Managerial Economics – Page 1

ASSIGNMENT

Q1. What is Managerial Economics? Explain the nature and cope of

Managerial Economics?

Ans. Managerial Economics refer to the integration of economic theory with

business practice. While economics provides the tools which explain
various concepts of Demand, Supply, Price, etc. managerial economics
applied these tools to the management of business.

Managerial Economics is concerned with using logic of economics,

mathematics and statistics to provide effective ways of thinking about
business decision problems – Prof. Hague.

In simple words, management deals with principles which help in decision

making under uncertainty & improve effectives of organization and
economics, on the other hand, provides a set of propositions for optimum
allocation of scarce resources to achieve the desired objectives.

NATURE OF MANAGEMENT ECONOMICS

i) Helps in Decision Making: Managerial economics aims at providing help
in decision making based on the propositions of micro economic theory i.e.
study of the phenomenon at the individual’s level behaviour of individual
consumers, firms. The concepts frequently covered by managerial
economics are: (i) elasticity of demand, (ii) marginal cost, (iii) marginal
revenue, (iv) market structures and their significance in pricing policies, etc.

ii) Assists Firms in Forecasting: Forecasting is an important aspect of the

managerial economics. Macro economics studies the economy at an
aggregative level. For eg: (i) the magnitude of investment and the level of
employment (iii) the level of consumption and the national income, etc.,
This helps in identifying the level of demand at some future time based on
the relationship of national income and demand for a particulate product.

For Eg.: The demand for cars depends upon the level of national income,
etc.

iii) Applied Branch of Knowledge: Managerial economics lays emphasis on

those propositions which are likely to be useful to the management.
Improvement in the accuracy of the results is attempted, provided the
additional cost is not very high and the decision maker can wait. Accurate
forecasting is not justified on the grounds of time and cost.
 Managerial Economics – Page 2

iv) Prescriptive in Nature & Character: Managerial Economics is

prescriptive in nature and character in the sense that it recommends steps be
taken under alternative conditions. The example, if the analysis suggests
that the cost-benefit ratio of a large plant is less than that of a smaller plant
and the ratio, is used as the criterion for project appraisal, the installation of
a small plant is recommended. Managerial economics is one of the
normative sciences and reflects upon the desirability.

v) Managerial Economics is an Applied Science: It is an applied science to

the extent that it uses economic thought. Economic thought uses deductive
logic, but to be sure of the findings, the propositions need to be verified
empirically.
For example, empirical studies verify whether cost curves of the firm are
actually U-shaped as suggested by the theory. In addition, there is an
attempt to generalize the proposition which provide a predictive character.

For eg.: Empirical studies may suggest that for every 1% rise in
advertisement cost or expenditure, the demand for a product shall increase
by 0.5%.

The nature of managerial economics suggests that it uses a scientific

approach. Some firms use past experience to set rules for future but by
using a systematic approach the quality of discussions can be improved.

SCOPE OF MANAGERIAL ECONOMICS

The scope of managerial economics is very wide and covers almost all the
problems and areas of the manager and firm. Its scope can be explained as:-
i) Demand Analysis & Forecasting: Managerial economics helps in
analyzing the various types of demand which in turn helps the manager to
estimate the demand for the products of his company. The estimation of
demand is not restricted to just current demand, but it also takes into
consideration the future demand. This is demand forecasting. He even
considers the income and cross elasticity.

ii) Production Function : Resources are scarce and have alternative uses.
Production is primarily based on inputs. The factors of production are
combined in such a way so as to yield maximum output. When the cost of
the factors of production increases, the combination is made such so as to
reduce the cost combination. This production function is applied by
managerial economics
iii) Cost Analysis: Managerial economics studies cost analysis also.
Determinants of cost, the relationship between cost and output, the forecast
of cost and profit, methods of estimating cost are all covered by managerial
economics. The success of a firm is dependent on the cost analysis.
iv) Inventory Management: Inventory means stock of raw materials and it
plays an important role. The problem faced by the firm is that what quantity
 Managerial Economics – Page 3

