in that case his demand is ineffective
• Effective demand involves:
• Desire
• Means to purchase and
• Willingness to use those means for that purchase.

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Objectives of Demand Analysis

• Demand Forecasting
• Production Planning
• Sales Forecasting
• Control of Business
• Inventory control

Demand Forecasting

Production Planning

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Sales Forecasting

Control of Business

Inventory
control

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Price of the Commodity

Tastes and Preferences
Income of the consumer
Advertisement and Sales Propaganda

Determination Prices of Related Goods

Consumer’s Expectations
Of
Demand Growth of Population
Weather Conditions
Tax Rate
Availability of Credit
Pattern of Saving
Circulation of Money

Steps in Market Demand Analysis

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Market identification
• One of the first steps in market demand is to identify the target
market for the company’s products or services.
• Surveys or customer feedbacks can be leveraged to determine the
current customer satisfaction levels.
• Any comments indicating dissatisfaction can be taken into
consideration for planning improvements that will eventually
enhance customer satisfaction.

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Product Niche
• Once the market and their respective business cycles have been
reviewed, companies must develop products or tailor their services to
meet a specific niche in the market.
• Products must be differentiated from the peers in the market so that
they meet the specific needs of consumers, and thereby create higher
demand for the company’s goods or services.
• Example: handmade items, pet food or pet owners, trendy t-shirts, eco-
friendly products, beauty products, gadgets,or other trending products.

Evaluate competition
• A crucial factor of demand analysis is determining the number
of competitors in the market and their current market share.
• Markets in the emerging stage of the business cycle tend to
have fewer competitors. This translates to a higher profit
margin for your company.

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Theory of Demand
• Theory of Demand expresses the relation between the price and
quantity demanded by consumers at different prices in a
given period of time.

• Consumers seek utility maximization which means satisfaction they derive from
consuming goods and services for a given period and paying the price. Different
income levels of consumers determine the different quantity of goods demanded
to reflect their purchasing power.

Example: A consumer is willing to buy

Mercedes Benz with his low
level of income

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Terms related to Theory of Demand

•Demand Schedule
• It is a tabular representation of the correlation between the price of
the commodity and quantity demanded for a period of time.

• Individual Demand Schedule

• Market Demand Schedule

• Individual Demand Schedule

• It is a tabular representation of different quantities of a commodity at which
a consumer is willing to buy at different price levels during a given period of
time.

It also represent as the price keeps on declining the quantity demanded keep on
increasing.

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• Market Demand Schedule

• It is a tabular statement showing different quantities of a commodity that
all the consumers are willing to buy at various price levels during a given
period of time.

The price goes on declining, in result the market demand keeps on

increasing.

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Terms related to Theory of Demand

• Demand Curve
• It is a graphical representation of the correlation between the price
of the commodity and quantity demanded for a period of
time.

• Individual Demand Curve

• Market Demand Curve

• Individual Demand Curve

• It is a graphical representation of corresponding quantities demanded by an
individual of a specific item at different price levels. It is the locus of all those
points showing various quantities of an item that a consumer is willing to buy
at various price levels during a period of time.

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• Market Demand Curve

• It refers to the summation of individual demand curves in the market.
• In other words, it is the graphical representation of the sum total of all
individual demand for a specific commodity for a given period of time in the
given market.

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Perfectly Elastic Demand (Ep = ∞):

• The demand is said to be perfectly elastic when a small rise in price would result in a fall in
demand to zero. It is represented by a horizontal demand curve.
• A 5% increase in demand with no fall in price will
give us the equation :
• EP = 5 / 0 = infinity elasticity of demand
• For example: If people like both coffee and tea and
the price of tea goes up, people will have no problem
switching over to coffee. The demand for tea will thus
fall, and the demand for coffee will increase as the
products are substitutes for each other.
• Suppose the price of a commodity is Rs.10/- and its
demand is 50 units. As the price falls to Rs.9/-, its
demand increases to infinity.

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Perfectly Inelastic Demand (Ep =0):

• When demand doesn’t change with change in price (whether rising or fall), then demand is said to
be perfectly inelastic.
• Perfect inelasticity occurs in products or services where
consumers do not have any substitute goods to meet their
demands. If a 1% change in the price of a product, there will be
less than 1% change in the quantity demanded or supplied.

• For example: The price of insulin changed from $100 to $101, this is
a 1% increase, the demand varies from 1,000 units to 996 units which
are less than 1%, this will be considered inelastic. Even with the price
change, there is no impact on the amount of insulin needed.
• Suppose the price of a bottle of water is Rs.15/- and its demand is 200
units. As the price increases to Rs.20/- , the demand remains constant at
200 units. It implies the demand is perfectly inelastic.

Unitary Elastic Demand (Ep =1)

• The demand can be said as unitary elastic when the % change in quantity demanded is equal
to the % change in price.
• let us say, a 20% increase in price leads to a 20% fall in
demand.Then
EP = 20 / 20 = 1
• Example: The price of digital cameras increases by 10%, the
quantity of digital cameras demanded decreases by 10%. The
price elasticity of demand is (unitary elastic demand).
• Suppose, the price of a commodity is Rs.50/- and the quantity
demanded in a specific market is 200 units. As the price
increases to Rs.60/-, its demand declines to 160 units. It
implies unitary elastic demand

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Relatively Elastic Demand (E>1)

• When the percentage change in demand is more than
the percentage change in price, the demand is
relatively elastic.
• For example: A popular shoe brand sells its
flagship pair of shoes for $100, and it sells 2,000
pairs of these shoes per month. The company
decides to decrease the price of the shoes to $80,
which is a 20% change. It begins selling 2,500
pairs per month at the new price, which is a 25%
change. The shoes are relatively elastic since the
25% change in demand is more than the 20%
change in cost.

Relatively Inelastic Demand (E<1)

• When the percentage for the demand is less than the percentage change in price, the
demand is relatively inelastic. Most essential goods are often relatively inelastic.

• If the Demand for a product, increases by 5% following a

10% rise in price, then
EP = 5 / 10 = 0.5
• Example: A software company sells a service for $100 per
year and has 50,000 subscribers. The company raises the price
of the subscription service to $130 per year, which is a 30%
change. After the price increase, the company has 52,000
subscribers, which is a 4% change. Since the price increased by
30% and the demand increased by only 4%, the service is
relatively inelastic.

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Elasticity measures
NUMERICAL TYPE OF PRICE ELASTICITY
CONDITION
VALUE OF DEMAND
Greater change in demand in response to percentage or
= ∞ Perfectly elastic demand
smaller change in the price.
No change in demand in response to percentage or smaller
= 0 Perfectly inelastic demand
change in the price.
>1 Relatively elastic demand A change in demand is greater than the change in price.
<1 Relatively inelastic demand A change in demand is less than the change in price.

=1 Unitary elastic demand A change in demand is equivalent to change in price.

Joint demand
• It refers to a scenario where the demand for one product is directly proportional to the
demand for another. Both products are interlinked. They are used in a set; some examples
are bread and butter, milk and cereals, shoes, and socks. Naturally, they are also sold with
each other.
• Example: In 1921, Gillette reduced the price of razors—to the extent that it made no profits off
razors. Naturally, the demand rose. But right under the nose of customers, Gillette maintained the
price of razor blades. Due to exponential growth in razor sales, the demand for razor blades also
rose.Gillette made hefty profits on their razor blades and almost none on the razors.
• Between 1909 and 1924, Gillette sold a dozen blades for $1. Instead of reducing price, Gillette
reduced the number of blades per pack—from 12 to 10. In a way, Gillette increased the price per
blade and further increased profits.

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Composite Demand
• When commodities or services may be put to more than one use, a phenomenon known as
composite demand can occur. This means that a rise in the demand for one item may
cause a reduction in the supply of another.
For example: milk may be transformed into a variety of
dairy products such as cheese, yogurt, cream, and butter. As
a result, when more milk is utilized in cheese production,
there is less milk available to produce butter.

For example: people wanting to have a good camera buy

a phone, people willing to connect with others also buy a
phone, and someone who wants an internet connection also
buys a phone. Thus, the company researched buying
behavior and demand for phones and considered their
varied use cases.

Direct and Derived demand

• Direct Demand is the demand for commodities or services meant for final
consumption. This demand arises out of the natural desire of an individual to consume a
particular product.
• For example: the demand for food, shelter, clothes, and vehicles is direct demand as it
arises out of the biological, physical, and other personal needs of consumers.
• Derived demand refers to the demand for a product that arises due to the demand for
other products.
• For example: the demand for cotton to produce cotton fabrics is derived demand.
• Derived demand is applicable to manufacturers’ goods, such as raw materials,
intermediate goods, or machines and equipment. Apart from this, the factors of
production (land, labour, capital, and enterprise) also have a derived demand. For
example, the demand for labour in the construction of buildings is a derived demand.

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Cross Demand
• Change in the Quantity demanded of a product due to the change in the
price of some other product. • Coke & Pepsi
• McDonald’s & Burger King
• Tea & Coffee
• Cross Demand is divided into: • Butter & Margarine
• Substitute Goods •
•
Kindle & Books Printed on Paper
Potatoes in one Supermarket &
Potatoes in another Supermarket.
Identical Similar Comparable
• Complementary Goods

Imagine that the price of a can of Coke increases from P1 to P2.

People would consume less Coke – the quantity declines from Q1 to
Q2. For a can of Pepsi – the substitute good – the demand curve
shifts out for all price levels, from D to D1, leading to a greater
consumption of the substitute good.

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Complementary Vs. Substitute Goods

Particulars Complementary Goods Substitute Goods
Consumers use these goods in place of each other.
Consumers use these goods together. Thus, one
Definition Thus, the demand for one is linked to the other
good’s demand can affect the other’s demand.
good’s price.
• Pen and paper
• Eyeglasses and contact lenses
• Coffee and milk
Examples • Butter and margarine
• Car and fuel
• Laptops and desktops
• Razors and razor blades
Inverse relationship: Increase in the price of one Direct relationship:
Price Relationship good lead to a decrease in demand for both An increase in the price of one good lead to an
goods. increase in demand for the other good.
Cross-Price Elasticity Negative Positive
Sales of one product affect (increases or Sales of one product may increase when the price of
Impact on Sales
decreases) sales of the other. the other product increases

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Demand forecasting
• It is a process of predicting the demand for an organization's products or services in a
specified time period in the future.

Techniques & Methods of Demand Forecasting

• Different organizations rely on different techniques to forecast demand for their products
or services for a future time period depending on their requirements and budget.
• Methods of demand forecasting are broadly categorized into two types.

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QualitativeTechniques
• Qualitative techniques rely on collecting data on the buying behavior of
consumers from experts or through conducting surveys in order to forecast
demand.
• These techniques are generally used to make short term forecasts of
demand.
• Qualitative techniques are especially useful in situations when
historical data is not available
• For example: Introduction of a new product or service.
• These techniques are based on experience, judgment, intuition (perception),
conjecture (assumption), etc.

