Question Bank - Managerial Economics

Module 1

CO1: Given the details regarding Price and quantity, the future manager will be able to calculate and interpret
price elasticity, income elasticity and cross- price elasticity of demand.

Que-1Suppose that you have the following demand and supply curve for sneakers:
Qd= 400-3P
Qs = 200 + 2P

a) Solve for the equilibrium price and quantity.

b) Calculate consumer expenditures on sneakers
c) Calculate the elasticity of demand at the equilibrium found in (a)
d) Would a 5% increase in price cause consumer expenditures to rise or fall?Explain.

Solution:

a) we need to set supply equal to demand and solve for an equilibrium price.

400 – 3P = 200 + 2P
200 = 5P
P = 40

Qd= 400-3P = 400 – 3(40) = 280

Qs = 200 + 2P = 200 + 2 (40) = 280

b) Consumer expenditures would be price times quantity…

$40*280 = $11,200

c)

So, at this price, a 1% rise in price will lower expenditures by .43%

 d) A 5% rise in price would be from $40 to 40(1.05) = $42.
This will cause a 5(.43) = 2.15% drop in quantity to 280(1-.0215) = 274. $42*(274) = $11,508.
So, spending increases. In general, if the elasticity is smaller than 1 in absolute value, a rise in price
cases an increase in expenditures.

Que-2 Suppose individual demand schedules for A, B and C are given as follows:

Price A's B's C's

(Rs.) demand demand demand
5 80 40 20
10 40 20 10
15 20 10 5
20 10 5 0
25 0 0 0
Find,

(i) Market demand schedule,

(ii) Market demand curve,
(iii)Elasticity when price falls from Rs. 15 to Rs. 10, and
(iv) Elasticity when price rises from Rs. 10 to Rs. 15.

Solution
(i)
Price A’s Demand B’s Demand C’s Demand Market
demand
= (A + B + C )
5 80 40 20 140
10 40 20 10 70
15 20 10 5 35
25 0 0 0 0

(ii)Market demand curve,

 (iii) Elasticity when price falls from Rs. 15 to Rs. 10, and

Price Elasticity of demand = Percentage change in quantity demanded

Percentage change in price

Or ep = Q P Q × P
Q P QP

Q × P1
 P Q1
Q = 20
P = 5
P1 = 15
Q1 = 20

Therefore ep = 20× 15
5 20
ep = 3
Elasticity will 3 when price falls from Rs. 15 to Rs. 10,
(iv) Elasticity when price rises from Rs. 10 to Rs. 15
here P1 = 10 P2 = 15
Q1 = 40 Q2 = 20
Q = 20
 P = 5
Therefore ep = Q × P1
  P Q1

= 20 × 10
5 40
= 1
Therefore Elasticity when price rises from Rs. 10 to Rs. 15 will be 1

Que-3 If price of coffee rises from Rs.45 per 250 g pack to Rs.55 per 250 g pack and as a result the
consumers demand for tea increases from 600 packs to 800 packs of 250 g,then find the cross elasticity of
demand of tea for coffee.

Solution:

In the above problem:

∆qx = 800 – 600 = 200 packs

∆py – Rs. 55-45 = 10
Que -4 Suppose the following demand function for coffee in terms of price of tea is given. Find out the
cross elasticity of demand when price of tea rises from Rs.50 per 250 g pack to Rs.55 g per 250g pack. Qc
=100 + 2.5Pt.Where Qc is the quantity demanded of coffee in terms of packs of 250 grams and Pt is the
price of tea.

Solution:

The positive sign of the derivative of Pt shows that rise in price of tea will cause an increase in quantity

demanded of coffee. This implies that tea and coffee are substitutes.

In order to determine cross elasticity of demand between tea and coffee, we first find out quantity demanded
of coffee when price of tea is Rs. 50 per 250 grams. Thus,

Qc= 100 + 2.5 x 50 = 225

Cross elasticity, e. = dQc/dPt x Pt/Qc

dQc/dPt = 2.5

ec =2.5 x 50/225 = 125/225 = 0.51

Que-5 Suppose you are told that the price elasticity of demand for soft drinks is 2.0; the cross price
elasticity of demand of soft drinks for iced tea is 1.5; the cross price elasticity of demand of soft drinks for
popcorn is -2.0; and the income elasticity of demand for soft drinks is 1.2. Use this information to answer
the following question.

a) Describe verbally the relationship between soft drinks and popcorn. In your statement
describe how you know these two goods have this relationship.
b) Describe verbally the relationship between soft drinks and iced tea. In your statement
describe how you know these two goods have this relationship.
c) Are soft drinks a normal or an inferior good given the above information? Explain your
answer fully

Solution:
a. Soft drinks and popcorn are complements since the cross-price elasticity of demand between
these two goods is negative. The negative sign tells us that when the price of popcorn
increases this price increase results in a decrease in the quantity of soft drinks demanded.
Two goods are complements if an increase (decrease) in the price of one results in a decrease
(increase) in the quantity demanded of the other.
b. Soft drinks and iced tea are substitutes since the cross-price elasticity of demand between
these two goods is positive. The positive sign tells us that when the price of iced tea increases
this price increase results in an increase in the quantity of soft drinks demanded. Two goods
 are substitutes if an increase (decrease) in the price of one results in an increase (decrease) in
the quantity demanded of the other.
c. Soft drinks are a normal good in this example since the income elasticity of demand is a
positive number. When the price of soft drinks increases (decreases) this price increase
results in an increase (decrease) in the quantity demanded of soft drinks. A good is a normal
good if the quantity demanded of the good increases when income increases.

Que-6

a) Suppose the monthly income of an individual increases from Rs 20,000 to Rs 25,000 which increase
his demand for clothes from 40 units to 60 units. Calculate the income elasticity of demand.
b) Quantity demanded for tea has increased from 300 to 400 units with an increase in the price of the
coffee powder from Rs 25 to Rs 35. Calculate the cross elasticity of demand between tea and coffee

Solution a)

Where, Qf and Qi are the final and initial quantities demanded of product A, respectively; If and Ii are the
final and initial incomes of consumer.
We apply the formula noted above in order to determine the income elasticity of demand

If the value of income elasticity is greater than 1 is said to be income elastic. The value of income
elasticity can also show whether goods are normal goods or inferior goods. For normal goods, where an
increase in income results in an increase demand, the value of income elasticity will be positive (+).

Since clothes have positive income elasticity of demand, they are normal goods (also called superior
goods). Given model is therefore a normal good with elastic income elasticity coefficient equal to 1.8.

b)
Qf = 400 units,Qi = 300, If = Rs 35, Ii = Rs 25. We need to find the cross elasticity of demand between
tea and coffee

or
So, what does that tell us? In order to answer the question, we use the following rules of thumb to help us
determine the relationship between the two goods.

If cross price elasticity > 0 then the two goods are substitutes;
If cross price elasticity = 0 then the two goods are independent;
If cross price elasticity < 0 then the two goods are complements.

Since the cross elasticity of demand is positive, product A and B are substitute goods. Substitute goods have
positive cross-price elasticity: as the price of one good increases, the demand for the other good increases. We can
see that with an increase in the price of the coffee powder (A) the demand for tea (B) has increased. The two
commodities are considered as substitutes. In this case, the consumer substitutes tea for coffee.

Que-7
The price elasticity of demand of colour TVs is estimated to be -2.5. If the price of colour TVs is reduced
by 20 percent how much percentage increase in the quantity of colour TVs sold to do you expect?

Solution :

Price elasticity ep= -2.5

Percentage change in quantity demanded = ?

Percentage change in price = 20

Price Elasticity of demand = Percentage change in quantity demanded

Percentage change in price
2.5 = Percentage change in quantity demanded
20
Percentage change in quantity demanded = 2.5 x 20
= 50

Que-8
Colgate sells its standard size toothpaste for Rs 25. Its sales have been on an average 8000 units per
month over the last year. Recently its close competitor Pepsodent reduced the price of its same standard
size toothpaste from Rs 35 to Rs 30. As a result, Colgate sales declined by 1500 units per month.
a) Calculate the cross elasticity between the two Products.
b) What does your estimate indicate about the relationship between the two.
 Solution

a) Cross elasticity for Colgate over Pepsodent

ec p = Percentage change in demand for Colgate
Percentage change in price of Pepsodent

ec p = Qc Pp
Pp Qc
Q = 1500

P = 5

Pp = 35

Qc = 8000

Therefore e c p = 1500 * 35
5 8000

ec p = 1.31
so the cross elasticity of Colgate over Pepsodent will be 1.31

b) What does your estimate indicate about the relationship between the two.
If cross price elasticity > 0 then the two goods are substitutes;
If cross price elasticity = 0 then the two goods are independent;
If cross price elasticity < 0 then the two goods are complements

Since the cross elasticity of demand is positive, Colgate and Pepsodentare substitute goods. Substitute goods have
positive cross-price elasticity: as the price of one good increases, the demand for the other good increases. We can
see that with a decrease in the price of the pepsodent, the demand for Colgate has decreasedThe two commodities
are considered as substitutes. In this case, the consumer substitutes Pepsodent for Colgate.

Module 2
CO-2 Given the information about scale of production, the future manager will be able to analyze
various aspects of empirical production functions and also will be able to comprehend the difference
sources of economies and diseconomies of scale.

1. What are the economies and diseconomies of scale for Indian Railways, according to you? Elaborate each
of them.

Answer:

Internal economies of scale:

1. Indian Railways is a Public sector unit funded by Government and a separate budget. Thus it does face
dearth of funds for capital investments as well as working capital.
 2. It has a well established infrastructure ( railway routs, stations, trains, R&D setups , Yards, logistic set up,
etc) . This reduces the marginal costs of handling shipments as well as passenger travels.
3. Large connectivity and geographical penetration
4. Easy accessibility and use of internet services
5. Economical transportation due to movement consolidation
6. Price discrimination in passenger travels based on age , gender and economic affordability
7. Specialized labour and division of labour
8. Large employee strength

External economies of scale

1. Use of IRCTC portal for online ticketing , accommodation and food facilities
2. Special holiday packages
3. Premium Trains for luxurious travel and ordinary trains for mass transportation
4. Strong Brand Image
5. Monopoly

Diseconomies of Scale

1. Difficulty in supervision and maintenance of facilities due to large scale operations

2. Mismanagement due to typical Government reporting structure
3. Chaos due to large organizational hierarchy
4. Inefficiency of third party service providers and suppliers
5. Political interferences
6. Losses due to natural calamities

Conclusion: Large-scale organizations like Indian Railways have stronger economies of scale but also face
multiple diseconomies of scale as a result of their large –scale nature.
2. Compare the economies and diseconomies of scale of new startup Courier Company with a well
established old organization like DTDC.

