7/29/2019 mb 0042

1/17

Dr.Shradha Sudin Naik

Roll No :541111376

MBA-HCS

MB0042Managerial Economics (Book ID B1131)

Set 1

Q.1 What is a business cycle? Describe the different phases of a business cycle.

Ans. The business cycle is the periodic but irregular up-and-down movements ineconomic activity, measured by fluctuations in real GDP and other macroeconomicvariables.

Or others define

The term business cycle (or economic cycle) refers to economy-wide fluctuations inproduction or economic activity over several months or years. These fluctuations occuraround a long-term growth trend, and typically involve shifts over time between periods ofrelatively rapid economic growth (an expansion or boom), and periods of relativestagnation or decline (a contraction or recession).[1]

Business cycles are usually measured by considering the growth rate ofreal gross domesticproduct. Despite being termed cycles, these fluctuations in economic activity do not followa mechanical or predictable periodic pattern.

Cycles or fluctuations?

In recent years economic theory has moved towards the study ofeconomicfluctuation rather than a 'business cycle'[17] though some economists use the phrase'business cycle' as a convenient shorthand. For Milton Friedman calling the business cycle a"cycle" is a misnomer, because of its non-cyclical nature. Friedman believed that for themost part, excluding very large supply shocks, business declines are more of a monetaryphenomenon.[18]

Rational expectations theory leads to the efficient-market hypothesis, which states that nodeterministic cycle can persist because it would consistentlycreate arbitrage opportunities.[19]Much economic theory also holds that the economy is

http://economics.about.com/cs/macrohelp/a/nominal_vs_real.htmhttp://en.wikipedia.org/wiki/Economic_expansionhttp://en.wikipedia.org/wiki/Economic_boomhttp://en.wikipedia.org/wiki/Recessionhttp://en.wikipedia.org/wiki/Business_cycle#cite_note-0http://en.wikipedia.org/wiki/Business_cycle#cite_note-0http://en.wikipedia.org/wiki/Business_cycle#cite_note-0http://en.wikipedia.org/wiki/Real_versus_nominal_value_%28economics%29http://en.wikipedia.org/wiki/Gross_domestic_producthttp://en.wikipedia.org/wiki/Gross_domestic_producthttp://en.wiktionary.org/wiki/cyclehttp://en.wikipedia.org/wiki/Business_cycle#cite_note-16http://en.wikipedia.org/wiki/Business_cycle#cite_note-16http://en.wikipedia.org/wiki/Business_cycle#cite_note-16http://en.wikipedia.org/wiki/Milton_Friedmanhttp://en.wikipedia.org/wiki/Misnomerhttp://en.wikipedia.org/wiki/Business_cycle#cite_note-17http://en.wikipedia.org/wiki/Business_cycle#cite_note-17http://en.wikipedia.org/wiki/Business_cycle#cite_note-17http://en.wikipedia.org/wiki/Rational_expectationshttp://en.wikipedia.org/wiki/Efficient-market_hypothesishttp://en.wikipedia.org/wiki/Arbitragehttp://en.wikipedia.org/wiki/Business_cycle#cite_note-18http://en.wikipedia.org/wiki/Business_cycle#cite_note-18http://en.wikipedia.org/wiki/Business_cycle#cite_note-18http://en.wikipedia.org/wiki/Business_cycle#cite_note-18http://en.wikipedia.org/wiki/Arbitragehttp://en.wikipedia.org/wiki/Efficient-market_hypothesishttp://en.wikipedia.org/wiki/Rational_expectationshttp://en.wikipedia.org/wiki/Business_cycle#cite_note-17http://en.wikipedia.org/wiki/Misnomerhttp://en.wikipedia.org/wiki/Milton_Friedmanhttp://en.wikipedia.org/wiki/Business_cycle#cite_note-16http://en.wiktionary.org/wiki/cyclehttp://en.wikipedia.org/wiki/Gross_domestic_producthttp://en.wikipedia.org/wiki/Gross_domestic_producthttp://en.wikipedia.org/wiki/Real_versus_nominal_value_%28economics%29http://en.wikipedia.org/wiki/Business_cycle#cite_note-0http://en.wikipedia.org/wiki/Recessionhttp://en.wikipedia.org/wiki/Economic_boomhttp://en.wikipedia.org/wiki/Economic_expansionhttp://economics.about.com/cs/macrohelp/a/nominal_vs_real.htm

7/29/2019 mb 0042

2/17

usually at or close to equilibrium.[citation needed] These views led to the formulation of the ideathat observed economic fluctuations can be modeled as shocks to a system.

In the tradition ofSlutsky, business cycles can be viewed as the result ofstochastic shocksthat on aggregate form a moving average series. However, the recent research

employing spectral analysis has confirmed the presence of business (Juglar) cycles in theworld GDP dynamics at an acceptable level of statistical significance.[15]

A business cycle is not a regular, predictable, or repeating phenomenon like the swing ofthe pendulum of a clock. Its timing is random and, to a large degress, unpredictable. Abusiness cycle is identified as a sequence of four phases:

Contraction: A slowdown in the pace of economic activity

The lower turning point of a business cycle, where a contraction turns into anexpansion

Expansion: A speedup in the pace of economic activity

Peak: The upper turning of a business cycle

The four phases of business cycles are shown in the following diagram :-

The business cycle starts from a trough (lower point) and passes through a recovery phase

followed by a period of expansion (upper turning point) and prosperity. After the peak

point is reached there is a declining phase of recession followed by a depression. Again the

business cycle continues similarly with ups and downs.

