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Q.No.1: Mention the demand function. What is elasticity of demand? Describe the determinants of
elasticity of demand.
Answer: Demand function: The demand for a product or service is affected by its price, the income
of the individual, the price of other substitutes, population, habit etc Thus we can say that dem and is
a function of the price of the product, and others as mentioned above.
Demand function is a comprehensive formulation, which specifies the factors that influence the
demand for a product. Mathematically, a demand function can be represented in the f ollowing
manner.
Elasticity of Demand
In economics the term elasticity refers to a ratio of the relative changes in two quantities. It measures
the responsiveness of one variable to the changes in another variable.
The elasticity of demand depends on several factors of which the following are some of the
important ones.
2. Existence of Substitutes
Substitute goods are those that are considered to be economically interchangeable by buyers. If a
commodity has no substitutes in the market, demand tends to be inelastic because people have to
pay higher price for such articles. For example. Salt, onions, garlic, ginger etc. In case of
commodities having different substitutes, demand tends to be elastic. For example, blades, tooth
pastes, soaps etc.
7. Range of Prices
There are certain goods or products like imported cars, computers, refrigerators, TV etc, which are
costly in nature. Similarly, a few other goods like nails; needles etc. are low priced goods. I n all these
cases, a small fall or rise in prices will have insignificant effect on their demand. Hence, demand for
them is inelastic in nature. However, commodities having normal prices are elastic in nature.
9. Habits
When people are habituated for the use of a commodity, they do not care for price changes over a
certain range. For example, in case of smoking, drinking, us e of tobacco etc. In that case, demand
tends to be inelastic. If people are not habituated for the use of any products, then demand
generally tends to be elastic.
Demand forecasts for short periods are made on the assumption that the company has a given
production capacity and the period is too short to change the existing production capacity.
Generally it would be one year period.
· Production planning: It helps in determining the level of output at va rious periods and avoiding
under or over production.
· Helps to formulate right purchase policy: It helps in better material management, of buying inputs
and control its inventory level which cuts down cost of operation.
· Helps to frame realistic pricing policy: A rational pricing policy can be formulated to suit short run
and seasonal variations in demand.
· Sales forecasting: It helps the company to set realistic sales targets for each individual salesman
and for the company as a whole.
· Helps in estimating short run financial requirements: It helps the company to plan the finances
required for achieving the production and sales targets. The company will be able to raise the
required finance well in advance at reasonable rates of interest.
· Reduce the dependence on chances: The firm would be able to plan its production properly and
face the challenges of competition efficiently.
· Helps to evolve a suitable labour policy: A proper sales and production policies help to determine
the exact number of labourers to be employed in the short run.
Long run forecasting of probable demand for a product of a company is generally for a period of 3
to 5 or 10 years.
1. Business planning:
It helps to plan expansion of the existing unit o r a new production unit. Capital budgeting of a firm is
based on long run demand forecasting.
2. Financial planning:
It helps to plan long run financial requirements and investment programs by floating shares and
debentures in the open market.
3. Manpower planning:
It helps in preparing long term planning for imparting training to the existing staff and recruit skilled
and efficient labour force for its long run growth.
4. Business control:
Effective control over total costs and revenues of a company he lps to determine the value and
volume of business. This in its turn helps to estimate the total profits of the firm. Thus it is possible to
regulate business effectively to meet the challenges of the market.
The entire theory of production centre round the concept of production function. “A production
Function” expresses the technological or engineering relationship between physical quantity of
inputs employed and physical quantity of outputs obtained by a firm. It specifies a flow of output
resulting from a flow of inputs during a specified period of time. It may be in the form of a table, a
graph or an equation specifying maximum output rate from a given am ount of inputs used. Since it
relates inputs to outputs, it is also called “Input -output relation.” The production is purely physical in
Generally speaking, there are two types of production functions. They are as follows.