New Courier Start up DTDC (established logistics company)

Internal Economies of Scale
Economies of Lack of expertise and business Expertise and know0how due to long
Production/ services and technological know-how term operations and field/ technology
experience
Economies of New management , systems not Seasoned management with well
Management established properly established systems
Economies of Need to invest in facilities like Already established and in-place facilities
Transport and vehicles, go downs, machineries, reduces operating costs and leverage
Storage etc operations
External Economies of Scale
Economies of Brand name is not know, lot of Established reputed brand creates trust
Marketing investments in advertising, in the minds of customers
promotions and direct sales
Economies of New companies face lack of Due to large scale operations, companies
sourcing /purchasing bargaining power while buying like DTDC source factors in larger
so cannot get better discounts quantities and possess bargaining
and deals while buying any powers leading to lower factor rates
factors
Diseconomies of Scale
Diseconomies due to Smaller firms have strong Due to large scale structure, optimization
operational wastes / optimization and can avoid is hardly possible leading to larger
non-optimization operational wastes to a larger operational waste
 extent
Diseconomies of Close and effective supervision
supervision / keeps the organization in tune.
coordination Coordination is better.
Other diseconomies Employees work in job rotation
and are able to multi tasking
increasing the utility of
employees
Supervision becomes difficult to larges
and weaker span of control. Leads to
chaos at work place.
Super specialization of labour makes
many employees redundant and
employee engagement becomes an
issue. It leads to compartmentation and
sometimes organizational conflicts

Conclusion : New start ups lack economies of scale but have lesser diseconomies of scale while established firms like
DTDC have stronger economies and scale and face larger diseconomies of scale, too.

3. Explain Laws of return to scale. Relate laws of return to scale with Cobb Douglas production function.

Answer: In the long run all factors of production are variable. No factor is fixed. Accordingly, the scale of production
can be changed by changing the quantity of all factors of production. Returns to scale relates to the behaviour of
total output as all inputs are varied and is a long run concept. In the long run, output can be increased by increasing
all factors in the same proportion. Generally, laws of returns to scale refer to an increase in output due to increase in
all factors in the same proportion. Such an increase is called returns to scale.

Returns to scale are of the following three types:

1. Increasing Returns to scale.

2. Constant Returns to Scale

3. Diminishing Returns to Scale

Above table explains three laws of returns to scale.

 +

1. 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. This increase is due to many reasons like division external
economies of scale.

2. 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.

The main cause of the operation of diminishing returns to scale is that internal and external economies are less than
internal and external diseconomies. It is clear from diagram 9.

3. 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. Cobb-Douglas linear homogenous production function is a good
example of this kind.

The Cobb-Douglas production function is a particular form of the production function. It is widely used because it
has many attractive characteristics, as we will see below.

The basic form of the Cobb-Douglas production function is as follows:

Q(L,K) = A Lβ Kα

Where:
- Q is the quantity of products.
- L is the quantity of labor.
- K is the quantity of capital.
- A is a positive constant. Also called as technology coefficient.
- β and α are constants between 0 and 1. These are also called as output elasticities.

If β+α=1 , the production function has constant returns to scale.

If β+α >1 , the production function has increasing returns to scale.

Q. 4 Analyze various stages of Law of Variable Proportions along with its Assumptions. Also analyze in which stage
rational decision is possible.

Answer

Law of Variable Proportions occupies an important place in economic theory. This law is also known as Law of
Proportionality.

Keeping other factors fixed, the law explains the production function with one factor variable. In the short run when
output of a commodity is sought to be increased, the law of variable proportions comes into operation.

Therefore, when the number of one factor is increased or decreased, while other factors are constant, the
proportion between the factors is altered. For instance, there are two factors of production viz., land and labour.

Land is a fixed factor whereas labour is a variable factor. Now, suppose we have a land measuring 5 hectares. We
grow wheat on it with the help of variable factor i.e., labour. Accordingly, the proportion between land and labour
will be 1: 5. If the number of laborers is increased to 2, the new proportion between labour and land will be 2: 5. Due
to change in the proportion of factors there will also emerge a change in total output at different rates. This
tendency in the theory of production called the Law of Variable Proportion.

Definitions:

“As the proportion of the factor in a combination of factors is increased after a point, first the marginal and then the
average product of that factor will diminish.” Benham

“An increase in some inputs relative to other fixed inputs will in a given state of technology cause output to increase,
but after a point the extra output resulting from the same additions of extra inputs will become less and less.”
Samuelson

“The law of variable proportion states that if the inputs of one resource is increased by equal increment per unit of
time while the inputs of other resources are held constant, total output will increase, but beyond some point the
resulting output increases will become smaller and smaller.” Leftwitch

Assumptions:

Law of variable proportions is based on following assumptions:

(i) Constant Technology:

The state of technology is assumed to be given and constant. If there is an improvement in technology the
production function will move upward.

(ii) Factor Proportions are Variable:

The law assumes that factor proportions are variable. If factors of production are to be combined in a fixed
proportion, the law has no validity.

(iii) Homogeneous Factor Units:

The units of variable factor are homogeneous. Each unit is identical in quality and amount with every other unit.
(iv) Short-Run:

The law operates in the short-run when it is not possible to vary all factor inputs.

Explanation of the Law:

In order to understand the law of variable proportions we take the example of agriculture. Suppose land and labour
are the only two factors of production.

By keeping land as a fixed factor, the production of variable factor i.e., labour can be shown with the help of the
following table:

Variable Factor of Production

From the table 1 it is clear that there are three stages of the law of variable proportion. In the first stage average
production increases as there are more and more doses of labour and capital employed with fixed factors (land). We
see that total product, average product, and marginal product increases but average product and marginal product
increases up to 40 units. Later on, both start decreasing because proportion of workers to land was sufficient and
land is not properly used. This is the end of the first stage.

The second stage starts from where the first stage ends or where AP=MP. In this stage, average product and
marginal product start falling. We should note that marginal product falls at a faster rate than the average product.
Here, total product increases at a diminishing rate. It is also maximum at 70 units of labour where marginal product
becomes zero while average product is never zero or negative.

The third stage begins where second stage ends. This starts from 8th unit. Here, marginal product is negative and
total product falls but average product is still positive. At this stage, any additional dose leads to positive nuisance
because additional dose leads to negative marginal product.

Graphic Presentation:

In fig. 1, on OX axis, we have measured number of labourers while quantity of product is shown on OY axis. TP is
total product curve. Up to point ‘E’, total product is increasing at increasing rate. Between points E and G it is
increasing at the decreasing rate. Here marginal product has started falling. At point ‘G’ i.e., when 7 units of
labourers are employed, total product is maximum while, marginal product is zero. Thereafter, it begins to diminish
corresponding to negative marginal product. In the lower part of the figure MP is marginal product curve.

Graphical Presentation of Variable Factor of Production

Up to point ‘H’ marginal product increases. At point ‘H’, i.e., when 3 units of labourers are employed, it is maximum.
After that, marginal product begins to decrease. Before point ‘I’ marginal product becomes zero at point C and it
turns negative. AP curve represents average product. Before point ‘I’, average product is less than marginal product.
At point ‘I’ average product is maximum. Up to point T, average product increases but after that it starts to diminish.

Three Stages of the Law:

1. First Stage:

First stage starts from point ‘O’ and ends up to point F. At point F average product is maximum and is equal to
marginal product. In this stage, total product increases initially at increasing rate up to point E. between ‘E’ and ‘F’ it
increases at diminishing rate. Similarly marginal product also increases initially and reaches its maximum at point ‘H’.
Later on, it begins to diminish and becomes equal to average product at point T. In this stage, marginal product
exceeds average product (MP > AP).

2. Second Stage:

It begins from the point F. In this stage, total product increases at diminishing rate and is at its maximum at point ‘G’
correspondingly marginal product diminishes rapidly and becomes ‘zero’ at point ‘C’. Average product is maximum
at point ‘I’ and thereafter it begins to decrease. In this stage, marginal product is less than average product (MP <
AP).

3. Third Stage:

This stage begins beyond point ‘G’. Here total product starts diminishing. Average product also declines. Marginal
product turns negative. Law of diminishing returns firmly manifests itself. In this stage, no firm will produce anything.
This happens because marginal product of the labour becomes negative. The employer will suffer losses by
employing more units of labourers. However, of the three stages, a firm will like to produce up to any given point in
the second stage only.

Three Stages of Law of Production Function

In Which Stage Rational Decision is Possible:

To make the things simple, let us suppose that, a is variable factor and b is the fixed factor. And a1, a2 , a3….are units
of a and b1 b2b3…… are unit of b.
Stage I is characterized by increasing AP, so that the total product must also be increasing. This means that the
efficiency of the variable factor of production is increasing i.e., output per unit of a is increasing. The efficiency of b,
the fixed factor, is also increasing, since the total product with b1 is increasing.

The stage II is characterized by decreasing AP and a decreasing MP, but with MP not negative. Thus, the efficiency of
the variable factor is falling, while the efficiency of b, the fixed factor, is increasing, since the TP with b1 continues to
increase.

Finally, stage III is characterized by falling AP and MP, and further by negative MP. Thus, the efficiency of both the
fixed and variable factor is decreasing.

Rational Decision:

Stage II becomes the relevant and important stage of production. Production will not take place in either of the
other two stages. It means production will not take place in stage III and stage I. Thus, a rational producer will
operate in stage II.

Suppose b were a free resource; i.e., it commanded no price. An entrepreneur would want to achieve the greatest
efficiency possible from the factor for which he is paying, i.e., from factor a. Thus, he would want to produce where
AP is maximum or at the boundary between stage I and II.

If on the other hand, a were the free resource, then he would want to employ b to its most efficient point; this is the
boundary between stage II and III.

Obviously, if both resources commanded a price, he would produce somewhere in stage II. At what place in this
stage production takes place would depend upon the relative prices of a and b.

Q5 Discuss “Indian agriculture’s problem of scale”

Answer

The past few days have neatly summed up the scale and nature of the challenges facing India’s agriculture sector.
First, the provisional agriculture census 2015-16 showed that landholdings have continued their decades-long trend
of fragmentation, leading to a further rise in the proportion of small and marginal farmers. Then, 30,000 farmers,
who had started their march from Uttarakhand last month, reached the national capital on Tuesday, demanding
various relief measures. As a real world demonstration of the challenges posed by farm fragmentation, it could not
have been better timed.

When the census, carried out every five years, started in 1970-71, it had reported that India had 71 million
landholdings. These have more than doubled now to 146 million. Over 86% of cultivated farmland is held by small
and marginal farmers who own less than two hectares, while only 0.57% farmers hold 10 hectares or more.
Consequently, the average size of operational holdings has more than halved since the first census—from 2.28
hectares to 1.08 hectares.

Farmers consigned to subsistence farming by this fragmentation—that is, the vast majority of them—are unable to
generate enough surplus for the investment needed to improve productivity. This is widely accepted. But the policy
approach to the problem depends on how the specifics are diagnosed.

In his famous 1962 The Economic Weekly (later renamed to the Economic and Political Weekly) article, “An aspect of
Indian agriculture", Amartya Sen had argued that small farms have higher per-acre output. A number of economists
in the 1960s and 1970s drew similar conclusions. Ramesh Chand, P.A. Lakshmi Prasanna and Aruna Singh had
presented an intriguing update of this argument in 2011 in Farm size and productivity: Understanding the strengths
of smallholders and improving their livelihoods. Cobbling together data from the National Sample Survey
Organisation, agriculture census and the Union ministry of agriculture’s input survey, they found that the inverse
relationship between farm size and per-hectare agricultural productivity still holds.

But this is misleading if taken at face value. The productivity argument is contingent on a number of factors--from
soil quality to the level of farming technology adopted. And as Sen, with a sting in his article’s tail, had pointed out,
“the factor that makes the crucial difference is not size as such, which is incidental, but the system of farming,
whether it is wage-based or family-based."

Andrew D. Foster and Mark R. Rosensweig backed this up last year, studying village-level survey data on farms to
find that productivity actually follows a U-shaped distribution curve. While intermediate sized farms, which have to
spend resources on wage labour are less productive than small farms, which get by on family labour, farms larger
than a certain threshold are more productive than even the most productive small farms. The landowners have the
necessary resources for economies of scale to kick in.