Explanation of Four Phases of Business Cycle

The four phases of a business cycle are briefly explained as follows :-

1. Prosperity Phase

When there is an expansion of output, income, employment, prices and profits, there is also

a rise in the standard of living. This period is termed as Prosperity phase.

The features of prosperity are :-

http://en.wikipedia.org/wiki/Economic_equilibriumhttp://en.wikipedia.org/wiki/Wikipedia%3aCitation_neededhttp://en.wikipedia.org/wiki/Wikipedia%3aCitation_neededhttp://en.wikipedia.org/wiki/Wikipedia%3aCitation_neededhttp://en.wikipedia.org/wiki/Eugen_Slutskyhttp://en.wikipedia.org/wiki/Stochastichttp://en.wikipedia.org/wiki/Moving_average_%28technical_analysis%29http://en.wikipedia.org/wiki/Spectral_analysishttp://en.wikipedia.org/wiki/Business_cycle#cite_note-See-14http://en.wikipedia.org/wiki/Business_cycle#cite_note-See-14http://en.wikipedia.org/wiki/Business_cycle#cite_note-See-14http://en.wikipedia.org/wiki/Business_cycle#cite_note-See-14http://en.wikipedia.org/wiki/Spectral_analysishttp://en.wikipedia.org/wiki/Moving_average_%28technical_analysis%29http://en.wikipedia.org/wiki/Stochastichttp://en.wikipedia.org/wiki/Eugen_Slutskyhttp://en.wikipedia.org/wiki/Wikipedia%3aCitation_neededhttp://en.wikipedia.org/wiki/Economic_equilibrium

7/29/2019 mb 0042

3/17

1. High level of output and trade.

2. High level of effective demand.

3. High level of income and employment.

4. Rising interest rates.

5. Inflation.

6. Large expansion of bank credit.

7. Overall business optimism.

8. A high level of MEC (Marginal efficiency of capital) and investment.

Due to full employment of resources, the level of production is Maximum and there is a rise

in GNP (Gross National Product). Due to a high level ofeconomic activity, it causes a rise in

prices and profits. There is an upswing in the economic activity and economy reaches

its Peak. This is also called as a Boom Period.

2. Recession Phase

The turning point from prosperity to depression is termed as Recession Phase.

During a recession period, the economic activities slow down. When demand starts falling,

the overproduction and future investment plans are also given up. There is a steady decline

in the output, income, employment, prices and profits. The businessmen lose confidence

and become pessimistic (Negative). It reduces investment. The banks and the people try to

get greater liquidity, so credit also contracts. Expansion of business stops, stock market

falls. Orders are cancelled and people start losing their jobs. The increase in unemployment

causes a sharp decline in income and aggregate demand. Generally, recession lasts for a

short period.

3. Depression Phase

When there is a continuous decrease of output, income, employment, prices and profits,

there is a fall in the standard of living and depression sets in.

The features of depression are :-

1. Fall in volume of output and trade.

http://kalyan-city.blogspot.com/2011/03/what-are-economic-activities-types-of.htmlhttp://kalyan-city.blogspot.com/2011/03/what-are-economic-activities-types-of.html

7/29/2019 mb 0042

4/17

2. Fall in income and rise in unemployment.

3. Decline in consumption and demand.

4. Fall in interest rate.

5. Deflation.

6. Contraction of bank credit.

7. Overall business pessimism.

8. Fall in MEC (Marginal efficiency of capital) and investment.

In depression, there is under-utilization of resources and fall in GNP (Gross National

Product). The aggregate economic activity is at the lowest, causing a decline in prices and

profits until the economy reaches its Trough (low point).

4. Recovery Phase

The turning point from depression to expansion is termed as Recovery or Revival Phase.

During the period of revival or recovery, there are expansions and rise in economic

activities. When demand starts rising, production increases and this causes an increase in

investment. There is a steady rise in output, income, employment, prices and profits. The

businessmen gain confidence and become optimistic (Positive). This increases investments.

The stimulation of investment brings about the revival or recovery of the economy. Thebanks expand credit, business expansion takes place and stock markets are activated.

There is an increase in employment, production, income and aggregate demand, prices and

profits start rising, and business expands. Revival slowly emerges into prosperity, and the

business cycle is repeated.

Thus we see that, during the expansionary or prosperity phase, there is inflation and

during the contraction or depression phase, there is a deflation

Q.2 What is the monetary policy ? Explain the general objectives and instruments ofmonetary policy?