In this case, the producer will keep all fixed factors as constant and change only a few variable
factor inputs. In the short run, we come across two kinds of production functions:
1. Quantities of all inputs both fixed and variab le will be kept constant and only one variable input
will be varied. For example, Law of Variable Proportions.
2. Quantities of all factor inputs are kept constant and only two variable factor inputs are varied.
For example, Iso -Quants and Iso -Cost curves.
Though production function may appear as highly abstract and unrealistic, in reality, it is both logical
and useful. It is of immense utility to the managers and executives in the decision making process at
the firm level.
There are several possible combinations of inputs and decision -makers have to choose the most
appropriate among them. The following are some of the important uses of production function.
1. It can be used to calculate or work out the least cost input combination for a given outpu t or the
maximum output -input combination for a given cost.
2. It is useful in working out an optimum, and economic combination of inputs for getting a certain
level of output. The utility of employing a unit of variable factor input in the production proces s
can be better judged with the help of production function. Additional employment of a variable
factor input is desirable only when the marginal revenue productivity of that variable factor input
is greater than or equal to cost of employing it in an orga nization.
3. Production function also helps in making long run decisions. If returns to scale are increasing, it is
wise to employ more factor units and increase production. If returns to scale are diminishing, it is
unwise to employ more factor inputs & increase production. Managers will be indifferent whether to
increase or decrease production, if production is subject to constant returns to scale.
Thus, production function helps both in the short run and long run decision – making process.
External Economies
These economies will arise as a result of getting quick, latest and up to date information from various
sources. Another form of benefit that arises due to localization of industry is economies of
information. Since a large number of firms are loca ted in a region, it becomes possible for them to
exchange their views frequently, to have discussions with others, to organize lectures, symposiums,
seminars, workshops, training camps, demonstrations on topics of mutual interest. Revolution in the
field of information technology, expansion in inter -net facilities, mobile phones,
e-mails, video conferences, etc. has helped in the free flow of latest information from all parts of the
globe in a very short span of time. Similarly, publication of journals, ma gazines, information papers
etc have helped a lot in the dissemination of quick information. Statistical, technical and other
market information becomes more readily available to all firms. This will help in developing contacts
between different firms. Whe n inter-firm relationship strengthens, it helps a lot to economize the
expenditure of a single firm.
3. Economies of Disintegration
These economies will arise as a result of dividing one big unit in to different small units for the sake of
convenience of management and administration. When an industry grows beyond a limit, in that
case, it becomes necessary to split it in to small units. New subsidiary units may grow up to serve the
needs of the main industry. For example, in cotton textiles industry, some firms may specialize in
manufacturing threads, a few others in printing, and some others in dyeing and coloring etc. This will
certainly enhance the efficiency in the working of a firm and cut down unit costs considerably.
These economies will arise as a result of active support and assistance given by the government to
stimulate production in the private sector units. In recent years, the government in order to
encourage the development of private industries has come up w ith several kinds of assistance. It is
granting tax-concessions, tax-holidays, tax-exemptions, subsidies, development rebates, financial
assistance at low interest rates etc.
It is quite clear from the above detailed description that both internal and exte rnal economies arise
on account of large-scale production and they are benefits to a firm and cost reducing in nature.
These economies will arise due to the availability of favorable physical factors and environment. As
the size of an industry expands, positive physical environment may help to reduce the costs of all
firms working in the industry. For example, Climate, weather conditions, fertility of the soil, physical
environment in a particular place may help all firms to enjoy certain physical benefits.
6. Economies of Welfare
These economies will arise on account of various welfare programs under taken by an industry to
help its own staff. A big industry is in a better position to provide welfare facilities to the worker s. It
may get land at concessional rates and procure special facilities from the local governments for
setting up housing colonies for the workers. It may also establish health care units, training centers,
computer centers and educational institutions of all types. It may grant concessions to its workers. All
these measures would help in raising the overall efficiency and productivity of workers.