Survey Methods

Opinion poll
• Opinion poll methods involve taking the opinion of those who
possess knowledge of market trends, such as sales representatives,
marketing experts, and consultants.
• The most commonly used opinion polls methods are
• Expert opinion method
• Delphi method
• Market studies and experiments

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QuantitativeTechniques
• Quantitative techniques for demand forecasting usually make use of
statistical tools.
• In these techniques, demand is forecasted based on historical
data.
• These methods are generally used to make long-term forecasts of
demand. Unlike survey methods, statistical methods are cost effective
and reliable as the element of subjectivity is minimum in these
methods.

Time Series Analysis

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Smoothing Techniques
• In cases where the time series lacks significant trends, smoothing techniques can be used
for demand forecasting. Smoothing techniques are used to eliminate a random variation
from the historical demand.
• The simple moving average method is used to calculate the mean of average prices
over a period of time and plot these mean prices on a graph which acts as a scale.
For example: a five-day simple moving average is the sum of values of
all five days divided by five.
• The weighted moving average method uses a predefined number of time periods to
calculate the average, all of which have the same importance.
For example: in a four-month moving average, each month represents
25% of the moving average.

Barometric Methods
• Barometric methods are used to speculate the future trends based on current developments.This methods are
also referred to as the leading indicators approach to demand forecasting.

The barometric methods make use of the following indicators:

• Leading indicators: When an event that has already occurred is considered to predict the future event, the past event
would act as a leading indicator.
For example, the data relating to working women would act as a leading indicator for the demand of working women
hostels.
• Coincident indicators:These indicators move simultaneously with the current event.
For example, a number of employees in the non-agricultural sector, rate of unemployment, per capita income, etc., act
as indicators for the current state of a nation’s economy.
• Lagging indicators: These indicators include events that follow a change. Lagging indicators are critical to interpret how
the economy would shape up in the future.These indicators are useful in predicting the future economic events.
For example,inflation,unemployment levels, etc. are the indicators of the performance of a country’s economy.

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Econometric Methods
• Econometric methods make use of statistical tools combined with economic theories to assess various
economic variables (for example, price change, income level of consumers, changes in economic
policies,and so on) for forecasting demand.
• The forecasts made using econometric methods are much more reliable than any other demand
forecasting method. An econometric model for demand forecasting could be single equation regression
analysis or a system of simultaneous equations.

Regression Analysis
The regression analysis method for demand forecasting measures the relationship between
two variables. Using regression analysis a relationship is established between the
dependent (quantity demanded) and independent variable (income of the consumer, price
of related goods, advertisements, etc.).
• For example, regression analysis may be used to establish a relationship between the income of
consumers and their demand for a luxury product. In other words, regression analysis is a statistical
tool to estimate the unknown value of a variable when the value of the other variable is known.
• After establishing the relationship, the regression equation is derived assuming the relationship
between variables is linear.
• The formula for a simple linear regression is as follows:
• Y =a + bX
• Where Y is the dependent variable for which the demand needs to be forecasted; b is the slope of the
regression curve; X is the independent variable; and a is the Y-intercept. The intercept a will be
equal toY if the value of X is zero.

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Consumer’s Equilibrium
• A situation where a consumer spends his given income
purchasing one or more commodities so that he gets
maximum satisfaction and has no urge to change this
level of consumption, given the prices of commodities, is known
as the consumer’s equilibrium.

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Condition of consumer equilibrium in case of a

single commodity
• The consumer will be in the state of equilibrium when the
following condition is fulfilled:

• The marginal utility of commodity X in terms of rupees is equal to the price

of commodity X in rupees.

[MUx (in ₹) = Px (in ₹)]

Hypothetical Schedule/ Numerical

Example
• Let us take the example of a fruit ice cream. The price of an ice cream scoop is
• ₹30 and MUm, i.e., MU of money (₹1) = 1 util
MU of ice -cream MU of money MU of ice -
Price of ice -cream
Units scoop (Re. 1) cream scoop
scoop
Consumed (in utils) (in utils) (in ₹)
(₹)
{a} {b} = {a}/ {b}
1 50 1 50 > 30
2 40 1 40 > 30
3 30 1 30 = 30
4 20 1 20 < 30
5 10 1 10 < 30

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Explanation and conclusion

In the given example, the level of consumer’s equilibrium is 3 units.
• Where,
• MU of ice cream in rupees = Price of ice cream in rupees, i.e., ₹30
• Before this level, e., at the first and the second level, MU > Price, i.e., benefit is more than
cost. So, the consumer increases the consumption to attain equilibrium.
• After this level, i.e., at the fourth and the fifth level, MU < Price, e., benefit is less than
cost. So, the consumer cuts or decreases the consumption to be in the state of equilibrium.
Only at the level of 3 units, the condition of consumer’s equilibrium is fulfilled.
• A consumer consumes the quantity at which MUx = Px to be in the state of equilibrium.

Alfred Marshall John R. Hicks

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Cardinal Utility Ordinal Utility

It explains that the satisfaction level
It explains that the satisfaction level after after consuming any goods or services
Definition consuming any goods or services can be cannot be scaled in numbers. However,
scaled in terms of countable numbers. these things can be arranged in the order
of preference.
Pizza gives Sam 60 utils of satisfaction, Sam gets more satisfaction from a pizza
Example
whereas burger gives him only 40 utils. as compared to that of a burger.
Measurement Utility is measured based on utils. Utility is ranked based on satisfaction.
Realistic It is less practical. It is more practical and sensible.
Other Name Utility Analysis Indifference Curve Analysis

Indifference Curve Approach

• Indifference curve can be defined as the locus of points each representing a different
combination of two goods, which yield the same level of utility and satisfaction to a
consumer.
• Therefore, the consumer is indifferent to any combination of two commodities if he/she
has to make a choice between them. This is because an individual consumes a variety of
goods over time and realizes that one good can be substituted with another without
compromising on the satisfaction level.
• When these combinations are plotted on the graph, the resulting curve is
called indifference curve. This curve is also called the iso-utility curve or equal
utility curve.

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Indifference Curve Analysis

• Assume that a consumer consumes two commodities X and Y and makes
five combinations for the two commodities a, b, c, d, and e, which is
shown in Table 1:
UNITS OF UNITS OF TOTAL
COMBINATION
COMMODITY Y COMMODITY X UTILITY

a 25 3 U
b 15 5 U
c 8 9 U
d 4 17 U
e 2 30 U

UNITS OF UNITS OF
COMBINATION
COMMODITY Y COMMODITY X

a 25 3

b 15 5

c 8 9 On the indifference curve (IC), there can

d 4 17
be several other points in between the
e 2 30
points a, b, c, d, and e, which would yield
the same level of satisfaction to the
consumer. Therefore, the consumer
remains indifferent towards any
combinations of two substitutes yielding
the same level of satisfaction.

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Revealed preference theory

• What we want is revealed by what we do, rather than what we say –
actions speak louder than words – so the theory says.
• When making a purchase, as consumers, we had considered a set of alternatives
beforehand, revealed preference theory suggests. Therefore, given that we chose one option
out of a set, whatever we chose has to be the preferred option.
• Revealed preference theory was pioneered by Paul Anthony Samuelson (1938), an
American economist, the first US citizen to be awarded the Nobel Memorial
Prize in Economic Sciences.
• Since Samuelson first introduced the theory, several economists have expanded it.
Revealed preference theory remains a key theory of consumption behavior – it is
especially useful when you want to analyze consumer choice **empirically
(practice).

• The basic hypothesis of the revealed preference theory is that ‘choice

reveals preference’.

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Axiom of Revealed Preference Theory

• Weak Axiom of Revealed Preference (WARP)
• A consumer always makes the same choice while purchasing one commodity instead of the
other at the given price and income. The consumer makes a different choice if the other
commodity provides more benefit in terms of more affordability or better quality.
• Strong Axiom of Revealed Preference (SARP)
• If a consumer chooses commodity A over commodity B. The consumer is consistent over his
choice of action. In no other situation he/she will change.
• Generalised Axiom of Revealed Preference (GARP)
• It states that more than one combination of two commodities provides the same level of
satisfaction to a consumer at a given market price and income level. As per GARP, there is
no unique combination of two commodities that provides maximum utility to the
consumer.

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Example
• Suppose that Mr.A wants to purchase a fully-automatic top load 7kg washing machine
with 700 rpm, temperature control feature, and an auto detergent dispenser. He is also
ready to spend a maximum of $800. Nonetheless, he discovers a reputed electronic store
offering the desired product at just $500.

Now, let’s apply the formula for calculating consumer surplus:

CS = Highest product price consumers are ready to invest – Market price
= $800-$500
= $300

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References
• https://theinvestorsbook.com/sales-forecast.html
• https://www.edureka.co/blog/types-and-methods-of-demand-forecasting/
• https://tutorstips.com/price-elasticity-of-demand/
• https://businessjargons.com/types-of-price-elasticity-of-demand.html
• https://www.geektonight.com/cross-elasticity-demand/

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Economics For Business Decisions – 1.4

Theory of
Production Module - 3

Module – 3 Theory of Production (10 hours)

Production function: Laws of variable proportions and Return
to scale, Economies and diseconomies of scale, Isoquants and
Isocost, optimum combination of inputs, Elasticity of
substitutions.

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Introduction
In economics, production theory explains the principles in which the
business has to take decisions on how much of each commodity it
sells and how much it produces and also how much of raw
material ie., fixed capital and labor it employs and how
much it will use.
It defines the relationships between the prices of the
commodities and productive factors on one hand and the
quantities of these commodities and productive factors
that are produced on the other hand.

Production Function
• The Production function signifies a technical relationship between the physical inputs
and physical outputs of the firm, for a given state of the technology.
Q = f (a, b, c, . . . . . . z)
Where
a,b,c ....z are various inputs such as land, labor ,capital etc.
Q is the level of the output for a firm.
• If labor (L) and capital (K) are only the input factors, the production function reduces to
Q = f(L, K)
• Production Function describes the technological relationship between inputs and outputs.
It is a tool that analysis the qualitative input – output relationship and also represents
the technology of a firm or the economy as a whole.

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Production Analysis
• Production analysis basically is concerned with the analysis in which the
resources such as land, labor, and capital are employed to produce a
firm’s final product.
• To produce these goods the basic inputs are classified into two divisions −
• Variable Inputs
• Inputs those change or are variable in the short run or long run are
variable inputs.
• Fixed Inputs
• Inputs that remain constant in the short term are fixed inputs.