Ans. Monetary policy is the process by which the monetary authority of a country controlsthe supply of money, often targeting a rate ofinterestfor the purpose of

http://en.wikipedia.org/wiki/Monetary_authorityhttp://en.wikipedia.org/wiki/Supply_of_moneyhttp://en.wikipedia.org/wiki/Interesthttp://en.wikipedia.org/wiki/Interesthttp://en.wikipedia.org/wiki/Supply_of_moneyhttp://en.wikipedia.org/wiki/Monetary_authority

7/29/2019 mb 0042

5/17

promoting economic growth and stability.[1][2]The official goals usually include relativelystable prices and low unemployment. Monetary theory provides insight into how to craftoptimal monetary policy. It is referred to as either being expansionary or contractionary,where an expansionary policy increases the total supply of money in the economy morerapidly than usual, and contractionary policy expands the money supply more slowly than

usual or even shrinks it. Expansionary policy is traditionally used to try tocombatunemploymentin a recession by lowering interest rates in the hope that easy creditwill entice businesses into expanding. Contractionary policy is intended to slow inflation inhopes of avoiding the resulting distortions and deterioration of asset values.

Monetary policy differs from fiscal policy, which refers to taxation, government spending,and associated borrowing.[3]

General objectives of monetary policy.

Objectives of Monetary Policy

The objectives of a monetary policy in India are similar to the objectives of its five year

plans. In a nutshell planning in India aims at growth, stability and social justice. After

the Keynesian revolution in economics, many people accepted significance of monetary

policy in attaining following objectives.

1. Rapid Economic Growth

2. Price Stability

3. Exchange Rate Stability

4. Balance of Payments (BOP) Equilibrium

5. Full Employment

6. Neutrality of Money

7. Equal Income Distribution

These are the general objectives which every central bank of a nation tries to attain by

employing certain tools (Instruments) of a monetary policy. In India, the RBI has alwaysaimed at the controlled expansion of bank credit and money supply, with special attention

to the seasonal needs of a credit.

Let us now see objectives of monetary policy in detail :-

http://en.wikipedia.org/wiki/Economyhttp://en.wikipedia.org/wiki/Monetary_policy#cite_note-fed-0http://en.wikipedia.org/wiki/Monetary_policy#cite_note-fed-0http://en.wikipedia.org/wiki/Monetary_policy#cite_note-Handbook_of_Development_Economics.2C_vol._5-1http://en.wikipedia.org/wiki/Monetary_policy#cite_note-Handbook_of_Development_Economics.2C_vol._5-1http://en.wikipedia.org/wiki/Monetary_policy#cite_note-Handbook_of_Development_Economics.2C_vol._5-1http://en.wikipedia.org/wiki/Unemploymenthttp://en.wikipedia.org/wiki/Monetary_economicshttp://en.wikipedia.org/wiki/Expansionary_monetary_policyhttp://en.wikipedia.org/wiki/Contractionary_monetary_policyhttp://en.wikipedia.org/wiki/Unemploymenthttp://en.wikipedia.org/wiki/Recessionhttp://en.wikipedia.org/wiki/Interest_rateshttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Fiscal_policyhttp://en.wikipedia.org/wiki/Taxhttp://en.wikipedia.org/wiki/Government_spendinghttp://en.wikipedia.org/wiki/Government_borrowinghttp://en.wikipedia.org/wiki/Monetary_policy#cite_note-ben-2http://en.wikipedia.org/wiki/Monetary_policy#cite_note-ben-2http://en.wikipedia.org/wiki/Monetary_policy#cite_note-ben-2http://en.wikipedia.org/wiki/Monetary_policy#cite_note-ben-2http://en.wikipedia.org/wiki/Government_borrowinghttp://en.wikipedia.org/wiki/Government_spendinghttp://en.wikipedia.org/wiki/Taxhttp://en.wikipedia.org/wiki/Fiscal_policyhttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Interest_rateshttp://en.wikipedia.org/wiki/Recessionhttp://en.wikipedia.org/wiki/Unemploymenthttp://en.wikipedia.org/wiki/Contractionary_monetary_policyhttp://en.wikipedia.org/wiki/Expansionary_monetary_policyhttp://en.wikipedia.org/wiki/Monetary_economicshttp://en.wikipedia.org/wiki/Unemploymenthttp://en.wikipedia.org/wiki/Monetary_policy#cite_note-Handbook_of_Development_Economics.2C_vol._5-1http://en.wikipedia.org/wiki/Monetary_policy#cite_note-fed-0http://en.wikipedia.org/wiki/Economy

7/29/2019 mb 0042

6/17

1. Rapid Economic Growth : It is the most important objective of a monetary policy. The

monetary policy can influence economic growth by controlling real interest rate and its

resultant impact on the investment. If the RBI opts for a cheap or easy credit policy by

reducing interest rates, the investment level in the economy can be encouraged. This

increased investment can speed up economic growth. Faster economic growth is possible

if the monetary policy succeeds in maintaining income and price stability.

2. Price Stability : All the economics suffer from inflation and deflation. It can also be

called as Price Instability. Both inflation are harmful to the economy. Thus, the monetary

policy having an objective of price stability tries to keep the value of money stable. It

helps in reducing the income and wealth inequalities. When the economy suffers from

recession the monetary policy should be an 'easy money policy' but when there is

inflationary situation there should be a 'dear money policy'.

