Foundation Paper 4 Business Economics Past Paper PDF

SARANSH Last Mile Referencer for FOUNDATION PAPER 4 BUSINESS ECONOMICS The Institute of Chartered Accountants of India (Set up by an Act of Parliament) Board of Studies www.icai.org I https:// boslive.icai.org  PR...

SARANSH Last Mile Referencer for FOUNDATION PAPER 4 BUSINESS ECONOMICS The Institute of Chartered Accountants of India (Set up by an Act of Parliament) Board of Studies www.icai.org I https:// boslive.icai.org  PREFACE The Board of Studies is dedicated to delivering outstanding services to its students, tirelessly striving for the highest standards of education and support. It imparts quality academic education through its value-added study materials, that explain concepts clearly and in simple language. Illustrations and Test Your Knowledge Questions contained therein facilitate enhanced understanding and application of concepts learnt. Mock Test Papers empower students to gauge their readiness ahead of each examination, ensuring confidence and clarity. Additionally, BoS offers engaging live virtual classes led by distinguished faculty, reaching students far and wide across the nation. To effectively engage with its students, the Board of Studies has been publishing subject-specific capsules in its monthly Students’ Journal, "The Chartered Accountant Student," since 2017. These capsules are aimed at facilitating efficient revision of concepts covered across various topics at the Foundation, Intermediate, and Final levels of the Chartered Accountancy Course. This initiative underscores the BoS commitment to enhancing learning and comprehension among its students through accessible and attractive educational materials. Each issue of the journal includes a capsule relating to specific topic(s) in one subject at each of the three levels. In these capsules, the concepts and provisions are presented in attractive colours in the form of tables, diagrams and flow charts for facilitating easy retention and quick revision of topics. The Board of Studies (BoS) is now introducing a comprehensive booklet titled 'Saransh - Last Mile Referencer for Foundation Paper 4 – Business Economics'. This booklet aims to consolidate significant concepts across various topics in Business Economics, particularly those included in the syllabi at the Foundation level of CA Course. It features diagrams, flow charts, tables, and illustrated journal entries, providing a one-stop repository for key accounting topics. However, the readers are advised to refer the study material for comprehensive study and revision.Under no circumstances, this booklet substitutes the detailed study of the material provided by the Board of Studies. By capturing essential points in a concise format, 'Saransh' will facilitate better understanding and retention of basic Concept of Business Economics, enhancing the learning experience for students preparing for their examinations and beyond. It will indeed serve as a valuable ready reckoner for readers, enabling them to grasp the essence of the subject comprehensively. Happy Reading!  PRESIDENT’S MESSAGE It is with immense pride that I introduce the Saransh booklets, a meticulously curated resource available across the Foundation, Intermediate, and Final levels of the Chartered Accountancy course. ICAI has always been dedicated to providing our students with the best possible resources to succeed in their studies and careers, and Saransh is a demonstration of this commitment. The Saransh — Last Mile Referencers have been thoughtfully designed by the Board of Studies (BoS) to serve as an invaluable companion for your studies and exam preparation. Our aim is to simplify complex concepts and provisions, making them easier to understand, memorize, and revise. However, Saransh is not a substitute for the detailed BoS study material but a supplementary tool to complement your in-depth study. The newly revamped Saransh booklets have been updated not only in content but also in their presentation. With a more logical and organized structure, enhanced visual appeal, and a user- friendly layout, these booklets are now more effective in aiding your studies. We have extended the Saransh series to cover all core areas of the Chartered Accountancy course. Whether you are studying Direct Tax Laws and International Taxation, Indirect Tax Laws, Accounting Standards, Indian Accounting Standards, Auditing, Cost and Management Accounting, Strategic Cost Management and Performance Evaluation, Company Law, or Financial Management and Strategic Management, you will find a Saransh booklet for each subject. Saransh is designed not only to help you grasp and recall essential concepts but also to guide you in approaching each subject strategically. The insights provided in these booklets will help you develop a structured approach to your studies, ensuring that you are well-prepared for your examinations. I urge you to make the most of the Saransh booklets. While these booklets will support you, it is your dedication, perseverance, and hard work that will ultimately determine your success. I wish each of you the very best in your studies and future careers. Warm regards, CA. Ranjeet Kumar Agarwal President, ICAI  TABLE OF CONTENTS S.No. Particulars Page No. 1. Introduction to Business Economics Meaning and scope of Business Economics 1-3 Basic Problems of an Economy and Role of Price Mechanism. 2. Theory of Demand and Supply Meaning and Determinants of Demand, Law of Demand and Elasticity of Demand – Price, Income and Cross Elasticity Theory of Consumer’s Behaviour –Indifference Curve 4-8 approach Meaning and Determinants of Supply, Law of Supply and Elasticity of Supply, Market Equilibrium and Social Efficiency. 3. Theory of Production and Cost Meaning and Factors of Production, Short Run and Long Run Law of Production – The Law of Variable Proportions and Laws of Returns to Scale, 9-15 Producer’s Equilibrium Concepts of Costs – Short-run and long-run costs, Average and Marginal Costs, Total, Fixed and Variable Costs 4. Price Determination in Different Markets Market Structures: Perfect Competition, Monopoly and Monopolistic Competition. Using Game Theory to study 16-26 Oligopoly. Price Determination in these Markets Price- Output Determination under different Market Forms 5. Business Cycles Meaning Phases 27-28 Features Causes behind theseCycles 6. Determination of National Income Macro Economic Aggregates and Measurement of National Income 29-35 Determination of National Income: Keynes’ Two Sector Basic Model, Three Sectors and Four Sectors Models S.No. Particulars Page No. 7. Public Finance Fiscal functions: An Overview, Centre and State Finance Market Failure/ Government intervention to correct market failure. 