Cost Function

Cost function is defined as the relationship between the cost of

the product and the output.
• Short Run Cost
• Long Run Cost

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Short Run Cost

• Short run cost is an analysis in which few factors are constant which won’t
change during the period of analysis. The output can be changed ie.,
increased or decreased in the short run by changing the variable factors.
• Following are the basic three types of short run cost −

Long Run Cost

• Long-run cost is variable and a firm adjusts all its inputs to make sure that
its cost of production is as low as possible.
Long run cost = Long run variable cost
• In the long run, firms don’t have the liberty to reach equilibrium between
supply and demand by altering the levels of production.They can only expand
or reduce the production capacity as per the profits.
• In the long run, a firm can choose any amount of fixed costs it wants to make
short run decisions.

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Law of Variable Proportions

• The Law of Variable Proportions concerns itself with the way the output
changes when you increase the number of units of a variable
factor. Hence, it refers to the effect of the changing factor-ratio on the
output.
• As one input varies and all others remain constant, the factor ratio
or the factor proportion varies.
• Example: Let’s say that you have 10 acres of land and 1 unit of labour for
production. Therefore, the land-labour ratio is 10:1. Now, if you keep the land
constant but increase the units of labour to 2, the land-labour ratio becomes 5:1.

Example: the land is the fixed factor and

labour is the variable factor. The table shows
the different amounts of output when you
apply different units of labour to one acre of
land.

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Three Stages of the Law

• Stage I – The TPP increases at an increasing rate and the MPP increases too. The
MPP increases with an increase in the units of the variable factor.
Therefore, it is also called the stage of increasing returns. In this example, the
Stage I of the law runs up to three units of labour (between the points O and L).
• Stage II – The TPP continues to increase but at a diminishing rate. However, the
increase is positive. Further, the MPP decreases with an increase in
the number of units of the variable factor. Hence, it is called the stage of
diminishing returns. In this example, Stage II runs between four to six units of labour
(between the points L and M). This stage reaches a point where TPP is maximum (18 in
the above example) and MPP becomes zero (point R).
• Stage III – Now, the TPP starts declining, MPP decreases and becomes
negative. Therefore, it is called the stage of negative returns. In this example, Stage
III runs between seven to eight units of labour (from the point M onwards).

Returns to Scale
• An increasing returns to scale occurs when the output increases by
a larger proportion than the increase in inputs during the production
process.
• For example, if input is increased by 3 times, but output increases by
3.75 times, then the firm or economy has experienced an increasing
returns to scale.

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• Example: The firm cannot build a new factory to increase its returns to
scale because it takes time and money to build one. It can, however, hire
additional workers to increase its short-run returns, but only up to a certain
point due to the law of diminishing marginal returns. However after
the factory is built, the firm can hire more workers. These changes in the
firm's inputs (labour, land, etc.) can help increase the firm's output, known as
returns to scale.
• Diminishing marginal utility refers to the phenomenon that each
additional unit of gain leads to an ever-smaller increase in subjective
value. For example, three bites of candy are better than two bites, but
the twentieth bite does not add much to the experience beyond the
nineteenth (and could even make it worse).

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Constant Returns to Scale

• Constant returns to scale or constant cost refers to the production situation in
which output increases exactly in the same proportion in which factors of
production are increased. In simple terms, if factors of production are
doubled output will also be doubled.

In this case internal and external economies are

exactly equal to internal and external diseconomies.
This situation arises when after reaching a certain
level of production, economies of scale are balanced
by diseconomies of scale. This is known as
homogeneous production function.

Increasing Returns to Scale

• Increasing returns to scale or diminishing cost refers to a situation when all
factors of production are increased, output increases at a higher rate. It
means if all inputs are doubled, output will also increase at the faster rate than
double. Hence, it is said to be increasing returns to scale.

OX axis represents increase in labour and

capital while OY axis shows increase in
output. When labour and capital increases
from Q to Q1, output also increases from P to
P1 which is higher than the factors of
production i.e. labour and capital.

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Diminishing Returns to Scale

• Diminishing returns or increasing costs refer to that production situation, where if all the
factors of production are increased in a given proportion, output increases
in a smaller proportion. It means, if inputs are doubled, output will be less than
doubled. If 20 percent increase in labour and capital is followed by 10 percent increase in
output, then it is an instance of diminishing returns to scale.
OX axis, labour and capital are given while on OY
axis, output. When factors of production increase from
Q to Q1 (more quantity) but as a result increase in
output, i.e. P to P1 is less. We see that increase in factors
of production is more and increase in production is
comparatively less, thus diminishing returns to scale
apply.

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Isoquant and isocosts

• An isoquant shows all combination of factors that produce a
certain output
• An isocost show all combinations of factors that cost the same
amount
• Isocosts and isoquants can show the optimal combination of
factors of production to produce the maximum output at
minimum cost

Isoquants
• The term "isoquant" broken down in Latin, means “equal quantity” with
“iso” meaning equal and “quant” meaning quantity.
• The isoquant is known, alternatively, as an equal product curve or a production
indifference curve. It may also be called an iso-product curve.
• Isoquants are a geometric representation of the production function. The same level
of output can be produced by various combinations of factor inputs.
• The locus of all possible combinations is called the ‘Isoquant’.
• Example, say 24. There several ways to compute the value 24. They are 24x1,
12x2, 8x3, 4x6 etc and each combination will equal 24.

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Isoquant shows all the combinations of labour and

capital that can produce a total output (Total Physical
Product TPP) of 4,000.
In the graph isoquant could be
20 capital and 18 labour (more capital intensive)
9 capital and 35 labour (more labour intensive)
An isoquant is usually shaped concave because of the law
of diminishing returns. With fixed capital employing extra
workers gives a declining increase in the marginal
product (MP)

Let us suppose a firm producing 20 units of a product using different

combination of factors. It is shown below:

Factor Units of Units of Total Units

Combination Labour Capital of Output
P 2 20 20
Q 4 12 20
R 6 7 20
S 8 5 20
T 10 4 20

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• Isoquant Map – A number of isoquants depicting different levels of output

are known as isoquant map.

Isoquant IQ1 depicts the lowest level of

output of 20 units while isoquants IQ2
and IQ3 depict higher level of output of
30 units and 40 units respectively.
Higher isoquant represents higher level
of output than the lower one.

Isoquant Curve vs. Indifference Curve

• The isoquant curve addresses cost-minimization problems
for producers—the best way to manufacture goods.

• The indifference curve, on the other hand, measures the

optimal ways consumers use goods. It attempts to
analyze consumer behavior, and map out consumer
demand.

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Properties/Characteristics of Isoquants
1. Two isoquants do not intersect each other 2. No isoquant can touch either axis

3. Isoquant is oval in shape 4. A higher IQ implies a higher level of output

Isocost line
• An isocost line shows all combinations of inputs which cost
the same total amount.
• Although similar to the budget constraint in consumer theory, the use
of the isocost line pertains to cost-minimization in
production,as opposed to utility-maximization.

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Shift in Isocost line

Case: 1 (Change in Wage rate only) Case: 2 (Change in Interest rate only)
Initial IC = L, K Initial IC = L, K
Right Shift IC = L”, K, when w Upward Shift IC = L, K”, when r
Left shift IC = L’, K, when w Downward shift IC = L, K’, when r

Case: 3 (Change in Budget only)

Initial IC = L, K
Right Shift IC = L”, K”, when B
Left shift IC = L’, K’, when B

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Producer’s Equilibrium / Optimal Combination

of Input
• The producer is in equilibrium whereas the producer earns the maximum profit. A
rational producer earns the maximum profit at the point when he/she produce maximum
level of output at minimum cost.
• The producer equilibrium required the
following two conditions:
i. Necessary condition: Iso-cost line
tangent to iso-quant. It means, slope of iso-quant is
equal to slope iso-cost line.
ii. Sufficient condition: In point of
contact iso-quant is convex to the origin.

Elasticity of Substitution
• An elasticity of substitution is a measure of the extent to which one input substitutes for
another input along an isoquant.To the extent inputs substitute for each other,
• For example: A farmer can respond to changing relative input prices by adjusting the combination
or mix of inputs that are used.
• The elasticity of technical substitution is defined as the percentage change in the ratio of
the two factors of production (say Capital-labour ratio), divided by the percentage
change in the marginal rate of technical substitution.

Percentage change in K/L

Es =
Percentage change in MRTS LK

• Greater the degree of substitutability, higher the value of Es and vice-versa.

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References
• https://www.mbaknol.com/managerial-economics/introduction-to-managerial-economics/
• https://www.economicsdiscussion.net/production/law-of-returns-to-scale-definition-explanation-and-its-types/6940
• https://www.economicshelp.org/blog/glossary/isoquant-and-isocosts/
• https://www.businesstopia.net/economics/micro/concept-isocost-line
• https://policonomics.com/isocost/
• https://www.google.com/imgres?imgurl=https%3A%2F%2Fbusinesstopia.b-cdn.net%2Fwp
• https://www.tutorialspoint.com/managerial_economics/theory_of_production.htm
• https://k12.libretexts.org/Bookshelves/Economics/03%3A_Entrepreneurship_and_Economic_Growth/3.16%3A_The_
Theory_of_Production
• https://www.slideshare.net/ayushparekh/law-of-variable-proportions-and-law-of-returns-to-scale
• https://www.geeksforgeeks.org/law-of-returns-to-scale-meaning-and-stages/
• https://www.toppr.com/guides/business-economics/theory-of-cost/economies-and-diseconomies-of-
scale/#:~:text=Economies%20of%20scale%20refer%20to,cost%20per%20unit%20starts%20increasing

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Economics For Business Decisions 1.4

Cost
&
Revenue Module - 4

Module – 4 Cost & Revenue Concepts (10 hours)

Cost and Revenue concepts: kind of costs, interrelationship of
cost. Cost reduction and cost control, Short run and long run
cost functions and Market Equilibrium, Revenue Concepts –
Relationship between total, marginal and average revenue,
significance of revenue curves, Relation between cost and
revenue curves. Optimal Input Choice revisited: Cost
Minimization vs. Output Maximization - Relation between SR
and LR Costs - Economies of Scale in terms of Cost Function.

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Meaning of Cost
• In order to understand the meaning of cost let us take the Example of a
farmer who is producing rice/paddy. You know that, it normally takes 5 to 6
months to produce rice.The production of rice involves the following:
1.Getting the land for cultivation
2.Using labour to prepare the land and make it suitable for growing
the crop.This includes tilling the soil, sowing seed, fertilizing and
irrigating the land and finally harvesting.
3.Transporting rice to godown/mandi.