This has several policy implications. Promoting cooperative farming, for instance, will allow small and marginal
farmers to take the advantage of their family labour. Corporate farming, meanwhile, could allow economies of scale
to kick in at lower thresholds. The trickiest issue is improving land-man ratio. Urban growth with economic
opportunities that will attract rural migrants is one way. But the evidence of the past few decades shows that India’s
urban areas are ill-equipped to deal with the inflow.

The rise of the proportion of non-farm income in small and marginal farmers’ earnings points to the other possibility.
Rural construction and industrialization are important supplementary sources of income. In a NITI Aayog paper last
year, Ramesh Chand, S.K. Srivastava and Jaspal Singh pointed out that while these sectors have seen considerable
growth, rural industrial employment hasn’t budged in the past few decades. Solving this puzzle could help move
rural workers to more productive sectors full time, while simultaneously boosting per-capita farm productivity. This
could have useful secondary effects as well. Rising wages due to more productive non-farm rural employment could
make larger and more mechanized farms the increasingly more efficient option.

The exact policy mix will vary from state to state. Crop and landholding patterns vary widely, after all. Nagaland, with
an average operational land holding size of 5.06 hectares, will need a very different approach from Kerala which
averages 0.18 hectares. But they—and every other state—have one thing in common. Loan waivers and electricity
subsidies are band-aids at best. A deeper transformation is needed.

Q. 6 Discuss the Laws of Returns to Scale in Terms of Isoquant Approach

Answer

The laws of returns to scale can also be explained in terms of the isoquant approach. The laws of returns to scale
refer to the effects of a change in the scale of factors (inputs) upon output in the long-run when the combinations of
factors are changed in some proportion.

If by increasing two factors, say labour and capital, in the same proportion, output increases in exactly the same
proportion, there are constant returns to scale.

If in order to secure equal increases in output, both factors are increased in larger proportionate units, there are
decreasing returns to scale. If in order to get equal increases in output, both factors are increased in smaller
proportionate units, there are increasing returns to scale.

The returns to scale can be shown diagrammatically on an expansion path “by the distance between successive
‘multiple-level-of-output’ isoquants, that is, isoquants that show levels of output which are multiples of some base
level of output, e.g., 100, 200, 300, etc.”

Increasing Returns to Scale:

Figure 11 shows the case of increasing returns to scale where to get equal increases in output, lesser proportionate
increases in both factors, labour and capital, are required. It follows that in the figure

100 units of output require 3C + 3L

200 units of output require 5C + 5L

300 units of output require 6C + 6L

so that along the expansion path OR, OA > AB > BC. In this case, the production function is homogeneous of degree
greater than one.

The increasing returns to scale are attributed to the following factors:

1. There may be indivisibilities in machines, management, labour, finance, etc. Some items of equipment or some
activities have a minimum size and cannot be divided into smaller units. When a business unit expands, the returns
to scale increase because the indivisible factors are employed to their full capacity.

2. Increasing returns to scale also result from specialisation and division of labour. When the scale of the firm
expands, there is wide scope for specialisation and division of labour. Work can be divided into small tasks and
workers can be concentrated to narrower range of processes. For this, specialized equipment can be installed. Thus
with specialization, efficiency increases and increasing returns to scale follow.

3. As the firm expands, it enjoys internal economies of production. It may be able to install better machines, sell its
products more easily, borrow money cheaply, procure the services of more efficient manager and workers, etc. All
these economies help in increasing the returns to scale more than proportionately.

4. A firm also enjoys increasing returns to scale due to external economies. When the industry itself expands to meet
the increased long-run demand for its product, external economies appear which are shared by all the firms in the
industry.

When a large number of firms are concentrated at one place, skilled labour, credit and transport facilities are easily
available. Subsidiary industries crop up to help the main industry. Trade journals, research and training centres
appear which help in increasing the productive efficiency of the firms. Thus these external economies are also the
cause of increasing returns to scale.

Decreasing Returns to Scale:

Figure 12 shows the case of decreasing returns where to get equal increases in output, larger proportionate
increases in both labour and capital are required. It follows that

100 units of output require 2C + 2L

200 units of output require 5C + 5L 300 units of output require 9C + 9L so that along the expansion path OR, OG < GH
< HK.

In this case, the production function is homogeneous of degree less than one.

Returns to scale may start diminishing due to the following factors:

1. Indivisible factors may become inefficient and less productive.

2. The firm experiences internal diseconomies. Business may become unwieldy and produce problems of supervision
and coordination. Large management creates difficulties of control and rigidities.

3. To these internal diseconomies are added external diseconomies of scale. These arise from higher factor prices or
from diminishing productivities of the factors. As the industry continues to expand the demand for skilled labour,
land, capital, etc. rises.

There being perfect competition, intensive bidding raises wages, rent and interest. Prices of raw materials also go
up. Transport and marketing difficulties emerge. All these factors tend to raise costs and the expansion of the firms
leads to diminishing returns to scale so that doubling the scale would not lead to doubling the output.

Constant Returns to Scale:

Figure 13 shows the case of constant returns to scale. Where the distance between the isoquants 100, 200 and 300
along the expansion path OR is the same, i.e., OD = DE = EE It means that if units of both factors, labour and capital,
are doubled, the output is doubled. To treble output, units of both factors are trebled. It follows that

100 units of output require 1 (2C + 2L) = 2C + 2L

200 units of output require 2(2C + 2L) = 4C + 4L

300 units of output require 3(2C + 2L) = 6C + 6L

Returns to scale are constant due to the following factors:

1. The returns to scale are constant when internal economies enjoyed by a firm are neutralized by internal
diseconomies so that output increases in the same proportion.

2. Another reason is the balancing of external economies and external diseconomies.

3. Constant returns to scale also result when factors of production are perfectly divisible, substitutable, and
homogeneous and their supplies are perfectly elastic at given prices.

That is why, in the case of constant returns to scale, the production function is homogeneous of degree one.

We have explained above the three laws of returns to scale separately on the assumption that there are three
processes and each process shows the same returns over all ranges of output.

“However, the technological conditions of production may be such that returns to scale may vary over different
ranges of output. Over some range, we may have constant returns to scale, while over another range we may have
increasing or decreasing returns to scale”.

To explain it, we draw an expansion path OR from the origin. This is divided into segments by the successive
isoquants representing equal increments in output, i.e., 100, 200, 300 and so on. As we move along the expansion
path, the distance between the successive isoquants diminishes; it is a case of increasing returns to scale. This stage
is shown in Figure 13(A) from K to M.

Labour and Capital

The distance between KL and LM becomes smaller LM < KL. The firm, therefore, requires smaller increases in the
quantities of labour and capital to produce equal increments of output. If the segments between two isoquants are
of equal length, there are constant returns to scale.

If labour and capital are doubled, the output would also be doubled. Thus when output increases from 300 to 400
and to 500 units, the isoquants representing these output levels mark off equal distances along the scale line, up to
point P, i.e., MN = NP.

If there are decreasing returns to scale, the distance between a pair of isoquants would become longer on the
expansion path. ST is longer than PS. It shows that to increase output larger increases in quantities of labour and
capital are required. Thus, on the same expansion path from K to M, there are increasing returns to scale, from M to
P, there are constant returns to scale and from P to T, and there are diminishing returns to scale.

Q7. What are the factors affecting production?

Solution:
 Return on investment - High returns from selling cocoa for little input will naturally cause more cocoa
planting to take place. As a tree crop this affects long term production. In the short term higher returns
encourage growers to apply more inputs such as fertilisers and pesticides which increases the yield.
However, farmer prices are sometimes set by governments or can be influenced by internal market factors
other than the world cocoa price.
 Government schemes - The role of government in assisting growers is a leading factor in the grower's
decision whether or not to plant cocoa. Assistance can take different forms, from assistance with setting up
and rehabilitation to cheap loans. For example, in Indonesia in 1990 the government made available loans at
 low rates of interest for the establishment of plantations and many companies were tempted into cocoa
growing. Extension services may also assist smallholders.
 Alternative crops - Land suitable for cocoa is also able to support other crops. If cocoa has a low return for a
long time, the farmer may switch to another commodity or food crop despite the costs of uprooting and
replanting.
 Pests, diseases, drought and floods - Pests and diseases, droughts and floods can destroy crops and make
the decision to switch to another crop easier.
 Yield - Yield depends on the age, type and planting distribution of trees and level of inputs needed. The
balance between yield and input costs is important to the grower. For example, Malaysia had high yields of
700 kg per hectare but also had high costs of between 70 cents and $1.30 per kg.
 Tree-stock characteristics - The production capability of the trees and their ability to resist disease are also
an important factor in productivity. The grower with a large estate and more resources will naturally make
more use of the most up-to-date planting material whereas the smallholder will depend on government
extension services or neighbours. The age profile of tree-stock is also important when assessing potential
production as yields will vary with age.
 Environmental influences - The climate, soil, water supply, human actions and other environmental factors
can also affect productivity.
 Costs -A large part of the cost of establishment and maintenance of production is labour. The next major
cost is inputs such as fertilisers and pesticides. Both these costs will vary with the size of the farm and the
type of farming carried out. Financial success in setting up a cocoa farm depends on quick returns from the
initial investment and increasing yields to cut unit costs

Module 3
CO-3 Given the information pertaining to market structure, the future manager will be able to
determine the optimal price and output for firms under different market structures.

Q.1 The Demand function of a monopolistic firm is given as P=240-10Q ; its cost function is

C=Q3 -12Q2 +220 Q-570. Determine the profit maximizing level of price & output.

Solution TR=PQ

TR=(240-10Q)Q

=240Q-10Q2

MR can be obtain by differentiating the function

MR=dTC/dQ =240-20Q

MC can be obtained by differentiating cost function

MC=dTC/dQ =3Q3-24Q +220

We get profit maximization output as

MC=MR

3Q3 -24Q +220 =240 -20Q

 3Q3 -4Q-20=0

Q=4, -3

Q=4 ( negative output cannot be considered)

At Q=4

TR=240 x4 -10x16 =800

TC= 43 -12 x420+220 x4-570 =182

Maximum profit output of 4 units is TR-TC=618

Q. 2 Suppose the firm is operating under perfectly competitive conditions in the market. It faces the
following revenue and cost conditions

TR = 12Q

TC = 2+4Q+Q2

Determine the equilibrium level of output using both the first order and second order conditions of
equilibrium. Calculate total profits made.

Solution

Profits are maximized when the firm equates marginal cost with marginal revenue and marginal cost is
rising. Thus, in order to obtain the equilibrium output we equate MC = MR

TR = 12Q

MR = dTR/ dQ = 12

MC = dTC/dQ = 4+2Q

In equilibrium,

MC = MR

4+2Q=12

Q=4

Total Profits = TR-TC

= 12Q-(2+4Q+Q2)

Substituting Q =4 we have

Profit = (12*4)-2-(4*4)-16

=48-34=14

Note that in order to ensure for the fulfillment of second order condition, we have to test whether MC is rising.
For this, we take the derivative of MC i.e. second derivative of TC

Thus,
 MC= dTC = 4+2Q

d2TC/dQ2= +2

The positive sign of the second derivative of TC implies that MC is rising.