36-40 Process of budget making: Sources of Revenue, Expenditure Management, and Management of Public Debt. Fiscal Policy 8. Money Market Concept of Money Demand Important theories of Demand for Money 41-48 Concept of Money Supply, Cryptocurrency and other new terminology Monetary Policy 9. International Trade Theories of International Trade including theories of intra- industry trade by Krugman. Trade Policy – The Instruments of Trade Policy 49-60 Trade Negotiations Exchange Rates and its economic effects International Capital Movements: Foreign Direct Investment 10. Indian Economy (Before 1950- Chanakya and Nand Vansh, OECD Paper (1950- 61-63 1991), Basic knowledge 1991 Onwards  BEFORE WE BEGIN The term ‘Economics’ owes its origin to the Greek word ‘Oikonomia’ which means ‘household’. Till 19th century, Economics was known as ‘Political Economy.’ The book named ‘An Inquiry into the Nature and Causes of the Wealth of Nations’ (1776) usually abbreviated as ‘The Wealth of Nations’, by Adam Smith is considered as the first modern work of Economics. Economics is the study of the processes by which the relatively scarce resources are allocated to satisfy the competing unlimited wants of human beings in a society. Of course, the available resources will be efficiently used when they are allocated to their highest valued uses. The origin of economics as a formal discipline can be traced back to ancient civilizations, where rudimentary forms of economic activity existed. However, the systematic study of economics as we know it today began to emerge much later in history. Ancient Roots: Economic activities have been a part of human civilization since its early stages. Ancient civilizations such as Mesopotamia, Egypt, Greece, Rome, India, and China engaged in trade, agriculture, and commerce. Early philosophers like Plato, Aristotle, and Xenophon discussed economic concepts in their works, laying the groundwork for later economic thought. Mercantilism: In the late Middle Ages and the early modern period, particularly during the 16th to 18th centuries, mercantilist economists emerged in Europe. Mercantilism focused on increasing a nation's wealth through trade, emphasizing policies such as hoarding precious metals and establishing colonies to secure raw materials. Classical Economics: The late 18th and early 19th centuries saw the rise of classical economists such as Adam Smith, David Ricardo, and John Stuart Mill. Adam Smith's seminal work, "The Wealth of Nations" (1776), is often regarded as the foundation of modern economics. Classical economists focused on principles of free markets, specialization, and the division of labour. Keynesian Economics: The Great Depression of the 1930s prompted a re-evaluation of economic theories. John Maynard Keynes emerged as a prominent figure with his book "The General Theory of Employment, Interest, and Money" (1936). Keynesian economics advocated for government intervention in the economy to manage aggregate demand and stabilize economic fluctuations. Modern Economics: The latter half of the 20th century saw the development of various schools of economic thought, including monetarism, supply-side economics, and more recently, behavioural economics and complexity economics. Economists like Milton Friedman, Friedrich Hayek, and Amartya Sen have contributed significantly to modern economic theory.  BEFORE WE BEGIN Business Economics which has been introduced at the Foundation level of the Revised CA course, has been developed keeping in mind the fact that CAs now a days have to take up the role of not merely an accountant or auditor but a business Solution provider. The paper is of 100 marks and the syllabus of the earlier paper has been increased commensurate with the marks in the Examination. Business Economics which integrates economic theory with business practice will help them in the process of business decision making. There are ten chapters in Business Economics namely, Introduction to Business Economics, Theory of Demand and Supply, Theory of Production and Cost, Price Determination in Different Markets, Business Cycles, Determination of National Income, Public Finance, The Money Market, International Trade, and Indian Economy. Relevance to Accounting and Finance Professionals: The syllabus is tailored to the needs of accounting and finance professionals, as it includes topics such as national income accounting, money and banking, and international trade, which are directly relevant to financial decision- making and analysis. This ensures that students are equipped with the necessary economic knowledge to apply in their future careers. Focus on Application: While covering theoretical concepts, the syllabus also emphasizes the application of economic principles to real-world scenarios. This helps students develop analytical skills and problem-solving abilities, which are valuable in accounting and finance professions where decision-making is often based on economic considerations. Comprehensive Coverage: The syllabus provides a comprehensive overview of various aspects of economics, including microeconomics, macroeconomics, and international economics. This ensures that students gain a holistic understanding of the discipline and its relevance to different areas of business and finance. Integration with Other Subjects: The syllabus is integrated with other subjects in the CA Foundation curriculum, such as Business Laws and Business Mathematics, ensuring coherence and reinforcing learning across different domains. This interdisciplinary approach helps students develop a holistic understanding of business and finance. Overall, the CA Foundation Economics syllabus effectively equips students with the knowledge and skills required to analyse economic factors, make informed financial decisions, and contribute effectively to the accounting and finance profession.  