Internal Economies:
2. Managerial Economies:
They arise because of bette r, efficient, and scientific management of a firm. Such economies arise in
two different ways.
a) Delegation of details: The general manager of a firm cannot look after the working of all
processes of production. In order to keep an eye on each production process he has to delegate
some of his powers or functions to trained or specialized personnel and thus relieve himself for co -
ordination, planning and executing the plans. This will enable him to bring about improvements in
production process and in bring ing down the cost of production.
b) Functional Specialization: It is possible to secure economies of large scale production by dividing
the work of management into several separate departments. Each department is placed under an
expert and the rest of the work is left into the hands of specialists. This will ensure better and more
efficient productive management with scientific business administration. This would lead to higher
efficiency and reduction in the cost of production.
4. Financial Economies
They arise because of the advantages secured by a firm in mobilizing huge financial resources. A
large firm on account of its reputation, name and fame can mobilize huge funds from money
market, capital market, and other private financial inst itutions at concessional interest rates. It can
borrow from banks at relatively cheaper rates. It is also possible to have large overdrafts from banks.
5. Labor Economies
These economies will arise as a result of employing skilled, trained, qualified and highly experienced
persons by offering higher wages and salaries. As a firm expands, it can employ a large number of
highly talented persons and get the benefits of specialization and division of labor. It can also impart
training to existing labor force in order to raise skills, efficiency and productivity of workers. New
schemes may be chalked out to speed up the work , conserve the scarce resources, economize the
expenditure and save labor time. It can provide better working conditions, promotional
opportunities, rest rooms, sports rooms etc, and create facilities like subsidized canteen, crèches for
infants, recreations. All these measures will definitely raise the average productivity of a worker and
reduce the cost per unit of output.
1. A firm is a producing unit and as such it conver ts various inputs into outputs of higher value under
a given technique of production.
2. The basic objective of each firm is to earn maximum profit.
3. A firm operates under a given market condition.
4. A firm will select that alternative course of acti on which helps to maximize consistent profits
1. A firm makes an attempt to change its prices, input and output quantity to maximize its profit.
Profit-maximization implies earning highest possible amount of profits during a given period of time.
A firm has to generate largest amount of profits by building optimum productive capacity both in
the short run and long run depending upon various internal and external factors and forces. There
should be proper balance between short run and long run objectives. I n the short run a firm is able
to make only slight or minor adjustments in the production process as well as in business conditions.
The plant capacity in the short run is fixed and as such, it can increase its production and sales by
intensive utilization of existing plants and machineries, having over time work for the existing staff etc.
Thus, in the short run, a firm has its own technical and managerial constraints. But in the long run, as
there is plenty of time at the disposal of a firm, it can expand and add to the existing capacities
build up new plants; employ additional workers etc to meet the rising demand in the market. Thus, in
the long run, a firm will have adequate time and ample opportunity to make all kinds of adjustments
and readjustments i n production process and in its marketing strategies.
It is to be noted with great care that a firm has to maximize its profits after taking in to consideration
of various factors in to account. They are as follows –
1. Pricing and business strategies o f rival firms and its impact on the working of the given firm.
2. Aggressive sales promotion policies adopted by rival firms in the market.
3. Without inducing the workers to demand higher wages and salaries leading to rise in operation
costs.
4. Without resorting to monopolistic and exploitative practices inviting government controls and
takeovers.
5. Maintaining the quality of the product and services to the customers.
6. Taking various kinds of risks and uncertainties in the changing business environment .
7. Adopting a stable business policy.
8. Avoiding any sort of clash between short run and long run profits in the business policy and
maintaining proper balance between them.
9. Maintaining its reputation, name, fame and image in the market.
10. Profit maximization is necessary in both perfect and imperfect markets. In a perfect market, a firm
is a price-taker and under imperfect market it becomes a price -searcher.