is an ideal quantity because if the stock is high, the capital is blocked which
could otherwise have been used productively. On the hand, if the stock is
low it can hamper production. Thus, managerial economics uses such
methods as would minimize the inventory cost. It also considers the need
for inventory control, classifies them and discusses its cost.
v) Advertising: Advertisement is also an area covered by managerial
economics. The problems of cost and the budget of advertising are fields
actually covered by the manager. Advertising forms an integral part of
decision making and forward planning because it is an important aspect that
what is produced is to be marketed.
vi) Price System: Pricing is one of the central functions of an enterprise. For
the determination of the price the cost of production is also considered,
along with a complete knowledge of the price system. Pricing is actually
guided by considerations of cost plus pricing ad the policies of public
enterprises. The system of pricing is different under different competitions
and for different markets. The other things to be considered are price
leadership and non-price competition. Thus, the price system touches the
various aspects of managerial economics and guides the manager towards
valid and profitable decisions.
vii) Resource Allocation: Resources are scarce and have to be allocated in such
a way so as to achieve optimization. The two kinds of problems are of
utmost importance and concern, firstly, how to arrive at an optimum
combination of inputs in order to get maximum output? Secondly, when the
prices of inputs increase, what type of sub-situation should be resort to?

viii) Capital Budgeting: Capital budgeting plays an important role for arriving
at meaningful decisions. The problems faced by the manager are: how to
ensure that capital becomes rational, how to face budgeting problems, how
to arrive at investment decisions under conditions of uncertainty, how to
effect a cost-benefit analysis, etc.
Some other areas covered by Managerial Economics are:-
i) Linear programming, its assumptions and solutions
ii) Decision making under risk and uncertainty
iii) Profit planning and investment analysis, etc.

Conclusion
Managerial Economics covers two important areas, decision making and
forward planning and these areas are essential for every stage of production,
marketing, etc. The nature and scope of managerial economics makes it
obvious that it is an applied economics.
 Managerial Economics – Page 4

Q2. State and Explain the law of demand. What are its exceptions?

Ans. Introduction – Demand can be defined as an effective desire, i.e. a desire

backed by means as well as willingness to pay for it. For a consumer’s
desire to become a ‘demand’ the following conditions must be fulfilled:-
a) Desire to possess a commodity,
b) Means (i.e. money) to purchase it, and
c) Willingness to part with the means for purchasing it

The demand is always at a prices and the consumer varies his consumption
according to changes in price. Such a variation has been described by the
law of demand.

THE LAW OF DEMAND

The law has been stated as, “Other things being equal, the higher the price
of a commodity, the smaller is the quantity demanded and lower the price,
larger is the quantity demanded”.

The law of demand states the relationship between the price levels and the
quantity demanded. The phrase “other things remaining the same “is a very
important qualifying phrase in the law because, demand does not depend on
price alone. It depends on many other factors like population, size of
income, prices of related commodities, etc.

The conventional law of demand, however, relates to the much simplified

demand function = D = f(P), where ‘D’ represents demand, ‘P’ price and
‘F’ the functional relationship. The relation between price and quantity
demanded is usually an inverse relation, indicating less being demanded at
higher price and more at lower price.

Explanation: The law of demand usually refers to market demand. The aw

of demand can be explained with the help of a demand schedule:-

Price of Commodity/Unity Quantity Demanded/Week

5 10
4 20
3 30
2 40
1 50

The above table represents a hypothetical demand schedule for a commodity ‘X’.T
he table clearly explains that with every fall in price there is an increase in the
quantity demanded and vice-versa. There is an inverse relation between price and
quantity demanded.
 Managerial Economics – Page 5

The above schedule can be better explained with the help of a demand curve:-
Y
D
5

1
D
0
10 20 30 40 50 X

In the figure, DD is the downward sloping curve indicating that the price and
quantity demanded have an inverse relation i.e. when price increases demand falls
and when price falls demand increases.

OX represents the quantity demanded per week.

OY represents the price per unit.

ASSUMPTIONS UNDERLYING THE LAW OF DEMAND

The law of demand is based on certain assumptions. The statement ‘other things
being equal’ is indicative of these assumptions. These assumptions are:-

i) No Change In Consumer’s Income: The law of demand assumes that the

income of the consumer remains constant. If the income of the consumer
rises, he may by more even at a higher price and if his income decreases he
may buy less even at a decreased price, thus, invalidating the law of
demand.

ii) No Change in Consumer’s Preferences: The law assumes that the habits,
tastes and preferences of the consumer remains constant. This is so because
if the preference or taste of consumers changes then his demand will shift
from one commodity to another and hill demand less even at decreased
price.

iii) No Change in Fashion: Fashion is an influencing the commodity in

question goes out of fashion the consumers will not buy more of it, even if
the price is less. Thus, the law of demand will not hold good if there is a
change in fashion and so it is assumed to be constant.

iv) No Change in the Prices of Related Goods: The prices of substitutes and
complementary goods are assumed to remain unchanged. If the prices of
 Managerial Economics – Page 6

substitutes change the demand will shift to substitutes and the consumer
will buy less even at a decreased price.