• How does the farmer get land? It could be possible that, the farmer has ancestral land. Otherwise he
has to hire land from others by paying rent. He has also the option of purchasing land by paying a
very heavy amount. In the present example, let us say, that the farmer hires 5 acres of land
on rent.
• Suppose,he has to pay Rs. 5,000 as rent to the owner of the land for the whole period he uses it.
• The farmer also needs labourers to work on the field for 5 months. Let us say the farmer hires 4
labourers. In the first two months he uses the labourers to till the soil, sow seeds, transporting the
seedlings and planting them by hand, fertilising and irrigating the field. In order to hire a labourer, the
famer must pay wage. The wage rate prevailing in the market on an average is say, Rs. 75 per worker per
day. When the farmer used only two labourers for two months to look after the standing crop. When the
time of harvesting arrives, he again hires 4 labourers for 15 days. What is the total amount paid to the
labourers by the farmer? First, 4 labourers work for two months or sixty days. So at Rs. 75 per worker it
comes to 75 × 4 × 60 = Rs.18,000/-. Then two labourers work for two months. This comes to 75 ×
2 × 60 = Rs.9000/-. Finally 4 labourers worked for 15 days. This comes out to be 75 × 4 × 15 =
Rs.4,500/-.The total money paid to the labourers was 18,000 + 9,000 + 4,500 = Rs.31,500/-.

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• To grow the crop, the farmer uses some raw materials such as seeds, water, fertilizer,
pesticicdes etc. for which he spends, say, Rs. 3,000/-. He also uses tractor for which he
pays rent of Rs. 2500/-.After harvesting the farmer produces, say, 30 quintals of rice.
• Now, calculate the total money spent by the farmer to produce rice? We can do it in the
following manner.
Items Expenditure (Rs.)
Rent paid to Landlord 5,000
Wages to labour 31,500
Raw materials 3,000
Service of Tractor 2,500
Total 42,000
• We can say that, the farmer spent Rs.42,000/- to produce 30 quintals of rice.

Definition of Cost
• Cost is defined as the money expenditure incurred by the producer to purchase
(or hire) factors of production and raw materials to produce goods and
services.
• In a way, cost is a kind of sacrifice made by the producer.
• In the above Example, the sacrifice was made in terms of making
payments; such as wages to labourers, rent for the use of land and tractor
and incurring expenditure on raw materials etc.

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Types of Cost

• Fixed cost
• Variable cost
• Explicit cost
• Implicit cost

Fixed Cost
• In the above example, we said that the farmer paid Rs. 5,000/- as rent to
the owner of the land. Once the land is procured for cultivation, the farmer
must pay rent for it, even if he does not produce any thing on it.
• The land is also fixed factor of production here. Because, whether or not the
farmer cultivates on the entire 5 acres of land, he has to pay rent for the
whole 5 acres.
• So fixed cost is defined as the expenditure, on hiring or
purchasing of fixed factors/ inputs, which are compulsory and
has nothing to do with the amount of production of the good or
service.Similarly, rent paid for the use of tractor is also a fixed cost.

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Variable Cost
• In the above example, the farmer paid Rs.31,500/- towards wage for labourers and
Rs.3000/- for purchase of raw materials. How much of wage was paid depends on how
many labourers the producer hired.
• Labour as a factor of production can be changed. In the example, we said
that the producer used 4 labourers during the first two months and only 2 labourers for
the next two months. This is because in the beginning the amount of work was more and
more labourers were required. Accordingly more amount of money, i.e Rs.18,000/-, was
paid. But when the amount of work was less during the next two months, only 2 labourers
were hired and accordingly the wage bill also decreased to Rs.9,000/-. Hence,
payment towards wages can be changed.
• So it is called variable cost. We can define variable cost as the expenditure on
variable factors/inputs, such as labour, which can be changed.

Explicit Cost
• Both the rent and wages paid by the farmer and the expenditure on
raw materials incurred by him are also called explicit cost.
• Explicit cost is defined as the money expenditure incurred by the
producer on both fixed and variable factors of production and raw
materials etc.
• These are direct payments and are properly calculated and
recorded separately. Bills, money receipts or vouchers etc exist
with respect to such expenditure by the producer.

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Implicit Cost
• Besides purchasing factors of production and raw materials, the producer also
uses his own factors and materials for producing goods and services. For
this he does not pay any money to himself. But he bears this
expenditure indirectly.
• Suppose, a farmer uses his own tractor to cultivate land. Had he hired a tractor from
somebody else, he would have paid rent for this. In that case it would have been called
explicit cost of the farmer. Let us say the rent for using the services of a tractor is Rs.
3,000/- for a particular period of time. So the farmer can earn Rs.3,000/- if he gives
his tractor on rent. Otherwise, if he uses it for himself, then he will consume a value of Rs.
3,000/- for the purpose of production. In this case, it will be called implicit cost of the
farmer. So implicit cost is the cost of self supplied factors. The value of such
cost has to be calculated on the basis of market value.

Total and Average Cost

• Total cost is the sum of total fixed cost and total variable
cost which are given explicitly.
• Average total cost or simply the average cost is the ratio of
total cost to the total output.
• We can also write,
• Total Cost (TC) = Total Fixed Cost + TotalVariable Cost
• Average Cost (AC) = Total Cost/Total Output.
• Average Cost is the cost per unit of output.

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Marginal Cost (MC)

• If the producer wants to increase output, then he has to engage extra units of
labour. Extra units of labour will lead to extra expenditure on wage paid to
the labour. As a result the total cost of production will increase. In short,
increase in total output will lead to increase in total cost of production. In
this context marginal cost is defined as increase in the total cost
due to increase in one extra unit of output.
• Example: Suppose a tailor makes 10 pieces of shirts by incuring a total cost of
Rs. 1,110/-. Then he increased shirt production to 11 pieces for which
he incurred Rs. 1,199/- as total cost.What is the marginal cost?
• Ans: Here increase in output is 11-10 = 1 unit. Because of increase in output by one unit,
cost.

Comparing Marginal Cost & Average Cost

• In the above Example while there is one value of marginal cost as calculated above, we can
compute two different values of average cost.
• First value of average cost relates to 10 pieces of shirts.With a total cost of Rs. 1,110/-
• So AC = 1110/10 = Rs. 111/-
• Second value of average cost relates to output of 11 shirt pieces with total cost of Rs. 1,199/-
• Here AC = 1199/11 = Rs. 109/-
• From this we can say that average cost is calculated for every given level of output. On the other hand,
marginal cost is calculated when a given level of output is increased by one unit. That is, marginal cost is
calculated between two successive levels of output.
• We can express the above example in the form of a table as follows:

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Revenue
• Revenue is another very important concept in economics. In fact the study of cost is
not complete, if we do not talk about revenue.What is revenue?
• Definition of Revenue
• Revenue is defined as the amount a person receives by selling a certain quantity of
the commodity. So revenue can be calculated by multiplying price and quantity of the
commodity. Hence we can write
• Revenue = Price of the Commodity × Quantity of the Commodity
• During a given period of time, the seller sells certain quantity of the commodity.
• So the total amount of money received by the seller during that time period is called
total revenue.We denote it asTR, price as ‘P’ and quantity as ‘Q’ then we can write
• Total Revenue = Price × Quantity orTR = P × Q

• Example: Continue with the example of the farmer in our section on “Cost”.Think that
the farmer produced 30 quintals of rice. Let us say that the price of rice is Rs. 1,600 per
quintal in the market. If the farmer sells all this rice then he will earn 1600 × 30 =
Rs. 48,000/-. So his total revenue will be Rs. 48,000/-.
• From this example, we can also say that revenue is the money receipts of the producer
or seller from the sale of his output.
• Another term used for “total revenue” is total sales proceeds. Because revenue is
received by selling a commodity. It is also called total sales proceeds from that
Commodity.

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Use of Revenue and Cost

• Both revenue and cost are important concepts in economics. While cost is the
expenditure incurred to produce a good or service during the production
process, revenue is the money received by the producer by selling that good
or service.
• So cost symbolizes sacrifice made by the producer and revenue symbolizes
gains for the producer.
• By getting the required revenue from sale of the commodity the producer is able to recover
the cost he has incurred earlier. In that case we say that the producer earned
his due share which is called profit. We can define that profit is the surplus of
revenue over the total cost of production.
Profit =Total Revenue – Total Cost

Cost control and Cost reduction

Definition of Cost Control
• Cost Control is a process in which we focus on controlling the total cost through competitive
analysis. It is a practice which works to align the actual cost in agreement with the
established norms.
• It ensures that the cost incurred on production should not go beyond the pre-determined cost.
Cost Control involves a chain of various activities, which starts with the preparation of the
budget in relation to production.
• For example- control wastage of material, any embezzlement and so on.
• It involves:
• Determination of standards
• Ascertaining actual results comparing the standards
• An analysis of the variances
• Establishing the action that may be taken.

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Definition of Cost Reduction

• Cost Reduction is a process, which aims to lower the unit cost of a product manufactured or
service rendered without affecting its quality. It can be done by using new and improved
methods and techniques. It ascertains substitute ways to reduce the production cost of a unit.
• Thus, cost reduction ensures savings in per unit cost and maximization of profits of the
enterprise. Cost Reduction aims at cutting off the unnecessary expenses which
occur during the production Process, storage, selling and distribution of the
product.
• To identify cost reduction we should focus on the following major elements:
• Savings in per unit production cost.
• The quality of the product should not be affected.
• Savings should be non-volatile in nature.
• Tools of cost reduction focus on Quality operation and research, Improvement in product design,
Job Evaluation & merit rating,variety reduction,etc.

Difference Between Cost Control and Cost

Reduction
Cost Control Cost Reduction
Cost Control focuses on decreasing the total cost Cost reduction focuses on decreasing per unit
of production. cost of a product.
Cost Control is a temporary process in nature. Cost Reduction which is a permanent process.
The process of cost reduction is a continuous
The process of cost control will be completed when the
process. It has no visible end. It targets for
specified target is achieved.
eliminating wasteful expenses.
Cost control does not guarantee quality Cost reduction assured 100% quality
maintenance of products. maintenance.
Cost Control is a preventive function because it
Cost Reduction is a corrective function.
ascertains the cost before its occurrence.

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Short run and long run cost functions

Short Run Costs
• It is the cost incurred in production during a fixed period of time when all the factors
and inputs vary, except one. Assessing the short run costs of an organisation or an
economy helps us to study how it behaves in response to sudden environmental
changes.
Long Run Cost
• Long Run Cost is the minimum cost at which a certain level of output can be achieved in
the long run when all factors of production are variable.
• These costs enable a business to understand its asset value and make necessary
improvements in the production cycle. As a result, this helps organisations
analyse their factors of production and expand or reduce their operational costs
accordingly.

Difference Between Short Run and Long

Run Cost
Short Run Cost Long Run Cost
In the short run, a firm is constrained by In the long run, all inputs can be adjusted, and
atleast one fixed input, such as a factory a firm has more flexibility to optimize its production
or specialized labor. process for maximum efficiency.

A firm’s costs are partially fixed and In the long run, a firm’s costs are entirely variable
partially variable.

Fixed costs cannot be changed in the The firm can adjust all inputs, including land,
short run, while variable costs can be labor, capital, and raw materials, to
adjusted to some extent minimize its costs and maximize its output.

