Managerial Economics U1-U15 PDF

MANAGERIAL ECONOMICS UNIT 1 INTRODUCTION TO MANAGERIAL ECONOMICS Learning Objectives After going through this unit, you will be able to: Describe the meaning of Economics. Distinguish various economics technological term. Apply economic principles which help in making business decisions. Compare the relationships of Managerial Economics with other subjects. Structure 1.1 Introduction 1.2 Deﬁnition of economics & Managerial Economics 1.3 Managerial economics, its nature & scope 1.4 Application of managerial economics in business decision making 1.5 Application of managerial Economics in business 1.6 Summary 1.7 Keywords 1.1 Introduction The business managers have to take appropriate decisions to reach their goals and attain their objectives. The managers have to optimize the output at the lowest cost and to earn more proﬁt. The study of economics helps them in applying economics logic, tools, methodology, concepts, and theories of economic analysis, to achieve the objectives of the ﬁrm. The world is dynamics and changing, hence the managers have to keep abreast with the modern and latest knowledge. The managers have to use the modern tools to get the desired results. Now business has become very complex and many factors aﬀect the business. The main features of modern business environments are, ever increasing inter-ﬁrm and inter-industry competition with domestics as well as international competition. Here China is the main example how China is selling mass produced goods cheaply and trying to put the Indian market in a bad shape and aﬀecting the Indian economy. Hence the study of Managerial economics and economics helps the managers 01 | Page MANAGERIAL ECONOMICS to take proper decision to achieve their goals. 1.1 Deﬁnitions Managerial economics refers to the integration of Economic principles and methodologies practices for the purpose of facilitating decision making and forward planning by the management within the given situation. It focuses in identifying the problems and solving the problems by taking proper decision. For example a manager has to decide whether he should get the work done by hiring labor or give it to an outside contractor. Diﬀerent economist have deﬁned economics diﬀerently Dr. Alfred Marshall: “Economics is the study of mankind in the ordinary business of life; it examines the part of individual and social action which is most closely connected with the attainment and with the use of material requirements of well being”. This deﬁnition gives more importance on the welfare of human being. In the modern world there is need of human welfare and it has become the policies of all the governments in the world. Prof. Lionel Robins: “Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses. This deﬁnition shows that wants are unlimited and means are limited and scarce and the means can be put to other alternate uses. Unlimited wants are natural for human beings and all wants cannot be satisﬁed at a time, hence he has to adopt the method of choice. He tries to select that choice, which gives him maximum satisfaction.. Available means can be used in various ways. All the economic problems arise due to scarce means and unlimited ways to use those means. This leads to choice among most competing ends. This is the main cause of basic problems for the study of economics Economics deals with optimum utilization of scarce resources to achieve the objectives and to maximize proﬁt of the ﬁrm. In nutshell economics is “the study of how people and society choose to employ scarce resources that could have alternative uses in order to produce various commodities and to distribute them for consumption, now or in future, among various persons and groups. In nutshell economics is “the study of how people and society choose to employ scarce resources that have alternative uses in order to produce various commodities and to distribute them for consumption, now or in future, among society.” 02 | Page MANAGERIAL ECONOMICS Economics is applied in decision making. It is that branch of economics which operates as a link between abstract theory and managerial practices.. It is based on economic analysis for identifying, problems, organizing, information and evaluating alternatives. Suppose your have Rs.100/- to spend. You have many choices, such as buy a book; or go to a picture or entertain friends. If you make one of the choices, you cannot think of other choices at all. But you will make a choice which will give you maximum satisfaction. Unlimited Choice Limited Resources SCARCITY What to produce ? How to produce ? For whom to produce ? Study of economics mainly divided into 2 broad sections: MICRO-ECONOMICS & MACRO-ECONOMICS MICRO-ECONOMICS: Micro Economics deals with the study of Micro organs of the economy and their related matter. Following ﬂow-chart explain the elements covered under the study of micro-economics. MICRO ECONOMICS Theory of Commodity Theory of Factor Economics of Welfare Pricing Pricing Theory of Theory of Rent Wages Interest Proﬁts Demand Supply Chart 1.1 Importance of Micro economics in the Managerial Economics 03 | Page MANAGERIAL ECONOMICS · Micro economics has to study the performance of Individual units in the economy at present and in future. If the share of factors of production increases, it means an increase in income of an individual. This will lead to an increase in the demand of all the products and it will increase the economic activities. In other words we can say that if the purchasing power of an individual increases his demand of various goods and services will also increase. Another example can further give the picture of the consumer. With a fall in price of a product the demand for that product increases and if the price rises the demand decreases. · It also reveals the cost of production of a product and how is it priced. Here we also study the concept of elasticity of demand. · How diﬀerent factors of production get their share in the nation income It also gives the idea of welfare economics Macro Economics Other part of economics is Macro Economics. The subject matter of Macro Economics includes the total economic units of an economy. It is the study of aggregates, i.e. aggregate employment, aggregate income, aggregate saving and investment, trade cycles, government policies, imports and exports and global eﬀects on the economy of the country. Role of banking policies also plays an important role in the economy. Savings and investments are controlled by the monetary policy of the government through its central bank. Recently the prices of petroleum products were increased by the govt. You can study the eﬀects of this increase on the economy and on the individual. Similarly when prices are rising, causing inﬂation you can study the eﬀects of it on the poor who have to spend all the income on the demand of essential goods and services. This reduces the total demand and aﬀects the economy. 04 | Page MANAGERIAL ECONOMICS MACRO ECONOMICS Theory of Income Theory of General Theory of Macro & Employment Price Level and Economic Economic Inﬂation Growth Theory of Distribution Theory of Theory of Consumption Investment Theory of Business Cycles Chart 1.2 Importance of Macro economics in the Managerial Economics meaning · To use the scarce resources to obtain optimum output and proﬁt. · To use the tools to select the best alternatives to achieve the objectives. · To study the market regarding demand, supply availability of factors of productions and risk management. · To decide the pricing of the product after studying the market conditions, income of the people and their taste, religion, and culture. · To study the implication and eﬀects of ﬁscal and monetary policies i.e. Policy of taxation and subsidy and its eﬀect on the price of the ﬁnal product. Recently the govt. increased the tax on petrol and the price of petrol went up. Similarly cooking gas is subsidized by Rs. 400/- and the people are paying less price for the cooking gas. Monetary policy aﬀects the cost of borrowing for investment · To study the external forces such as business cycle, political situation, social structure, these aﬀect the business. · To study labour relations in order to maintain productivity and eﬃciency of labour by giving incentives and motivate them. Government intervention through diﬀerent laws in the country which regulate, control the business activities. It has become necessary to control the adverse eﬀects of capitalism on the economy. 