3. Exchange Rate Stability : Exchange rate is the price of a home currency expressed in

terms of any foreign currency. If this exchange rate is very volatile leading to frequentups and downs in the exchange rate, the international community might lose confidence

in our economy. The monetary policy aims at maintaining the relative stability in the

exchange rate. The RBI by altering the foreign exchange reserves tries to influence the

demand for foreign exchange and tries to maintain the exchange rate stability.

4. Balance of Payments (BOP) Equilibrium : Many developing countries like India

suffers from the Disequilibrium in the BOP. The Reserve Bank of India through its

monetary policy tries to maintain equilibrium in the balance of payments. The BOP has

two aspects i.e. the 'BOP Surplus' and the 'BOP Deficit'. The former reflects an excess

money supply in the domestic economy, while the later stands for stringency of money. Ifthe monetary policy succeeds in maintaining monetary equilibrium, then the BOP

equilibrium can be achieved.

5. Full Employment: The concept of full employment was much discussed after Keynes's

publication of the "General Theory" in 1936. It refers to absence of involuntary

unemployment. In simple words 'Full Employment' stands for a situation in which

everybody who wants jobs get jobs. However it does not mean that there is a Zero

unemployment. In that senses the full employment is never full. Monetary policy can be

used for achieving full employment. If the monetary policy is expansionary then credit

supply can be encouraged. It could help in creating more jobs in different sector of the

economy.

6. Neutrality of Money : Economist such as Wicksted, Robertson have always

considered money as a passive factor. According to them, money should play only a role

of medium of exchange and not more than that. Therefore, the monetary policy should

regulate the supply of money. The change in money supply creates monetary

disequilibrium. Thus monetary policy has to regulate the supply of money and neutralize

7/29/2019 mb 0042

7/17

the effect of money expansion. However this objective of a monetary policy is always

criticized on the ground that if money supply is kept constant then it would be difficult to

attain price stability.

7. Equal Income Distribution : Many economists used to justify the role of the fiscal

policy is maintaining economic equality. However in resent years economists have giventhe opinion that the monetary policy can help and play a supplementary role in attainting

an economic equality. monetary policy can make special provisions for the neglect supply

such as agriculture, small-scale industries, village industries, etc. and provide them with

cheaper credit for longer term. This can prove fruitful for these sectors to come up. Thus

in recent period, monetary policy can help in reducing economic inequalities among

different sections of society.

Instruments of monetary policy

The instrument of monetary policy are tools or devise which are used by the monetaryauthority in order to attain some predetermined objectives. There are two types of

instruments of the monetary policy as shown below.

(A) Quantitative Instruments or General Tools

The Quantitative Instruments are also known as the General Tools of monetary policy.

These tools are related to the Quantity or Volume of the money. The Quantitative Tools of

credit control are also called as General Tools for credit control. They are designed to

regulate or control the total volume of bank credit in the economy. These tools are indirect

in nature and are employed for influencing the quantity of credit in the country. The

general tool of credit control comprises of following instruments.

1. Bank Rate Policy (BRP)

The Bank Rate Policy (BRP) is a very important technique used in the monetary policy for

influencing the volume or the quantity of the credit in a country. The bank rate refers to

rate at which the central bank (i.e RBI) rediscounts bills and prepares of commercial banks

or provides advance to commercial banks against approved securities. It is "the standard

rate at which the bank is prepared to buy or rediscount bills of exchange or other

commercial paper eligible for purchase under the RBI Act". The Bank Rate affects the actual

availability and the cost of the credit. Any change in the bank rate necessarily brings out aresultant change in the cost of credit available to commercial banks. If the RBI increases the

bank rate than it reduce the volume of commercial banks borrowing from the RBI. It deters

banks from further credit expansion as it becomes a more costly affair. Even with increased

bank rate the actual interest rates for a short term lending go up checking the credit

expansion. On the other hand, if the RBI reduces the bank rate, borrowing for commercial

banks will be easy and cheaper. This will boost the credit creation. Thus any change in the

7/29/2019 mb 0042

8/17

bank rate is normally associated with the resulting changes in the lending rate and in the

market rate of interest. However, the efficiency of the bank rate as a tool of monetary policy

depends on existing banking network, interest elasticity of investment demand, size and

strength of the money market, international flow of funds, etc.

2. Open Market Operation (OMO)

The open market operation refers to the purchase and/or sale of short term and long term

securities by the RBI in the open market. This is very effective and popular instrument of

the monetary policy. The OMO is used to wipe out shortage of money in the money market,

to influence the term and structure of the interest rate and to stabilize the market for

government securities, etc. It is important to understand the working of the OMO. If the RBI

sells securities in an open market, commercial banks and private individuals buy it. This

reduces the existing money supply as money gets transferred from commercial banks to

the RBI. Contrary to this when the RBI buys the securities from commercial banks in the

open market, commercial banks sell it and get back the money they had invested in them.Obviously the stock of money in the economy increases. This way when the RBI enters in

the OMO transactions, the actual stock of money gets changed. Normally during the

inflation period in order to reduce the purchasing power, the RBI sells securities and

during the recession or depression phase she buys securities and makes more money

available in the economy through the banking system. Thus under OMO there is continuous

buying and selling of securities taking place leading to changes in the availability of credit

in an economy.