SARANSH BUSINESS ECONOMICS BUSINESS ECONOMICS Economics deals with problems and questions that affect almost all kinds of individuals in their capacities as consumers and producers. Therefore, economic literacy is essential for everyone. Business Economics may be defined as the use of economic analysis to make business decisions involving the best use of an organization’s scarce resources. The graphs and charts will assist them in revision of concept discussed in study material in minimum time. NATURE AND SCOPE OF BUSINESS ECONOMICS Definition Scope Nature Basic Economic Problems A Science Based on Micro What to Economics Produce? Micro Macro Incorporates How to Economics Economics elements of Produce? Macro For whom Economics to Produce? An Art Pragmatic Normative The book named ‘An Inquiry into the Nature and Causes of the Wealth of Nations’ (1776) Two fundamental facts: usually abbreviated as ‘The Human beings have Wealth of Nations’, by Adam unlimited wants ‘The means Micro Economics is Smith is considered as the first to satisfy these unlimited basically the study of the modern work of Economics. wants are relatively scarce’ behaviour of different form the subject matter of individuals and Economics organizations within an economic system In Macro-Economics, we study the behaviour of the large economic aggregates, such as, the overall While Business Economics levels of output and employment, is basically concerned with total consumption, total saving and Micro Economics , Macro total investment, exports, imports and economic analysis also foreign investment and also how has got an important role these aggregates shift over time to play. Nature of Business Economics A Science Incorporates Use of theory of Markets Normative in Nature elements of and Private Enterprises Macro Analysis Based on Micro Economics Pragmatic in Approach Interdisciplinary in Nature ICAI BOS 1  SARANSH BUSINESS ECONOMICS The scope of Business Economics is quite wide. It covers most of the practical problems a manager or a firm faces. Internal issues or operational issues (this can be solved using Micro There are two Economics) categories of business issues to which economic theories can be directly applied, External issues or environmental issues (this can be solved using Macro Economics) In Micro Economics we study about- Consumer Factor Product Behaviour Pricing Pricing The Economic condition of a Behaviour Location of section of of firms Industry people In Macro Economics we study about- National Income Consumer and National Output Behaviour The General Price Level and Interest Rates The overall Level of Savings and Investment The Level of Employment and Rate of Economic Growth External value of Currency ICAI BOS 2 SARANSH BUSINESS ECONOMICS Basis of Difference Economics Business Economics It involves the framing of It involves the application of Meaning economic principles to solve economic principles to solve economic problems. economic problems. It is microeconomic as well as Character It is microeconomic in character. macroeconomic in character. The fulfilment of needs of Proper decision making in a Main Task individuals as well as entities. particular business entity. It is positive as well as normative Nature It is only normative in nature. in nature. It has a comparatively narrow Scope It has a wider scope. scope. It has business economics as its It is an applied branch of Branches applied branch. economics. All the theories from production It is concerned with only profit Concerned with to consumption including theory ignoring other theories. distribution. It includes the analysis of macro It includes the analysis of micro Analysis Involved level issues like growth, inflation level issues like demand, supply and employment, etc. and profit etc. It concentrates only on the It concentrates on both economic Concentration economic aspects of any as well as non-economic aspects business problem. of any business problem. Validity of It is based on certain Some assumptions become Assumptions assumptions. invalid when applied. Business decisions cannot be taken without considering these present and future environmental factors. As the management of the firm has no control over these factors, it should fine-tune its policies to minimise their adverse effects. ICAI BOS 3 SARANSH BUSINESS ECONOMICS BASIC PROBLEMS OF AN ECONOMY What to produce? How to produce? Central Economic Problems What provisions are to be made for economic growth? For whom to produce? Socialist Economy The resources are allocated according to the commands of a central planning authority Capitalist Economy and therefore, market forces have no role in the allocation of Private property is the mainstay of resources capitalism and profit motive is its driving force. Decisions of consumers and businesses determine economic activity. Some examples of a capitalist Mixed Economy economy may include United States and United Kingdom, Hong Kong, South In a mixed economy, the aim is Korea etc to develop a system which tries to include the best features of both the controlled economy and the market economy while excluding the demerits of both MEANING OF DEMAND Demand means desire or The law of demand states wish to buy and consume that people will buy more a commodity or service at lower prices and less at backed by adequate higher prices, other things ability to pay and being equal. willingness to pay. According to Marshall, the The demand curve usually slopes demand curve slopes downwards downwards; but exceptionally slopes due to the operation of the law of upwards under certain circumstances diminishing marginal utility. as in the case of conspicuous goods, However, according to Hicks and Giffen goods, conspicuous necessities, Allen it is due to income effect future expectations about prices, and substitution effect. demand for necessaries and speculative goods. ICAI BOS 4 SARANSH BUSINESS ECONOMICS The demand curve will shift to the right A demand schedule is a table that when there is a rise in income (unless shows various prices and the the good is an inferior one), a rise in the corresponding quantities demanded. price of a substitute, a fall in the price The demand schedules are of two of a complement, a rise in population types: and a change in tastes in favour of Individual demand schedule commodity. The opposite changes will Market demand schedule shift the demand curve to the left. ELASTICITY OF DEMAND Elasticity of demand is defined as the responsiveness of the quantity demanded of a good to changes in one of the variables on which demand depends. 