For Eg.: Tea & Coffee are substitute of each other. The change in the price
of one will affect the demanded of another.

Similarly, the change in the price of a complementary good will affect the
demand for a commodity, thereby invalidating the law of demand.

For Eg.: If the price of ink rises the demand for pen will fall, a factor other
than the price of the commodity itself, and so the law will not hold good.

v) No Expectations of Future Price Changes or Shortages: The consumer

expects the current price change to be normal and speculation is ignored. If
it is not so i.e. if the consumer expects a future change in price or shortage,
his demand will change accordingly.

Supposedly, he assumes a future price rise or shortage of a commodity he’ll

buy or demand more even at a higher price, hence invalidating the law of
demand.

For Eg.: If there is an expectation of shortage of onion in future, the

consumer will demand more even at a higher price, in order to store for
future use.

vi) No Change in Size, Age-Composition & Sex Ratio of Population: An

essential assumption of the law of demand is that the size of population or
age composition or sesc ratio is constant. This is so because with additional
buyers in the market, the total market demand may not contract with a rise
in price. Increased number of buyers would mean that even if an individual
demand would fall with a rise in price, the total market demand will remain
constant. This would violate the law.

vii) No Change in the Range of Goods Available to the consumers: This

assumption implies that there is no change in the range of goods currently
available in the market. If there’ll be a change the consumers preference
would change and will affect the demand. A variety in products gives an
option to the consumer to those and this leads to a fall in demand of a
commodity even at a less price.

viii) No Change in the Distribution of Income & Wealth of the Community:

There should be no change in the distribution of income and wealth of the
community because this would change the income level of the consumers,
which in turn would affect the demand for a commodity.
 Managerial Economics – Page 7

ix) No Change In Government Policy: This implies that the level of taxation
and fiscal policy of the government remains constant. Changes in income
tax would change a consumer’s income and changes in sales tax or excise
duty, etc. would change consumer’s preference thus changing the demand.

x) No Change in Weather Conditions: It is assumed that the climatic

conditions remain constant. This is so because climatic changes would
automatically change the demand for weather related commodities.

For Eg.: The demand for umbrellas would be more during rainy reason than
during winters.
The law of demand is actually a function of price alone. It does not consider
other factors that can affect a change in demand. Therefore, these
assumptions are necessary for the operation of the law of demand.

EXCEPTIONS TO THE LAW OF DEMAND

The law of demand operates on a universal phenomenon that when price
falls demand increases and when price rises demand decreases. But
sometimes, though very rarely, with a fall in price demand also falls and
with a rise in price demand also increases. This is a situation which is
contrary to the law of demand such cases are referred to as exceptions to the
law of demand. The demand curve in such a case is an upward sloping
curve and is represented as:-

Y
Price Per Unit

P2

P1

0
10 Q1 Q2 X

Quantity Demanded

EXCEPTIONAL DEMAND CURVE

In the figure, DD is the demand curve which slopes upward.
OX represents quantity demanded
OY represents price per unit
 Managerial Economics – Page 8

The graph clearly shows that when price is OP, the quantity demanded is
OQ and when price rises to OP2 demand also increases to OQ2.

The upward sloping curves is contradictory to the law of demand as it lays

stress on ‘more being demanded at a higher price and vice-versa’.

The exceptions to the law of demand can be categorized as:-

i) Giffen Goods: Sir Robert Giffin observed that sometimes people buy less
quantity of a commodity at lower price and more quantity at a higher price.
Such goods are called giffen goods or inferior goods and they exhibit an
assumption to the law of demand Giffen sited an example of low paid
British workers who bought more bread at higher price during the early
period of 19th century. This phenomenon is known as Giffin Pradox’.

For Eg.: If the price of inferior goods like cheap potatoes, bajra, etc. fall it’s
demand will also fall because consumers would then shift their demand to
superior goods also.

ii) Articles of Snob Appeal or ‘Status Symbol;: A commodity is bought

sometimes not because it has any intrinsic value, but because its possession
confers a social distinction on the holder.