05 | Page MANAGERIAL ECONOMICS Activity A: Diﬀerentiate - wants and means a) Purchase LCD TV______________________________________ b) Import of crude oil______________________________________ c) Promotion in the organization with salary hike -________________ d) Got a bonus payment___________________________________ e) Foreign exchange reserve_______________________________ f) Going for world tour____________________________________ Name any current 4 Economics problems of world _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ _______________________________________________________________ Diﬀerentiate between Micro economic and Macro economics for following 1. Unemployment________________________________________ 2. Inﬂation______________________________________________ 3. Price revision of LG Refrigerator___________________________ 4. RBI decision to increase interest rate________________________ The demand for Bajaj DTSI bike will grow by 5% in year 2012-13 1.3 Managerial Economics - Nature And Scope Nature of Managerial Economics · It is essentially MICRO economics in nature. · It is pragmatic. · It is normative. · It uses some of the theories of macro economics · It is problems solving of business in nature. · Economics has limited application and has to study multidimensional areas which include social, cultural, religious, political and international environment. · Every happening in the world aﬀect the economy of the country for example recession in US has aﬀected the economies of Europe, china, Japan and still its eﬀect is felt in the world. Microeconomic deals with individual units of an economy such as an 06 | Page MANAGERIAL ECONOMICS individual, or a ﬁrm and their related matter. It is a practical subject and goes beyond providing abstract theoretical framework for managers. This main source of concepts and analytical tools for management is found in the study of economics. It studies essentials of demand, and supply, marginal cost, short run and long run cost, diﬀerent forms of markets such as perfect competitive, monopoly, monopolistic competition, and oligopoly and how these markets operate regarding pricing of the product and output. Macro economics deals in forecasting of demand in order to plan for future needs of capital and investment. This is based on market demand at macro level and individual, organization demand at micro level. At Macro level we study the theory of income and employment, Trade cycle and its eﬀects of the economy. Diﬀerent causes of inﬂation, recession and depression. Further we have to study the role of the government and its policies to meet these challenges in the economy. Scope of Managerial Economics Managerial Economics is a very useful subject. It explains and clariﬁes most of the major business problems such as; Estimation of product demand and source of supply of various factors. Analysis of product demand and plan the production schedule. Decide the input combination to obtain maximum output at minimum cost. Estimation and analysis cost of the product. And how the cost of the product can be reduced Analysis of price of the product and try to push the product in the market as per the market conditions Study of the market structure. Proﬁt maximization and planning. To Plan and control capital expenditure To evaluate the various policies adopted by the government and judge the eﬀects of it on the business. 1.4 Application Of Managerial Economics In Decision Making. Demand is the origin of all economic activities hence it needs a special attention. Here estimation of demand is very important. Estimation of demand depends on various factors such as income, distribution of income, likes and dislikes of the people, their culture and the way of life. When we are using inputs we have to use various scarce resources 07 | Page MANAGERIAL ECONOMICS and their combination to get maximum output at a minimum costs by avoiding any wastage. Pricing of the product is another important issue which has to be decided after studying various factors such as elasticity of the demand and the market structure i.e. completive market, monopoly, monopolistic competition, and oligopoly. There is also a need to estimate the demand and how long the demand will last. It studies the concept of production function, optimum utilization of resources, inventory management, and maximization of sale. Market structure also decides pricing system based on elasticity of demand of the product To maximize proﬁt and plan to maximize it depend on the decision of the managers who base their decision after study of the market How to utilize the capital so that it can bring maximum returns.This is a very important. Capital budgeting and study of relationship between inputs and outputs. Planning for future by using multi disciplinary approach by using tools provided by accounting, ﬁnance, marketing, and quantitative analysis by using scientiﬁc methods. Activity B: Identify the type of market: 1 FMCG__________________________________________________ 2 Mobile service providers____________________________________ 3 Cement manufacturer and recent CCI decision to penalize 11 cement companies 08 | Page MANAGERIAL ECONOMICS 1.5 Application of Managerial Economics In A Business Managerial Decision Problems Economic theory Decision Sciences Microeconomics Mathematical Economics Macroeconomics Econometrics MANAGERIAL ECONOMIC Application of economic theory and decision science tools to solve managerial decision problems OPTIMAL SOLUTIONS TO MANAGERIAL DECISION PROBLEMS Chart 1.3 Applications of Managerial Economics Managerial Economics and Marketing. - Planning for product demand in coming year. - Forecast demand for diﬀerent product and draft strategies and tap new market. Managerial Economics and Finance. - Forecast the cash ﬂow of the organization on the basis of demand and supply - Pricing strategy and earning and proﬁt. Managerial Economics and HR - How much manpower required in coming days. - Required skill availability Managerial Economics is used all the streams directly or indirectly. Managerial economics and other social sciences The part of Sociology, Psychology and other social sciences is equally helpful in Managerial economics and are used for market research and behavior of the society. Sociology shows the social eﬀect of social life. We have to use many conventional concepts have to be used as society and social life needs them. E.g. Gifts at the time marriage is a social custom. Lot of expenditure is done in marriage 09 | Page MANAGERIAL ECONOMICS Goods and Services Product Goods and Services Market Consumers Firms Economic Economic Resources Resources Income Factor Factor Payment Market Chart 1-4 1.6 Summary Managerial Economics refers to the application of principles of economics in decision making in the business. It uses the help from accounting and other subjects like mathematics, statistics,.operational research, sociology psychology etc. It uses the help of account, production, marketing techniques and ﬁnance to take decision. Managerial economics is applied economics and based on normative economics Managerial economics has to decide: What to produce? How to produce? How much to produce? For whom to produce? At what cost it is to be produced? How to decide price? Managerial economics has to study the market, determine the demand based on forecasting and other circumstances. While pricing the product it has to study elasticity of demand, income of the people and has to prepare strategy for increasing its proﬁt and its share in the market. It has many tools given by other social and natural sciences such as social set up, religion, mathematics, statistics, operational research, capital management and pricing. Finance has greater role to play in the study of managerial economics.But the scope of Economics is wider than the scope of 10 | Page MANAGERIAL ECONOMICS managerial economics. 1.7 Keywords Aggregate demand: The expenditure that the households and ﬁrms are undertaking on consumption and investment. Consumption: act of satisfying one's wants. Demand: The quantity of goods and services desired by a customer duly supported by the ability and willingness to purchase by parting with money. Economics: The science of choice when faced with unlimited ends and scarce resources having alternative uses. Fiscal Policy: A set of guidelines for the government's earning and spending. Macro Economics: The branch of economics which studies the aggregate behavior of the economic system. Micro Economics: The branch of economics that deals with small individual units of an economy. Monetary Policy: A mechanism to regulate the money supply in an economy. It is concerned with the cost and availability of credit. Price: Value when expressed in terms of money. Utility: The want satisfying quality of goods. 11 | Page MANAGERIAL ECONOMICS UNIT 2 DEMAND ANALYSIS Learning Objectives After going through this unit, you will be able to: Explain the concept of utility and its importance. Explain the concept of demand. Study the law of demand. Draw demand schedule and curves. Discuss the exceptions to the law of demand. Evaluate the importance of the law of demand. State factors which aﬀect demand other than price Structure 2.1 Introduction 2.2 Concept of utility 2.3 Meaning of demand. 2.4 Types of demand 2.5 Determinants of demand 2.6 Summary 2.7 Keywords 2.1 Introduction In the ﬁrst unit we have given the idea of managerial economics and how ME is dependent upon economics. The managers have to study all the possibilities of using scarce resources to get the maximum output at minimum cost. In this unit we are going to study the idea of utility and how it is related to demand of a product. We are also going to study the idea of demand. Demand is the origin of all economic activities. Demand is aﬀected by many factors apart from price. The factors, which aﬀect demand, are income of a consumer, population, climate and government policies activities. 