1. PRICE ELASTICITY OF DEMAND Price Elasticity of Demand refers to the 3. CROSS ELASTICITY OF DEMAND percentage change in quantity demanded of a commodity as a result of a percentage The cross elasticity of demand is change in price of that commodity. the percentage change in the As demand curve slopes downwards to the quantity demanded of commodity right, the sign of price elasticity is negative. X as a result of a percentage We normally ignore the sign of elasticity change in the price of some related commodity Y. and concentrate on the coefficient. Greater the absolute coefficient, greater is the price elasticity. In symbolic form, rice elasticity= Ep= % 4. POINT ELASTICITY OF DEMAND change in quantity demanded / % change in price. In point elasticity we measure elasticity at a given point on a 2. INCOME ELASTICITY OF DEMAND demand curve. When It is Positive, price change is somewhat larger Income elasticity of demand is the degree of or when price elasticity is to be responsiveness of quantity demanded of a found between two prices or two good to changes in the income of consumers. points on positive demand curve, In symbolic form, percentage change in we use ARC Elasticity. demand / PERCENTAGE change in income. For all normal goods, income elasticity is positive, on the other hand, goods having 5. ARC ELASTICITY negative income elasticity are known as When price and quantity changes inferior goods. are discrete and large, we have to If the income elasticity for a good is greater measure elasticity over an arc of than one, such goods are called luxury goods. the demand curve. On the other hand, if the income elasticity is less than one, it is a necessity. ICAI BOS 5  SARANSH BUSINESS ECONOMICS DIFFERENCE BETWEEN DEMONSTRATION/BANDWAGON EFFECT AND SNOB EFFECT Demonstration/Bandwagon Effect Snob Effect It is understood as the desire to possess a It is a psychological effect in which people do unique commodity having a prestige value. It is the same what others are doing. They do not quite opposite to the bandwagon or have their own belief and thinking. demonstration effect. It leads to increase in demand of a particular It leads to decrease in demand of a particular commodity. commodity. Example: If Miss. X and Miss. Y are rich rivals of Example: When some people start investing each other and if in any party Miss. X wears an money in share market then many people expensive dress and on seeing it Miss. Y who start following the same without considering also having the same dress decided to reject its advantages and disadvantages. the use of the same dress further. Rather Miss. Y will try to use even more expensive one. ICAI BOS 6  SARANSH BUSINESS ECONOMICS DEMAND FORECASTING Forecasting of demand is the art and science of predicting the probable demand for a product or a service at some future date on the basis of certain past behaviour patterns of some related events and the prevailing trends in the present. UTILITY The utility of a consumer is a measure of the satisfaction that the consumer expects to obtain from consumption of goods and services when he spends money on a stock of commodity which has the capacity to satisfy his want. Two important theories are (i) Marginal Utility Analysis propounded by Alfred Marshall, and (ii) Indifference Curve Analysis propounded by J R Hicks and R G D Allen. The law of diminishing marginal utility states that as a consumer increases the consumption of a commodity, every successive unit of the commodity gives lesser and lesser satisfaction to the consumer. The indifference curve theory, which is an ordinal theory, shows the household’s preference between alternative bundles of goods by means of indifference curves. The important properties of an Indifference curve are Indifference curve slopes downwards to the right, it is always convex to the origin, two ICs never intersect each other, it will never touch the axes and higher the indifference curve higher is the level of satisfaction. The consumer attains equilibrium at the point where the budget line is tangent to the indifference curve and MUX / PX =MUY /PY = MUZ /PZ Marginal rate of Substitution MRSxy=MUx/MUy Budget Line/ Price Line Budget line or price line shows all those combinations of two goods which the consumer can buy spending his given money income on the two goods at their given prices. The slope of the budget line is determined by the relative prices of the two goods. It is equal to ‘Price Ratio’ of two goods. i.e. PX /PY i.e. It measures the rate at which the consumer can trade one good for the other. ICAI BOS 7 SARANSH BUSINESS ECONOMICS (CONSUMER’S EQUILIBRIUM) Consumer's Surplus What a consumer is ready to pay - What he actually pays (CONSUMER SURPLUS) Substitute/ Complement When two goods are perfect substitutes of each other, indifference curves for these two goods are straight, parallel lines with a constant slope along the curve, or the indifference curve has a constant MRS. Goods are perfect complements when a consumer is interested in consuming only in fixed proportions. In such a case, the indifference curve will consist of two straight lines with a right angle bent which is convex to the origin, or in other words, it will be L shaped. ICAI BOS 8  SARANSH BUSINESS ECONOMICS SUPPLY The term ‘supply’ refers to the amount of a good or service that the producers are willing and able to offer to the market at various prices during a given period. The law of supply can be stated as: Other things remaining constant, the quantity of a good produced and offered for sale will increase as the price of the good rises and decrease as the price falls. Price of the Goods Other Factors Price of the related Goods Determinants of Supply Price of the Factor of Production Nature of Competition and Size of Industry State of Technology Government Policy (SUPPLY CURVE) EQUILIBRIUM PRICE ELASTICITY OF SUPPLY It measures the responsiveness of the quantity supplied of a good to a change in its price. Es=0, Elasticity Measures of Supply Es=∞, Perfectly Inelastic Perfectly Elastic