Profits of a firm are estimated by making c omparison between total revenue and total costs. Profit is
the difference between TR and TC. In other words, excess of revenue over costs is the profits. Profit =
TR – TC. If TR is equal to TC in that case, there will be break even point. If TR is less tha n TC, in that
b) MR and MC approach
In this case, we take in to account of revenue earned from one unit and cost incurred to produce
only one unit of output. A firm will be maximizing its profits when MR= MC and MC curve cuts MR
curve from below. If MC curve cuts MR cur ve from above either under perfect market or under
imperfect market, no doubt MR equals MC but total output will not be maximized and hence total
profits also will not be maximized. Hence, two conditions are necessary for profit maximization -
Q.No.6: Examine the relationship between revenue concepts and price elasticity of demand.
Answer; Relationship between Revenue Concepts and Price Elasticity of Demand
In the diagram AR and MR respectively are the average revenue and the marginal revenue cur ves.
Elasticity of demand at point R on the average revenue curve = RT/Rt Now in the triangles PtR and
MRT.
Hence elasticity at R = RM / RM – QM
It is also clear from the diagram that RM is average revenue and QM is the marginal revenue at the
output OM which corresponds to the point R on the average revenue curve. Therefore elastic ity at R
= Average Revenue / Average Revenue – Marginal Revenue
If A stands for Average Revenue, M stands for Marginal Revenue and e stands for point elasticity on
the average revenue curve Then e = A / A – M.
Thus, elasticity of demand is equal to AR ove r AR minus MR.
By using the above elasticity formula, we can derive the formula for AR and MR separately.
e=
This can be changed into (through cross multiplication)
eA – eM = A bringing A’s together, we have
eA – A = eM
A ( e – 1 ) = eM
A = eM / e – 1
A =M (e / e – 1)
Therefore Average Revenue or price = M (e / e – 1)
Thus the price (i.e., AR) per unit is equal to marginal revenue x elasticity over elasticity minus one. The
marginal revenue formula can be written straight away as
M = A ((e – 1) / e)
The general rule therefore is: at any output,
Average Revenue = Marginal Revenue x (e / e – 1) and
Marginal Revenue = Average Revenue x (e – 1 / e)
Where, e stands for point elasticity of demand on the average revenue curve. With the help of these
formulae, we can find marginal revenue at any point from average revenue at the same point,
provided we know the point elasticity of demand on the average revenue curve. Suppose that the
price of a product is Rs.8 and the elasticity is 4 at that price. Marginal reve nue will be:
M = A (( e – 1) / e)
= 8 (( 4 – 1 / 4)
= 8 x 3 /4
= 24 / 4
= 6. Marginal Revenue is Rs. 6.
Suppose that the price of a product is Rs.4 and the elasticity coefficient is 2 then the corresponding
MR will be:
M = A ( ( e-1) / e)
= 4 ( ( 2 – 1) / 4)
=4x1/4
=4/4
= 1 Marginal revenue is Rs. 1
Suppose that the price of commodity is Rs.10 and the elasticity coefficient at that price is 1 MR will
be:
M = A ( ( e-1) / e)
=10 ( (1-1) /1)
=10 x 0/1
=0
MBA Semester 1
MB0042 – Managerial Economics
Assignment Set - 2
Q.No.1: Under perfect competition how is equilibrium price determined in the shor t and long run?
Answer: The price at which demand and supply are equal is known as equilibrium price. The quantity
bought and sold at the equilibrium price is known as equilibrium output
1. There is no scope for either expansion or contraction of the output in the entire industry. This is
possible when all firms in the industry are producing an equilibrium level of output at which MR = MC.
In brief, the total output remains constant in the short run at the equilibrium point. Thus a firm in the
short run has only temporary equilibrium.
2. There is no scope for the new firms to enter the industry or existing firms to leave the industry.
3. Short run demand should be equal to short run supply. The price so determined is called as
‘subnormal price’. Normal price is determined only in the long run. Hence, short run price is not a
stable price.
Equilibrium of the competitive firm in the short run
A competitive firm will reach equilibrium position at the poin t where short run MR equals MC. At this
point equilibrium output and price is determined.
The firm in the short run will have only temporary equilibrium. The short run equilibrium price is not a
stable price. It is also called as sub – normal price.