Thus, when the prices of diamonds rise, their demand may expand because
being costlier they are considered a better mark of distinction and so rich
people purchase it more. The opposite will be true if their price falls.

iii) Speculation: If the price of a commodity is increasing and is expected to

increase still further, the consumers will buy more of the commodity at the
higher price than they did at lower price. Thus, an increase in price may not
be accompanied by a decrease in demand negativing the law of demand. In
the stock exchange market, some people tend to buy more shares when the
prices are rising, in the hope that the prices will continue to rise further and
they would earn profit.

iv) Psychological Bias Or Illusion: The consumers, at times, judges the

quality of a commodity by its price, i.e. higher the price, i.e. higher the price
letter the quality. In such cases the demand increases with a rise in price and
vice versa. The producers of several goods, such as cosmetics, have
discovered through experience that their sales g up with an increase in
price. This is the reason why some sophisticated consumers do by from the
stock clearance sales.

Thus, despite, these exceptions, the law of demand is a valid generalization

for most of the commodities sold in the market.
 Managerial Economics – Page 9

Conclusion
The law of demand states the inverse relationship between the price and
commodity. However, the law of demand is only an indicative and not a
quantitative statement. It indicates only the direction of change and not the
magnitude of change.

On the whole, it is not untrue to say that other things remaining the same,
more of a commodity is bought at a lower price than at a higher price,
though some consumers behave in an opposite manner.
 Managerial Economics – Page 10

Q3. State and Explain the Law of Variable Proportion

Ans. Introduction: The law of diminishing returns is a very old economic law.
The classical economists like Adam Smith, Ricardo & Mathus associated
the law of diminishing returns with agriculture. But modern economists do
not agree with this view. They are of the opinion that this law can be
operational in any industry at any stage of production, without linking them
to any specific sector.

The law which explain the relationship between the change in the
proportions between fixed and variable inputs and increased output is
known as the law of variable proportions. The law of variable proportion is
the new name for ‘Law of Diminishing Returns’.

STATEMENT OF THE LAW

The law of variable proportion state that, “if one factor of production is fixed while
another factor of production (variable) is increased, average and marginal products
will rise, reach a maximum and then decline.

ASSUMPTIONS OF THE LAW OF VARIABLE PROPORTION

The law of variable proportion holds good only under the following conditions:-
i) Constant state of Technology: The law is primarily based on the
assumption that the techniques of production remain constant. If there is an
improvement in technology, then marginal and average product may rise
instead of diminishing. This does not imply that the use of improved
methods and techniques in production will stop the operation of the law, but
will just postpone it to some future date.

ii) Homogeneous Nature of Units of Variable Factors of Production: It is

assumed that the various are exactly similar to each other. If the units of
variable to each other. If the units are dissimilar, i.e., say if the variable
factors used later are bigger in size than before then the increments in
output maybe larger than before. The law of diminishing returns or variable
proportions may thus be rendered inoperative.

iii) Variable Proportion of Productive Factors: The law assumes the

possibility of varying the proportions in which the various factors can be
combined to produce a product. The law will fail to work if the proportions
between factors are fixed.

iv) Quantity of Some Inputs Kept Fixed: There must be some input whose
quantity is kept fixed because it is only this way that we can alter the factor
proportions and know its effect on output. If all the inputs are variable then
the actual effect on output cannot be analysed.
 Managerial Economics – Page 11

v) Variable Factors Are Divisible: It is assumed that units of variable factor

are divisible into smaller homogeneous units. Divisibility helps in altering
the proportion of factors and homogeneity is an essential assumptions of the
law of variable proportion. But, this assumption may not always be true.

vi) Law Concerned with Only Physical Quantity & Not its monetary
values: The law relates to physical quantities, of the factors of production
are conceived in monetary terms. The law considers only physical
relationship between factor inputs and output of products.

vii) Organizational Structure & Managerial Efficiency Remains

Unchanged: The law assumes that the organizational structure and
managerial efficiency is increased then the marginal product and average
product may rise instead of diminishing.