14 | Page MANAGERIAL ECONOMICS 2.1 The Concept Of Utility The concept of utility is very important because the demand of a product depends upon its utility to the buyer. More utility means more demand and more prices. Meaning of utility It is want satisfying power of a commodity. If man is thirsty he quenches his thirst by taking a glass of water. Here water has UTILITY because it has the power to satisfy human want and sometime a person is prepared to pay for it. So we can deﬁne utility as satisfying power of a commodity. Law of diminishing marginal utility. The LAW OF DIMINISHING MARGINAL UTILITY was formulated by Prof. Marshall. According to Prof. Marshall The law means “more a person has anything the less he wants to have more of it.” That means the value of that product goes on diminishing as a person acquires more and more of it. The Law of diminishing marginal utility The law states that as a consumer increases the consumption of a product, the utility gained from the successive units goes on decreasing. For example if a man is thirsty he takes a glass of water which gives him good satisfaction and if he takes the second glass of water he will get less satisfaction than what he got from the ﬁrst glass of water. If he continues to take further the satisfaction he gets, goes on decreasing and a time will come when instead of giving satisfaction he gets dissatisfaction. Diminishing Marginal Utility schedule Total and Marginal utility Table 2.1 diminishing marginal utility 15 | Page MANAGERIAL ECONOMICS Graph 2.1 DMU Curve Assumptions of Law of DMU Rational Behavior. This means choosing those goods and that quantity which gives maximum satisfaction. No change in the taste and fashion, likes and dislikes No change in income of the person Consumer always prefers more quantity. Constant utility of money. Application of the Law of DMU · It gives the ides of value-in-use and value-in-exchange. For example Water has a very high value in use but less value in exchange because water supply is very high hence its value is less. Similarly the price of diamond is more in exchange but it has less value in use. · Application to Money: the law of MDU applies to money also and the tax system in the whole world is based on this concept. Man by nature would like to have more and more money. But as the stock of money goes on increasing its value goes on decreasing. For example a person X has an income of Rs.3000/-PM and another person Y has an income of Rs. 50,000/- P.M. If X loses 10/- he will search for it but if Y loses 100/- he will not bother much because the value of money to the poor is high and to the rich is low. Hence the rich pay higher taxes than the poor. · The Law of demand can be derived from the law of DMU and it also 16 | Page MANAGERIAL ECONOMICS helps to analyze why price falls. The Law of demand clearly indicates that a fall in price of a commodity the demand for it increases and the marginal utility goes on decreasing of the commodity. This law explains the idea of redistribution of the national income in the society and it has greater aﬀect on the development of an economy because the poor, if have money, go for purchasing the goods and services more and more. This will increase demand. This will increase more production and more economic activities and economic growth. Limitation of the law of DMU or when the does not apply. · Suitable unit - If a thirsty person is given a spoonful of water, he will like to have more and more till he has consumed reasonable quantity and till then this law will not apply here. · Time gap - If a person has his breakfast at 8.00AM and next food he is oﬀered at 8 PM he will get more satisfaction by consuming food at 8 PM because the time gap is longer. · This law does not apply to eccentric person. For example a drunkard would like to have more and more drinks. Similar is the case of a miser who is not happy with what he has but would like to accumulate more and more wealth. · No change in the quality of the product it means the law will not apply if successive units are of superior quality. For example if a person is eating ordinary mangoes he gets some satisfaction. But if he given the best quality of mango he will likely to get more satisfaction. Activity A: Explain why water has less value in exchange but high value in use. _________________________________________________________ _________________________________________________________ _________________________________________________________ Explain the situation under which a miser is happier when he gets more and more money. _________________________________________________________ _________________________________________________________ _________________________________________________________ 17 | Page MANAGERIAL ECONOMICS Justify the idea that the rich should pay higher taxes than the poor. ________________________________________________________ _________________________________________________________ _________________________________________________________ 2.3 Demand Meaning of demand Demand means eﬀective demand. Demand is deﬁned as the quantity of goods or services desired by an individual backed by the ability and willingness to pay at particular time and at particular price. The elements of demand are Desire, Backed by money Willingness to pay and part with the money. If any one of the elements is missing, it will not lead to demand. A beggar has a desire to eat but he has no money so his demand cannot be fulﬁlled. Secondly if a man has desire and he has money but he is not prepared to part with it. This will not be a demand, for example the case of a miser who wants the goods but is not prepared to part with the money. So his demand cannot be fulﬁlled Thirdly a man has desire and prepared to pay for the product but has no money. In this case his demand is fulﬁlled if he gets the goods on credit. In the modem time most of the durable goods (white goods) are purchased on EMI bases and the ﬁnancial companies are prepared to ﬁnance such transactions. This has completely changed the pattern of demand in the market Demand is the core of almost all the major activities and decisions of a ﬁrm. 18 | Page MANAGERIAL ECONOMICS Law of Demand and exceptions to the law of demand. All things remaining the constant (ceteris paribus) when the price of a product increases the demand of the product decreases and if the price reduces the demand increases. It means that demand is the function of price i.e dd=f (p) Demand and price are inversely related but not proportionally The equation of demand is: DD=a-bP, Here P is the price and a & b are constant. This shows that initial demand will remain constant whatever be the price of the product may be for that we have used sign a, b is again constant but it represents functional relationship between demand and price. b is having (-) sign which denotes negative function and shows downward slopping demand curve. Exceptions to the Law of Demand Under the following situations the law of demand is not applicable Giﬀen goods. Costly luxury items Speculative goods Out dated goods, out of fashion goods Goods in short supply There are certain goods whose demand increases with the rise in its price. Giﬀen goods: These goods are inferior goods consumed mostly by the poor as essential commodities e.g. BAJRA. The demand of these goods increases as the price rises and vice versa. Consumers spend a considerable portion of their limited income on these goods. For example A poor man income is Rs. 200/- and he needs 30 kg of grains to survive. The price of BAJRA is Rs 5/-Kg and of wheat Rs.10/- per kg. He consumes 20kgs of BAJRA and 10 kgs of wheat. Now the price of BAJRA rises to Rs.6/- per kg. Now he can buy 20 kg of BAJRA and 8 kg of wheat to meet his needs. This happens because of Giﬀen goods. Costly luxury goods: These are not essential goods and are consumed by the rich only. Here when the price increases the demand for these goods also increases. Because the rich people attach a lot of value to costly luxury goods that distinguish them from the common people and these goods have prestige value for the rich. If the price of gold falls, the demand from the rich will come down and if the price of gold rises the demand will increase. 19 | Page MANAGERIAL ECONOMICS Speculative goods: Such as shares which are traded in the share market which do not follow the law of demand. In speculation a further rise in price is expected by the investor and the traders buy more and hold them to sell the shares at a higher price later. Outdated goods: These goods are generally desired by the people and these are durable goods such as radio, TV, telephones. When anything becomes outdated the people would not buy them. For example the demand for black and white TV has become negligible even though the prices have fallen. This also applies to seasonal goods, e.g. the demand of raincoat is always in rainy season. Goods in short supply: The supply of certain goods is uncertain; hence even if the price is going up the people would like to buy them because of uncertainty.For example when the shortage of sugar is felt the people are prepared to pay more to buy sugar to avoid inconvenience. Hence in above circumstances the law of demand does not apply. Fig.2.1 Table of Demand Sr. Price of the Milk Per liter Quantity demanded in the market (Liters) 1. Rs 10 500 2. Rs 15 300 3. Rs 18 200 4. Rs 20 100 5. Rs 25 50 Demand Graph Fig.2.1 Demand Curve 20 | Page MANAGERIAL ECONOMICS Demand Schedule This demand schedule and demand curve clearly indicates that as the price of milk decrease the demand for milk increases and when the price increases the demand for milk decreases. Shift in the Demand Curve Shift in demand curves happens when price has no role to play and other factors other than price aﬀect the demand of the product. Sometimes even if there is no change in the price of a product the demand increases or decreases. For example if some guests visit you so you have to buy more goods and services to serve the guests. You may buy more milk, tea leaves and sugar. When some family members leave the house for a few days the demand is reduced of some goods. The shift can be due to reduction or increase in income of a person. Price of substitute goods has fallen so the demand of the original goods is reduced. The goods have become out of fashion and taste or there is a change in technology. I. Demand Shifts Increase in Demand: We represent an increase in demand by an outward shift in the curve (from D1 to D2). In the graph below at the price p1, demand has increased from Q1 to Q2. At every price there will be a greater demand than there was before the 'shock' of increased demand. We could expect this to describe the eﬀect of an increase in income or an increase in the size of potential demanders if the economy was expanding rapidly and families had more income to spend on education, or if high school grads were having real problems ﬁnding jobs Increase/Decrease in Quantity Fig.2.2 Increase in Demand 21 | Page MANAGERIAL ECONOMICS Decrease in Demand: We represent a decrease in demand by an inward shift in the curve (from D1 to D2). In the graph below at p1, demand has decreased from Q1 to Q2. At every price there will be a less demand than there was before the 'shock' of decreased demand. We could expect this to describe the