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Types of Short Run Costs

• It should be kept in mind that these costs are crucial to determine the long run costs of a company.
1. Short Run Total Cost (STC)
• Short run total cost is a company’s total cost of production for a given output. It is further divided into two types
which are total fixed and variable costs.
• Total variable costs (TVC) are costs that change when the output changes in the short run,
like cost of raw materials.
• Total fixed costs (TFC) are costs that remain the same with an increase in production in
the short run, like the cost of machinery.
2. Short Run Average Cost (SAC)
• SAC is the average cost of a given production of a company in the short run. It is the average cost per unit when
all inputs are variable except one. Short run total cost divided by output equals SAC.
3. Short Run Marginal Cost (SMC)
• It is the additional cost incurred to produce a certain output. SMC is incurred when there is a change in
total cost due to a change in production input costs. It is calculated by dividing the total cost by
the change in total output.

Types of Long Run Costs

1. Long Run Total Cost (LTC)
• The minimum cost required to produce a particular quantity of commodity with
variable factors of production is LTC.
2. Long Run Average Cost (LAC)
• LAC can be described as the average cost to produce a particular quantity of commodity when all
factors of production are variable. It is the LTC divided by the output level, which
derives a per-piece cost of the total output.
3. Long Run Marginal Cost (LMC)
• It depicts the additional costs a company incurs to expand its factors of production when all
units are variable. LMC is the extra cost of expanding a plant or facility.

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Economics For
1.4
Business Decisions

Module – 5 Market Structure And Equilibrium

(12 hours)
Characteristics of different market structure, Price
determination and firm’s equilibrium under perfect
competition, monopolistic competition, monopoly and
oligopoly, price discrimination, international price
discrimination and dumping, pricing methods. Theories of factor
pricing, theories of interest and investment decisions.

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• Based on the above competition, the market structure has been classified into
two broad categories like Perfectly competitive and
Imperfectly competitive.
• Perfect Competition is not found in the real world market because it is
based on many assumptions. But an Imperfect Competition is associated
with a practical approach.

• The type of market structure decides the market share of a

firm in the market.
• If there exists a single firm, it will serve the entire market, and
the demand of the customers are satisfied with that firm only.

• But if we increase the number of firms to two, the market will also be
shared by the two. Similarly, if there are about 100 small firms in
the market,the market is shared by all of them in proportion.

• Therefore, it is the market structure, which affects the market. So here we

are going to describe the differences between perfect competition and
imperfect competition, in economics.

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Basis For Comparison Perfect Competition Imperfect Competition

Perfect Competition is a type of Imperfect Competition is an
competitive market where there economic structure, which does
are numerous sellers selling not fulfill the conditions
Meaning
homogeneous products or of the perfect competition.
services to numerous
buyers.
Nature of concept Theoretical Practical
Product Differentiation None Slight to Substantial
Players Many Few to many
Restricted entry No Yes
Firms are Price Takers Price Makers

Perfect competition - Example

• Suppose you go to a vegetable market to buy tomatoes. There are

many tomato vendors and buyers. You go to a vendor and inquire
about the cost of 1 kg tomatoes, the vendor replies, it will cost Rs. 10.
Then you go ahead and inquire some more vendors. The prices of all
the vendors are same for the demanded quantity.

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Salient features of the perfect competition:

• Many buyers and sellers.
• Product offered is identical in all respects.
• Any firm can come and go, as per its own discretion.
• Both the parties to the transaction are having complete knowledge about the
product, quantity, price,market and market conditions as well.
• Transportation and Advertising cost is nil.
• Free from government interference.
• The price for a product is uniform across the market. It decided by the
demand and supply forces; no firm can affect the prices, that’s why the
firms are price takers.
• Each firm earns a normal profit.

Imperfect Competition
• The competition, which does not satisfy one or the other condition,
attached to the perfect competition is imperfect competition. Under
this type of competition, the firms can easily influence the price of
a product in the market and reap surplus profits.
• In the real world, it is hard to find perfect competition in any
industry, but there are so many industries
like telecommunications, automobiles, soaps, cosmetics,
detergents, cold drinks and technology, where you can
find imperfect competition.

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There are various forms of imperfect competition, described

below:
• Monopoly:Single seller dominates the entire market.
• Duopoly:Two sellers share the whole market.
• Oligopoly: Few sellers are there who either act in collusion or
competition.
• Monopsony:Many sellers and a single buyer.
• Oligopsony:Many sellers and few buyers.
• Monopolistic Competition:Numerous sellers offering unique products.

• Monopoly
• A monopoly is a market structure where the participant is a single seller
that dominates the overall market as he is offering a unique product or
service.
• Example: Although an ideal monopoly market is hard to exist in
reality, we can quote some examples from the government sector. The
government-provided infrastructure like railways between cities is
still under a monopoly market. The competition is nil, and product-
related characteristics are all under the government’s discretion.

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• Duopoly
• It is a special case of oligopoly, in which there are exactly two sellers. Under
duopoly, it is assumed that the product sold by the two firms is homogeneous
and there is no substitute for it.
• Examples where two companies control a large proportion of a market
are:
• Soft drinks industry: dominated by Coca-Cola Company and PepsiCo
• Commercial large jet aircraft market: dominated by Airbus and
Boeing
• Consumer desktop computer microprocessor market: dominated by
Intel and AMD
• Mobile operating systems: dominated by Android and Apple iOS

• Oligopoly
• An oligopoly is a market structure wherein a small number of
dominating firms make up an industry.
• These firms hold major chunks of the overall market share for a commodity.
• The Greek word ‘oligos’ means “small” and the prefix ‘polein’ means to
“sell”. Hence, the word oligopoly translates to small number of sellers.
• Example:
• Music Streaming Applications (Global): Players like Spotify (30% of
the total market share), Apple Music (25%), and Amazon Music (12%)
dominate the industry.
• Video Streaming Services (USA): Players like Netflix (51% of the total
market share), Hulu (31%), and Amazon Prime Videos (14%) dominate the
video streaming industry.

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Types of Oligopoly
1. Pure or Perfect Oligopoly
2. Imperfect or Differentiated Oligopoly
3. Collusive Oligopoly
4. Non-collusive Oligopoly

1. Pure or Perfect Oligopoly:

• If the firms produce homogeneous products, then it is called pure or perfect oligopoly. Though, it is rare
to find pure oligopoly situation cement, steel, aluminum and chemicals producing industries
approach pure oligopoly.
2. Imperfect or Differentiated Oligopoly:
• If firms in an oligopoly produce differentiated products, it is known as an imperfect oligopoly. For
example, the automobile industry, wherein firms engage in adding different features, innovations and
designs to their car models which consequently make them stand out in the car market.
3. Collusive Oligopoly:
• When the firms in an oligopoly cooperate with each other and then come to a common agreement with
regards to the price and the output, it is known as a collusive oligopoly.
4. Non-collusive Oligopoly:
• When the firms refuse to cooperate with other firms in the oligopoly and instead decide to compete
with each other, it is referred to as a non-collusive oligopoly.

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Oligopoly - Characteristics
• Profit maximization conditions
• Ability to set price: They are price setters rather than price takers.
• Entry and exit
• Number of firms: "Few" – a "handful" of sellers.There are so few firms that the actions of one firm can
influence the actions of the other firms.
• Long run profits
• Product differentiation
• Perfect knowledge
• Interdependence
• Non-Price Competition

• Monopsony
• Monopsony is a market condition with a single buyer and multiple
sellers. It is an imperfect market condition—the single buyer is the
controlling entity. Similar to monopoly, where a single seller dominates and
controls product price. In a monopsony, a single buyer determines the factor
price.
• Example:
• Food supermarket retail brands like Walmart are the most common example of monopsony. A
single retailer has a huge buying power due to his deep pockets.
• Another example could be China negotiating the prices of minerals. China buys them from low-
income African countries.This again is down to China’s massive purchasing power.
• If a country has only one electricity producing company, then that company can control or
negotiate the buying price of coal.

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• Oligopsony
• Is a market structure consisting of a large number of sellers but a
few buyers. Sellers have little negotiation power and compete to
sell their goods and services to a handful of buyers.
• In Greek, the term ‘oligo’ means few
and ‘opsonia’ means to purchase. So,
in this system, only a few purchasers
exist.These few powerful buyers control
the market through their reach and scale.

• Example
• Let us suppose that three coffee buying companies – Starbucks, Café Coffee Day
and Nestlé buy the entire coffee produced globally. Nestlé decides to pay a lower
price than Starbucks and Café Coffee Day to the coffee producers. Then, in this
case, the coffee producers will try to sell their coffee to Starbucks and Café Coffee
Day instead of Nestlé.
• However, Starbucks and Café Coffee Day decide to follow the suit of Nestlé and
buy coffee at reduced price from the coffee producers. In this scenario, the coffee
producers will be forced to sell their produce at a lower price as these three coffee buyers
control the coffee market.
• Thus, the price of the coffee is controlled by the buyers. They can command the desired
prices from the producers. Hence, it is a fine example where a few powerful buyers
control the whole market by having the ability to buy the entire produce of the farmers.

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•Oligopsony - Characteristics
• A few big buyers control the whole market as they can purchase
all items sold in the market.
• These powerful buyers influence product price and quality.
• Few other options are available to the sellers in the market,
offering higher prices than these big players.
• Each seller works to maximize its profit at the cost of sellers.
• In the case of natural calamity, sellers are made to bear the
losses instead of passing them on to the buyers.

• Any wastage of products and overproduction is the

responsibility of sellers.
• Likewise, the sellers also bear losses arising from changes in the
cyclical demand.
• There is no safety for the sellers and their products.
• The buyers reap all the benefits.
• Customers benefit from lower prices on the products under this
system.

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• Monopolistic competition
• Monopolistic competition is a market structure where various firms produce and offer
differentiated products and services, which are close but not perfect
substitutes for each other (sellers offering unique products). The firms
highly compete with each other on multiple factors other than prices.

Monopolistic competition – characteristics

• There are many producers and many consumers in the market,
and no business has total control over the market price.
• Consumers perceive that there are non-price differences among
the competitors' products.
• There are few barriers to entry and exit.
• Producers have a degree of control over price.

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Price Discrimination
• Price discrimination is a pricing strategy whereby firms sell the same products or
services at different prices in different markets.
• It is the means adopted to ensure healthy competition by letting consumers purchase
goods at a reasonable yet different rate than the competitors.
• The strategy works effectively only when the company enjoys a monopoly in
the market.
• Secondly, the customer’s interests and preferences matter as to how
unique a product to be sold is.
• Finally, when the brands shift the prices of the products in the different
markets under monopoly price discrimination, it maximizes profits for
businesses,thereby reducing costs for most customers.