EXPLANATION OF THE LAW OF VARIABLE PROPORTIONS

The law of variable proportion actually covers all the tree stages i.e. increasing
returns, constant returns and diminishing returns. This can**

THE PRODUCTION SCHEDULE

Fixed Factor Variable Total Product Average Marginal
(say land & factor (labour (Units) (T.P.) Product Product
Cap.) Units) (Units) (A.P (Units) (M.P.)
K 1 8 8 810 Increasing Returns
K 2 18 9 12
K 3 30 10
K 4 44 11 14 Constant Returns
K 5 58 11.6 14
K 6 72 12 14
K 7 80 11.4 18 Diminishing
K 8 80 10 10 Returns
K 9 76 8.4 -4 Negative Return

OBSERVATION OF THE TABLE: RELATIONSHIP:

The above table shows that the total product also declines but the marginal product
declines first. The relationship between them can be explained as:-

i) As long as average product is rising, the marginal product is large than

average product.

ii) When average product is decreasing, margin product is less than average
product, as from 7th labour unit to 9th labour unit.

iii) Total Product is maximum when marginal product is zero, as in 8ty labour
unit.

iv) When total product falls, marginal product becomes negative like in 9th
labour unit.
 Managerial Economics – Page 12

v) The table shows that as the number of units of labour increase marginal
product rises from 8 to 10 to 12 and then 14. This shows that the total
product is increasing at an increasing rate. This is the stage of increasing
return.

vi) After the 4th labour unit the total output increases but at a constant rate and
so the marginal product does not change.

It remains the same at 14 units upto 6th labour unit. This is the 2nd stage of
the law and represents constant returns.

vii) After the 6th labour unit the marginal product continuous to fall. This is the
33rd stage of diminishing returns and finally reaches negative returns. The
law of variable proportion can also be represented on a graph as:-

The above graph clearly shows that T.P. curve goes on increasing to a point
and after that it starts declining. AP & MP curve also rises and then
declines. MP curve declines faster than AP curve. The law can be divided
into three stages:-

State I: Increasing Returns

In this stage T.P. to a point increases at an increasing rate. In the figure, upto point
F, the slope of the TP curve in increasing at an increasing rate, which means MP
rises.

During state I, the quantity of fixed factor in abundant relative to the quantity of
variable factor. As more and more units of variable factor. As more and more units
of variable factors are added to constant quantity of fixed factor, the fixed factor
(land or capital) gets more intensively and effectively utilized and the production
increases at an increasing rate.

Stage II- Constant Returns

In this state, TP increases but at a constant rate. In the figure, from F to G the T.P.
curve is increasing at a constant rate, which means MP is constant.

During stage II, the quantity of fixed factor is constant but is enhanced by the
addition of variable factor. At this stage, the addition of variable factor does
increase the T.P. but not as much as in stage I i.e. the T.P. increases but at a
constant rate and the M.P. is constant.

Stage III – Diminishing Returns and Negative Returns

In this stage T.P. increases but at a diminishing rate and then declines. From point
G, T.P. first increases at a diminishing rate and starts to decline and M.P.
diminishes but is positive, then zero and then becomes negative. The point G,
where the TP starts to increase at a diminishing rate is called the point of inflexion
corresponding to this point M.P. is maximum after which it starts to decline.
 Managerial Economics – Page 13

During stage III, the quantity of variable factor added increases the T.P. but at a
diminishing rate and then starts to decline. This is so because after appoint, an
addition in the variable factor would make the fixed factor inadequate and so M.P.
& A.P. will fall.

EXCEPTIONS/LIMITATIONS TO THE LAW OF DIMINISHING

RETURN

i) New Methods of Cultivation: The law of variable proportion assumes no

change in the technique of production scientific rotation of crops, better
quality seeds, modern implements, etc are the regular changes which take
place in agriculture. In such a case the marginal product will in fact
increase. So, this stands as an exception to the law of diminishing returns.

ii) New Soil: New land (soil) brings about better cultivation such a land is
supposed to be more fertile and so the marginal product will increase for a
time. Thus, the law of diminishing returns does not operate in the
beginning.

iii) Insufficient Capital: If the capital is not sufficient more capital will be
required. The increase in capital will give more than proportionate return,
but later the marginal return will decrease. The early stage is an exception
to the law of variable proportion.