eﬀect of a decrease in the price of a substitute good, see the demand curve shift inward, if the economy was falling into a recession and families had less income to spend on education, or if high school grads were ﬁnding jobs quite easily. Fig.2.2 Decrease in Demand So we can say that in case of increase in demand of a product the demand curve will move toward the right and in case of decrease in demand the demand curve will move towards left. Activity B: Price of vegetables in the vegetable market is high in the morning and as the time passes on the price goes on decreasing. Give reason _________________________________________________________ _________________________________________________________ _________________________________________________________ During festival season the price of milk goes up and the demand is also increasing, explain this situation under the law of demand. _________________________________________________________ _________________________________________________________ _________________________________________________________ 22 | Page MANAGERIAL ECONOMICS Activity B: The demand for car has come down because the price of petrol has increased. Study this situation under the law of demand. _________________________________________________________ _________________________________________________________ _________________________________________________________ 2.4 Types Of Demand Direct demand & indirect demand. Derived and autonomous demand. Price demand, income demand, cross demand. Joint demand and composite demand. Individual demand and market demand. Demand for durable and non-durable Goods. Demand for Perishable good and non- perishable goods. Direct Demand and Indirect Demand Direct demand of goods is demand of those goods and services which are directly consumed by the ultimate consumer. These goods are used for ﬁnal consumption by the consumers the examples of such goods are bread, butter, milk, tea and readymade garments, service of a doctor etc. Indirect demand consists of those goods which are not directly consumed by the consumer but these are used by producers for the production of other goods. These are also known as producers demand. Example - The demand for machine, tools, raw material, is known as indirect demand. Also sewing machine is demanded by a house wife to stitch clothes for the family it is a direct demand but when a tailor uses the sewing machine for making shirts, blouses etc it is indirect demand for the machine. 23 | Page MANAGERIAL ECONOMICS Derived and Autonomous Demand It is just like indirect and direct demand. The demand for cotton for making shirt is a derived demand whereas the demand for milk is autonomous demand. Let us say that the demand for shirts have gone up it will force the producers to produce more by increasing the demand for cloth. Price Demand It refers to diﬀerent quantities of a product or service that a consumer would like to buy at a given time, and at a given price, other things remaining constant. It is related to price Income Demand It refers to the situation where diﬀerent quantity of goods or services would be purchased by the consumer at various levels of income. If income increases demand for various goods would also increase but the demand for basic food shall remain the same. And with the higher income the consumer may substitute superior quality of goods replacing inferior goods. For example the income of a consumer increase he may demand more goods and secondly he may substitute superior quality of rice to inferior quality of rice Cross Demand This refers to the demand of interrelated good. E.g. tea & coﬀee.Increase in the price of tea will increase the demand for coﬀee. Joint Demand: It means when more than one commodity is required to satisfy a demand. For example to satisfy the demand for tea, consumer requires tea leaves, milk, sugar etc. Composite Demand: Any commodity can be put to many uses, and the use of it depends upon its price. For example water, where water is costly it is only used for drinking and cooking purposes and if the price of water reduces it can be put for other uses also. Individual Demand and Market Demand An individual in order to satisfy his want would like to have some vegetable and 24 | Page MANAGERIAL ECONOMICS he buys it. When the demand of all the people is taken together it is market demand of vegetable it will be called market demand. For example X demand depends upon his income and he may demand one kg of cabbage but all people demand for cabbage may be 100 kg that will be market demand. Demand for durable goods and No-durable goods Durable goods are those which can be used more than once over a period of time for example the use of TV, fan, furniture, car, and ready- made clothes etc. · Whereas non-durable goods are those which can be used once and consumed directly such as bread Policy of the government · Change in the habits of savings · Innovation and invention · Special inﬂuence and climate · Future expectation of consumers · Change in the level of distribution of income. 2.4.7 Demand for Perishable good and non- perishable goods. Activity C Activity C: a) Sewing machine is a consumer goods and it also a producer good. _________________________________________________________ _________________________________________________________ _________________________________________________________ b) In order to have a cup of tea you need tea leaves, milk and sugar it is called _________________________________________________________ _________________________________________________________ _________________________________________________________ c) Government policy aﬀects demand. Give some example to prove it. _________________________________________________________ _________________________________________________________ _________________________________________________________ 25 | Page MANAGERIAL ECONOMICS d) EMI scheme has increased the demand for white goods. Agree. _________________________________________________________ _________________________________________________________ _________________________________________________________ e) Change in the habit of saving more, will aﬀect the demand of goods and service. _________________________________________________________ _________________________________________________________ _________________________________________________________ 2.5 Determinants Of Demand The Determinants of Demand o It is determined by o Own Price - Po o Price of other products, especially close substitutes and complements, Pc,s o Consumers' disposable incomes, Yd o Consumers' tastes, T o The amount spent on advertising the product, Ao o The amount spent on advertising complements and substitutes, A c,s o Interest rates (i) and credit availability (C) o Expectations of future prices and supply conditions(E) A 'demand function' - the general mathematical form Qd = f(Po,Po,Ps,Yd,Ao,Ac,As,I,C,E) 2.6 Summary We have studied the idea of utility. We have also studied the law of diminishing marginal utility. The idea of utility is useful in taxation also it gives the idea of Value-in-use and Value-in-exchange. We also studied the meaning of demand and its law.i.e. how change in price aﬀects the quantity demanded. We learnt how demand is determined and also exceptions to the law of demand.We also got the idea of increase and decrease in demand. 26 | Page MANAGERIAL ECONOMICS 2.7 Keywords Complementary goods: goods which are used along with some other goods. · Demand: The quantity of a good or service desired by a customer duly supported by the ability and willingness to pay with reference to a point of time and the price. · Giﬀen goods: inferior goods, consumed mostly by the poor people as essential commodities. The demand of these goods increases with a rise in price. · Law of demand: Other thins remaining the same the demand for goods increases as the price decreases and vice-versa. · Law of Diminishing Marginal Utility: As a consumer increases the consumption of a product, the utility gained from successive units of consumption goes on decreasing. · Price: value expressed in terms of money. · Utility: The want satisfying quality of goods. 27 | Page MANAGERIAL ECONOMICS UNIT 3 ELASTICITY OF DEMAND AND FORECASTING OF DEMAND Learning Objectives After going through this unit, you will be able to: Explain the meaning of elasticity of demand. Discuss how a small change in price aﬀect the demand. State diﬀerent concepts of elasticity. State Measurement, and uses of the concept of elasticity of demand. Establish how demand is estimated. State Methods of estimating. Structure 3.1 Introduction 3.2 Concept of elasticity of demand. 3.2.1 Elastic demand. 3.2.2 Inelastic demand. 3.3 Classiﬁcation of elasticity of demand. 3.3.1 Price elasticity of demand. 3.3.2 Income elasticity of demand. 3.3.3 Cross elasticity of demand 3.4 Measurement of elasticity of demand. 3.4.1 Total Outlay method. 3.4.2 Percentage method. 3.4.3 Point method 3.4.4 Arc method. 3.5 Application of elasticity of demand. 3.6 Factors determining elasticity of demand 3.7 Meaning of forecasting of demand. 3.7.1 Techniques of forecasting. 3.7.2 Forecasting of demand for a new product. 3.7.3 Uses of forecasting of demand. 