Q. 3 suppose the following demand and supply unction of a commodity are given which is being produced
under conditions of perfect competition. Find out the equilibrium price and quantity
d s
q =750-25p, q =300+20p
Solution
d s
We can find out the equilibrium price and quantity by using the equilibrium condition, namely, q =q .
d s
Since in equilibrium, q =q
750-25p = 300+20p
45p = 750-300
P = 450/45 = 10
Now, substituting the value of p in the demand equation
d
q = 750-25*10

Q 4 For a perfectly competitive firm, the following short-run function is given

TC=2+4Q+Q2
If price of the product prevailing in the market is Rs. 8 at what level of output the firm will
maximize profits?
Solution
Since total revenue is price multiplied by quantity of output, total revenue function is
TR = PQ = 8Q
TC = 2+4Q+Q2
MR-MC Approach
In this approach profits are maximum at the output level at which MR equals MC. We
therefore first derive the marginal revenue and marginal cost from TR and TC functions.
TR = 8Q
MR = d (TR) / dQ = 8
TC = 2 + 4Q + Q2
MC= d(TC)/dQ = 4+2Q
In order to determine profit-maximizing output we set MR equal to MC. Thus,
MR= MC
8 = 4+2Q
2Q = 8-4 = 4
Q=2
Q 5 Suppose for a monopolist the following demand and total cost function are given. Find out how much he
will produce and what price he will charge
Q = 360-20P (demand function)
TC = 6Q+0.05Q2 (cost function)

Solution
In order to find the profit maximizing solution we have to derive the marginal revenue and marginal
cost from the demand and cost equations given above. In order to find out the marginal revenue we
have to first obtain the total revenue function.
Thus we first derive the inverse demand unction as under:
Q=360-20P
20P=360-Q
P=18-0.05Q -- (i)
Total revenue (TR) = PQ = 18Q – 0.05Q2
Differentiating it with respect to output Q we can get MR. Thus
MR = dTR/dQ = d(PQ)/dQ = 18-0.1Q -- (ii)
Marginal cost can be obtained by differentiating the total function (TC=6Q+0.05Q2)
Thus, we have
MC= dTC/dQ = 6+0.1Q
Since the profits of the monopolist will be maximized when he equates marginal revenue with
marginal cost, setting MR = MC
18-0.1Q = 6+0.1Q
0.2Q=18-6=12
Q=12*10/2 = 60
To find out price we substitute the value of output Q in the demand function (i) above we have
P = 18-0.05Q
=18-0.05*60 = 18-3 = 15
To obtain total profits we calculate total revenue and total cost
TR = PQ = 15*60 = 900
TC = 6Q+0.05Q2 = 6*60+0.05(60)2
= 360 + (5/100)*3600 = 540
Profit = TR-TC = 900-540= 360
Thus, output (Q) = 60; price (P) = Rs. 15 and profits = Rs. 360

Q. 6 given the following linear demand and cost functions, show that monopolist will produce half the
output under perfect competition.
Q = 300 – 2P
TC = 150+10Q
Solution
Given
TC = 150+10Q
MC = dTC/dQ = 10
Now, the given liner demand function is
Q = 300-2P
2P = 300-Q
 P =150-0.5Q
TR = PQ = 150Q-0.5Q2
MR = d (PQ)/ dQ = 150-Q
Output under perfect competition
10 = 150-0.5Q
0.5Q = 150-10 = 140
Hence, Qpc= 280 - - (i)
In equilibrium under monopoly,
MR = MC
From (iii) we know MR = 150-Q and from (i) we know that MC = 10
Thus, in equilibrium under monopoly
150-Q = 10
Q = 150 – 10 = 140
Thus, Qm = 140 - - (ii)
Comparing (i) and (ii) we find that output under monopoly is half of the produced under perfect
competition.

Q . 7 Analyze the price-output determination under low-cost price leadership and under price leadership by
the dominant firm.
Q. 8 Analyze the individual firm’s equilibrium under monopolistic competition.

MODULE 4

CO-4 Given the circular flow model of an economy, the future manager will be able to interpret the role
and importance of each component with regard to factor market and product market and will also be
able to comment on the implications and control of inflation.

Q1. Explain the meaning of inflation in Indian Context and extend its types causes and effects.

Inflation: Types, Causes and Effects (With Diagram)

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

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

Almost everyone is sure that he knows what inflation exactly is, but it remains a source of great deal of
confu¬sion because it is difficult to define it unam¬biguously.

1. Meaning of Inflation:

Inflation is often defined in terms of its supposed causes. Inflation exists when money supply exceeds
available goods and services. Or inflation is attributed to budget deficit financing. A deficit budget may be
financed by the additional money creation. But the situation of monetary expansion or budget deficit may
not cause price level to rise. Hence the difficulty of defining ‘inflation’.
Inflation may be defined as ‘a sustained upward trend in the general level of prices’ and not the price of only
one or two goods. G. Ackley defined inflation as ‘a persistent and appreciable rise in the general level or
aver¬age of prices’. In other words, inflation is a state of rising prices, but not high prices.

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

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

It is to be pointed out here that inflation is a state of disequilib¬rium when there occurs a sustained rise in
price level. It is inflation if the prices of most goods go up. Such rate of increases in prices may be both slow
and rapid. However, it is difficult to detect whether there is an upward trend in prices and whether this trend
is sus¬tained. That is why inflation is difficult to define in an unambiguous sense.

Let’s measure inflation rate. Suppose, in December 2007, the consumer price index was 193.6 and, in
December 2008, it was 223.8. Thus, the inflation rate during the last one year was

223.8- 193.6/ 193.6 x 100 = 15.6

As inflation is a state of rising prices, de¬flation may be defined as a state of falling prices but not fall in
prices. Deflation is, thus, the opposite of inflation, i.e., a rise in the value of money or purchasing power of
money. Disinflation is a slowing down of the rate of inflation.

2. Types of Inflation:

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

Thus, one may observe different types of inflation in the contemporary society:

A. On the Basis of Causes:

(i) Currency inflation:

This type of infla¬tion is caused by the printing of cur¬rency notes.

(ii) Credit inflation:

Being profit-making institutions, commercial banks sanction more loans and advances to the public than
what the economy needs. Such credit expansion leads to a rise in price level.

(iii) Deficit-induced inflation:

The budget of the government reflects a deficit when expenditure exceeds revenue. To meet this gap, the
government may ask the central bank to print additional money. Since pumping of additional money is
required to meet the budget deficit, any price rise may the be called the deficit-induced inflation.
(iv) Demand-pull inflation:

An increase in aggregate demand over the available output leads to a rise in the price level. Such inflation is
called demand-pull in¬flation (henceforth DPI). But why does aggregate demand rise? Classical economists
attribute this rise in aggre¬gate demand to money supply. If the supply of money in an economy ex¬ceeds
the available goods and services, DPI appears. It has been described by Coulborn as a situation of “too much
money chasing too few goods.”

Keynesians hold a different argu¬ment. They argue that there can be an autonomous increase in aggregate
de¬mand or spending, such as a rise in con¬sumption demand or investment or government spending or a
tax cut or a net increase in exports (i.e., C + I + G + X – M) with no increase in money sup¬ply. This would
prompt upward adjust¬ment in price. Thus, DPI is caused by monetary factors (classical adjustment) and
non-monetary factors (Keynesian argument).

DPI can be explained in terms of Fig. 4.2, where we measure output on the horizontal axis and price level on
the vertical axis. In Range 1, total spending is too short of full employment out¬put, YF. There is little or no
rise in the price level. As demand now rises, out¬put will rise. The economy enters Range 2, where output
approaches towards full employment situation. Note that in this region price level begins to rise.
Ul¬timately, the economy reaches full em-ployment situation, i.e., Range 3, where output does not rise but
price level is pulled upward. This is demand-pull in¬flation. The essence of this type of in¬flation is that
“too much spending chas¬ing too few goods.”

(v) Cost-push inflation:

Inflation in an economy may arise from the overall increase in the cost of production. This type of inflation
is known as cost-push inflation (henceforth CPI). Cost of pro¬duction may rise due to an increase in the
prices of raw materials, wages, etc. Often trade unions are blamed for wage rise since wage rate is not
completely market-determinded. Higher wage means high cost of production. Prices of commodities are
thereby increased.
A wage-price spiral comes into opera¬tion. But, at the same time, firms are to be blamed also for the price
rise since they simply raise prices to expand their profit margins. Thus, we have two im¬portant variants of
CPI wage-push in¬flation and profit-push inflation.

Any¬way, CPI stems from the leftward shift of the aggregate supply curve:

B. On the Basis of Speed or Intensity:

(i) Creeping or Mild Inflation:

If the speed of upward thrust in prices is slow but small then we have creeping inflation. What speed of
annual price rise is a creeping one has not been stated by the economists. To some, a creeping or mild
inflation is one when annual price rise varies between 2 p.c. and 3 p.c. If a rate of price rise is kept at this
level, it is con¬sidered to be helpful for economic development. Others argue that if annual price rise goes
slightly beyond 3 p.c. mark, still then it is considered to be of no danger.

(ii) Walking Inflation:

If the rate of annual price increase lies between 3 p.c. and 4 p.c., then we have a situation of walking
inflation. When mild inflation is allowed to fan out, walking inflation appears. These two types of inflation
may be described as ‘moderate inflation’.

Often, one-digit inflation rate is called ‘moder¬ate inflation’ which is not only predict¬able, but also keep
people’s faith on the monetary system of the country. Peoples’ confidence get lost once moderately
maintained rate of inflation goes out of control and the economy is then caught with the galloping inflation.

(iii) Galloping and Hyperinflation:

Walking inflation may be converted into running inflation. Running inflation is danger¬ous. If it is not
controlled, it may ulti¬mately be converted to galloping or hyperinflation. It is an extreme form of inflation
when an economy gets shatter¬ed.”Inflation in the double or triple digit range of 20, 100 or 200 p.c. a year is
labelled “galloping inflation”.

(iv) Government’s Reaction to Inflation:

In¬flationary situation may be open or suppressed. Because of anti-infla¬tionary policies pursued by the
govern¬ment, inflation may not be an embar¬rassing one. For instance, increase in income leads to an
increase in con¬sumption spending which pulls the price level up.

If the consumption spending is countered by the govern¬ment via price control and rationing device, the
inflationary situation may be called a suppressed one. Once the government curbs are lifted, the sup¬pressed
inflation becomes open infla¬tion. Open inflation may then result in hyperinflation.

Q2. Explain in detail the causes of Inflation in economy?

Causes of Inflation:
Inflation is mainly caused by excess demand/ or decline in aggregate supply or output. Former leads to a
rightward shift of the aggregate demand curve while the latter causes aggregate supply curve to shift
left¬ward. Former is called demand-pull inflation (DPI), and the latter is called cost-push infla¬tion (CPI).
Before describing the factors, that lead to a rise in aggregate demand and a de¬cline in aggregate supply, we
like to explain “demand-pull” and “cost-push” theories of inflation.

(i) Demand-Pull Inflation Theory:

There are two theoretical approaches to the DPI—one is classical and other is the Keynesian.

According to classical economists or mon¬etarists, inflation is caused by an increase in money supply which
leads to a rightward shift in negative sloping aggregate demand curve. Given a situation of full employment,
classi¬cists maintained that a change in money supply brings about an equiproportionate change in price
level.

That is why monetarists argue that inflation is always and everywhere a monetary phenomenon. Keynesians
do not find any link between money supply and price level causing an upward shift in aggregate demand.

According to Keynesians, aggregate demand may rise due to a rise in consumer demand or investment
demand or govern¬ment expenditure or net exports or the com¬bination of these four components of
aggreate demand. Given full employment, such in¬crease in aggregate demand leads to an up¬ward pressure
in prices. Such a situation is called DPI. This can be explained graphically.