IMPORTANCE OF THE LAW OF VARIABLE PROPORTION

i) Universal Applicability: The law is a fundamental law which is not
applicable in agriculture and industries alone, rather it is of universal
applicability, such, mining, fishing, housing, etc in all branches of
production.

ii) Basis of Mathus Theory of Population: Mathu’s theory of populations

states that the food supply does not increase of the operation of the law of
diminishing returns in agriculture.

iii) Basis of Ricardo’s Theory of Rent: Rent arises in the Ricardian sense
because the operation of the law of diminishing returns on land forces the
application of additional doses of labour and capital on a piece of land but
does not increase the output in the same proportion due to the operation of
this law.

iv) Migration of Population: This law is responsible for migration of

population from one country to another. The migration of population is
because of two reason.
 Managerial Economics – Page 14

i) Pressure on land due to increase in population and (ii) reduction in the

amount of production on account of the operation of law of diminishing
returns.

v) Basis of Marginal Productivity Theory: The return to factors of

production is given to marginal productivity theory which itself is based on
the law of diminishing returns.

vi) Underdeveloped Countries: Agriculture is the main occupation of

underdeveloped countries and so the law of diminishing returns is of utmost
importance for them.

vii) Affects the Standard of Living of the People: The standard of living is
affected in the sense that where the population increases at a faster rate than
agriculture and other production, capital, etc the standard is bound to lower
on account of the operation of law of diminishing returns.

viii) Responsible for New Researches and Inventions: The law of diminishing
returns is also responsible for new researches and inventions which take
place in a country simply to check it.

Conclusion
The above explanation of the law of variable proportion explains clearly that the
modern approach has a wider meaning. According to the modern economists, the
law works not only in agriculture, but also in other fields of economic activity
including manufacturing industries. The modern version of the law of return is that
the total output increases, first at an increasing rate and later at a diminishing rate
but the old approach was that output increases only at a diminishing rate. Lastly,
the modern approach says that the law will operate in all those activities where one
or two factors of production are fixed while others are variable, while the old
approach assumed land alone to be fixed factor.
 Managerial Economics – Page 15

Q4. Define “Business Cycle” Explain various phases of Business Cycle?

Ans. Introduction – Business cycle is a part of the capitalist system. It refers to

the phenomenon of cyclical booms and depressions. In a business cycle
there are wave – like fluctuations in aggregate employment, income, output
and price level. They influence business decisions tremendously and set the
trend for future business. The period of prosperity opens up new and larger
opportunities for investment, employment and production and thereby
promotes business. On the other hand, depression reduces the business
opportunities.

Definitions
The term business cycle has been defined in various ways by different economists.

Prof. Harberber’s is very simple, “The business cycle in general sense may be
defined as an alteration of periods of prosperity and depression of good and bad
trade”.

Keyness definition is more explicit, “A trade cycle is composed of periods of good

trade characterized by rising prices and low unemployment percentages, altering
with periods of bad trade characterized by falling prices and high unemployment
percentages”.

CHARACTERISTICS OF TRADE CYCLE

i) A business cycle is a wave like movement
ii) Expansion and contraction in a business cycle are cumulative in effect
iii) Business cycle operates periodically at fairly regular intervals of 10 to12
years
iv) Business cycle is of an all embracing nature i.e. it prevails in all areas of a
country.
v) Business cycle is characterized by expansion and contraction in a business.
vi) A trade cycle is characterized by the presence of crisis. ie. The pea and the
trough are not symmetrical i.e, the downward movement is more sudden
and violent than the change from downward to upward.
vii) Though cycles differ in timing and amplitude, they have a common pattern
of phases which are sequential in nature.

Phases of Business Cycle

The ups and downs in the economy are reflected by the fluctuations in aggregate
economic magnitudes, such as, production, investment, employment, prices,
wages, bank, credits, etc. The upward and downward movement in these
magnitudes show different phases of a business cycle. Basically there are two
phases, prosperity and depression, but considering the intermediate stages it has be
divided into five phases:-
1) Expansion, 2) Peak, 3) Recession, 4) Trough and 5) Recovery & expansion
 Managerial Economics – Page 16

These phases are uniform and recurrent in the case of different cycles. But no
phase has definite periodicity or time interval.

The give phases of the cycle can be figurised as:-

Growth Rate

Y
Steady Growth Line

Prosperity

Prosperity
Depression

0
Time X

Business Fluctuations
In the above figure, OX shows the time period and OY shows the growth rate. The
steady growth line shows the growth of the economy when there are no economic
fluctuations. The various phases of the business cycle are shown by the line of
cycle which moves up and down the steady growth line. The line of cycle moving
above the steady growth line marks, the beginning of the period of expansion
which reaches a peak and when the downward slide in the growth rate becomes
rapid and steady the phase of recession begins. When the growth rate goes below
the steady growth rate, it makes the beginning of depression in the economy.
Trough is the phase during which the down trend in the economy slows down and
eventually stops and the economic activities once again start an upward movement.
Through this upward movement the economy enters the phase of recovery though
the growth rate remains below the steady growth line. When it exceeds this line it
enters the phase of expansion and prosperity.