3.8 Summary 3.9 Keywords 30 | Page MANAGERIAL ECONOMICS 3.1 Introduction In the previous unit no 2 you are given the idea of marginal utility and its importance. Secondly you learnt the idea of demand and other concepts related to demand such as diﬀerent types of demand. We know that demand is the beginning of all economic activities.In this unit we are giving you some ideas of edacity of demand. This is a very important component of business decision making. It is a measure of responsiveness of demand of a product to the change in the price of the product. Sometimes a small fall in the price of a product may increase the demand of the product much more than expected for example If the price of TV is reduced, it demand always increases. But the fall in the price of salt will not increase its demand. Prof. Marshall “Elasticity of demand in a market is great or small depending on whether the amount demanded increases much or little for a given fall in price and diminishes much or little for a given rise in price In the second half we shall study the idea of estimation of the level of demand of a product in future. The businessman has to plan for future production on the basis of future estimates. The businessman has to arrange for Finance, space, Manpower; material etc. This idea is known as forecasting of demand of a product 3.2 Concept Of Elasticity Of Demand The law of demand gives only the direction of change in the quantity demanded of a commodity in response to a change in price. But law of demand does not tell by how much and to what extend the quantity demanded of a commodity will change in response to a change in price. This idea can be explained with the help of price elasticity of demand. 3.2.1. Elastic Demand Under elastic demand gives the idea that is if the price of a product changes what will be its eﬀect on the quantity demanded of the product. How much the demand is responsive to change in price? For example if there is a fall in the prices of white goods (TV, Washing Machines, A.C) the response of the market will be in the form of more and more demand. This means that there is elastic demand this idea is applicable to all non-essential goods. 3.2.2 Inelastic Demand Inelastic demand is a situation even if there is a great fall in the price of a product the quantity demanded will not increase much or it may not increase at all. This is the idea of inelastic demand. For example if the price of wheat and 31 | Page MANAGERIAL ECONOMICS rice fall the demand may not increase or there may be marginal increase. But in case of salt the demand may not increase at all. Generally these products come under necessaries and are essential for human life. 3.3 Classiﬁcation Of Elasticity Of Demand The concept of elasticity of demand is put in three categories. 3.3.1 Price elasticity of demand. 3.3.2 Income elasticity of demand 3.3.3 Cross elasticity of demand 3.3.1 Price Elasticity of Demand. When the demand of a commodity is responsive to price then it is known as price elasticity of demand. If there is a fall in price demand may rise a little or more depends upon whether the demand is elastic or inelastic. This concept enables the manager to know the eﬀects of change in the price of a commodity on the total revenue which depends upon nature of product and its elasticity. Price elasticity of demand can be shown as under Pe= % change in quantity demanded÷% change in price. Pe= ∆q/q / ∆p/p Pe=∆q/∆p*p/q ∆q means a small change in the quantity demanded ∆p means a small change in the price of the commodity. Q means quantity demanded. P means price of the commodity. Suppose he price of tea is Rs.20/-and the quantity demanded by a house hold is 10 kg. Subsequently the price of tea has risen to Rs.22/- and demand has come down to 9 kg. Pe=- ∆q/∆p*p/q Pe=1/2*20/10 = -1 Hence the elasticity is less elastic Price elasticity of demand can range from 0 to ∞.Hence it can be seen that Pe=1;Pe>1; Pe1, E 0) The project should be taken up. In general form it is – NPV = -C + R1 + R2 + + Rn (1 + 1) (1 + i) (1+ i) 2 n Let us say that the cost of the project is Rs. 10,000/- Market rate of interest is 15% and its yields are net return Rs. 16,100/- next year. Now decide if investment should be done? NPV = -co + R1 (1 + I) = -10000 + 16,100 = -10,000 + 16,100 X 100 1+.15 115 = -10,000 + 14000 = Rs. 4000/- Since NPV is positive, project will be proﬁtable hence it should be done. In another case, planning is done to purchase machine costing Rs.20, 000/-. The rate of interest is 10% and the yield of the next year is Rs. 22,000/- machine has no salvage value. NPV = - co + R1 = -20,000 + 22000 i+I i +.1 = - 20,000 + = -22,000 + 20,000 = 0 1.1 So, since there is no proﬁt, the project need not be done. (a) Proﬁtability Index NPV has an absolute value hence it is not good for comparing proﬁtability between diﬀerent projects – PI or Beneﬁt Cost Ratio (B – C ratio) PI = Present value of inﬂows Present value of outﬂows If PI is greater than 1 then project is acceptable and if it is less than 1, it should not be accepted. Activity III a) Concept of Proﬁtability index Proﬁtability Index or Beneﬁt cost ratio – PI = Present value of inﬂow Present value of outﬂow 198 | Page MANAGERIAL ECONOMICS If PI is greater than 1, the project is acceptable otherwise not. b) Solve the problem the cost of the project is Rs.10,000/-. Market rate of interest is 15% and net yield return is R.16, 100/- next year. Decide whether investment should be done or not. NPV = -C+ R1 (1 + I) NPV = 16,000 + 16100 = -10000 + 16,100 x 100 1 +.15 115 = -10,000 + 14,000 = Rs. 4000- Since NPV is positive, the project is proﬁtable and should be done. 13.6 Summary In Unit No. 14 (Capital budgeting) we have taken up a very important concept which has to be used often to take any investment decision. The study of capital budgeting becomes essential, when some new project or new investment, has to be done. The capital investment decisions are inﬂuence mainly by factors like technological change, demand charge, competitor behavior, ﬁscal policy of the Govt. and some non economic factors. We have classiﬁed diﬀerent types of physical assets and why these are acquired. Then we put more emphasis on the process of capital budgeting. Diﬀerent methods are suggested to evaluate a project. This evaluation is based on the objectives of the ﬁrm, condition of the market. We have stated simple and complex methods of evaluation.. These are in the form of Net Present Value, Internal Rate of Return and proﬁtability index, cash inﬂows in and cash ﬂows out. Special mention has to be done on the price concept of value of money. So study of this unit will enable you to have some basic knowledge of ﬁnance. 13.7 Keywords Capital budgeting.It is a decision making process concerned with whether or not: (1) The ﬁrm should invest funds in an attempt to make proﬁt (2) How to choose among competing projects. Internal Rate of Return. (I.R.R.) it is a method of evaluating investment proposals. It is the rate of discount (or interest rate) that equals the present 199 | Page MANAGERIAL ECONOMICS value of outﬂow to the present value of inﬂows. Thus making NPV = O. Net present value (NPV). It is a method of evaluation consisting of present value of all net cash ﬂows (discounted by cost of capital as the interest rate), to initial investment cost. Capital in Physical form i.e. Plant, equipment, buildings, machinery. Cash ﬂows. It is cash transaction. Receipts are called cash ﬂows in and payments are known as cash ﬂows out. Opportunity cost. It is the possible earning that can be made from resources from its alternative use. Scrap value. It is the value which may be received from the sale of assets after the project is over. CFAT (Cash Flow after tax). It is cash receipt or cash payment after tax. It is the net value of cash ﬂow. Payment period. A method of evaluation investment proposal which determines the time a project's cash inﬂows will take to repay the original investments of the project. 200 | Page MANAGERIAL ECONOMICS UNIT 14 NATIONAL INCOME AND ITS MEASUREMENT GDP; GNP; PI; DI Learning Objectives After going through this unit, you will be able to: State the National income of a country Discuss how to measure the National Income by diﬀerent methods Explain the diﬃculties in the measurement of National Income State diﬀerent concepts related to National Income such as GDP; GNP; PI, DI Structure 14.1 Introduction 14.2 Deﬁnition of National Income 14.2.1 Feature of National Income 14.3 Measurement of National Income – Method 14.3.1. Output method 14.3.2. Income method 14.3.3. Expenditure method 14.4 Diﬃculties in the measurement of National Income 14.5 Diﬀerent concepts of National Income 14.5.1 G.D.P. 14.5.2 G.N.P. 14.5.3 Net National Income 14.5.4 P.I. (Personal Income) 14.5.5 D.I. (Disposable Income) 14.6 Importance of National Income estimates 14.7 Summary 14.8 Keywords 14.1 Introduction In Unit No. 12 we have tried to explain the concept of cost beneﬁt which is very essential to know the return on our investment. Also we have given the idea of steps to be taken to get the full idea of costs beneﬁts. How cost beneﬁt analysis helps the managers to take decision in selection of diﬀerent projects. In this unit you will learn something about National Income. Method of 203 | Page MANAGERIAL ECONOMICS National Income measurement and what diﬃculties are faced when we try to measure the National Income. You will also learn some concepts of National Income. These concepts are made clear and easy to understand about National Income. You will also learn the importance of the study of national income. 14.2 Deﬁnition Of National Income National Income is the money value of all the goods and services produced in an economy over a period of one year. Prof. Pigou, “National Income as that part of objective income of the community including income derived from abroad which can be measured in money. Prof J. R. Hicks – the National Income consists of a collection of goods and services reduced to a common basis by being measured in terms of money.” 14.2.1 Features of National Income · National Income is a ﬂow and not a stock · National Income in real terms is the ﬂow of goods and services produced during a particular period of time. · The concept of National Income is linked with some economic activities. · In National Income accounting the concept of National Income is visualized as a ﬂow of national output, National Income and National Expenditure. Thus the three ﬂows are equal to each other i.e. National Income = National output = National Expenditure. · No commodity or services should be counted twice for example if raw cotton has been evaluated. It should not be counted in cotton textiles. That means only the ﬁnal product has to be taken in the National Income. Capital gain made by an individual should not be counted. Because these capital gains do not represent any productive activity. 