Just like the price of a commodity, the level of prices is determined by the interaction of aggregate demand
and aggregate supply. In Fig. 4.3, aggregate demand curve is negative sloping while aggregate supply curve
before the full employment stage is positive sloping and becomes vertical after the full employ¬ment stage
is reached. AD1 is the initial aggregate demand curve that intersects the aggregate supply curve AS at point
E1.

The price level, thus, determined is OP1. As ag¬gregate demand curve shifts to AD2, price level rises to
OP2. Thus, an increase in aggre¬gate demand at the full employment stage leads to an increase in price level
only, rather than the level of output. However, how much price level will rise following an increase in
aggregate demand depends on the slope of the AS curve.

(ii) Causes of Demand-Pull Inflation:

DPI originates in the monetary sector. Mon¬etarists’ argument that “only money matters” is based on the
assumption that at or near full employment excessive money supply will in¬crease aggregate demand and
will, thus, cause inflation.

An increase in nominal money supply shifts aggregate demand curve rightward. This enables people to hold
excess cash bal¬ances. Spending of excess cash balances by them causes price level to rise. Price level will
continue to rise until aggregate demand equals aggregate supply.

Keynesians argue that inflation originates in the non-monetary sector or the real sector. Aggregate demand
may rise if there is an increase in consumption expenditure following a tax cut. There may be an
autonomous increase in business investment or government expendi¬ture. Government expenditure is
inflationary if the needed money is procured by the gov¬ernment by printing additional money.

In brief, increase in aggregate demand i.e., in¬crease in (C + I + G + X – M) causes price level to rise.
However, aggregate demand may rise following an increase in money supply gen-erated by the printing of
additional money (classical argument) which drives prices up¬ward. Thus, money plays a vital role. That is
why Milton Friedman argues that inflation is always and everywhere a monetary phenom¬enon.

There are other reasons that may push ag¬gregate demand and, hence, price level up¬wards. For instance,
growth of population stimulates aggregate demand. Higher export earnings increase the purchasing power of
the exporting countries. Additional purchasing power means additional aggregate demand. Purchasing
power and, hence, aggregate de¬mand may also go up if government repays public debt.

Again, there is a tendency on the part of the holders of black money to spend more on conspicuous
consumption goods. Such tendency fuels inflationary fire. Thus, DPI is caused by a variety of factors.

(iii) Cost-Push Inflation Theory:

In addition to aggregate demand, aggregate supply also generates inflationary process. As inflation is caused
by a leftward shift of the aggregate supply, we call it CPI. CPI is usu¬ally associated with non-monetary
factors. CPI arises due to the increase in cost of produc¬tion. Cost of production may rise due to a rise in
cost of raw materials or increase in wages.

However, wage increase may lead to an in¬crease in productivity of workers. If this hap¬pens, then the AS
curve will shift to the right- ward not leftward—direction. We assume here that productivity does not change
in spite of an increase in wages.

Such increases in costs are passed on to consumers by firms by rais¬ing the prices of the products. Rising
wages lead to rising costs. Rising costs lead to rising prices. And, rising prices again prompt trade unions to
demand higher wages. Thus, an inflationary wage-price spiral starts. This causes aggregate supply curve to
shift leftward.
This can be demonstrated graphically where AS1 is the initial aggregate supply curve. Below the full
employment stage this AS curve is positive sloping and at full em¬ployment stage it becomes perfectly
inelastic.

Intersection point (E1) of AD1 and AS1 curves determine the price level (OP1). Now there is a leftward
shift of aggregate supply curve to AS2. With no change in aggregate demand, this causes price level to rise
to OP2 and output to fall to OY2. With the reduction in output, employment in the economy de¬clines or
unemployment rises. Further shift in AS curve to AS3 results in a higher price level (OP3) and a lower
volume of aggregate out¬put (OY3). Thus, CPI may arise even below the full employment (YF) stage.

(iv) Causes of Cost-Push Inflation:

It is the cost factors that pull the prices up¬ward. One of the important causes of price rise is the rise in price
of raw materials. For in¬stance, by an administrative order the govern¬ment may hike the price of petrol or
diesel or freight rate. Firms buy these inputs now at a higher price. This leads to an upward pres¬sure on
cost of production.

Not only this, CPI is often imported from outside the economy. Increase in the price of petrol by OPEC
com¬pels the government to increase the price of petrol and diesel. These two important raw materials are
needed by every sector, espe¬cially the transport sector. As a result, trans¬port costs go up resulting in
higher general price level.

Again, CPI may be induced by wage-push inflation or profit-push inflation. Trade unions demand higher
money wages as a compen¬sation against inflationary price rise. If in¬creasein money wages exceed
labourproduc¬tivity, aggregate supply will shift upward and leftward. Firms often exercise power by
push¬ing prices up independently of consumer de¬mand to expand their profit margins.

Fiscal policy changes, such as increase in tax rates also leads to an upward pressure in cost of production.
For instance, an overall in¬crease in excise tax of mass consumption goods is definitely inflationary. That is
why govern¬ment is then accused of causing inflation.

Finally, production setbacks may result in decreases in output. Natural disaster, gradual exhaustion of
natural resources, work stop¬pages, electric power cuts, etc., may cause ag-gregate output to decline. In the
midst of this output reduction, artificial scarcity of any goods created by traders and hoarders just simply
ignite the situation.
Inefficiency, corruption, mismanagement of the economy may also be the other reasons. Thus, inflation is
caused by the interplay of various factors. A particular factor cannot be held responsible for any inflationary
price rise.

4. Effects of Inflation:

People’s desires are inconsistent. When they act as buyers they want prices of goods and services to remain
stable but as sellers they expect the prices of goods and services should go up. Such a happy outcome may
arise for some individuals; “but, when this happens, others will be getting the worst of both worlds.”

When price level goes up, there is both a gainer and a loser. To evaluate the conse¬quence of inflation, one
must identify the na¬ture of inflation which may be anticipated and unanticipated. If inflation is anticipated,
peo¬ple can adjust with the new situation and costs of inflation to the society will be smaller.

In reality, people cannot predict accurately fu¬ture events or people often make mistakes in predicting the
course of inflation. In other words, inflation may be unanticipated when people fail to adjust completely.
This creates various problems.

One can study the effects of unanticipated inflation under two broad head¬ings:

(a) Effect on distribution of income and wealth; and

(b) Effect on economic growth.

Q3. Explain effects of inflation on distribution of Income and wealth

(a) Effects of Inflation on Distribution of Income and Wealth:

During inflation, usu¬ally people experience rise in incomes. But some people gain during inflation at the
ex¬pense of others. Some individuals gain be¬cause their money incomes rise more rapidly than the prices
and some lose because prices rise more rapidly than their incomes during inflation. Thus, it redistributes
income and wealth.

Though no conclusive evidence can be cited, it can be asserted that following catego¬ries of people are
affected by inflation differ¬ently:

(i) Creditors and debtors:

Borrowers gain and lenders lose during inflation because debts are fixed in rupee terms. When debts are
repaid their real value declines by the price level increase and, hence, creditors lose. An individual may be
interested in buying a house by taking loan of Rs. 7 lakh from an in¬stitution for 7 years.

The borrower now wel¬comes inflation since he will have to pay less in real terms than when it was
borrowed. Lender, in the process, loses since the rate of interest payable remains unaltered as per
agree¬ment. Because of inflation, the borrower is given ‘dear’ rupees, but pays back ‘cheap’ ru¬pees.
However, if in an inflation-ridden economy creditors chronically loose, it is wise not to advance loans or to
shut down business.

Never does it happen. Rather, the loan-giving institution makes adequate safeguard against the erosion of
real value. Above all, banks do not pay any interest on current account but charges interest on loans.

(ii) Bond and debenture-holders:

In an economy, there are some people who live on interest income—they suffer most. Bondhold¬ers earn
fixed interest income: These people suffer a reduction in real income when prices rise. In other words, the
value of one’s sav¬ings decline if the interest rate falls short of inflation rate. Similarly, beneficiaries from
life insurance programmes are also hit badly by inflation since real value of savings deterio¬rate.

(iii) Investors:

People who put their money in shares during inflation are expected to gain since the possibility of earning of
business profit brightens. Higher profit induces own¬ers of firm to distribute profit among inves¬tors or
shareholders.

(iv) Salaried people and wage-earners:

Any¬one earning a fixed income is damaged by in¬flation. Sometimes, unionised worker suc-ceeds in
raising wage rates of white-collar workers as a compensation against price rise. But wage rate changes with
a long time lag. In other words, wage rate increases always lag behind price increases. Naturally, inflation
results in a reduction in real purchasing power of fixed income-earners.

On the other hand, people earning flexible incomes may gain during inflation. The nominal incomes of such
people outstrip the general price rise. As a re¬sult, real incomes of this income group in¬crease.

(v) Profit-earners, speculators and black marketers:

It is argued that profit-earners gain from inflation. Profit tends to rise during inflation. Seeing inflation,
businessmen raise the prices of their products. This results in a bigger profit. Profit margin, however, may
not be high when the rate of inflation climbs to a high level.

However, speculators dealing in business in essential commodities usually stand to gain by inflation. Black
marketers are also ben¬efited by inflation.

Thus, there occurs a redistribution of in¬come and wealth. It is said that rich becomes richer and poor
becomes poorer during infla¬tion. However, no such hard and fast gener¬alisation can be made. It is clear
that someone wins and someone loses during inflation.

These effects of inflation may persist if in¬flation is unanticipated. However, the redistributive burdens of
inflation on income and wealth are most likely to be minimal if inflation is anticipated by the people. With
anticipated inflation, people can build up their strategies to cope with inflation.

If the annual rate of inflation in an economy is anticipated correctly people will try to protect them against
losses resulting from inflation. Workers will demand 10 p.c. wage increase if inflation is expected to rise by
10 p.c.

Similarly, a percent¬age of inflation premium will be demanded by creditors from debtors. Business firms
will also fix prices of their products in accordance with the anticipated price rise. Now if the en¬tire society
“learn to live with inflation”, the redistributive effect of inflation will be mini¬mal.

However, it is difficult to anticipate prop¬erly every episode of inflation. Further, even if it is anticipated it
cannot be perfect. In addi¬tion, adjustment with the new expected infla¬tionary conditions may not be
possible for all categories of people. Thus, adverse redistributive effects are likely to occur.

Finally, anticipated inflation may also be costly to the society. If people’s expectation regarding future price
rise become stronger they will hold less liquid money. Mere hold¬ing of cash balances during inflation is
unwise since its real value declines. That is why peo¬ple use their money balances in buying real estate,
gold, jewellery, etc. Such investment is referred to as unproductive investment. Thus, during inflation of
anticipated variety, there occurs a diversion of resources from priority to non-priority or unproductive
sectors.

Q4. Explain effect of inflation on Economic Growth?

Inflation may or may not result in higher output. Below the full employment stage, inflation has a favourable
effect on production. In general, profit is a rising function of the price level. An inflationary situation gives
an incen¬tive to businessmen to raise prices of their prod¬ucts so as to earn higher volume of profit. Ris¬ing
price and rising profit encourage firms to make larger investments.

As a result, the multi¬plier effect of investment will come into opera¬tion resulting in a higher national
output. How¬ever, such a favourable effect of inflation will be temporary if wages and production costs rise
very rapidly.

Further, inflationary situation may be as¬sociated with the fall in output, particularly if inflation is of the
cost-push variety. Thus, there is no strict relationship between prices and output. An increase in aggregate
demand will increase both prices and output, but a supply shock will raise prices and lower output.