The various phases can be described as:-

1) Expansion: In the prosperity or expansion phase, demand, output,
employment and income are at a high level. They tend to raise prices. But
wages, salaries, interest rates, rentals and taxes do not rise in proportion to
the rise in prices The gap between prices and costs increase the margin of
profit. The economy is engulfed in waves of optimism. Larger profit
expectations further increases investment which is helped by liberal bank
credit. They lead to considerable expansion in economic activity by
increasing the demand for consumer goods and further raising the price
 Managerial Economics – Page 17

level. This encourages retailers, wholesalers and manufacturers to add to

inventories. In this way, the expansionary process becomes cumulative and
self rein-forcing.

2) Peak: The expansionary process comes to a halt when the economy reaches
a very high level of production, known as the peak or loom. The peak may
lead the economy to over full employment and to inflationary rise in prices.
It is an indication of the end of the prosperity phase and beginning of
recession. The seeds of recession are contained in the loom in the form of
strains in the economic structure. They are:-
i) Scarcities of labour, raw material, etc. leading to rise in costs relative to
price, which brings a decline in profit margins.
ii) Rise in the rate of interest due to scarcity of capital, which makes
investments costly and along with the first lowers business expectations.
iii) Failure of consumption to rise due to rising prices and stable propensity to
consume when incomes increase, which leads to the piling up of inventories
indicating that sales or consumption lags behind production.

3) Recession: Recession starts when there is a downwards descend from the

‘peak’. Once the economy reaches the peak, increase in demand is hated. It
even starts decreasing in some sector producers and unaware of this fact
continue to maintain their existing levels of production and investment. As
a result, profit margins decline further because costs start overtaking
production and by to sell out of accumulated stocks. Investment,
employment, incomes and demand decline.

Produces even reduce prices to get rid of stock, but, consumers postpone
their purchases expecting a further reduction in price. As a result, the gap
between demand and supply grows further When this process gathers speed,
the recession becomes irreversible Investment decline which leads to a
decline in income and consumption. Curtailed investments reduces the
demand for both consumer and capital goods. At this stage, the process of
recession is complete and the economy enters the phase of depression.

4) Depression & Trough: During depression there is a general decline in the

economic activity. There is a considerable reduction in the production of
goods and services, employment, income, demand and prices. The general
decline in economic activity leads to a fall in bank deposits credit expansion
stops because the business community is not willing to borrow. Bank rates
fall considerably.

Thus, a depression is characterized by mass unemployment; general fall in

prices, profits, wages, interest rate, consumption, expenditure, investment,
bank deposits and loans; factories close-down, and construction of all types
of capital goods, buildings, etc come to a ‘standstill. These forces are
cumulative and self-reinforcing and the economy is at the trough.
 Managerial Economics – Page 18

The trough or depression may be short-lived or it may continue at the

bottom for considerable time. But sooner or later limiting forces are set in
motion which ultimately tend to bring the contraction, phase to end and
pane the way for the revival.

5) Recovery: As the recovery gathers momentum, some firms plan additional

investment, some undertake renovation programmes and some undertake
both. Suppose the semi-durable goods wear out which necessitate their
replacement in the economy, it leads to an increased demand. To meet this
demand, investment and employment increase. Industry begins to revive.
Revival also starts in related capital goods industries. Once begun, the
process of revival becomes cumulative. As a result, the levels of
employment, income and output rises steadily in the economy. In the early
stages of the revival phase, there is considerable excess or idle capacity in
the economy so that output increases without a proportionate increase in
total costs. Profit increases. Investment is encouraged which tends to raise
the demand for bank loans. It leads to credit expansion

With this process catching up, the economy enters the phase of expansion &
prosperity. The cycle is thus complete

CAUSES OF TRADE CYCLE

i) Expansion & Contraction of Loans by bank: When banks adopt the

policy of credit expansion, firms are in a better position to borrow and so it
leads to the phase of prosperity.