14.3 Measurement Of National Income The concept of National Income involves three interpretations – 1. It represents the monetary value of aggregate annual production in an economy i.e. National Output. 2. It represents the aggregate income of the country (National Income). 3. It represents the aggregate expenditure in the economy that is National 204 | Page The above interpretation has given three methods of measurement of National Income: (i) Census of production method (ii) Census of Income Method (iii) Census of Expenditure Method 14.3.1 Production Method GNP – It is the sum of the market value of all the ﬁnal goods and services produced in an economy during a given period of time. This method is also called Net Product or Value added method. Here the sum of value of goods and services produced at market price is found. Here we have to take the gross product duly calculated by summing up the money value of output in diﬀerent sector of economy like Agriculture, industry, transport. The money value of raw material and services used in the production and the amount of depreciation of physical assets involved in the production process are summed up. The Net output or value added is found by subtracting the aggregate of cost of raw material, services and depreciation from the gross product found above. G N P = Gross National Product G N P = Money value of total goods and services and income from abroad. N.I = GNP – Depreciation Here the following steps to be considered - a) Here in order to avoid double counting, intermediate goods must be excluded and only the ﬁnal good should be taken into account. When the value of shirt is included the value of cloth is already accounted for. b) Only new net capital assets produced during the period under consideration are included. c) Net receipt from international trade in included (i.e. x – m).Depreciation or replacement cost must be excluded. 14.3.2 Income Method It is also known as factor share method. In this income received by all the basic factors of production used in the production process are summed up i.e. income received by Labour, capital and income of professional such as doctors, lawyers etc. National Income is obtained by summing up of the incomes of all individuals in the country. National Income = Rent + wage + interest + Proﬁt + income from abroad. But transfer income is not to be included. This method indicates the 205 | Page distribution of National Income among diﬀerent income groups. This is also known as National Income at factors cost. GNP income method = wages and salaries + rent + interest + Dividends + undistributed corporate proﬁts + mixed income + Direct taxes and indirect tax + depreciation + net income from abroad. Some precautions must be taken while calculation in National Income by Income method. These are – a) Transfer payment should not be included i.e. Transfer payment means relief payment like old age pension; pension etc. must not be included. b) Payments due to owners' owned factors of production must be counted on the basis of the market price c) Goods and services for which no money payment is made must not be included. d) Proﬁt not distributed by the corporate sector and kept in reserve fund must be included in the National Income. 13.3.3 Expenditure Method This method is used by adding up all the expenditure made on goods and services during a year. Income can be spent either on consumer goods or investment goods. G.N.I. = Individual expenditure and Govt. expenditure. GNP = Private consumption expenditure (c) + Gross domestic private investment (I) +Net foreign Investment (x – m) + Govt. expenditure on goods and services (G) = C + I + (x – m) + G Since this method is not reliable this is not popular in practice because without earning a man has to survive and spend on goods and services. Secondly the data are not available. Thirdly many people do not work and have to spend a lot of money to themselves alive. Activity I: a) Explain the idea of production method. _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ 206 | Page b) Income method _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ c) Expenditure method is diﬃcult to give proper idea of national income. _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ 14.4 Diﬃculties In The Measurement Of National Income The measurement of National Income is a diﬃcult task. This is due to non availability of detailed and reliable data about diﬀerent sectors of economy. 1) The data available in many countries are inadequate and unreliable 2) Existence of a large amount of non-monetized sector in under developed countries. Most of the agriculture produce does not reach the market because it is consumed at home or is exchanged for other goods and services or stored. 3) Illiteracy and ignorance of the small producers creates diﬃculties because they do not keep any account and they are not aware of its advantages. 4) The people have many occupations at the same time. They undertake more than one activity. For example a small farmer does farming and also work somewhere during slack season, so no account is kept for the income of such activity. 5) Existence of underground economy and illegal activities where black money/Hawala system is used for transaction purposes and are not reported. So how this amount can be counted. Most of the illegal activities , which generate income, are not counted. 6) Depreciation system is not considered properly and many people are 207 | Page not aware of such system. In order to maintain assets depreciation has to be provided for which can be used for replacement of obsolete assets. 7) Free services rendered by the Govt. are not considered. Govt. spends a lot money on police, military, judicial system administration and provides street lighting, irrigation, education, public health, road etc. 8) Services of house wives are not considered since these are unpaid services. 9) Capital Gains when the prices of capital assets increase and sold on proﬁt. This income is not considered in National Income. 10) Transfer payment is not considered in National Income. These payments are in the form of Pension, unemployment allowance, subsidies interest on national debt etc. 14.5 Diﬀerent Concepts Of National Income 14.5.1 G D P ( gross domestic product) 14.5.2i G N P ( gross national product) 14.5.3 N N P ( Net national product) 14.5.4 N.N.P. at factors cost 14.5.5 P I ( Personal Income) 14.5.6 D.I. ( Disposable income) 14.5.1 G D P (Gross Domestic Product) GDP is the money value of all ﬁnal goods and services produced in the domestic country in an accounting year. It is a measure of country's overall economic output. It is the market value of all the ﬁnal goods and services made within the borders of a country in a year. It includes all private and public consumption, Govt. expenditure, investment and net of exports and Imports. GDP = C + G + I +Nx C = all private consumption G = sum of Govt. spending I = sum of all the country's business spending on capital Nx = Nation's total net exports that is Exports – Imports. GDP at Factor cost and GDP at market price GDP at factor cost is estimated as the sum of net value added by diﬀerent producing units and the consumption of ﬁxed capital. GDP at market price, include indirect taxes and exclude subsidies given by the 208 | Page Govt. So GDP at factor cost = GDP at market price – IT + S IT = indirect taxes and S = Subsidies 14.5.2 GNP (Gross National Product) Gross National Product is the sum of gross domestic product and net factor incomes from abroad. GNP = GDP + Net factor income from abroad GNP is a monetary value of annual ﬁnal output. 14.5.3 NNP (Net National Product) It is the net production of goods and services in a country during the year. NNP = GNP – Depreciation It is also referred to as national income market prices. It is a very useful concept for the study of growth of economies. It has a diﬃculty about ﬁxing the appropriate rate of deprecation. 14.5.4 Net National Product at Factor cost or National Income National income is the total of all income payments received by the factors of production N.I. = Net National Product – Indirect taxes + subsidies- Proﬁt accruing to the Govt. Because Indirect taxes and proﬁt accruing to the Govt. are not available to the factors hence this is reduced from the National Income. 14.5.5 Personal Income It is that income which is actually received by the individuals or household in a 209 | Page country. It includes whole of the National Income earned by the factors of products in one year which is not available to them. So we have to reduce all these elements which are not available for distribution among the factors of production. We have to add to National Income the transfer payment made by Govt. to some people. P I = N.I – corporate Income Tax – undistributed proﬁts – social security contribution + transfer payments P I is an important concept. It helps us in estimating the potential purchasing power of the household in the economy. But this concept does not tell us the actual amount of money that is available to the household for spending and saving. 