Competitive firm will reach equilibrium position at the point where short run MR equals MC. At this
point equilibrium output and price is determined.
The firm in the short run will have only temporary equilibrium. The short run equilibrium price is not a
stable price. It is also called as sub – normal price.
The competitive firm, in the short run, will not be in a position to cover its fixed costs. But it must
recover short run variable costs for its survival and to continue in the industry. A firm will no t produce
any output unless the price is at least equal to the minimum AVC. If short run price is just equal to
AVC, it will not cover fixed costs and hence, there will be losses. But it will continue in the industry with
the hope that it will recover the fixed costs in the future.
1. At the point of equilibrium, the long run demand and supply of the products of the industry must
be equal to each other. This will determine long run normal price .
2. There will be no scope for the industry to either expand or contract output. Hence, the total
production remains stable in the long run.
3. All the firms in the industry should be in the position of equilibrium. All firms in the industry must be
producing an equilibrium level of output at which long run MC is equated to long run MR. (MC =
MR).
4. There should be no scope for entry of new firms into the industry or exit of old firms out of the
industry. In brief, the total number of firms in the industr y should remain constant.
5. All firms should be earning only normal profits. This happens when all firms equate AR (Price) with
AC. This will help the industry in attaining a stable equilibrium in the long run.
A competitive firm reaches the equilibrium position when it maximizes its profits. This is possible when:
1. The firm would produce that level of output at which MR = MC and MC curve cuts MR curve from
below. The firm adjusts its output and the scale of its plant so as to equate MC with market pri ce.
Price = MC = MR
2. The firm in the long run must cover its full costs and should earn only normal profits. This is possible
when long run normal price is equal to long run average cost of production. Hence,
Price = AR = AC
3. When AR is greater than AC, there will be place for super normal profits. This leads to entry of new
firms – increase in total number of firms – expansion in output – increase in supply – fall in price – fall in
the ratio of profits. This process will continue till supernormal pr ofits are reduced to zero. On the other
hand, when AC is greater than AR the industry will be incurring losses. This leads to exit of old firms,
number of firms decrease, contraction in output, rise in price, and rise in the ratio of profits. Thus,
losses are avoided by automatic adjustments. Such adjustments will continue till the firm reaches the
position of equilibrium when AC becomes equal to AR. Thus losses and profits are incompatible with
the position of equilibrium. Hence,
Price = MR = MC = AR = AC
4. The firm is operating at its minimum AC making optimum use of available resources.
LAR = LAC
A competitive firm in the long run must operate at the minimum point of the LAC curve. It cannot
afford to operate at any other point on the LAC curve. Other wise, it cannot produce the optimum
output or it will incur losses.
1. Personal differences:
This is nothing but charging different prices for the same commodity because of personal differences
arising out of ignorance and irrationality of con sumers, preferences, prejudices and needs.
2. Place:
Markets may be divided on the basis of entry barriers, for e.g. price of goods will be high in the place
where taxes are imposed. Price will be low in the place where there are no taxes or low taxes.
4. Time:
Special concessions or rebates may be given during festival seasons or on important occasions.
5. Distance:
Railway companies and other transporters, for e.g., char ge lower rates per KM if the distance is long
and higher rates if the distance is short.
6. Special orders:
When the goods are made to order it is easy to charge different prices to different customers. In this
case, particular consumer will not know the price charged by the firm for other consumers.
8. Quantity of purchase:
9. Geographical area:
Business enterprises may charge different prices at the natio nal and international markets. For
example, dumping – charging lower price in the competitive foreign market and higher price in
protected home market.
12. Age:
Cinema houses in rural areas and transport authorities charge different rates for adults and children.
17. If price differences are minor, customers do not bother about such discrimi nation.
Thus, APC =
Suppose the income of the community is Rs. 10, 000 crore and consumption expenditure is Rs. 8,000
crore, then the APC is 8000/10,000 = 80% or 0.8. Thus, we can derive APC by dividing consumption
expenditure by the total income.