Inflation may also lower down further pro¬duction levels. It is commonly assumed that if inflationary
tendencies nurtured by experi¬enced inflation persist in future, people will now save less and consume
more. Rising sav¬ing propensities will result in lower further outputs.

One may also argue that inflation creates an air of uncertainty in the minds of business community,
particularly when the rate of in¬flation fluctuates. In the midst of rising infla-tionary trend, firms cannot
accurately estimate their costs and revenues. That is, in a situa¬tion of unanticipated inflation, a great deal of
risk element exists.

It is because of uncertainty of expected inflation, investors become reluc¬tant to invest in their business and
to make long-term commitments. Under the circum¬stance, business firms may be deterred in in¬vesting.
This will adversely affect the growth performance of the economy.

However, slight dose of inflation is neces¬sary for economic growth. Mild inflation has an encouraging
effect on national output. But it is difficult to make the price rise of a creep¬ing variety. High rate of
inflation acts as a dis¬incentive to long run economic growth. The way the hyperinflation affects economic
growth is summed up here. We know that hyper-inflation discourages savings.

A fall in savings means a lower rate of capital forma¬tion. A low rate of capital formation hinders economic
growth. Further, during excessive price rise, there occurs an increase in unpro¬ductive investment in real
estate, gold, jewel¬lery, etc. Above all, speculative businesses flourish during inflation resulting in artificial
scarcities and, hence, further rise in prices.

Again, following hyperinflation, export earn¬ings decline resulting in a wide imbalances in the balance of
payment account. Often gallop¬ing inflation results in a ‘flight’ of capital to foreign countries since people
lose confidence and faith over the monetary arrangements of the country, thereby resulting in a scarcity of
resources. Finally, real value of tax revenue also declines under the impact of hyperinfla¬tion. Government
then experiences a shortfall in investible resources.

Thus economists and policymakers are unanimous regarding the dangers of high price rise. But the
consequence of hyperinfla¬tion are disastrous. In the past, some of the world economies (e.g., Germany
after the First World War (1914-1918), Latin American coun¬tries in the 1980s) had been greatly ravaged
by hyperinflation.
Q5. Explain the circular flow of income with respect to Indian Economy.

The Circular Flow of Income: Meaning, Sectors and Importance!

Contents:

1. Meaning

2. Circular Flow in a Two Sector Economy

3. Circular Flow in a Three- Sector Closed Economy

4. Importance of the Circular Flow

1. Meaning:

The circular flow of income and expenditure refers to the process whereby the national income and
expenditure of an economy flow in a circular manner continuously through time.

The various components of national income and expenditure such as saving, investment, taxation,
government expenditure, exports, imports, etc. are shown on diagrams in the form of currents and cross-
currents in such a manner that national income equals national expenditure.

2. Circular Flow in a Two Sector Economy:

We begin with a simple hypothetical economy where there are only two sectors, the household and business.
The household sector owns all the factors of production, that is, land, labour and capital. This sector receives
income by selling the services of these factors to the business sector.

The business sector consists of producers who produce products and sell them to the household sector or
consumers. Thus the household sector buys the output of products of the business sector. The circular flow
of income and expenditure in such an economy is shown in Figure 1 where the product market is shown in
the upper portion and the factor market in the lower portion.

In the product market, the household sector purchases goods and services from the business sector while in
the factor market the household sector receives income from the former for providing services. Thus the
household sector purchases all goods and services provided by the business sector and makes payments to
the latter in lieu of these.

The business sector, in turn, makes payments to the households for the services rendered by the latter to the
business-wage payments for labour services, profit for capital supplied, etc. Thus payments go around in a
circular manner from the business sector to the household sector and from the household sector to the
business sector, as shown by arrows in the output portion of the figure.

There are also flows of goods and services in the opposite direction to the money payments flows. Goods
flow from the business sector to the household sector in the product market, and services flow from the
household sector to the business sector in the factor market, as shown in the inner portion of the figure.
These two flows give GNP=GNI.

Circular Flow with Saving and Investment Added:

The actual economy is not as explained above. In an economy, “inflows” and “leakages” occur in the
expenditure and income flows. Such leakages are saving, and inflows or injections are investment which
equals each other.

Expenditure has now two alternative paths from household and product markets:

(i) Directly via consumption expenditure, and

(ii) indirectly via investment expenditure.

there is a capital or credit market in between saving and investment flows from households to business
firms. The capital market refers to a number of financial institutions such as commercial banks, sav¬ings
banks, loan institutions, the stock and bond markets, etc. The capital market coordinates the saving and
investment activities of the households and the business firms. The households supply saving to the capital
market and the firms, in turn, obtain investment funds from the capital market.

3. Circular Flow in a Three- Sector Closed Economy:

So far we have been working on the circular flow of a two-sector model of an economy. To this we add the
government sector so as to make it a three-sector closed model of circular flow of income and expenditure.
For this, we add taxation and government purchases (or expenditure) in our presentation. Taxation is a
leakage from the circular flow and government purchases are injections into the circular flow.

First, take the circular flow between the household sector and the government sector. Taxes in the form of
personal income tax and commodity taxes paid by the household sector are outflows or leakages from the
circular flow.

But the government purchases the services of the households, makes transfer payments in the form of old
age pensions, unemployment relief, sickness benefit, etc., and also spends on them to provide certain social
services like education, health, housing, water, parks and other facilities. All such expenditures by the
government are injections into the circular flow.

Next take the circular flow between the business sector and the government sector. All types of taxes paid
by the business sector to the government are leakages from the circular flow. On the other hand, the
government purchases all its requirements of goods of all types from the business sector, gives subsidies and
makes transfer payments to firms in order to encourage their production. These government expenditures are
injections into the circular flow.

Now we take the household, business and government sectors together to show their inflows and outflows in
the circular flow. As already noted, taxation is a leakage from the circular flow. It tends to reduce
consumption and saving of the household sector. Reduced consumption, in turn, reduces the sales and
incomes of the firms. On the other hand, taxes on business firms tend to reduce their investment and
production.

The government offsets these leakages by making purchases from the business sector and buying services of
the household sector equal to the amount of taxes. Thus total sales again equal production of firms. In this
way, the circular flows of income and expenditure remain in equilibrium.

Figure 3 shows that taxes flow out of the household and business sectors and go to the government. Now the
government makes investment and for this purchases goods from firms and also factors of production from
households. Thus government purchases of goods and services are an injection in the circular flow of
income and taxes are leakages.
If government purchases exceed net taxes then the government will incur a deficit equal to the difference
between the two, i.e., government expenditure and taxes. The government finances its deficit by borrowing
from the capital market which receives funds from households in the form of saving.

On the other hand, if net taxes exceed government purchases the government will have a budget surplus. In
this case, the government reduces the public debt and supplies funds to the capital market which are received
by firms.

Adding Foreign Sector: Circular Flow in a Four-sector Open Economy:

So far the circular flow of income and expenditure has been shown in the case of a closed economy. But the
actual economy is an open one where foreign trade plays an important role. Exports are an injection or
inflows into the economy.

They create incomes for the domestic firms. When foreigners buy goods and services produced by domestic
firms, they are exports in the circular flow of income. On the other hand, imports are leakages from the
circular flow. They are expenditures incurred by the household sector to pur¬chase goods from foreign
countries. These exports and imports in the circular flow are shown in Figure 4.

Take the inflows and outflows of the household, business and government sectors in relation to the foreign
sector. The household sector buys goods imported from abroad and makes payment for them which is a
leakage from the circular flow. The households may receive transfer payments from the foreign sector for
the services rendered by them in foreign countries.

On the other hand, the business sector exports goods to foreign countries and its receipts are an injection in
the circular flow. Similarly, there are many services rendered by business firms to foreign countries such as
shipping, insurance, banking, etc. for which they receive payments from abroad.

They also receive royalties, interests, dividends, profits, etc. for investments made in foreign countries. On
the other hand, the business sector makes payments to the foreign sector for imports of capital goods,
machinery, raw materials, consumer goods, and services from abroad. These are the leakages from the
circular flow.

Like the business sector, modern governments also export and import goods and services, and lend to and
borrow from foreign countries. For all exports of goods, the government receives payments from abroad.

Similarly, the government receives payments from foreigners when they visit the country as tourists and for
receiving education, etc. and also when the government provides shipping, insurance and banking services
to foreigners through the state-owned agencies.

It also receives royalties, interest, dividends etc. for investments made abroad. These are injections into the
circular flow. On other hand, the leakages are payments made for the purchase of goods and services to
foreigners.

Figure 4 shows the circular flow of the four-sector open economy with saving, taxes and imports shown as
leakages from the circular flow on the right hand side of the figure, and investment, government purchases
and exports as injections into the circular flow on the left side of the figure.

Further, imports, exports and transfer payments have been shown to arise from the three domestic sectors—
the household, the business and the government. These outflows and inflows pass through the foreign sector
which is also called the “Balance of Payments Sector.”
If exports exceed imports, the economy has a surplus in the balance of payments. And if imports exceed
exports, it has a deficit in the balance of payments. But in the long run, exports of an economy must balance
its imports. This is achieved by the foreign trade policies adopted by the economy.

The whole analysis can be shown in simple equations:

Y= C +I+ G … (1)

Where Y represents the production of goods and services, C for consumption expenditure, I investment level
in the economy and G for government expenditure respectively.

Now we introduce taxation in the model to equate the government expenditure.

Therefore, Y= C + S + T … (2)

Where S is saving T is taxation.

By equating (1) and (2), we get

C+I+G=C+S+T

I+G=S+T

With the introduction of the foreign sector, we divide investment into domestic investment (Id) and foreign
investment (If) and get

Id + IF + G = S + T

But If = X – M

Where X is exports and M is imports

Id + (X – M) + G = S + T

ld + (X – M) = S + (T – G)

The equation shows the equilibrium condition in the circular flow of income and expenditure.

Q6. Explain the Importance of circular Flow in Macro Economy.

Importance of the Circular Flow:

________________________________________

The concept of the circular flow gives a clear-cut picture of the economy. We can know whether the
economy is working efficiently or whether there is any disturbance in its smooth functioning. As such, the
circular flow is of immense significance for studying the functioning of the economy and for helping the
government in formulating policy measures.

1. Study of Problems of Disequilibrium:

It is with the help of circular flow that the problems of disequilibrium and the restoration of equilibrium can
be studied.

2. Effects of Leakages and Inflows:

The role of leakages enables us to study their effects on the national economy. For example, imports are a
leakage out of the circular flow of income because they are payments made to a foreign country. To stop this
leakage, government should adopt appropriate measures so as to increase exports and decrease imports.

3. Link between Producers and Consumers:

The circular flow establishes a link between producers and consumers. It is through income that producers
buy the services of the factors of production with which the latter, in turn, purchase goods from the
producers.

4. Creates a Network of Markets:

As a corollary to the above point, the linking of producers and consumers through the circular flow of
income and expenditure has created a network of markets for different goods and services where problems
relating to their sale and purchase are automatically solved.

5. Inflationary and Deflationary Tendencies:

Leakages or injections in the circular flow disturb the smooth functioning of the economy. For example,
saving is a leakage out of the expenditure stream. If saving increases, this depresses the circular flow of
income. This tends to reduce employment, income and prices, thereby leading to a deflationary process in
the economy. On the other hand, consumption tends to increase employment, income, output and prices that
lead to inflationary tendencies.