Types

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•First degree price discrimination, also referred to as

perfect price discrimination, is the strategy whereby firms fix the
maximum price for each unit of product and service.
• As the ability of consumers to bear the cost of products is hard to
determine, companies refrain from adopting this strategy.
• Consumer surplus is nowhere in this type of cost
discrimination.

•Second degree price discrimination refers to the

price set per the quantity consumed.
• It is also known as product versioning or menu pricing.
• It may also involve creating a different product line similar to a
menu card in which more options are given for the same product
with minor changes to sell them at a differential price.
• For example, a mobile data recharge plan is priced differently
from the amount of data used.

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•Third degree discrimination, also termed group pricing,

occurs when firms divide their consumers into different groups
and sell the same products at different prices to specific groups.
• For example, infants can enjoy a flight free of cost, while
anyone above two has to pay for the flight tickets.

• Examples
• Let us consider the following price discrimination examples to understand how the
strategy works:
• Example - 1
• In the case of weddings, the seller of the goods and services may charge a slightly higher price than
its usual charges, taking advantage of the event to earn more, thereby highlighting the benefits
of price discrimination.
• Example - 2
• The wholesalers of the goods and services may charge a differential pricing strategy to the retailers
who buy in bulk compared to those who buy in small quantities. For example, they might offer
hefty discounts for bulk purchases.
• Example - 3
• In the case of a flat, the per-square-feet rate for one area may be very expensive due to the location
accessibility,and facilities,while the same flat may have a lower price if located in another area.

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Dumping in International Trade

• Dumping refers to the practice of exporting goods to a foreign country
at lower prices than the price of the same goods in the exporting
country’s domestic market. As a result, affordable or cheaper exported
goods invade (occupy) the market in the importing country.
• In addition, It explains an example and occurrence of price
discrimination because the exporter follows different prices at different
markets.

Types of Dumping
• Predatory dumping:
• Under the predatory type, exporters drive out competition in the international market by selling goods
at low prices. Once the competition is eliminated, the firm can raise the product’s price and gain
additional revenue. The importing country can be skeptical (uncertain) and cautious of this practice because it can
result in a foreign monopoly controlling its market.
• Sporadic dumping:
• It is the practice of occasionally dumping products at lower prices primarily to eliminate excess
inventory stocks. It signifies that the business does not regularly sell its products at such low prices.
Hence it is an impermanent phenomenon.
• Persistent dumping:
• This type is the most popular form of cross-border dumping due to constant demand for a particular
product. It helps exporting entities establish a presence and a significant market share in overseas
marketplaces.
• Reverse dumping:
• In this type, the scenario is the product is priced low in the local market. At the same time, the product price is set
high in the foreign market because high prices do not affect the demand.

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Examples
• Let us look at the dumping examples to understand the concept better:
• Example - 1
• Suppose country X manufactures toys and exports them to country Y. X dumps many toys in
country Y at cheaper rates than the original price of the toys in Y’s market. As a result,X can
subsidize or reduce the price of the toys until the companies of country Y are beaten at
competitive toy prices. Then, country X can reach normal price levels, at which they would
stop reducing the prices of the toys.
• Example - 2
• China is the leading steel-producing country in the world, and Russia is also on the top 10
list. The government of Britain planned to have restricting measures resembling anti-
dumping duty on the dumping of cold-rolled flat steel imports from China and
Russia until 2026. If the restriction is lifted, cold-rolled flat steel from China and Russia
would be dumped in Britain, affecting UK companies that cater to 40–50% of the local
market.

• Advantages
• The method helps firms who want to grow their financial footprint
globally. They enter a foreign nation, seize control of the existing
market, and remove the competitors by selling goods at cheaper
rates.
• Importers gain from the lower price of products.
• Production on a large scale enables producers to take advantage
of economies of scale in their operations.
• Exporters can obtain subsidies from the government.
• Increases in production and market contribute to an increase in
employment in the exporter’s country.

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Disadvantages
• Sometimes the revenue from the export is less than the
production cost, indicating that the business is losing money on
exports.
• The cost of subsidies affects the Government.
• The exporting entity can form a monopoly and sets its prices. Moreover,
they could grow to such a size that they begin to influence the
Government in the importing country and its policies, which would harm
any nation.
• Dumping below the cost of production affects the local markets.

Pricing Methods
• The Pricing Methods are the ways in which the price of goods and
services can be calculated by considering all the factors such as the
product/service, competition, target audience, product’s life cycle, firm’s
vision of expansion, etc. influencing the pricing strategy as a whole.
• The pricing methods can be broadly classified into two parts:
• Cost Oriented Pricing Method
• Market Oriented Pricing Method

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• Cost-Oriented Pricing Method:

• Many firms consider the Cost of Production as a base for calculating the
price of the finished goods.
• Cost-Plus Pricing: It is one of the simplest pricing method wherein
the manufacturer calculates the cost of production incurred and add a certain
percentage of markup to it to realize the selling price. The markup is the
percentage of profit calculated on total cost i.e. fixed and variable cost.
• E.g. If the Cost of Production of product-A is Rs 500 with a markup of 25% on total
cost,
• Selling Price = cost of production + Cost of Production x Markup Percentage/100
Selling Price=500+500 x 0.25= 625
Thus, a firm earns a profit of Rs 125 (Profit=Selling price - Cost price)

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• Markup pricing- This pricing method is the variation of cost plus

pricing wherein the percentage of markup is calculated on the selling price.
• E.g. If the unit cost of a chocolate is Rs 16 and producer wants to earn the markup of
20% on sales.
Markup Price= Unit Cost/ 1- desired return on sales
Markup Price= 16/1-0.20 = 20
Thus, the producer will charge Rs 20 for one chocolate and will earn a profit of Rs 4 per
unit.

• Target-Return pricing – In this kind of pricing method the firm set the price to
yield a required Rate of Return on Investment (ROI) from the sale of goods and services.
• E.g. ABC Ltd has an objective of achieving a required rate of return of say 20% on
goods that they sell.
The company manufactures pencils and have already invested Rs.10,00,000/- in
the business. The cost of each pencil is Rs.16/-. Here, we are assuming that sales
can hit 50,000 units in a year.
Target return price= Unit Cost + (Desired Return x capital
invested)/ unit sales Target Return Price
= 16 + (20%*10,00,000)/50,000
= Rs 20.
So, to achieve the required rate of return, the company should sell the pencil at Rs 20 each.

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• Market-Oriented Pricing Method:

• Under this method price is calculated on the basis of market
conditions.
• Perceived-Value Pricing: In this pricing method, the manufacturer
decides the price on the basis of customer’s perception of the goods and
services taking into consideration all the elements such as advertising,
promotional tools, additional benefits, product quality, the channel of distribution,
etc. that influence the customer’s perception.
• E.g. Customer buy Sony products despite less price products available in the
market, this is because Sony company follows the perceived pricing policy
wherein the customer is willing to pay extra for better quality and durability of
the product.

• Value Pricing: Under this pricing method companies design the low
priced products and maintain the high-quality offering. Here the prices are
not kept low, but the product is re-engineered to reduce the cost of production
and maintain the quality simultaneously.
• E.g. Tata Nano is the best example of value pricing, despite several Tata cars, the
company designed a car with necessary features at a low price and lived up to its quality.
• Going-Rate Pricing- In this pricing method, the firms consider the
competitor’s price as a base in determining the price of its own offerings.
Generally, the prices are more or less same as that of the competitor and the price
war gets over among the firms.
• E.g. In Oligopolistic Industry such as steel, paper, fertilizer, etc. the price charged is
same.

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• Auction Type pricing: This type of pricing method is growing popular

with the more usage of internet. Several online sites such as eBay, Quikr,
OLX, etc. provides a platform to customers where they buy or sell the
commodities.There are three types of auctions:
1. English Auctions-There is one seller and many buyers. The seller puts the item on
site and bidders raise the price until the top best price is reached.
2. Dutch Auctions– There may be one seller and many buyers or one buyer and
many sellers. In the first case, the top best price is announced and then slowly it
comes down that suit the bidder whereas in the second kind buyer announces the product he
wants to buy then potential sellers competes by offering the lowest price.
3. Sealed-Bid Auctions: This kind of method is very common in the case of Government
or industrial purchases, wherein tenders are floated in the market, and potential
suppliers submit their bids in a closed envelope, not disclosing the bid to anyone.

• Differential Pricing: This pricing method is adopted when

different prices have to be charged from the different group of
customers. The prices can also vary with respect to time, area, and
product form.
• E.g. The best example of differential pricing is Mineral Water. The price of Mineral
Water varies in hotels, railway stations, retail stores.

• Thus, the companies can adopt either of these pricing

methods depending on the type of a product it is offering
and the ultimate objective for which the pricing is being
done.

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Theory of Factor Pricing

• The theory of factor pricing deals with the prices paid for factor
services (land, labour, capital, entrepreneur) and received by
the sellers of factor services.
• It deals with wage rate, interest rate specific rent and profit.
• In short theory of factor pricing studies how rent of land, wages of
labour interest on capital and profit of entrepreneur is determined.

• Difference in demand of factors and commodities:

• Derived Demand: Factors are demanded to produce commodities to satisfy
consumer’s demand.
• For example demand for bricks, cement iron etc. is derived from the demand for a building.

• Joint Demand: More than one factor is needed jointly to produce the commodity.
• For example one factor (labour) alone cannot produce apple. It is the outcome of efforts of Land,
labour,capital and entrepreneur jointly.
• Dependability: The demand for factors depends upon their marginal
productivities, while the demand for commodities depends upon their marginal
utilities.
• For example In the workplace is a quality employers look for in employees because it develops trust
and leads to productivity and growth.

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• Difference in supply of factors and commodities:

• Cost of production:
• Supply of commodities depends on its cost of production. But land has no
cost of production to an economy. Also it is not possible to estimate the
cost of production of labour.
• According to Modern economists supply of factors depend on their
opportunity cost.
Relationship between price and supply
There is positive relationship between price and supply of commodities, but there is no
definite relation between price and supply of factors. Thus due to these differences, there
is need for a separate theory for factor pricing.

Investment Theory
• Investment theory is framed with the basic idea that investment changes
capital stock over a specific period. However, investment is a flow
concept,not a stock concept.

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Types
• 1 –The AcceleratorTheory of Investment
• Economists predicate accelerator theory of investment on the idea that a certain
amount of capital stock is necessary to achieve a specific output. A few
major point to note are that the theory explains net investment, not gross
investment.
• 2 –The Internal Funds Theory of Investment
• The internal fund investment theory suggest that the profit level determines
the required capital stock. According to this, investment strongly
correlates with expected profits.

• 3 –The NeoclassicalTheory of Investment

• The neoclassical investment theory of optimal capital accumulation
serves as this theoretical underpinning.
• It states that output and the cost of capital services about the cost of
output determine the desirable capital stock. The cost of capital
goods, the interest rate, corporate income taxation, etc., influence
the cost of capital services.
• As a result, changes in the result or the cost of capital services
relative to the cost of output influence the desired capital stock
and, therefore, investment.