Es1, Relatively Less Elastic Relatively Greater Elastic Es=1, Unitary Elastic ICAI BOS 9 SARANSH BUSINESS ECONOMICS PRODUCTION Production is the outcome of the combined activity of the four factors of production viz, land, labour, capital and organization. In simple terms production, means ‘creation of utility’. i.e. Utility of form, utility of place, utility of time and personal utility. Factors of production Variable factors Fixed factors those factors those the whose quantity quantity of which remains change with a unchanged with change in the changes in level of output. output. Production Function The production function is a statement of the relationship between a firm’s scarce resources (i.e. its inputs) and the output that results from the use of these resources. The production function can be algebraically expressed in the form of an equation in which the output is the dependent variable and inputs are the independent variables. The equation is : Q = f (a, b, c, d …….n) Where ‘Q’ stands for the rate of output of given commodity and a, b, c, d…….n, are the different factors (inputs) and services used per unit of time. Short-Run Vs Long-Run Production Function The short-run is a period of time in which at The long run is a period of time in which all least one of the inputs used remains factors of production are variable. unchanged during that period. It is a time period when the firm will be able In the short run, a firm cannot install a new to install new machines and capital capital equipment to increase production. equipments apart from increasing the variable factors of production. The behaviour of production is the subject The behaviour of production is the subject matter of the law of variable proportion. matter of the law of returns to scale. Cobb-Douglas Production Function It stated as Q= KLaC(1-a) Where Q is output, L the quantity of labour ,C quantity of capital ,K and a are positive constants ICAI BOS 10 SARANSH BUSINESS ECONOMICS LAW OF VARIABLE PROPORTIONS Law of Increasing Three stages of the Law of Returns Variable Proportion The law of variable proportion or the law of diminishing returns is Law of Diminishing relevant when some Returns factors are kept fixed and others are varied. It is applicable to the short-run. Law of Negative Returns LAW OF VARIABLE PROPORTIONS Stage 1 Law of increasing returns. Stage 2 law of diminishing returns. Stage 3 Law of negative returns. RETURNS TO SCALE Returns to Scale It describes the relationship between inputs and output in the long run when all inputs Constant Increasing Decreasing are changed in the same proportion. ISOQUANTS Isoquants or product indifference curves show all those combinations of different factors of production which give the same output to the producer. ICAI BOS 11 SARANSH BUSINESS ECONOMICS ISOCOST LINES It shows various combinations of two factors which the firm can buy with given expenditure or outlay. Figure shows various isocost lines representing different combinations of factors with different outlays. AB, CD and EF are Iso -cost lines. LEAST COST COMBINATION For producing a given output, the tangency point of the relevant isoquant (representing the output) with an isocost line represents the least cost combination of factors. C is the tangency point of the given isoquant with an isocost line represents the least cost combination of factors for producing a given output. ICAI BOS 12 SARANSH BUSINESS ECONOMICS COST ANALYSIS It refers to the study of behaviour of cost in relation to one or more production criteria. It is concerned with the financial aspects of production. Accountable Costs & Types of Costs Fixed & Variable Economic Costs Costs Direct & Outlay Costs & Indirect Costs Private Costs & Opportunity Costs Social Costs Incremental & sunk Costs Historical costs & Replacement Costs COST FUNCTION The cost function refers to the mathematical relation between cost and the various determinants of cost. It expresses the relationship between cost and output. Economists are generally interested in two types of cost functions; the short run cost function and the long run cost function. Cost Function is divided into two Short-run cost function Long-run cost function Fixed or constant costs which those the quantity of which are not a function of output. change with Long -run cost a These are inescapable or change in the level of output. uncontrollable TYPES OF COSTS Total cost of a business is defined as the actual cost that must be incurred for producing a given quantity of output. AFC is obtained by dividing the total fixed cost by the number of units of output produced. Average variable cost is found out by dividing the total variable cost by the number of units of output produced. Average total cost is the sum of average fixed cost and average variable cost. Marginal cost is the addition made to the total cost by the production of an additional unit of output. Long run cost of production is the least possible cost of producing any given level of output when all individual factors are variable ICAI BOS 13  SARANSH BUSINESS ECONOMICS THE SHORT RUN TOTAL COST The short run total cost is composed of two major elements namely, total fixed cost and total variable cost. Symbolically TC = TFC + TVC TFC curve starts from a point on the Y-axis shows that fixed costs will be incurred even if the output is zero. On the other hand, the TVC curve rises upward indicating that as output increases, total variable cost increases. The TVC curve starts from the origin because variable costs are zero when the output is zero. The TC curve has been obtained by adding vertically the TFC curve and the TVC curve. RELATIONSHIP BETWEEN AVERAGE THE LONG RUN AVERAGE COST COST AND MARGINAL COST CURVE(LAC) When average cost falls as a result of The long run average cost curve, often an increase in output, marginal cost is called a planning curve, is so drawn as less than average cost. to be tangent to each of the short run When average cost rises as a result of average cost curves. an increase in output, marginal cost is more than average cost. When average cost is minimum, ECONOMIES OF SCALE AND marginal cost is equal to the average DISECONOMIES OF SCALE cost. In other words, marginal cost curve cuts average cost curve at its When increase in scale is upto minimum point (i.e. optimum point). optimum level, then it is economies of scale. On the other hand, increase in scale beyond the optimum level, results in diseconomies of scale. Economies of scale is of two types- Internal economies of scale which accrue to a firm when it engages in large scale production and External economies of scale accrue to a firm due to factors which are external to a firm. ICAI BOS 14 SARANSH BUSINESS ECONOMICS KINDS OF INTERNAL ECONOMIES AND DISECONOMIES One Three Five Technical Economies Commercial Economies Risk Bearing Economies and Diseconomies and Diseconomies and Diseconomies Two Four Managerial Economies Financial Economies and Diseconomies and Diseconomies KINDS OF EXTERNAL ECONOMIES AND DISECONOMIES Development of Growth of ancillary skilled Labour industries 03 04 Better transportation Technological 02 05 and marketing external economies facilities 01 06 Cheaper raw Economies of material and capital Information equipments ICAI BOS 15  SARANSH BUSINESS ECONOMICS PRICE DETERMINATION IN DIFFERENT MARKETS Markets Behavioural Principles Determination of Prices Perfect Competition Monopolistic Monopoly Oligopoly Competition MARKET Market is the whole set of arrangements for buying and selling of a The elements of a commodity or service. market are: Here, buyers and Buyers and sellers; sellers bargain over A product or service; price of a commodity. Bargaining for a price; Knowledge about market In Economics, generally the conditions; and classification of markets is One price for a product or made on the basis of: service at a given time. Geographical Area Spot or cash Market Time Nature of transaction Spot transactions or spot Regulation markets refer to those markets Volume of business where goods are exchanged Type of Competition for money payable either immediately or within a short Forward or Future span of time. For example, Market grains sold in the Mandi at the current prices and cash is paid In this market, immediately. Thus is a part of transactions involve Spot Market. contracts with a promise Wholesale Market to pay and deliver goods at some future date. For The wholesale market is example, purchase of the market where the foreign currency contract commodities are bought at future rate from bank. and sold in bulk or large quantities. Transactions Retail Market generally take place between traders. i.e. When the commodities Business to Business are sold in small (B2B). quantities, it is called retail market. This is the market for ultimate consumers. i.e. Business to Consumer (B2C). ICAI BOS 16 SARANSH BUSINESS ECONOMICS THEORETICAL MARKET Perfect Competition Monopoly Perfect competition is It is a situation where there is a single characterised by many seller producing for many buyers. Its sellers selling identical product is necessarily extremely products to many buyers differentiated since there are no competing sellers producing products which are close substitutes. For Monopolistic Competition example. Indian Railways It differs in only one respect. Namely, there are many sellers Oligopoly offering differentiated products There are a few sellers to many buyers. For example, selling competing products shampoo manufacturers. to many buyers. For example, Telecom Industry. Market Types Assumption Perfect Monopolistic Oligopoly Monopoly Competition Competition Small Number of sellers Very large Large One Numbers Product None to None Slight Extreme differentiation substantial Price elasticity of Infinite Large Small Small demand of a firm Degree of control None Some Some Very considerable over price CONCEPTS OF TOTAL REVENUE, AVERAGE REVENUE & MARGINAL REVENUE Total revenue refers to the Average revenue is the Marginal revenue is the amount of money which a revenue earned per unit change in total revenue firm realises by selling certain of output. resulting from the sale of an units of a commodity. additional unit of the commodity. MR = AR × e - 1 Where = price elasticity of demand ICAI BOS 17  SARANSH BUSINESS ECONOMICS Behavioural Principle Principle 1- A firm should not produce at all if its total variable costs are not met. Principle 2 - The firm will be making maximum profits by expanding output to the level where marginal revenue is equal to marginal cost. Equilibrium of the Firm: Maximisation of Profits The firm will maximise profits at the point at which marginal revenue is equal to marginal cost. DETERMINATION OF PRICES In an open competitive market, it is the interaction between demand and supply that tends to determine equilibrium price and quantity Determination of Equilibrium Price Stable equilibrium is achieved through price mechanism or market mechanism. If the market price is above the equilibrium price, the market supply is greater than market demand and there is an excess supply or surplus in the market. Competing sellers will lower prices in order to clear their unsold stock. As we know, other things remaining constant, as price falls quantity demanded rises and quantity supplied falls. In this process, the supply-demand gap is reduced and eventually eliminated thus restoring equilibrium. ICAI BOS 18  SARANSH BUSINESS ECONOMICS Stable Equilibrium Increase in Demand, causing an increase in equilibrium price and quantity Decrease in demand resulting in a decrease in price and quantity demanded Increase in supply, resulting in decrease in equilibrium price and increase in quantity supplied ICAI BOS 19  SARANSH BUSINESS ECONOMICS Decrease in supply causing an increase in the equilibrium price and a fall in quantity demanded It sometimes happens that events shift both the demand and supply curves at the same time. This is not unusual in real life, supply curves and demand curves for many goods and services typically shift quite often because of continuous change in economic environment. During a war, for example, shortage of goods will often lead to decrease in their supply while full employment causes high total wage payments which increase demand. Simultaneous change in demand and supply ICAI BOS 20 SARANSH BUSINESS ECONOMICS PERFECT COMPETITION A market is said to be perfectly competitive if it has large number of buyers and sellers, homogeneous product, free entry and exit, perfect mobility of factors of production, perfect knowledge about the market conditions, insignificant transaction