MPC =
1. When income increases, APC as well as MPC declines but the decline in MPC is greater than APC.
2. As income goes down, MPC falls and APC also falls but at a slower rate.
3. If MPC is rising, the APC will also be rising although at a slower rate.
4. When MPC is constant, APC may also remain constant.
5. APC, in some cases, may be equal to MPC. It is quite possible, if 50% of increased income is
consumed and the remaining 50% is saved.
6. MPC is generally high in poor countries when compared to rich countries. In rich countries the
basic requirements are satisfied and therefore, the MPC would be less and MPS would be high. But in
poor countries majority of the p eople have to satisfy their basic needs and hence as income
increases the MPC also increases while MPS is generally low.
Q.N o.4: What is monetary policy? What are the objectives of such policy?
Answer; Monetary policy can be explained in two different ways. In a narrow sense, it is concerned
with administering and controlling a country’s money supply including currency notes and coins,
credit money, level of interest rates and managing the exchange rates. In a broader sense,
monetary policy deals with all those monetary and non -monetary measures and decisions that
affect the total money supply and its circulation in an economy. It also includes sev eral non-
monetary measures like wages and price control, income policy, budgetary operations taken by the
government which indirectly influence the monetary situations in an economy.
Objectives of monetary policy must be r egarded as a part of overall economic objectives of the
government. It should be designed and directed to achieve different macro economic goals. The
objectives may be manifold in relation to the general economic policy of a nation. The various
objectives may be inter related, inter dependent and mutually complementary to each other. They
may also be mutually inconsistent and clash with each other. Hence, very often the monetary
authorities are concerned with a careful choice between alternative ends. The p riorities of the
objectives depend on the nature of economic problems, its magnitude and economic policy of a
nation. The various objectives also change over a time period.
Economists have conflicting and divergent views with regard to the objectives of m onetary policy in
a developed and developing economy. There are certain general objectives for which there is
common consent and certain other objectives are laid down to suit to the special conditions of a
developing economy. The main objective in a devel oped economy is to ensure economic stability
2. Price stability:
With the suspension of the gold stan dard, maintenance of domestic price level has become an
important aim of monetary policy all over the world. The bitter experience of 1920’s and 1930’s has
made all most all economies to go for price stability. Both inflation and deflation are dangerous an d
detrimental to smooth economic growth. They distort and disturb the working of the economic
system and create chaos. Both of them are bad as they bring unnecessary loss to some groups
where as undue advantage to some others. They have potential power to create economic
inequality, political upheavals and social unrest in any economy. In view of this, price stability is
considered as one of the main objectives of monetary policy in recent years. It is to be remembered
that price stability does not mean tha t prices of all commodities are kept constant or fixed over a
period of time. It refers to the absence of sharp variations or fluctuations in the average price level in
the country. A hundred percent price stability is neither possible nor desirable in any economy. It
simply implies relative price stability. A policy of price stability checks cyclical fluctuations and
smoothen production and distribution, keeps the value of money stable, prevent artificial scarcity or
prosperity, makes economic calculations possible, introduces an element of certainty, eliminate
socio-economic disturbances, ensure equitable distribution of income and wealth, secure social
justice and promote economic welfare. On account of all these benefits, monetary authorities have
to take concrete steps to check price oscillations. Price stability is considered as one of the
prerequisite condition for economic development and it contributes positively to the attainment of a
steady rate of growth in an economy. This is because price stabil ity will build up public morale and
instill confidence in the minds of people, boost up business activity, expand various kinds of
economic activities and ensure distributive justice in the country. Prof Basu rightly observes, “A
monetary policy which can maintain a reasonable degree of price stability and keep employment
reasonably full, sets the stage of economic development”.