However there are certain limitations that affect OMO viz; underdeveloped securities

market, excess reserves with commercial banks, indebtedness of commercial banks, etc.

3. Variation in the Reserve Ratios (VRR)

The Commercial Banks have to keep a certain proportion of their total assets in the form of

Cash Reserves. Some part of these cash reserves are their total assets in the form of cash.

Apart of these cash reserves are also to be kept with the RBI for the purpose of maintaining

liquidity and controlling credit in an economy. These reserve ratios are named as Cash

Reserve Ratio (CRR) and a Statutory Liquidity Ratio (SLR). The CRR refers to some

percentage of commercial bank's net demand and time liabilities which commercial banks

have to maintain with the central bank and SLR refers to some percent of reserves to be

maintained in the form of gold or foreign securities. In India the CRR by law remains inbetween 3-15 percent while the SLR remains in between 25-40 percent of bank reserves.

Any change in the VRR (i.e. CRR + SLR) brings out a change in commercial banks reserves

positions. Thus by varying VRR commercial banks lending capacity can be affected.

Changes in the VRR helps in bringing changes in the cash reserves of commercial banks and

thus it can affect the banks credit creation multiplier. RBI increases VRR during the

7/29/2019 mb 0042

9/17

inflation to reduce the purchasing power and credit creation. But during the recession or

depression it lowers the VRR making more cash reserves available for credit expansion.

(B) Qualitative Instruments or Selective Tools

The Qualitative Instruments are also known as the Selective Tools of monetary policy.

These tools are not directed towards the quality of credit or the use of the credit. They are

used for discriminating between different uses of credit. It can be discrimination favoring

export over import or essential over non-essential credit supply. This method can have

influence over the lender and borrower of the credit. The Selective Tools of credit control

comprises of following instruments.

1. Fixing Margin Requirements

The margin refers to the "proportion of the loan amount which is not financed by the

bank". Or in other words, it is that part of a loan which a borrower has to raise in order to

get finance for his purpose. A change in a margin implies a change in the loan size. This

method is used to encourage credit supply for the needy sector and discourage it for other

non-necessary sectors. This can be done by increasing margin for the non-necessary

sectors and by reducing it for other needy sectors. Example:- If the RBI feels that more

credit supply should be allocated to agriculture sector, then it will reduce the margin and

even 85-90 percent loan can be given.

2. Consumer Credit Regulation

Under this method, consumer credit supply is regulated through hire-purchase and

installment sale of consumer goods. Under this method the down payment, installment

amount, loan duration, etc is fixed in advance. This can help in checking the credit use and

then inflation in a country.

3. Publicity

This is yet another method of selective credit control. Through it Central Bank (RBI)

publishes various reports stating what is good and what is bad in the system. This

published information can help commercial banks to direct credit supply in the desiredsectors. Through its weekly and monthly bulletins, the information is made public and

banks can use it for attaining goals of monetary policy.

4. Credit Rationing

7/29/2019 mb 0042

10/17

Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount

available for each commercial bank. This method controls even bill rediscounting. For

certain purpose, upper limit of credit can be fixed and banks are told to stick to this limit.

This can help in lowering banks credit expoursure to unwanted sectors.

5. Moral Suasion

It implies to pressure exerted by the RBI on the indian banking system without any strict

action for compliance of the rules. It is a suggestion to banks. It helps in restraining credit

during inflationary periods. Commercial banks are informed about the expectations of the

central bank through a monetary policy. Under moral suasion central banks can issue

directives, guidelines and suggestions for commercial banks regarding reducing credit

supply for speculative purposes

6. Control Through Directives

Under this method the central bank issue frequent directives to commercial banks. These

directives guide commercial banks in framing their lending policy. Through a directive the

central bank can influence credit structures, supply of credit to certain limit for a specific

purpose. The RBI issues directives to commercial banks for not lending loans to speculative

sector such as securities, etc beyond a certain limit.

7. Direct Action

Under this method the RBI can impose an action against a bank. If certain banks are not

adhering to the RBI's directives, the RBI may refuse to rediscount their bills and securities.

Secondly, RBI may refuse credit supply to those banks whose borrowings are in excess totheir capital. Central bank can penalize a bank by changing some rates. At last it can even

put a ban on a particular bank if it dose not follow its directives and work against the

objectives of the monetary policy.

These are various selective instruments of the monetary policy. However the success of

these tools is limited by the availability of alternative sources of credit in economy,

working of the Non-Banking Financial Institutions (NBFIs), profit motive of commercial

banks and undemocratic nature off these tools. But a right mix of both the general and

selective tools of monetary policy can give the desired results.

Q.3 A firm supplied 3000 pens at the rate of Rs.10 , next month due to the rise of inthe price to 22 rs per pen the supple firm increases to 5000 pens. Find the elasticity

of the supply of pens.