14.5.6 D.I. (Disposable Income) D I = Personal income – Personal direct tax. After paying the personal direct tax from Personal Income what is remaining is D.I. which the house hold can spend on consumption. So we have made clear most of the concepts relating to National Income clear as above. The full equation for GDP using this approach is GDP = C + I + G + (X-M) where C: Household spending on goods and services I: Capital Investment spending G: Government spending X: Exports of Goods and Services M: Imports of Goods and Services The Income Method – adding together factor incomes GDP is the sum of the incomes earned through the production of goods and services. This is: Income from people in jobs and in self-employment (e.g. wages and salaries) + Proﬁts of private sector businesses + Rent income from the ownership of land = Gross Domestic product (by sum of factor incomes) 4. If the India experienced a devastating earthquake, GDP would most likely 210 | Page increase due to production necessary to repair the damage. decrease by the amount of the damage. increase due to the foreign imports we would need to purchase in order to sustain us through the crisis. None of the Above. 5. A recession is loosely deﬁned as an unemployment rate above the natural rate of unemployment. having more than 6 percent of the work force receiving unemployment insurance. more than two consecutive months of decline in the economy's level of consumption spending. six or more consecutive months of decline in the economy's level of output. none of the above 14.6 Importance Of Estimates Of National Income National Income is very important for an economy of a country. This gives the idea of the condition of the economy of the country: Growth of GDP always show that the economy is making progress. 1) It helps in analyzing the overall production performance of the economy 2) It helps in analyzing the performance of the economy whether it is growing, stagnant or declining. 3) It shows the contribution made by various sectors of the economy such as agriculture, industrial production trade and service sector. 4) It gives the idea of distribution of National Income indiﬀerent categories such as wages, proﬁts, rent and proﬁts. 5) It is a valuable guide for the policy makers. It assists in comparing National Income of diﬀerent countries. We can compare the standard of living of diﬀerent countries by its study. 6) It also throws light on the volume of consumption, saving and investment in the economy. 14.7 Summary National Income is the indicator of economic activity. It is total market value of all ﬁnal products and services produced in a country during a year. We have tried to explain about the National Income of the country. We have explained diﬀerent methods of measurement of National Income i.e. product 211 | Page method, income method, and expenditure method in details. We have given the idea of various diﬃculties faced while measuring the National Income. We have explained the concepts which are related to the N.I. i.e. GDP, GNP, PI and Disposable income. We have given the idea of GDP at factor cost and at Market price. We have also given the importance of the study of nation income. 14.8 Keywords Disposable Personal income - The total income earned by households in the society less the personal taxes. Gross National Product – The total market value of all ﬁnal goods and services produced in an economy in a year. Net National Product – means GNP – Depreciation GDP at Factor cost – is estimated as the sum of net value added by diﬀerent producing units and the consumption of ﬁxed capital. GDP at Market Price – the sum of domestic factor incomes and consumption of ﬁxed capital Net domestic product (NDP) here depreciation allowance (capital consumption allowance) is to be reduced from GDP. Personal Income. Sum of all incomes actually received by all individual or households during a year. Depreciation – It is the cost of consumption of ﬁxed capital. 212 | Page MANAGERIAL ECONOMICS UNIT 15 NEED OF GOVERNMENT INTERVENTION Learning Objectives After going through this unit, you will be able to: Discuss the need of Government intervention in the free Market State the need for price control Explain support price and administered price Clarify the meaning of dual prices Express the need of preventing and controlling of monopolies. Structure 15.1 Introduction 15.2 Failure of market mechanism 15.3 Need for Government Intervention 15.4 Meaning of price control 15.5 Methods of price control 15.5.1 Prevention control of monopolies 15.6 Summary 15.7 Keywords 15.1 Introduction In Unit No. 14we have tried to give you the idea of capital budgeting. What steps are needed for project evaluation? We have explained about time value of money. We have also explained how to appraise the investment and other related concepts. Now in this unit we shall explain the need of the Govt. intervention in business because of failure of the market economy. In detail we shall study how Govt. intervenes in the market. Some of the techniques which the Govt. adopts are price control, support price, administered price etc. and also how to control and prevent the formation of monopoly. Duel pricing system is also one of the ways to help the weaker sector of the society to get the essential goods. 215 | Page MANAGERIAL ECONOMICS 15.2 Failure Of Market Mechanism Adow Smith opposed any Govt. intervention in the private business. It may hinder the free play of the market mechanism in a capitalist economy. Later he accepted the same role of the Govt. is necessary in the market economy to remove some of the failure of the market mechanism. The failure of market mechanism has justiﬁed intervention of the Govt. in the market mechanism. Following are the failures of Market Systems – (i) Inequalities of income and wealth. Right to property and law of intervention has given advantage to the people who get a good start in life. Since they possess productive resources, which can be used to earn more income and accumulate more wealth so it has resulted in economic inequalities. (ii) Economic instability. Market economy is fully dependent on the level of demand. Any change in demand could upset an economy. A fall in demand could bring down the prices, leading to retrenchment of labour. This depression would engulf the whole economy. A rise in demand will increase the productive activities and may lead to inﬂation. This causes trade cycle which aﬀect the economy because of ﬂuctuation in the economy. (iii) Rise of Monopolies. Competition in the Market economy is healthy. It will improve eﬃciency and quality of the product. But it also leads to a cut throat competition which will help the strong and well established producers to drive away the new comers from the market. It would lead to creation of mo monopoly concentration of economic power in the hands of a few producers. The monopolists can exploit the consumers (iv) Failure to provide full employment. Market mechanism would automatically establish equilibrium at the level of full employment. But because of rigidity (especially wage rigidity due to trade union). The economy will be in equilibrium at less than full employment so labor force remains unemployed and hence wasted the chance of creative of wealth. (v) Sacriﬁce of Social welfare. In order to get maximum proﬁt, the producers produce these goods which have greater demand. So the resources are diverted to produce luxury, semi luxury goods. The goods are for mass consumption needed for the poor are neglected. So the society is neglected. (vi) Failure to satisfy all the needs. Market mechanism cannot satisfy 216 | Page MANAGERIAL ECONOMICS the total needs of the society. Market economy can satisfy private wants but it cannot satisfy social wants. Market economy works on exclusion principle i.e. who cannot pay are denied its beneﬁts but social wants such as defence street lights it is not possible to exclude a person who does not pay. So it is the responsibility of the Govt. to provide these services. Sluggish functioning of the price mechanism. Market being imperfect, there is a lack of perfect knowledge or inability of factors of production. Price mechanism may not function properly. So it is seen that free market economy has some good achievements to its credit, but it suﬀers from various evils. 15.3 Need For Government Intervention Seeing the failure of the capitalist free society, it is necessary that the Govt. should intervene for smooth running of the economy. To control cyclical ﬂuctuations The Govt. can adopt an anti-cyclical policy to control the economic in staturlity The Govt. can increase expenditure during depression on the construction of infrastructure. This helps to generate employment and stimulate aggregate demand in the economy. In case of inﬂation the Govt. can exercise control such as credit control and reduce Govt. expenditure and raise taxes. This will reduce the supply of money in the society aﬀecting aggregate demand. Humanitarian consideration Where market mechanism fails to serve the human needs, Govt. may intervene. In developing countries allowance is given to the unemployed destitute and the poor senior citizens. Similarly the Govt. can continue to operate loss working unit so that the workers may not use their job. Preventing Eco-inequality The state can reduce economic inequality. The Govt. can adopt the policy of progressive taxation such as income tax, estate duty and succession tax, more taxes on higher income and revenue thus collected to be used for the welfare schemes for the poor. It can pass the laws to curb monopoly. The Govt. can spend money to create more opportunity for employment. The Govt. can subsidize various essential goods for the poor and the weaker section of society. For example the Govt. has adopted the policy of subsidizing gas, kerosene oil, and fertilizer to enable the poor to use their essential commodities. So some of reasons stated above make the intervention of the Govt. desirable. It will help to reduce the bad eﬀect of market freedom to some extent. 217 | Page MANAGERIAL ECONOMICS It will help to reduce the bad eﬀect of market freedom to some extent. 