costs, no government interference and absence of collusion. ICAI BOS 21 SARANSH BUSINESS ECONOMICS EQUILIBRIUM OF THE FIRM Conditions for the Equilibrium of an individual firm: MC curve must cut MR curve MC = MR from below In the long Run, SMC = LMC = SAC = LAC = P = MR In the long Run all the Supernormal Profits or losses get wiped away with entry or exit of the firms from the Industry and all firms earn normal profit. ICAI BOS 22 SARANSH BUSINESS ECONOMICS MONOPOLY Monopoly is an extreme form of imperfect competition with a single seller of a product which has no close substitute. Single f Major features of the seller o Barriers Mark et Monopoly Market the to Entry No close er t pow produc substitutes ICAI BOS 23 SARANSH BUSINESS ECONOMICS PRICE DISCRIMINATION Price Discrimination is a method of pricing adopted by a monopolist in order to earn abnormal profits. It refers to the practices of charging different prices for different units of the same commodity. Conditions for price discrimination: Objectives of Price discrimination: The firm should have price-setting To earn maximum profit power, To dispose off surplus stock The seller should be able to divide his To enjoy economies of scale market into two or more submarkets. To capture foreign markets and The price elasticity of the product should To secure equity through pricing. be different in different submarkets, There must be no market arbitrage. Prof. Pigou classified three degrees of price discrimination FIRST DEGREE SECOND DEGREE THIRD DEGREE Under the first degree price discrimination, the Under the second monopolist separates Under the third degree degree price the market into each price discrimination, discrimination, different individual consumer and price varies by prices are charged for charges them the price attributes such as different quantities of they are willing and able location or by customer sold. The monopolist will to pay and thereby segment, example take away only a part of extract the entire dumping. the consumers’ surplus. consumer surplus. Doctors, lawyers, consultants etc. ICAI BOS 24 SARANSH BUSINESS ECONOMICS MONOPOLISTIC COMPETITION The essential feature of monopolistic competition is the existence of large number of firms, product differentiation, non price competition, high selling costs and freedom of entry and exit of firms. In monopolistic competition, the features of monopoly and perfect competition are partially present: Large Product Non-price Freedom of number of differentiation competition entry and exit sellers ICAI BOS 25 SARANSH BUSINESS ECONOMICS OLIGOPOLY Prof. Stigler defines oligopoly as that “situation in which a firm bases its market policy, in part, on the expected behaviour of a few close rivals”. TYPES OF OLIGOPOLY Partial or Collusive and full Syndicated and Competitive oligopoly Open and Pure oligopoly or organized oligopoly oligopoly closed oligopoly perfect oligopoly Strategic Interdependence Importance of advertising CHARACTERISTICS OF OLIGOPOLY MARKET and selling costs Group behavior PRICE AND OUTPUT DECISIONS IN AN OLIGOPOLISTIC MARKET When an oligopolistic firm changes its price, its rival firms will retaliate or react and change their prices which in turn would affect the demand of the former firm. Therefore, an PRICE LEADERSHIP oligopolistic firm cannot have sure and A group of firms that determinate demand curve, since the demand explicitly agree (collude) to curve keeps shifting as the rivals change their coordinate their activities is prices in reaction to the price changes made called a cartel. by it. KINKED DEMAND CURVE The demand curve facing an oligopolistic, according to the kinked demand curve hypothesis, has a ‘kink’ at the level of the prevailing price. It is because the segment of the demand curve above the prevailing price level is highly elastic and the segment of the demand curve below the prevailing price level is inelastic ICAI BOS 26 SARANSH BUSINESS ECONOMICS IMPORTANT MARKET FORMS MONOPSONY OLIGOPSONY is a market characterized by a single buyer of a product. or is a market characterized service and is mostly by a small number of large buyers and is mostly applicable to factor markets in relevant to factor markets. which a single firm is the only buyer of a factor. BILATERAL MONOPOLY DUOPOLY a subset of oligopoly, is a is a market structure in which market situation in which there is only a single buyer and a there are only two firms single seller i.e. it is a combination in the market. of monopoly market and a monopsony market. BUSINESS CYCLE Business cycle refers to alternate expansion and Phases of contraction of overall business cycle Expansion: business activity as Expansion The expansion phase is manifested in fluctuations Peak characterised by increase in in measures of aggregate Contraction national output, employment, economic activity, such Trough aggregate demand, capital as, gross national product, and consumer expenditure, employment and income. sales, profits, rising stock prices and bank credit. Peak: The term peak refers Contraction: Trough: to the top or the The economy cannot At the depth of highest point of the continue to grow endlessly. depression, all economic business cycle Once peak is reached, activities touch the increase in demand is halted bottom and the phase of and starts decreasing in trough is reached certain sectors. A noteworthy characteristic of these economic fluctuations is that they are recurrent and occur periodically. ICAI BOS 27 SARANSH BUSINESS ECONOMICS CAUSES OF BUSINESS CYCLE INTERNAL CAUSES EXTERNAL CAUSES Fluctuations in Effective Demand War Fluctuations in Investment Post War Reconstruction Variations in government spending Technology shock Macroeconomic policies Natural Factors Money Supply Population growth Psychological factors Examples of Business Cycle : Great Depression of 1930 Information Technology bubble burst of 2000 Global Economic Crisis (2008-09) Business cycles are contagious and are international in character. They begin in one country and mostly spread to other The phase of the business cycle is countries through trade relations. important for a new business to decide on entry into the market. ICAI BOS 28 SARANSH BUSINESS ECONOMICS NATIONAL INCOME ACCOUNTING Determination of National Income National Income Accounting Different