Ans :

7/29/2019 mb 0042

11/17

EDy= 5000-3000/3000

----------------------- = .555

22-10/10

Inelastic supply.

Give a brief description of

1) Implicit and explicit cost.

In economics, an implicit cost, also called an imputed cost, implied cost, or notionalcost, is the opportunity costequal to what a firm must give up in order to use factors whichit neither purchases nor hires. It is the opposite of anexplicit cost, which is bornedirectly.[1]In other words, an implicit cost is any cost that results from using an assetinstead of renting, selling, or lending it. The term also applies to forgone income fromchoosing not to work.

Implicit costs also represent the divergence between economic profit(total revenuesminus total costs, where total costs are the sum of implicit and explicit costs)and accounting profit(total revenues minus only explicit costs). Since economic profitincludes these extra opportunity costs, it will always be less than or equal to accounting

profit.

An explicit costis a direct payment made to others in the course of running a business,such as wage, rent and materials, as opposed toimplicit costs, which are those where noactual payment is made. It is possible still to underestimate these costs, however: forexample, pension contributions and other "perks" must be taken into account whenconsidering the cost of labour.

Explicit costs are taken into account along with implicit ones when considering economicprofit. Accounting profitonly takes explicit costs into account.

2) Actual and oppurtunity cost.

Opportunity costis the cost of any activity measured in terms of the value of the next bestalternative foregone (that is not chosen). It is the sacrifice related to the second best choiceavailable to someone, or group, who has picked among several mutuallyexclusive choices.[1]The opportunity cost is also the cost of the foregone products aftermaking a choice. Opportunity cost is a key concept in economics, and has been described asexpressing "the basic relationship between scarcity and choice".[2]The notion of

http://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Opportunity_costhttp://en.wikipedia.org/wiki/Explicit_costhttp://en.wikipedia.org/wiki/Explicit_costhttp://en.wikipedia.org/wiki/Explicit_costhttp://en.wikipedia.org/wiki/Implicit_cost#cite_note-lipsey-0http://en.wikipedia.org/wiki/Implicit_cost#cite_note-lipsey-0http://en.wikipedia.org/wiki/Implicit_cost#cite_note-lipsey-0http://en.wikipedia.org/wiki/Economic_profithttp://en.wikipedia.org/wiki/Total_costhttp://en.wikipedia.org/wiki/Accounting_profithttp://en.wikipedia.org/wiki/Implicit_costhttp://en.wikipedia.org/wiki/Implicit_costhttp://en.wikipedia.org/wiki/Implicit_costhttp://en.wikipedia.org/wiki/Economic_profithttp://en.wikipedia.org/wiki/Economic_profithttp://en.wikipedia.org/wiki/Accounting_profithttp://en.wikipedia.org/wiki/Mutually_exclusivehttp://en.wikipedia.org/wiki/Mutually_exclusivehttp://en.wikipedia.org/wiki/Opportunity_cost#cite_note-0http://en.wikipedia.org/wiki/Opportunity_cost#cite_note-0http://en.wikipedia.org/wiki/Opportunity_cost#cite_note-0http://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Scarcityhttp://en.wikipedia.org/wiki/Utilityhttp://en.wikipedia.org/wiki/Opportunity_cost#cite_note-1http://en.wikipedia.org/wiki/Opportunity_cost#cite_note-1http://en.wikipedia.org/wiki/Opportunity_cost#cite_note-1http://en.wikipedia.org/wiki/Opportunity_cost#cite_note-1http://en.wikipedia.org/wiki/Utilityhttp://en.wikipedia.org/wiki/Scarcityhttp://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Opportunity_cost#cite_note-0http://en.wikipedia.org/wiki/Mutually_exclusivehttp://en.wikipedia.org/wiki/Mutually_exclusivehttp://en.wikipedia.org/wiki/Accounting_profithttp://en.wikipedia.org/wiki/Economic_profithttp://en.wikipedia.org/wiki/Economic_profithttp://en.wikipedia.org/wiki/Implicit_costhttp://en.wikipedia.org/wiki/Accounting_profithttp://en.wikipedia.org/wiki/Total_costhttp://en.wikipedia.org/wiki/Economic_profithttp://en.wikipedia.org/wiki/Implicit_cost#cite_note-lipsey-0http://en.wikipedia.org/wiki/Explicit_costhttp://en.wikipedia.org/wiki/Opportunity_costhttp://en.wikipedia.org/wiki/Economics

7/29/2019 mb 0042

12/17

opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently.Thus, opportunity costs are not restricted to monetary or financial costs: the realcostofoutput foregone, lost time, pleasure or any other benefit that provides utility shouldalso be considered opportunity costs.

Actual costs refer to real transactions, whereas opportunity costs refer to the alternativetaken into consideration by decision makers who might want to choose the line of activitywhich minimise the costs. From an external point of view, it is difficult to ascertain whichare the alternative considered.

Q.5 Explain in brief the relationship between TR,AR and MR under different marketcondition.

Ans.