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• InternationalTrade And InvestmentTheory

• The study of international commerce’s patterns, causes, and welfare
effects is known as international trade theory.
• The idea of this interchange between individuals or groups operating in two
distinct nations is known as international trade.
• Some of those theories are as follows:
• Mercantilism
• Absolute Advantage
• Comparative Advantage
• Heckscher-Ohlin Theory (Factor Proportions Theory)
• Leontief Paradox
• Country Similarity Theory
• Product Life Cycle Theory
• The competitive advantage of nations

Consumption And Investment Theory

• Investment and consumption are interrelated. Investments are the sum of
any income received minus the amount consumed.
• Keynes’ theory of consumption, commonly known as “absolute
income theory,” emphasizes the absolute size of income as a
factor in determining consumption.
• In addition, Keynes proposed a psychological rule of
consumption, which states that when income rises, consumption
climbs too, but not as much as the growth in income.

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Saving And Investment Theory

• Saving and investment theory is also referred to as income theory and
was first used by economist ThomasTooke.
• The main goal here is to explain variations in the price level or the
value of money as per the classical investment theory view,
assuming that the economy is always in full employment equilibrium.
• It also operates under the assumption that investments and savings are equal.
• Interest rates contribute to the parity (uniformity) between saving and
investing.
• A shift in interest causes changes in savings and investments, respectively.

References
• https://www.simplilearn.com/market-structures-rar188-article
• https://businessjargons.com/pricing-methods.html
• https://www.dripcapital.com/en-us/resources/blog/what-is-
dumping-in-international-trade
• https://www.wallstreetmojo.com/investment-theory/

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Economics For
1.4
Business Decisions

Module 6: Macroeconomic Analysis (10 hours)

Indian Economic Environment: Measurement of National

Income: Basic Concepts, Components of GDP- Measuring GDP
and GNP, Difficulties in measuring National Income, Growth
Rate. Business Cycle – Features, Phases, Economic Indicators.
Inflation: Types, causes, supply of money, fiscal and monetary
Policy.

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• Macroeconomics focuses on the performance of economies –

• Changes in economic output
• Inflation
• Interest and foreign exchange rates, and
• The balance of payments

Poverty reduction, social equity, and sustainable growth are only

possible with sound monetary and fiscal policies.

Indian Economic Environment

• India is an example of a mixed economy where a mixed
economic system operates where both public and private sectors
co-exist.
• Economic Planning − Economic planning drives the
economic systems.
• Some examples of economic planning include five years' plan, an
annual budget, etc.
• Basic Characteristics of Indian Economy
• The Indian economy is a developing economy, and this is owed to the fact that
there are extremely high levels of poverty, unemployment, illiteracy, etc.

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Measurement of National Income

National income is the value of the aggregate output of the different
sectors during a certain time period. In other words, it is the flow of
goods and services produced in an economy in a particular year.
Thus, the measurement of National Income becomes important.
• Measurement of National Income
• There are three ways of measuring the National Income of a country.
They are from the income side, the output side and the expenditure
side. Thus, we can classify these perspectives into the following methods of
measurement of National Income.

•Methods of Measuring National Income

• Product Method
• Income Method
• Expenditure Method

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1. Product Method
• Under this method, we add the values of output produced or services rendered
by the different sectors of the Economy during the year in order to calculate
the National Income.
• In this method, we include only the value added by each firm in
the production process in the output figure.
• Hence, we use the value-added method. The value-added output of all the
sectors of the economy is the GNP at factor cost.
• However, this method is unscientific as it adds the value of only those goods
and services that are sold in the market or are available for sale in
the market.

2. Income Method
• Under this method, we add all the incomes from employment and
ownership of assets before taxation received from all the
production activities in an economy.
• Thus, it is also the Factor Income method. We also need to add the
undistributed profits of the private sector and the trading surplus of
the public sector corporations.
• However, we need to exclude items not arising from productive activities
such as sickness benefits, interest on the national debt, etc.

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3. Expenditure Method
• This method measures the total domestic expenditure of the Economy.
• It consists of two elements, viz.
• Consumption expenditure and
• Investment expenditure.
• Consumption expenditure includes household sector on goods and
services and consumption outlays of the business sector and public
authorities.
• Investment expenditure refers to the expenditure on the making of fixed
capital such as Plant and Machinery, buildings, etc.

Components
of
GDP

• It tells you what a country is good at producing.

• GDP is the country's total economic output for each
year. It's equivalent to what is being spent in that
economy.

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Measuring GDP and GNP

• GDP – Gross Domestic Product measures the value of goods
and services produced within a country's borders, by
citizens and non-citizens alike.
• GNP – Gross National Product measures the value of goods
and services produced by a country's citizens, both
domestically and abroad.
• GDP is the most commonly used by global economies.

Parameters GNP GDP

The gross national product amounts to the The gross domestic product amounts to the valuation of
valuation of such services and goods produced by a such services and goods which are produced within the
Concept citizen of a country without any constraint on geographical confines of a country. It is computed within
geographical boundaries. It is computed within a a particular financial year.
particular financial year.
Gross national product is for measuring all Gross domestic product is only for measuring the
Purpose production by the country’s nationals domestic production within the geographical boundaries
of a country.
The production made by the country’s citizens The production made only on the domestic front of a
Focus
irrespective of the boundary country
Measurement of the contribution of its citizens Measurement of the strength of the economy of a
What it seeks to measure
towards its economy country
Measuring productivity Production is measured on an international scale Production is measured only on a domestic scale
Services and goods which are produced by Services and goods which are produced outside the
Exclusion foreigners residing within the country is excluded domestic economy of a country is excluded from the gross
from the gross national product domestic product

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Difficulties in Measurement of National Income

Following are the difficulties in estimating the National Income
• Conceptual difficulties
• Statistical difficulties

A. Conceptual difficulties
• It is difficult to calculate the value of some of the items such as services
rendered for free and goods that are to be sold but are used for self-
consumption.
• Sometimes, it becomes difficult to make a clear distinction between
primary,intermediate and final goods.
• What price to choose to determine the monetary value of a National
Product is always a difficult question?
• Whether to include the income of the foreign companies in the National
Income or not because they emit a major part of their income outside
India?

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B. Statistical difficulties
• In case of changes in the price level, we need to use the Index numbers
which have their own inherent limitations.
• Statistical figures are not always accurate as they are based on
the sample surveys.Also, all the data are not often available.
• All the countries have different methods of estimating National Income.
Thus, it is not easily comparable.

Growth rate
• Growth rate is a measure of how your assets, businesses, investments or
portfolios increase in value over a specific period.
• This value can help you understand how different investments may
perform over time.
• You can then make reasonably accurate predictions of the revenues
you can expect from each of your assets and investments.

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Growth rate calculation methods

• Straight-line percent change
• Midpoint
• Average growth rate over time

• Straight-line percent change

• You can find out basic growth rates.
• These may not be useful for making comparisons with other growth rates.
• The limitation of the straight-line percent change method, also known as end-point
problem, is that it does not produce uniform results if the growth rate is
negative.
• Steps to use straight-line percent change
• Calculate growth rate with these steps:
• Use growth rate formula: It is necessary to know the original value and divide the absolute change with it.
The formula is Growth rate = Absolute change / Previous value
• Calculate the absolute change: Knowing the original value and the new value is essential for finding the
absolute change.The formula is Absolute change = New value - Previous value
• Use the original value for dividing the absolute change: You can get growth rate by dividing the
absolute change by the previous value.The formula is Growth rate = Absolute change / Previous value
• Find percent of change:To get the percent of change,you can use this formula the formula of
Percent of change = Growth rate x 100

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Straight-line percent change example

• A company sold 650 condensed milk cans in the current year and sold 500 condensed milk
cans in the previous year. Find the growth rate for the number of condensed milk cans it sold
over a two-year period:
• Growth rate = (650-500)/500
• Absolute change = 150 (650-500)
• Growth rate = 0.3 (150 / 500)
• Percent change = 30% (0.3 x 100)
• If you change the number of cans sold in the current year to 500 and to what was sold in the
previous year to 650, you get the following:
• Growth rate = (500-650)/650
• Absolute change = -150 (500-650)
• Growth rate = -0.2307 (-150 / 650)
• Percent change = -23.07% (-0.2307 x 100)

• Midpoint
• You can find the absolute change and average value, then find the growth rate by dividing the absolute
change by the average value.
• The midpoint method gives uniform results regardless of whether the growth rate is negative or positive.
• By using it, you can avoid the end-point problem that occurs with the straight-line
percent change method.
• Steps to use midpoint
• You can find growth rate with the following steps:
• Use growth rate formula: It is necessary to know the average value and use it to divide the absolute change. That
can give you the growth rate.The formula is Growth rate = Absolute change / Average value
• Get the absolute change: To find out the absolute change, it is essential to know the previous and new values.The
formula to follow is Absolute Change = NewValue - PreviousValue
• Calculate the average value: Adding the previous and new values and dividing the figure you get by two can
give you the average value.The formula is Average value = (PreviousValue + NewValue) / 2
• Use average value for dividing absolute change: Dividing the absolute change and average value can give
you the growth rate.The formula is Growth rate = Absolute change / Average value
• Find percent of change: Use this formula to get the percent of change:
Percent of change = Growth rate x 100

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Midpoint example
• Here is how to calculate the midpoint for the example above:
• Growth rate = [(650 - 500) / (650 + 500)/2] or [(500 - 650) / (650 + 500)/2]
• Growth rate = (150 / 575) or (-150 / 575)
• Growth rate = 0.2608 or -0.2608
• Percent change = 0.2608 x 100 or -0.2608 x 100
• Percent change = 26.08% or -26.08%

• Average growth rate over time

• You can compare the growth rate that takes place in two years by using the straight-line percent
change and the midpoint methods. However, if you have to compare the changes in growth rate that
take place over many years, it can help to calculate the annual average growth rate. You may want
to use this method when you're proving your company's potential to an investor.
• Steps to use average growth rate over time
• The following steps will help you to calculate growth rate:
• Use growth rate formula: Find growth rate by dividing the current value with the previous value, multiplying the
result with 1/N and subtracting one from that result. The N in the formula stands for the number of years. The formula is
Growth rate = (Current value / Previous value) x 1/N - 1
• Subtract the previous value from the current value: Get the difference between the previous and current values
by subtracting the previous value from the current one.The formula is
Current value - Previous value = Difference
• Multiply the difference to the 1/N power: N stands for the number of years.The formula is:
(Difference) x 1/N = Result
• Subtract one from the result:You can use the following formula to get growth rate:Growth rate = Result - 1
• Find percentage change:The following formula can help you to find percentage change:
Percent change = Growth rate x 100

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Average growth rate over time example

• To calculate the average annual growth rate over several years, you can use the method of
average growth rate over time:
• List the number of condensed milk cans sold by the company in the past four years:
• 2018 = 350
• 2019 = 450
• 2020 = 500
• 2021 = 650
• Next, calculate the company's average annual growth rate.
• So, if the present value is 650, the past value is 350 and the number of years is 4, you get:
• Growth rate after 2018: (450 - 350) / 350 x 100 = 28.57%
• Growth rate after 2019: (500 - 450) / 450 x 100 = 11.11%
• Growth rate after 2020: (650 - 500) / 500 x 100 = 30%
• Average growth rate over time = (28.57% + 11.11% + 30%) / 3 = 23.22% per year

Business Cycle
• The business cycle refers to the alternating phases of economic growth
and decline. Since the phases are recurring, they often occur in an
identifiable pattern where one phase usually follows the other.
• This cyclical nature of the economy is taken into account when
policymakers make major decisions. Just because the cycles are
repetitive doesn’t mean they can be avoided.
• The fluctuations are caused by parameters like GDP, production,
employment, aggregate demand, real income, and consumer
spending.
• Business cycles are also called trade cycles or economic cycles.