On the other hand, when the banks contract the loads, it leads to depression.

ii) Savings & Investment: When there is over investment it leads to the phase
of prosperity and when there is under investment it leads to the phase of
adversity.

iii) Demand & Supply: If the demand of goods is more than its supply it
causes a phase of prosperity because more demand means, greater
production and higher profits when the supply is more than demand it leads
to adversity as it causes the stock to be held and capital being blocked.

iv) Income and Expenditure of Consumers: If the income of consumers is

more than their expenses, they tend to save and invest more and this leads
to a phase of prosperity. On the other hand, if the expenditure is more than
income it leads to a phase of adversity.
 Managerial Economics – Page 19

v) Seasonal Fluctuations: Seasonal fluctuations affect agricultural production

to a large extent, which in turn causes trade cycle. If the climatic conditions
are favourable for a particular crop, then it leads to a phase of prosperity.
On the other hand, if the conditions are unfavourable it causes a phase of
depression.

vi) Development of New Technologies of Production: Technology plays a

great role in any industry technology affects the growth of any kind of
industry in the sense that the technology develops with passage of time it
causes prosperity. At the same time, if there is no advancement of
technology it causes depression because the gap between cost and price
increases.

vii) Feelings of Entrepreneurs: An important cause of trade cycle is the

feeling of entrepreneurs. If the entrepreneurs are optimistic it will lead to a
phase of prosperity because they will invest more. But, if they are
pessimistic it will cause a phase of depression.

viii) Psychology of Consumers: If the consumers are hopeful and optimistic it

will demand more. An increase production investment, etc. and hence
would cause a phase of prosperity. But, if they are pessimistic then it would
cause a phase of adversity.

Conclusion
Business fluctuations, booms and slumps, in the economic activities form
essentially the economic environment of a country. A profit maximizing
entrepreneur must therefore analyze the economic environment of the period
relevant for his important business decisions, particularly those pertaining to
forward planning. A good planning forms the basis for the success of any business.

The behaviour of a business cycle is difficult to determine because of the

multitudinous factors and circumstances that lie behind cyclical fluctuations.
 Managerial Economics – Page 20

Q5. Write short notes on: (e) Fiscal Policy

Ans.(e)
Introduction – Fiscal body refers to the whole body of policies dealing with
the revenue – expenditure process of the government. On the revenue side,
it involves the decisions regarding the taxes to be imposed (including the
rates of taxation), the public debt to be issued, etc. On the expenditure side,
it refers to the decision regarding the total amount of public expenditure to
be undertaken as well as its distribution among the different heads of
expenditure. Thus, taxes, subsidies, public debt, and public expenditure ar
the instruments of fiscal policy. Public expenditure increases the flow of
funds into the private economy and at the same time, taxation reduces
private disposable income.

The objectives of fiscal policy can be as an instrument of economic

stabilization. It is importance rests on the fact that government activities in
modern economics are greatly enlarged and government tax-reverse and
expenditure account for a considerable proportion of GNP, ranging from
10-25 per cent. Therefore the government may affect the private economic
activities to the same extent through variations in taxation and public
expenditure.

(f) Monetary Policy

It is the programme of the Central Bank’s variations, in the total supply of
money and cost of money to achieve certain pre determined objectives. It’s
primary aim is to achieve economic stability. The instruments used to carry
out the monetary policies are:

Quantitative credit control measures such as open market operations,

changes in bank rate (or discount rate) and changes in the statutory reserve
ratios.
Elaborating on the aboresaid terms:
Open Market Operations is the sale and purchase of government boards,
treasure bills, securities, etc to and from the public.
Bank Rat is the rate at which bank (central) discounts the commercial
bank’s bills of exchange of first class bill.

Statutory Reserve Ratio is the proportion of commercial bank’s time and

demand deposits, which they are required to deposit with the central bank
or keep cash in vault.

All these instruments when operated by the central bank reduce (or
enhance) directly or indirectly the credit creation capacity of the
commercial banks and thereby reduce (or increase) the flow of funds from
the banks to the public.
 Managerial Economics – Page 21

(c) Economic Stabilization

Stabilization broadly means preventing the extremes of ups and downs or
booms and depression in the economy without preventing factors of
economic growth to operate.

Economic stabilization also implies preventing over and under employment.

Stabilization should permit a reasonable degree of flexibility.

It’s major objectives are:

(i) Preventing excersise economic fluctuations
(ii) Efficient utilization of labor and productive resources as far as
possible
(iii) Encouraging free competitive enterprise with minimum interference
with the functioning of the market economy. The two most important
and widely used economic policies to achieve economic stability are
fiscal policy and monetary policy.