Total Average and Marginal Revenue

The revenue of a firm jointly with its costs ascertains profits. Now let us discuss theconcepts of revenue. The term revenue denotes to the receipts obtained by a firm from thescale of definite quantities of a commodity at various prices. The revenue concept relates tototal revenue, average revenue and marginal revenue.

1. Total Revenue It is the total sale proceeds of a firm by selling a commodity at a

given price. If a firm sells 3 units of an article at $ 24, its total revenue is 3 x 24. Thustotal revenue is price per unit proliferated by the number of nits sold, i.e. TR = P x Q,where TR is the total revenue, P the price and Q the quantity.

2. Average Revenue It is the average receipts from the sale of certain units of thecommodity. It is obtained by dividing the total revenue by the number of units sold.The average revenue of a firm is in fact the price of the commodity at each level ofoutput since TR = P x Q, therefore, AR = TR / Q = P x Q / Q = P.

3. Marginal Revenue MR In addition to total revenue as a result of a small hike in thesale of a firm. Algebraically it is the total revenue earned by selling N units of the

commodity instead of N-1 i.e., MRn = TRn TRn-1.

Relation Between AR and MR Curves

1. Under Ideal Rivalry The average revenue curve is a horizontal straight lineparallel to X axis and the marginal revenue curve coincides with it. This is sinceunder ideal rivalry the number of firms selling an identical product is very huge. The

http://en.wikipedia.org/wiki/Real_versus_nominal_value_%28economics%29http://en.wikipedia.org/wiki/Real_versus_nominal_value_%28economics%29http://en.wikipedia.org/wiki/Production_possibilities_frontierhttp://en.wikipedia.org/wiki/Utility_%28economics%29http://en.wikipedia.org/wiki/Utility_%28economics%29http://en.wikipedia.org/wiki/Production_possibilities_frontierhttp://en.wikipedia.org/wiki/Real_versus_nominal_value_%28economics%29http://en.wikipedia.org/wiki/Real_versus_nominal_value_%28economics%29

7/29/2019 mb 0042

13/17

price is determined the market forces of supply and demand so that only one pricetends to prevail for the whole industry.

In the diagram 1, each firm can sell as much itwishes at the market price OP. Thus thedemand for the firms product becomes

infinitely elastic.In the diagram 2, since the demand curve

is the firms average revenue curve, the shape ofAR curve is horizontal to the X axis at price OP andthe MR curve coincides with it. Any change in the

demand and supply circumstances will changethe market price of the product and consequentlythe horizontal AR curve of the firm.

2. Under Monopoly or Imperfect Competition, the average revenue curve is thedownward inclining industry demand curve and its related marginal revenue curvelies below it. The marginal revenue is lower than the average revenue. Given thedemand for his product the monopolist can increase his sales by lowering the price,marginal revenue also falls but the rate of fall in marginal revenue is greater thanthat in average revenue.

In the diagram 3, the MR curve falls below the AR curve and lie half a way on the

perpendicular drawn from AR to Y axis. This relation will always exist amidst straight linedownward sloping AR and MR curves.

In diagram 4, AR curve is convex to the origin, the MR curve will cut anyperpendicular from a point on the AR curve at more than halfway to he Y axis. MR passesto the left of the mid point B on the CA.

Alternatively, if the AR curve is concave to the origin, MR will cut the perpendicular at lessthan half way towards y axis, in the diagram 5, MR passes to the right of the mid point B on

the CA.

3. Monopolistic Competition The relationship between AR and MR is the same asunder monopoly. But there is an exclusion that the AR curve is more elastic and it isrepresented in the diagram 6. This is since products are close substitutes undermonopolistic competition. The firm can hikes sales by a reduction in its price.

7/29/2019 mb 0042

14/17

4. Under Oligopoly The average and marginal revenue cures do not have a smoothdownward slope under oligopoly. They acquire kinks. As the number of sellersunder oligopoly is small, the effect a price cut or price hikes on the par of one sellerwill be followed by some changes in the behaviour of the other firms. If a sellerraises the price of his product, the other seller will experience a fall in demand for

his product.

His average revenue curve is represented inthe diagram 7 becomes elastic after K and itsconsequent MR curve rises discontinuously from a to band then persists its course at the new higher level.

Alternatively, if the oligopolistic seller reducesthe price of his product, his rival also follows him inreducing the prices of their products so that he is not

able to enhance his sales. His AR curve becomes lesselastic from K onwards and it is represented inthe diagram 8. The consequent MR curve falls

vertically from a to b and then slopes at a lower level.

Importance of Revenue Costs

The AR and MR curves form significant tool for economic analysis.

Profit Determinants The A curve is the price line for the producer in all marketsituations. By relating the AR curve to the AC curve of a firm, it can ascertain

whether it is earning supernormal or normal profits or incurring losses. If the ARcurve is tangent to the AC curve at the point of equilibrium, the firm earns normalprofits. If the AR curve is above AC curve, it makes super normal profits. In case, ARcurve is below the AC curve at the equilibrium point, the firm incurs losses.

Determination of Full capacity It can also be known from their relationshipwhether the firm is producing at is full capacity or under capacity. If the AR curve istangent to the AC curve at its minimum point, under perfect rivalry, the firmproduces its full capacity. Where it is not so, under monopolistic competition, the

firm posses idle capacity.