15.4 Meaning Of Price Control And Method Of Price Control Meaning of Price Control Price control is a form of Govt. intervenes in the economy in which Govt. agency uses its law making power to regulate the prices. Govt. enforces maximum or maximum price that can be charged for speciﬁed goods such as food and consumer goods are increasing sharply. It is used to keep cost of living within manageable range. It is best for the short term. In the long term it can lead to shortages, falling quality and black marketing. It is mostly used in developing countries. Due to inﬂation the poor cannot aﬀord to buy food grin and other essential goods. So the Govt. has to play an important role to reduce the bad eﬀects of inﬂation by enforcing the system of price control. Price control system will make the essential goods cheaper and help the people and inﬂation will not have bad eﬀect on the society. The Govt. of India has reduced the prices of wheat, rice and oil for the poor whereas the market prices are very high. The prices of gas, kerosene oil are also higher subsidized to enable the people to consume these necessary goods. 15.5 Method Of Price Control The Govt. has the power to control the prices and following are some of ways the Govt. control the prices by – a) Fixing of minimum and maximum power b) Break up of monopoly power c) Direct state provisions of goods and services d) Fiscal policy intervention e) Rationing f) Support and Administered prices g) Dual price system. a) Fixing of minimum and maximum power The Govt. ﬁxes the wholesale and retail prices of good grains and other essential goods in India to see that food grains and other essential goods are available to the common man at a low price. Similarly the Govt. can ﬁx the maximum price of diﬀerent product. For example drug prices are controlled and the maximum price, which a seller can 218 | Page MANAGERIAL ECONOMICS charge, is ﬁxed. The customer can negotiate and buy at less price also especially the prices of essential drugs are controlled. b) Break up of monopoly power Whenever monopoly power is exercised by the monopolist, and he begins to exploit the people, the Govt. can break up it power for encouraging the development of sure substitute. For this MRTP (Monopoly Trade Practice Act) has been empowered to take action. For example till 1982 in India Fiat/Ambassador cars had the monopoly right from 1947 onward. The development of Maruti cars has broken the monopoly power of these two car makers. In two wheeler industry Bajaj, Rajdoot were dominating the market but introduction of Hero Honda and other two wheelers have changed the scene fully. The Monopoly power is broken. c) Direct state provisions of goods and services When certain goods and services are very essential but need large capital investment and long period to receive the return. The state has to invest funds to make the project operational. The private sector will not enter such areas in India. Indian Railways has the monopoly and providing service at reasonable charges. Post and telegraph, telephone is other services but gradually the private sector is allowed to enter but still the Govt. has dominantly position and has a last say. d) Fiscal policy intervention Fiscal policy which can aﬀect the prices is taxation policy and public expenditure. Indirect taxes (also known as commodity tax) can be levied on luxuries and other non essential goods. This will make the good costly. But it will tax the essential goods at a lower tax rate and make these good aﬀordable to the society. Further public expenditure can deﬁnitely help in controlling the prices. It is done through subsidy on various goods of mass consumption like gas, kerosene oil, fertilizer etc. in India. The state can also help the poor, the aged people through transfer payment, by providing monetary assistance. For example the Govt. provides unemployment allowances in some states in India. The senior citizens are also receiving some monetary help and concessions from the state. The state also undertakes civic works to create employment. These steps help the unemployment to get some purchasing power and fulﬁll their needs. The Govt. is spending a lot of money to provide education and health 219 | Page MANAGERIAL ECONOMICS services to the poor to make them more useful to the society. e) Rationing is the controlled distribution of scarce resources of goods and services. It is an artiﬁcial restriction on demand to keep the price low. The Govt. is providing essential goods and services to the masses through Rationing and Public Distribution System or Fair Price Shops. Govt. also controls the prices of certain input so that the ﬁnal output is not costly. This is necessary to maintain stable price conditions and eﬃcient management of the supplies of essential consumer goods. These goods are agriculture based subject to seasonal variation. So the PDS is very essential to serve the poor and to provide the essential goods to them such as wheat, rice, oil, cloth, pulses etc. For this in India Food Corporation of India is doing the work of procuring food grain, storing them and make these available through PDS to the masses. The state trading buﬀer stock operation on one hand and the PDS on the other are essential in case of agriculture products. This keeps the prices under check and assures of constant supply of goods. f) Support and Administered prices Support price may be either by a subsidy or by a price control. The state gives subsidy on these goods which are essential for common man. For example the Govt. gives subsidy on petroleum products to make these cheaper for common man. The prices of gas and kerosene oil are highly subsidized whereas the price of diesel is less subsidized. Administered Prices- Under this the price of a good or service is dictated by a Governmental or governing agency. Administered prices are not determined by the market forces. Administered Prices are often imposed to maintain certain goods aﬀordable to the people to prevent price going up during the period of shortages. In India Administered Prices have stabilized the cost of commodities such as sugar, staple food etc. Similarly the interest rates are ﬁxed by the central bank through monetary policy. This interest rate is one of the deciding factors for investment. g) Dual price system. There are certain basic needs of the weaker section of the society, which should be meet the Govt. should subsidize these goods; such policy has to be in favour of vulnerable section of the society and should not discourage the producers from expanding production and 220 | Page MANAGERIAL ECONOMICS investment in the particular sector. It is mainly applied in case of sugar, food grains, edible oil, and cheaper variety of cloth. It is a short cut price control. The Govt. acquires certain percentage of output of sugar from the producer in the form of levy sugar at a lower price and distributes it through some agencies such as PDS etc. For example sugar is acquired under levy system and sold at a lower price to the people below the poverty line by Fair Price Shops on Ration Card. The higher income group has to pay higher price and buy sugar in the open market. 15.5.1 Prevention And Control Of Monopoly In free market, where competition is fundamental it is found that these producers who have resources and eﬃcient can compel the smaller unit out of business and become monopolist. If Govt. ﬁnds monopolistic tendencies, either the Govt. can ﬁx the price and quality of the product or nationalize it. Especially state monopoly is necessary in the ﬁeld of public utilities i.e. water supply, electricity generates distribution and gas supply. Rail and road transport may be subject to wasteful competition and so it has to be under state monopoly. The Govt. of Indi has passed anti monopoly act (MRTP) to control monopolistic tendencies. Under this act an oﬃcer is appointed to look into this problem and recommend necessary action. Activity II: a) Explain the idea o rationing _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ b) Support price _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ 221 | Page MANAGERIAL ECONOMICS 15.6 Summary Unit 15 is regarding the need of the Govt. intervention in the free market and economy. Free market has ﬁled in many areas which has aﬀected the economy and has created many problems. Hence the Govt. intervention is felt necessary to control and regenerate the free market. This intervention of the Govt. is necessary to reduce the suﬀerings of the people and regulate its bad eﬀects on the economy. It is seen that there is a lot of ﬂuctuation in the economic activities in the free market. These ﬂuctuations cause inﬂation and depression in the economy which increase the suﬀerings of the people. During inﬂation, the poor suﬀer and essential goods are beyond their reach. Similarly during depression a large number of workers become unemployed and economic activities are at lower level and wages are low. So it is necessary to have some control over the prices of essential products and service so that the poor can aﬀord to buy these goods and services. So the Govt. adopts various methods to control the prices by adopting price control, ﬁxing minimum and maximum prices. The Govt. also provides subsidy on essential goods to make some goods cheaper. It adopts the policy of dual price system. The main idea of govt. intervention is to make the essential goods available to the masses at reasonable price. 15.7 Keywords Administered Price is imposed by the Govt. or governing agency to make some essential goods aﬀordable to the poor. Duel Price. Where diﬀerent prices are charged for identical product from diﬀerent people Support Price. It may be either subsidy or a price control in order to keep the market price higher than the free market price. Price control A price control is the minimum legal price a seller my chare. It is ﬁxed by the Government. Rationing is the controlled distribution of scarce resources, goods or services. It controls the size of the ration and everyone is assured of getting certain amount of goods or services. Exclusion Principle The owner of private goods may exclude others from use unless they pay for it. 222 | Page

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