5. Full employment:
In recent years it has become another major goal of monetary policy all over the world especially
with the publication of general theory by Lord Keynes. Many well -known economists like Crowther,
Halm. Gardner Ackley, William, Beveridge and Lord Keynes hav e strongly advocated this objective
in the context of present day situations in most of the countries. Advanced countries normally work
at near full employment conditions. Their major problem is to maintain this high level of employment
situation through various economic polices. This object has become much more important and
crucial in developing countries as there is unemployment and under employment of most of the
resources. Deliberate efforts are to be made by the monetary authorities to ensure adequate supply
of financial resources to exploit and utilize resources in the best possible manner so as to raise the
level of aggregate effective demand in the economy. It should also help to maintain balance
between aggregate savings and aggregate investments. This would ensure optimum utilization of all
kinds of resources, higher national output, income and higher living standards to the common man.
Q.No.5: Explain briefly the phases of business cycle. Through what phase did the world pass in 2009 -
10.
Phases of business Cycle
Basically, a business cycle has only two parts - expansions and contraction or prosperity and
depression. Burns and Mitchell observe that peaks and troughs are the two main mark -off points of a
business cycle. The expansion phase starts from revival and includes prosperity and boom.
Contraction phase includes reces sion, depression and trough. In between these two main parts, we
come across a few other interrelated transitional phases. In its broader perspective, a business cycle
has five phases. They are as follows
2. Recovery or revival
Depression cannot last long, forever. After a period of depressi on, recovery starts. It is a period where
in, economic activities receive stimulus and recover from the shocks. This is the lower turning point
from depression to revival towards upswing. Depression carries with itself the seeds of its own
recovery. After sometime, the rays of hope appear on the business horizon. Pessimism is slowly
replaced by optimism. Recovery helps to restore the confidence of the business people and create
a favorable climate for business ventures.
3. Prosperity or Full-employment
The recovery once started gathers momentum. The cumulative process of recovery continues till the
economy reaches full employment. Full employment may be defined as a situation where in all
available resources are fully employed at the current wage rate. Henc e, achieving full employment
has become the most important objective of all most all economies. Now, there is all round stability
in output, wages, prices, income, etc. According to Prof. Haberler “ Prosperity is a state of affair in
which the real income c onsumed, produced and the level of employment are high or rising and
there are no idle resources or unemployed workers or very few of either.” During the period of
prosperity an economy experiences -
Q.No.6: What are the causes of inflation? What were the causes that affected inflation in India during
the last quarter of 2009.
Answer: Causes of Inflation
Demand side
Increase in aggregate effectiv e demand is responsible for inflation. In this case, aggregate demand
exceeds aggregate supply of goods and services. Demand rises much faster than the supply. We
can enumerate the following reasons for increase in effective demand.
1. Increase in money supp ly: Supply of money in circulation increases on account of the following
reasons – deficit financing by the government, expansion in public expenditure, expansion in
bank credit and repayment of past debt by the government to the people, increase in legal
tender money and public borrowing.
2. Increase in disposable income: Aggregate effective demand rises when disposable income of
the people increases. Disposable income rises on account of the following reasons – reduction in
the rates of taxes, increase in n ational income while tax level remains constant and decline in
the level of savings.
3. Increase in private consumption expenditure and investment expenditure: An increase in private
expenditure both on consumption and on investment leads to emergence of exc ess demand in
an economy. When business is prosperous, business expectations are optimistic and prices are
rising, more investment is made by private entrepreneurs causing an increase in factor prices.
When the incomes of the factors rise, there is more ex penditure on consumer goods.
4. . Increase in Exports: An increase in the foreign demand for a country’s exports reduces the
stock of goods available for home consumption. This creates shortages in the country leading to
rise in price level.
5. Existence of Black Money: The existence of black money in a country due to corruption, tax
evasion, black-marketing etc, increases the aggregate demand. People spend such
unaccounted money extravagantly thereby creating un -necessary demand for goods and
services causing inflation.
Generally, the supply of goods and services do not keep pace with the ever -increasing demand for
goods and services. Thus, supply does not match with the demand. Supply falls short of demand.
Increase in supply of goods and services may be limited because of the following reasons.