6. Basis of the Multiplier:

Again, if leakages exceed injections in the circular flow, the total income becomes less than the total output.
This leads to a cumulative decline in employment, income, output, and prices over time. On the other hand,
if injections into the circular flow exceed leakages, the income is increased in the economy. This leads to a
cumulative rise in employment, income, output, and prices over a period of time. In fact, the basis of the
Keynesian multiplier is the cumulative movements in the circular flow of income.

7. Importance of Monetary Policy:

The study of circular flow also highlights the importance of monetary policy to bring about the equality of
saving and investment in the economy. Figure 2 shows that the equality between saving and investment
comes about through the credit or capital market.
The credit market itself is controlled by the government through monetary policy. When saving exceeds
investment or investment exceeds saving, money and credit policies help to stimulate or retard investment
spending. This is how a fall or rise in prices is also controlled.

8. Importance of Fiscal Policy:

The circular flow of income and expenditure points toward the importance of fiscal policy. For national
income to be in equilibrium desired saving plus taxes (S+T) must equal desired investment plus government
spending (I + G). S+ T represents leakages from the spending stream which must be offset by injections of I
+ G into the income stream. If S + T exceed I + G, government should adopt such fiscal measures as
reduction in taxes and spending more itself. On the contrary.

If I + G exceed S+T, the government should adjust its revenue and expenditure by encouraging saving and
tax revenue. Thus the circular flow of income and expenditure tells us about the importance of
compensatory fiscal policy.

9. Importance of Trade Policies:

Similarly, imports are leakages in the circular flow of money because they are payments made to a foreign
country. To stop it, the government adopts such measures as to increase exports and decrease imports. Thus
the circular flow points toward the importance of adopting export promotion and import control policies.

10. Basis of Flow of Funds Accounts:

The circular flow helps in calculating national income on the basis of the flow of funds accounts. The flow
of funds accounts are concerned with all transactions in the economy that are accomplished by money
transfers.

They show the financial transactions among different sectors of the economy, and the link between saving
and investment, and lending and borrowing by them. To conclude, the circular flow of income possesses
much theoretical and practical significance in an economy.

Q7. Differentiate between Demand-Pull and Cost-Push Inflation with respect to macro economics.

Inflation refers to the rate at which the overall prices of goods and services rises resulting in the decrease in
the purchasing power of the common man, which can be measured through Consumer Price Index. Modern
analysis of inflation revealed that it is mainly caused either by demand side or supply side or both the
factors. Demand side factors result in demand-pull inflation while supply side factors lead to cost-push
inflation.

The demand-pull inflation is when the aggregate demand is more than the aggregate supply in an economy,
whereas cost push inflation is when the aggregate demand is same and the fall in aggregate supply due to
external factors will result in increased price level. This article explains clearly the significant difference
between demand-pull and cost-push inflation.

Content: Demand-Pull Inflation Vs Cost-Push Inflation

1. Comparison Chart

2. Definition
3. Key Differences

4. Conclusion

Comparison Chart

BASIS FOR COMPARISON DEMAND-PULL INFLATION COST-PUSH INFLATION

Meaning When the aggregate demand increases at a faster rate than aggregate supply, it is known as
demand-pull inflation. When there is an increase in the price of inputs, resulting in decrease in the supply of
outputs, is is known as cost-push inflation.

Represents How price inflation begins? Why inflation is so difficult to stop, once started?

Caused by Monetary and real factors. Monopolistic groups of the society.

Policy recommendations Monetary and fiscal measures Administrative control on price rise and income
policy.

Definition of Demand-Pull Inflation

Demand Pull Inflation arises when the aggregate demand goes up rapidly than the aggregate supply in an
economy. In simple terms, it is a type of inflation which occurs when aggregate demand for products and
services outruns aggregate supply due to monetary factors and/or real factors.

• Demand-Pull Inflation due to monetary factors: One of the major cause of inflation is; increase in
money supply than the increase in the level of output. The German inflation, in the year 1922-23 is the
example of Demand-Pull Inflation caused by monetary expansion.

• Demand-Pull Inflation due to real factors: When the inflation is due to any one or more of the
following reasons, it is said to be caused by real factors:

• The increase in government spending without the change in tax revenue.

• Fall in tax rates, with no change in government spending

• Increase in investments

• Decrease in savings

• Increase in exports

• Decrease in imports

Out of these six factors, the first four factors, will result in the rise in the level of disposable income. The
increase in aggregate income result in the increase in aggregate demand for goods and services, causing
demand-pull inflation.

Definition of Cost-Push Inflation

Cost push inflation means the increase in the general price level caused by the rise in prices of the factors of
production, due to the shortage of inputs i.e. labour, raw material, capital, etc. It results in the decrease in the
supply of outputs which mainly use these inputs. So, the rise in prices of the goods emerges from the supply
side.

Moreover, cost-push inflation may also be caused by depletion of natural resources, monopoly and so on.
There are three kinds of cost-push inflation:

• Wage-push inflation: When the monopolistic groups of the society like labour union exercise their
monopoly power, to enhance their money wages above the competitive level, which cause an increase in the
cost of production.

• Profit-push inflation: When the monopoly power is used by the firms operating in the monopolistic
and oligopolistic market to increase their profit margin, leading to rise in the price of goods and services.

• Supply shock inflation: A type of inflation arising due to unexpected fall in the supply of necessary
consumer goods or major industrial inputs.

Key Differences Between Demand-Pull and Cost-Push Inflation

The differences between dDemand-pull and cost-push inflation can be drawn clearly on the following
grounds:

1. Demand-pull inflation arises when the aggregate demand increases at a faster rate than aggregate
supply. Cost-Push Inflation is a result of an increase in the price of inputs due to the shortage of cost of
production, leading to decrease in the supply of outputs.

2. Demand-pull inflation describes, how price inflation begins? On the other hand, cost-push inflation
explains Why inflation is so difficult to stop, once started?

3. The reason for demand-pull inflation is the increase in money supply, government spending and
foreign exchange rates. Conversely, cost-push inflation is mainly caused by the monopolistic groups of the
society.

4. The policy recommendation on demand-pull inflation is associated with the monetary and fiscal
measure which amounts to the high level of unemployment. Unlike, cost push inflation, where policy
recommendation is related to administrative control on price rise and income policy, whose objective is to
control inflation without increasing unemployment.

Conclusion

Therefore, you can conclude with the above discussion the main reason for causing inflation in the economy
is either by demand-pull or cost-push factors. It is often argued that which is the supreme factor for inflation,
which one of the two-factor causes rise in the general price level for the first time. Experts hold that
demand-pull factor the leading factor for inflation in any economy.

Q8. Explain the major causes leading to Inflation in India?

Major Causes leading to Inflation in India

major causes leading to inflation are as follows:

Causes

1. Increase in money supply:

Over the last few years the rate of increase in money supply has varied between 15 and 18 per cent, whereas
the national output has increased at an annual average rate of only 4 per cent.

Hence the rate of increase in output has not been sufficient to absorb the rising quantity of money in the
economy. Inflation is the obvious result.

2. Deficit financing:

When the government is unable to raise adequate revenue for its expenditure, it resorts to deficit financing.
During the sixth and seventh Plans, massive doses of deficit financing had been resorted to. It was Rs.
15,684 crores in the sixth Plan and Rs. 36,000 crores in the seventh Plan.

3. Increase in government expenditure:

Government expenditure in India during the recent years has been rising very fast. What is more disturbing,
proportion of non-development expenditure increased rapidly, being about 40 per cent of total government
expenditure. Non-development expenditure does not create real goods; it only creates purchasing power and
hence leads to inflation.

Not only the above mentioned factors on the Demand side cause inflation, factors on the Supply side also
add fuel to the flame of inflation.

4. Inadequate agricultural and industrial growth:

Agricultural and industrial growth in our country has been much below what we had targeted for. Over the
four decades period, food grains output has increased and-.i.e. of 3.2 per cent per annum.

But there are years of crop failure due to droughts. In the years of scarcity of food grains not only the prices
of food articles increased, the general price level also rose.

Failure of crops always encouraged big wholesale dealers to indulge in hoarding which accentuated scarcity
conditions and pushed up the price level.

Performance of the industrial sector, particularly in the period 1965 to 1985, has not been satisfactory. Over
the 15 years period from 1970 to 1985, industrial production increased at a modest rate of 4.7 per cent per
annum.

Our industrial structure, developed on the basis of heavy industry-led growth, is not suitable to meet the
current demand for consumer goods.

5. Rise in administered prices:

In our economy a large part of the market is regulated by government action. There are a number of
important commodities, both agricultural and industrial, for which the price level is administered by the
government.

The government keeps on raising prices from time to time in order to cover up losses in the public sector.
This policy leads to cost-push inflation.

The upward revision of administered prices of coal, iron and steel, electricity and fertilisers were made at
regular intervals. Once the administered prices are raised, it is a signal for other price to go up.
6. Rising import prices:

Inflation has been a global phenomenon. International inflation gets imported into the country through major
imports like fertilisers, edible oil, steel, cement, chemicals, and machinery. Increase in the import price of
petroleum has been most spectacular and its contribution to domestic price rise is very high.

7. Rising taxes:

To raise additional financial resources, government is depending more and more on indirect taxes such as
excise duties and sales tax. These taxes invariably raise the price level.

Q9.Differentiate between WPI and CPI as means to measure the inflation in economy.

Inflation is a market situation in which the price of goods and services increases continuously over a period
of time. Inflation is an important tool to control the flow of money in an economy and to measure inflation
in an economy WPI and CPI are used.

WPI is Wholesale prices index it is used to measure average change in price in sale of goods or services in
bulk quantity by the whole seller and CPI is consumer prices index which measures the change in the price
in sale of goods or services in retail or it measures price of goods or services sell directly to consumers.
Price Index means an index number which refers to the degree by which price of goods or services is
increased with reference to the base year.

What is the Wholesale Price Index (WPI)?

WPI is a Wholesale prices index it is used to measure the average change in price in the sale of goods in
bulk quantity by the whole seller. WPI also measures changes in commodity prices at the selected level
before it reaches the final level that is the consumer. WPI is the first level where the first price increase of
goods. WPI is published by the office of economic advisor that Ministry of Commerce and Industry. It is
restricted to goods only and goods covered under WPI primarily are fuel, power, and manufacturing
products. It releases on weekly basis for primary articles, fuel, and power for rest item in publishing
monthly. The base year for WPI is the financial year.

What is the Consumer Price Index (CPI)?

CPI is a consumer prices index which measures the change in the price in the sale of goods or services in
retail or it measures the price of goods or services sells directly to consumers. CPI is the final level where
the price increase of goods or services. CPI is published by Central Statistic Office that Ministry of Statistic
and Programme Implementation. It is both for goods and services. Goods and services covered under CPI
are education, food, transport, communication, recreation, apparel, housing, and medical care. It releases on
monthly basis. The base year for CPI is the calendar year.

Conclusion

Both WPI and CPI are used to calculate the inflation rate. WPI is used to measure the average change in
price in the sale of goods in bulk quantity by the whole seller and CPI is used to measure the change in the
price in the sale of goods or services in retail or directly to a consumer. Earlier on WPI was only in use but
as the government was unable to know its impact on common people as common people do transact
wholesale transaction CPI was introduced. WPI tells about inflation at the business level and CPI tells about
inflation at the consumer level.

Mainly WPI focus on prices of goods traded between business houses whereas CPI focuses on prices of
goods purchased by consumers. As CPI provides more clarity about inflation and its economy on the overall
economy hence CPI is widely used for calculating inflation as compared to WPI. So, monetary policy
primarily focuses on price stability and that can be achieved by controlling inflation and inflation can be
track and measured by WPI and CPI.