Equilibrium Determination The MR curve when intersected by the MC curvedetermines the equilibrium position of the firm under all market conditions. Theirpoint of intersection in fact determines price, output, and profit and loss of a firm.

7/29/2019 mb 0042

15/17

Factor Pricing Determination The use of the average marginal revenue helps indetermining factor prices. In factor pricing they are inverted U shaped and theaverage and marginal revenue curves become the average revenue productivity and

marginal revenue productivity curves ARP and MRP, also they are useful device indescribing the equilibrium of the firm under different market conditions.

Q.6 Distinguish between a firm and an industry . Explain the equlibrium of a firmand industry under perfect competition.

An industry is the name given to a certain type of manufacturing or retailing environment.

For example, the retail industry is the industry that involves everything from clothes tocomputers, anything in the shops that get sold to the public. The retail industry is very vastand has many sub divisions, such as electrical and cosmetics. More specialised industriesdeal with a specific thing. The steel industry is a more specialised industry, dealing with themaking of steel and selling it on to buyers.The difference between this and a firm is that a firm is the company that operates withinthe industry to create the product. The firm might be a factory, or the chain of stores thatsells the clothes, within its industry. For example, one firm that makes steel might be Avidasteel. They create the steel in that firm for the steel industry.A firm is usually a corporate company that controls a number of chains in the industry it isoperating within. For example in retail, the firm Arcadia stores owns the clothing chains

Topshop, Dorothy Perkins, Miss Selfridge, and Evans. These all operate for the firm Arcadiawithin the industry of retail.Several firms can operate in one industry to ensure that there is always competition tokeep prices reasonable and stop the market becoming a monopoly, which is where one firmis in charge of the whole industry. Sometimes, a firm is not necessary within the industryand independent chains and retailers can enter straight into the market without a firmbehind them, although this is risky. This is because one of the advantages of having a firmbehind you is that it is a safeguard against possible bankruptcy because the firm cansupport the chain that it owns

Equilibrium of a firm and industry under perfect competition.

When we speak of market equilibrium in economics it refers to level of prices at which thequantity demanded by the customers is same as the quantity offered for for supply by thesuppliers. Thus the market equilibrium has has two dimensions. (1) price, and (2) quantitysold and purchased. Please note that the we are talking about quantity actual sold andpurchased. Unlike quantities demanded and quantity offered for supply, the actual quantitysold and purchased is always equal.

http://www.blurtit.com/q694095.htmlhttp://www.blurtit.com/q694095.htmlhttp://www.blurtit.com/q694095.htmlhttp://www.blurtit.com/q694095.html

7/29/2019 mb 0042

16/17

In a monopoly market, the entire market supply is accounted by one firm. Therefore,equilibrium point for the market and for the firm are the same. In a perfectly competitivemarket, individual firms have no influence on the market price as the demand curve for thefirm is a horizontal line at the level of the market price. Thus same price is applicable tofirm level equilibrium. However the quantity supplied by each firm at this equilibrium price

depends on the cost structure of the firm. The firm can supply as much as it wishes,therefore it supplies a quantity that maximizes its profit. This occurs when the marginalcost of the firm just equals the marginal revenue. In a perfectly competitive market themarginal cost and revenue at this point are also same as the market price. Since marginalcost for every firm operating in a perfect competition is same as market price, thecombined marginal cost for all the firms in a perfectly competitive market is also same asmarket equilibrium price.

In an oligopoly it is not possible to give a fixed formula for the equilibrium point forindividual firms as it is dependent on actions of competitor firms and may change fromtime to time in response to changing competitive action and the competitive strategy of the

firm itself.

Average Fixed Cost:

Fixed cost refers to the minimum fixed cost that a firm incurs for manufacturingirrespective of the total quantity produced. Average fixed cost is simply this fixed costdivided by total quantity produced.

Thus: Average Fixed Cost = AFC = Fixed cost/Total quantity produced.

In the above equation for AFC we see that numerator (fixed cost) is constant, while

denominator (total quantity produced) is variable. Therefore, AFC reduces with increasingproduction quantity. As a result AFC curve, which is a graph showing AFC on y-axis andproduction of x-axis, is a downward sloping curve.

Marginal cost pricing is essential in determininghow firms should choose output. Inpractice, itis easier for firms to calculate their average costthan their marginal cost, butmarginal cost iswhat they need to know.In measuring marginal cost, expenditureslikeincreased maintenance and repairs should beattributed to the output that creates thesecosts.The timing of when the bill must be paid isirrelevant.Marginal cost pricing is useful insetting uptransfer prices within the firm. Example ofAT&T secretarial pool.Zero profits.

You cant just sit around. Profitsare transitory, and competition is fierce to be better than

the marginal firm.A big, but imitatable innovation is not asprofitable as a smallerinnovation that cannot be limitated.

Product vs. Process.

There is a tension between the invisible handand the incentive to imitate. This is whywehave patent laws. In a dynamic sense, allowing some market power could be beneficial.

7/29/2019 mb 0042

17/17