concepts of Limitations and Challenges of National Income National Income Computation Measurement of National Income in India INTRODUCTION Just as there are accounting conventions National Income Accounting, pioneered which measure the performance of by the Nobel prize-winning economists business, there are conventions for Simon Kuznets and Richard Stone, is one measuring and analysing the economic such measure. performance of a nation. NATIONAL INCOME National Income is defined as the net value of all economic goods and services produced within the domestic territory of a country in an accounting year plus the net factor income from abroad IMPORTANT CONCEPTS NNP MP =GNPMP - Depreciation =NNP MP = NDP MP + Ner Factor Income from abroad NDPMP =NNP MP = GDP MP + Net Factor = GDPMP- Depreciation Income from Abroad - Depreciation = NNPMP - Net Factor GNP MP = GDP MP + Income from Abroad Net Factor Income from Abroad ICAI BOS 29 SARANSH BUSINESS ECONOMICS GNP MP = GDP MP + Net Domestic Product at Net Factor Income Market Price Factor Cost (NDPFC) is defined from Abroad = Factor Cost + Net as the total factor incomes Indirect Taxes= earned by the factors of Factor Cost + Indirect production. Taxes – Subsidies = NDP FC = NDP MP - Net Factor Cost = Market Indirect Taxes Price - Net Indirect Taxes = Market Price - Indirect Taxes + Subsidies Disposable Personal Gross Domestic Product at Factor Cost (GDP FC) Income (DI) that is = GDP MP – Indirect available for their GNP MP = GDP MP + Net consumption or savings DI Taxes + Subsidies Factor Income from = PI - Personal Income Abroad Taxes - Non Tax Payments Personal income is a measure Private Income = Factor income of the actual current income from net domestic product accruing receipt of persons from all to the private sector + Net factor sources. income from abroad + National debt PI = NI + income received but interest + Current transfers from not earned - income earned government + Other net transfers but not received. from the rest of the world. CIRCULAR FLOW OF INCOME Production of goods and services Disposition Consumption / Distribution as factor incomes Investment (Rent, Wages, Interest, Profit) DATA REQUIREMENTS AND OUTCOMES OF DIFFERENT METHODS OF NATIONAL INCOME CALCULATION Method Date required What is measured Phase of Output: The sum of net values added by all Value added the producing enterprises of the Contribution of production units method (Product Method) country Phase of income: Total factor incomes generated in Relative contribution of factor Income Method the production of goods and services owners Sum of expenditures of the three spending units in the economy, Phase of income: Income Flow of consumption and namely, government, consumer Method investment expenditures households, and producion enterprises ICAI ICAI ICAIBOS BOS BOS (A) 30  SARANSH BUSINESS ECONOMICS THE SYSTEM OF REGIONAL ACCOUNTS IN INDIA At present, practically all the states and union territories of India compute state income estimates and district level estimates. State Income or Net State Domestic Product (NSDP) is a measure in monetary terms of the volume of all goods and services produced in the state within a given period of time (generally a year) accounted without duplication. INCOME METHOD NNPFC or National Income = Compensation of employees + Operating Surplus (rent + interest + profit) + Mixed Income of Self -employed + Net Factor Income from Abroad PRODUCTION METHOD Gross value added (GVA MP ) = Value of output – Intermediate consumption = (Sales + change in stock) – Intermediate consumption EXPENDITURE METHOD GDPMP = Private final consumption expenditure + Government final consumption expenditure + Gross domestic capital formation (Net domestic capital formation + depreciation) + Net export In agricultural sector, net value added is estimated by the production method, in small scale sector net value added is estimated by the income method and in the construction sector net value added is estimated by the expenditure method. LIMITATION OF NATIONAL INCOME Lack of an agreed definition of national Services of durable goods. income. Difficulty of incorporating distribution of Accurate distinction between final goods income. and intermediate goods. Valuation of a new good at constant Issue of transfer payments. prices, and valuation of government services. CHALLENGES Inadequacy of data and lack of Absence of recording of incomes reliability of available data. due to illiteracy and ignorance. Presence of non-monetized Lack of proper occupational sector. classification and Production for self-consumption. Accurate estimation of consumption of fixed capital. ICAI BOS 31 SARANSH BUSINESS ECONOMICS KEYNESIAN THEORY OF DETERMINATION OF NATIONAL INCOME The classical economists maintained that the economy is self-regulating Keynes argued that markets and is always capable of automatically would not automatically lead to achieving equilibrium at the ‘natural full-employment equilibrium level’ of real GDP or output, which is the and the resulting natural level level of real GDP that is obtained when of real GDP. The economy could the economy's resources are fully settle in equilibrium at any level employed. While circumstances arise of unemployment. Keynesians from time to time that cause the believe that prices and wages economy to fall below or to exceed the are not so flexible; they are natural level of real GDP, wage and sticky, especially downward. price flexibility will bring the economy back to the natural level of real GDP. BASIC CONCEPTS AND FUNCTIONS AGGREGATE DEMAND FUNCTION Aggregate demand (AD) is what economists call total planned expenditure. In a simple two- sector economy, the ex-ante aggregate demand (AD) for final goods or aggregate expenditure consists of only two components: (i) Ex ante aggregate demand for consumer goods (C), and (ii) Ex ante aggregate demand for investment goods (I) AD = C + I THE CONSUMPTION FUNCTION Consumption function expresses the functional relationship between aggregate consumption expenditure and aggregate disposable income, expressed as: C = f (Y) KEYNESIAN CONSUMPTION FUNCTION The Keynesian assumption is that consumption increases with an increase in disposable income, but that the increase in consumption will be less than the increase in disposable income (b