Q10. Explain Measures for Controlling Inflation (With Diagram)

Inflation is considered to be a complex situation for an economy. If inflation goes beyond a moderate rate, it
can create disastrous situations for an economy; therefore is should be under control.

It is not easy to control inflation by using a particular measure or instrument.

The main aim of every measure is to reduce the inflow of cash in the economy or reduce the liquidity in the
market.

The different measures used for controlling inflation are shown in Figure-5:

The different measures (as shown in Figure-5) used for controlling inflation are explained below.

1. Monetary Measures:

The government of a country takes several measures and formulates policies to control economic activities.
Monetary policy is one of the most commonly used measures taken by the government to control inflation.

In monetary policy, the central bank increases rate of interest on borrowings for commercial banks. As a
result, commercial banks increase their rate of interests on credit for the public. In such a situation,
individuals prefer to save money instead of investing in new ventures.

This would reduce money supply in the market, which, in turn, controls inflation. Apart from this, the
central bank reduces the credit creation capacity of commercial banks to control inflation.

The monetary policy of a country involves the following:

(a) Rise in Bank Rate:

Refers to one of the most widely used measure taken by the central bank to control inflation.

The bank rate is the rate at which the commercial bank gets a rediscount on loans and advances by the
central bank. The increase in the bank rate results in the rise of rate of interest on loans for the public. This
leads to the reduction in total spending of individuals.
The main reasons for reduction in total expenditure of individuals are as follows;

(i) Making the borrowing of money costlier:

Refers to the fact that with the rise in the bank rate by the central bank increases the interest rate on loans
and advances by commercial banks. This makes the borrowing of money expensive for general public.

Consequently, individuals postpone their investment plans and wait for fall in interest rates in future. The
reduction in investments results in the decreases in the total spending and helps in controlling inflation.

(ii) Creating adverse situations for businesses:

Implies that increase in bank rate has a psychological impact on some of the businesspersons. They consider
this situation adverse for carrying out their business activities. Therefore, they reduce their spending and
investment.

(iii) Increasing the propensity to save:

Refers to one of the most important reason for reduction in total expenditure of individuals. It is a well-
known fact that individuals generally prefer to save money in inflationary conditions. As a result, the total
expenditure of individuals on consumption and investment decreases.

(b) Direct Control on Credit Creation:

Constitutes the major part of monetary policy.

The central bank directly reduces the credit control capacity of commercial banks by using the following
methods:

(i) Performing Open Market Operations (OMO):

Refers to one of the important method used by the central bank to reduce the credit creation capacity of
commercial banks. The central bank issues government securities to commercial banks and certain private
businesses.

In this way, the cash with commercial banks would be spent on purchasing government securities. As a
result, commercial bank would reduce credit supply for the general public.

(ii) Changing Reserve Ratios:

Involves increase or decrease in reserve ratios by the central bank to reduce the credit creation capacity of
commercial banks. For example, when the central bank needs to reduce the credit creation capacity of
commercial banks, it increases Cash Reserve Ratio (CRR). As a result, commercial banks need to keep a
large amount of cash as reserve from their total deposits with the central bank. This would further reduce the
lending capacity of commercial banks. Consequently, the investment by individuals in an economy would
also reduce.

2. Fiscal Measures:

Apart from monetary policy, the government also uses fiscal measures to control inflation. The two main
components of fiscal policy are government revenue and government expenditure. In fiscal policy, the
government controls inflation either by reducing private spending or by decreasing government expenditure,
or by using both.
It reduces private spending by increasing taxes on private businesses. When private spending is more, the
government reduces its expenditure to control inflation. However, in present scenario, reducing government
expenditure is not possible because there may be certain on-going projects for social welfare that cannot be
postponed.

Besides this, the government expenditures are essential for other areas, such as defense, health, education,
and law and order. In such a case, reducing private spending is more preferable rather than decreasing
government expenditure. When the government reduces private spending by increasing taxes, individuals
decrease their total expenditure.

For example, if direct taxes on profits increase, the total disposable income would reduce. As a result, the
total spending of individuals decreases, which, in turn, reduces money supply in the market. Therefore, at
the time of inflation, the government reduces its expenditure and increases taxes for dropping private
spending.

3. Price Control:

Another method for ceasing inflation is preventing any further rise in the prices of goods and services. In
this method, inflation is suppressed by price control, but cannot be controlled for the long term. In such a
case, the basic inflationary pressure in the economy is not exhibited in the form of rise in prices for a short
time. Such inflation is termed as suppressed inflation.

The historical evidences have shown that price control alone cannot control inflation, but only reduces the
extent of inflation. For example, at the time of wars, the government of different countries imposed price
controls to prevent any further rise in the prices. However, prices remain at peak in different economies.
This was because of the reason that inflation was persistent in different economies, which caused sharp rise
in prices. Therefore, it can be said inflation cannot be ceased unless its cause is determined.

Module-5

CO-5 Given the information regarding expenses and income in an economy, the future manager will be
able to calculate and explicate the gross domestic product using expenditure and income approaches
and given the details about a phase of the business cycle, the future manager will be able to depict the
symptoms, causes and effects on economic activities of a nation.

Q1: Calculate: (1) Net Domestic Product at market prices and (2) National Income from the following data
of all the enterprises in an economy:

Particulars Rs. (in Crore)

Subsidies 10
Sales 1000
Closing Stock 100
Indirect taxes 50
Intermediate consumption 300
Opening stock 200
Consumption of fixed capital 150
Net factor income from abroad 10

Solution:
Value of output = sales + change in stock

= 1000+(closing stock – opening stock)

= 1000 + 100 – 200

= 900 crore

The Net value added at basic prices (NVABP)

= value of total output – intermediate consumption – consumption of fixed capital

= 900 – 300 – 150

= 450

NDPMP= NVABP+ Indirect Tax – Subsidies

= 450 + 50 – 10

= 490

NI = NDPMP – Net Indirect Taxes + Net factor income from abroad

= 490 – 40 + 10

= 460

Q2: Calculate (1) National Income and (2) Personal Disposable Income from the following
information

Particulars Rs. (in Crore)

GDPMP 6000
Receipts of factor income from the rest of the 150
world
Payments of factor income to the rest of the 225
world
Depreciation 800
Indirect taxes minus subsidies 700
Corporate profits 1200
Dividend 600
Transfer payments to persons 1300
Personal Taxes 1500

Solution:

1) NI = GDPMP – Depreciation – Indirect Tax + Net factor income from abroad

 = 6000 – 800 – 700 +(150 – 225)
= 6000 – 1500 -75
= 4425

2) Personal Disposable income = NI – Retained corporate profit + Transfer payments to person –

personal tax

= 4425 – (1200 – 600) + 1300 – 155

= 4425 – 600 + 1300 – 155

= 3625

Q3: Calculate: (1) GDP at market prices and (2) National Income from the following information:

Particulars Rs. (in Crore)

Personal consumption expenditure 6500
Indirect taxes less subsidies 150
State Govt. Consumption and investment expenditure 500
Central Govt. Consumption and investment expenditure 2000
Change in business inventories 100
Gross private domestic fixed investment 1200
Exports 900
Net factor payments to the rest of the world 100
Imports 1200
Depreciation 200

GDPMP = Pvt. consumption exp. + gross Pvt. Invest. + Govt. inventory + expenditure + Net exports (X-M)

= 6500 + (1200 + 100) + 500 + 2000 + (900 – 1200)

= 6500 + 1300 +2500 – 300

= 10000

NI – GDPMP – Depriciation – (Indirect tax –Subsidies) – Net factor payments to the rest of the world

= 10000 – 200 – (150-100)

= 9550

Q4: for an economy following consumption function is given:

C = 60 + 0.75Y
a. If investment in a year is Rs. 35 crores what will be the equilibrium level of income or output?

b.If full employment level of income (i.e. level of potential output) is Rs. 460 crores what investment
required to be undertaken to ensure equilibrium at full-employment.

Solution:

a.Y = C + I

Y = 60 + 0.75Y + 35

Y – 0.75Y = 60 + 35

Y(1 – 0.75) = 95

0.25Y = 95

Y = 380

At full employment level I = S

b.SF = YF – CF

= YF - (60 + 0.75YF)

= 460 – 60 – (0.75 x 460)

= 400 – 345

SF = 55

Q5 Suppose the level of autonomous investment in an economy is Rs. 200 crores. The following saving
function is given: S = - 80 + 0.25Y

Find the equilibrium level of Income.

Solution:

According to saving-investment approach, level of income is in equilibrium when

S = I -------------------------(1)

S = - 80 + 0.25Y and

I = 200

Substituting value

_80 + 0.25Y = 200

0.25Y = 200 + 80
Y = 200 + 80 = 1120

0.25

Q6. From the following data estimate (a) Net Indirect Taxes, and (b) Net Domestic Product at Factor Cost:

Items (Rs. in crore)

(i) Net national product at market price 1,400

(ii) Net factor income from abroad (–)20
(iii) Gross national product at factor cost 1,300
(iv) Consumption of fixed capital 100
(v) National debt interest 18

Solution:

(a) Net Indirect Taxes =

Net national product at market price – Net national product at factor cost (Gross national product at factor
cost – Consumption of fixed capital)
= 1,400 crore – (1,300 crore – 100 crore)
= 1,400 crore – 1,300 crore + 100 crore
= 200 crore

(b) Net Domestic Product at Factor Cost

= Gross national product at factor cost – Consumption of fixed capital – Net factor income from abroad
= 1,300 crore – 100 crore – (–) 20 crore
= 1,300 crore – 100 crore + 20 crore
= 1,220 crore

Q7 What are the Phases of the Business Cycle? Illustrate various factors causing swings in business activity and
measures to control business cycles.

Solution:

PHASES OF A TYPICAL BUSINESS CYCLE

A typical business cycle is characterised by five different phases or stages—(1) Depression. (2) Recovery (or Revival)
(3) Prosperity (or full employment), (4) Boom (or overfill employment), and (5) Recession.

Cyclical fluctuations in business and economic activities adversely effect the process of economic development of an
economy. Therefore, the government should take preventive and corrective measures to maintain stability in
economic system. Two types of measures are adopted to control business cycles.
(a) Preventive measures.

(b) Corrective measures.

Q8 Explain Circular Flow Model of Economy and discuss the role of Fiscal and Monetary policies as a
measure to monitor the flow of money in the economy.

Solution:

Fiscal Policy

General objectives of Fiscal Policy are given below:

1. To maintain and achieve full employment.
2. To stabilize the price level.
3. To stabilize the growth rate of the economy.
4. To maintain equilibrium in the Balance of Payments.
5. To promote the economic development of underdeveloped countries.

Monitory policy
Reserve Money (M0): It is also known as High-Powered Money, monetary base, base money etc.
M0 = Currency in Circulation + Bankers’ Deposits with RBI + Other deposits with RBI
It is the monetary base of economy.
Narrow Money (M1):
M1 = Currency with public + Demand deposits with the Banking system (current account, saving account)
+ Other deposits with RBI
M2 = M1 + Savings deposits of post office savings banks
Broad Money (M3)
M3 = M1 + Time deposits with the banking system
M4 = M3 + All deposits with post office savings banks

 Monetary policy addresses interest rates and the supply of money in circulation, and it generally is
managed by a central bank.
 Fiscal policy addresses taxation and government spending, and it generally is determined by
legislation.
 Monetary policy and fiscal policy together have great influence over a nation's economy.

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