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• Business Cycle Phases with Graph

• A country keeps track of the trade cycle to ensure that the economy is on the path of
growth, unemployment steeps down, and the inflation rate remains
under control.
• Expansion, Peak, Contraction, and Trough
• To understand the
economic fluctuations
and pattern, let us have
a look at the following
graph:

• An economy is expected to have constant growth, represented by the

growth trend line. In reality, though, the economy is unstable. National
output goes up and down periodically. It expands to touch the peak and contracts
down to the trough.
• Thus, a trade cycle consists of the following four phases:
• Expansion
• Peak
• Contraction
• Trough

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• Expansion: When a nation’s GDP shows an upward move or recovers with time,
this period of growth is remarked as economic expansion. During this phase, the
various economic indicators like consumer spending, income, demand, supply,
employment, output, and business returns shoot up.
• Peak: During the expansion phase, the GDP spikes to its highest level; this is
considered the economy’s peak. At this point, economic factors like income, consumer
spending, and employment level remain constant.
• Contraction: Next comes the phase of economic slowdown; it occurs when the
stagnant peak GDP starts tumbling down towards the trough. With this, the
nation’s production, employment level, demand, supply, income level, and
other economic parameters plummet.
• Trough: This is the stage at which the GDP and other economic indicators are at
their lowest. During this phase, the economy gets stuck at a negative growth
rate. Additionally, the demand for goods and services reduces.

• Features of a Business Cycle

• There are several features of a Business Cycle. Let us take a look at five features of a
Business Cycle.
• Occurs Periodically
• Synchronous
• Major Sectors are Affected
• ProfitVariation
• Worldwide Impact

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• Occurs Periodically:
• The different phases of a Business Cycle occur from time to time.
• Although, at certain times, these periods will vary according to the Economic conditions of the industry.
• This duration may last as long as 10-12 years.
• The intensity of the phases will also change depending on the Economy.
• For example: at times,the firm will see massive growth followed by a short span of depression.
• Synchronous:
• Another advantageous and prominent feature of the Business Cycle is that it is synchronic.
• The features of a Business Cycle are not restricted to a single firm or industry.
• They originate in a free Economy and are prevalent.
• If there is any kind of disturbance or Business boom in one industry, it will affect the other firms too.
Since different kinds of industries are interrelated, the Business in one firm disturbs that in another
firm.

• Major Sectors are Affected:

• It’s been noticed that fluctuations occur not only at the level of production but also in other variables such
as employment, consumption, investment, rate of interest, and price level.
• The investment and consumption of durable consumer goods like houses and cars are continually affected
by the periodical fluctuations. As the process of consumption is deferred the courses of the Business Cycle
are also affected widely.
• ProfitVariation:
• Another significant feature of the Business Cycle is that the profits fluctuate more than any other income
source.
• This makes any kind of Business a tricky and uncertain profession for many.
• It is difficult to predict Economic conditions. In situations of depression, profits may even become harmful.
That is why many Businesses go bankrupt.
• Worldwide Impact:
• Business Cycles are international in nature.
• If depression occurs in one country, then it is bound to spread to other nations too.
• This happens mainly because the countries depend on each other for import and export trades.

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Economic indicators
• Economic indicators include
• Measures of Macroeconomic
performance (gross domestic
product [GDP], consumption,
investment, and international
trade) and
• Stability (central government
budgets, prices, the money
supply, and the balance of
payments).

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• Leading indicators are those that indicate the changes that are about to hit
an economy.
• For example: the yield curve, new business formations, and share prices are some of the leading
indicators.
• Lagging economic indicators come to notice when the economy is already
affected.
• These determinants might not alert individuals and entities beforehand, but they help
them to assess and identify the pattern so that they are careful in similar events the next
time.
• For example: the unemployment rate indicates the changes that have already affected the economy.
• Coincident indicators are the factors that reflect the changes in the economy
parallelly.
• It means these determinants change with the changes in the economy, signaling growth or
contraction as and when it happens. GDP moves in the direction of the economy.

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Inflation
• Inflation is when the prices of goods and services keep increasing over
a certain period.
• It results in a decline in the purchasing power of customers.
• It aims to gauge the effect of increasing prices on the economy in a
financial year.

• Inflation Types
• Let us look at the types of inflation that are currently existing in
the economy:

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1 – Demand Pull Inflation

• It occurs when the demand exceeds supply. Thus, forcing the firms to
increase the prices.
2 – Cost-Pull Inflation
• This situation appears when the cost of production forces firms to
increase their prices.
• For example: the factors of production like labor, raw material, and technology
are getting expensive.
3 –Walking Inflation
• The hike is said to be walking when the rate rises by 3% to 10% yearly.
• In September 2022, Sweden’s central bank announced an inflation report of 9%,
probably the highest since 1990. Later, the western countries had inflation news of 7-
8%.

4 – Creeping Inflation
• In the initial stage, the inflation rate is around 2%, 3%, or 5%.
• At this point, the prices rise at a very minimal rate gradually. However, ignoring
them can cause prices to rise.
5 – Galloping Inflation (Running)
• Galloping inflation occurs when the rate is between 20-1000%.
• In such situations, there is too much instability within the economy.
• As a result, the governing bodies fail to bring situations within control.
• For example: in the 1990s, Russia faced a galloping situation where the prices of
food and goods increased severely. In 1993, the rate in Russia was 839.21 %.
6 – Hyperinflation
• Hyperinflation occurs when the rate is above 1000%. At this stage, the value of money
depreciates faster.

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Inflation Causes
• Increased Money Supply
• Government Policies
• Changes In Exchange Rates
• RisingWage Rates

• Increased Money Supply

• The money supply is one of the prime reasons for causing inflation. It occurs when the government prints
more currency than the prevailing growth rate. For example, in 2009, Zimbabwe printed excess currency
to normalize the economic situation. Similarly, other African nations also print money to increase their
supply.
• Government Policies
• Government plans and policies can also cause inflation. For example, restrictions on imports cause the
cost of production to rise. As a result, the firms try to adjust that extra cost by increasing the prices of
their products.
• Changes In Exchange Rates
• If the dollar’s value fluctuates, consumers have less purchasing power. As a result, the prices of products
rise, causing this situation.
• RisingWage Rates
• The rising wage rate is one of the vital factors for inflation. As the government increases the money
supply, the salaries of individuals also increase. Thus, consumers tend to buy products causing prices to
rise.

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Effects of Inflation
• Here are some inflation effects for understanding the concept clearly –
1 – Depreciation of Money
2 – Increased Bank Rates
3 – High Standard of Living
4 – Hiked Prices
5 – Income Distribution Inequality
6 – Negative Impact on Exports
7 – Impact on Investors
• As prices rise, investors try to save less and spend more. However, the market will react
negatively if a country has a high rate.

Money Supply
• Money supply in an economy
is the total volume of
currency in circulation at a
particular point in time.
• It can include cash and its
equivalents like currency
notes, coins, and bank
deposits. It is a critical concept
that greatly impacts a country’s
financial and economic situation.

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Measurement of Money Supply

• Since the supply of money is an important economic parameter, Governments
constantly monitor and regulate it. Therefore, they measure the amount of money
frequently to keep it in check.
• Standard measures of money supply include M1, M2, M3 and M4.
• The measurement of the supply begins with the M0 or monetary base. It denotes the
amount of currency in circulation, i.e., currency bills, coins, and bank reserves.
• M1 money supply: Also called the ‘narrow money’ it includes M0 and other highly liquid
deposits in the bank.
• M2 money supply: It is perhaps the most commonly accepted measure because it consists of M1 in
addition to marketable securities and less liquid deposits.
• M3 money supply: Known as ‘broad money’ it constitutes M2 and money market funds
like mutual funds, repurchase agreements, commercial papers,etc.
• M4 money supply: It comprises M3 and all other least liquid assets, usually
outside commercial banks.

• Thus, the above types of money supply measurements and their formulas can
be summarized as follows:
• M0 = Currency notes + coins + bank reserves
• M1 = M0 + demand deposits
• M2 = M1 + marketable securities + other less liquid bank deposits
• M3 = M2 + money market funds
• M4 = M3 + least liquid assets

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 25/06/2023

Fiscal and Monetary Policy

• Monetary policy and fiscal policy are two different tools that have an
impact on the economic activity of a country.
• Monetary policies are formed and managed by the Central Banks of a Country and
such a policy is concerned with the management of money supply and interest rates in an
economy.
• Fiscal policy is related to the way a Government is managing the aspects of
spending and taxation. It is the Government’s way of stabilizing the economy and
helping in the growth of the economy.
• Governments can modify the fiscal policy by bringing in measures and changes in tax
rates to control the fiscal deficit of the economy.

Basis for Comparison Fiscal Policy Monetary Policy

Monetary policy is the tool for the Central Bank
It helps control the spending and revenue collections
Meaning through which the movement and the flow of money in
of the government to influence the economy at large.
the economy are controlled.
Controlled by The Ministry of Finance of the country. The Central Bank of the country.
Complexity Comparatively less complex. Comparatively more complex.
Monetary policy does not change as per a particular
Fiscal policy changes every year after reviewing the
Nature period; rather, it changes whenever the economy needs
previous year’s results.
the change.
Monetary policy does not change as per a particular
The focus is to ensure the development and growth
Focus period; rather, it changes whenever the economy needs
of an economy.
the change.
Monetary policy works on money flow in the economy
Works on Works on the government’s spending and collections.
and credit control.
Does it have any
Yes. No.
political influence?
Tools used in the policy Tax rates,Demonetization,etc. Cash Reserve Ratio, Repo Rate,Interest Rate,etc.

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