Question 1.

The law of demand states that; holding other factors constant, the higher the price the lower the
quantity demanded and the lower the price the higher the quantity demanded. The law explains a
negative relationship between price and quantity demanded of the product. This can further be
explained by the demand curve illustrated below:

Price

Quantity demanded

At a low price (p1), the quantity demanded is high (q1), and at a high price (p2) the quantity is
low (q2).

A shift in demand curve arises when there is a change in demand of a commodity due to a
change in other factors affecting demand other than price. Such factors may lead to a decrease in
demand hence a back ward shift in the demand curve from (do-d1), or in other instances they
may lead to an increase in the demand of a commodity hence a forward shift from (do-d2), as in
the illustration below:
This shift in demand is usually caused by a number of factors which include among others the

following:

A change in consumer tastes and preferences. When consumers begin to consume less of a

product because of their changes in preferences, the demand of that price will reduce at a

constant price. This will lead to a shift of the demand curve downwards to the left. However if

the consumers tastes change positively, then there may be an increase in the demand of that

product even if the price is high. For example, if clothes are off fashion, the demand may shift

downwards even if the price is low, and fashionable garments will have an increased demand

even if the price is high. The change in demand will therefore be a result of changes in

preferences not price.

The change in the income of the consumer. When there is an increase in the income of the

consumer, there will be an increase in the quantity demanded at prevailing prices. A decrease in

the income may also lead to a decrease in the quantity demanded of the product. This will

therefore lead to a shift of the demand curve outwards and inward respectively.

Weather and climatic conditions may also lead to s shift in the demand curve. There are some

products that are consumed seasonally, for example winter jackets. In winter the demand of such

products will be high towards winter and that will lead to an increase in demand hence a shift of

the demand curve out wards. However a demand for similar products may drastically fall with

the onset of summer, which may cause a shift of the demand curve inwards.

The size of the population is yet another important factor in this respect. An increase in the

population may lead to an increased in quantity demanded of a product without consideration of

the price levels, hence a shift of the demand curve out wards to the right. For example the
demand for products in China tends to be bigger than that of similar products in Norway, because

of the differences in the population.

A change in the demand of a compliment. For complimentary goods, an increase in the demand

of one may lead to an increase in the demand for the other hence an outward shift of the demand

curve. For example an increase in the demand for cars automatically increases the demand for

fuel. A decrease in the demand of a compliment may also lead to a decrease in the demand of the

other. If less cars are bought into the market, then we expect a decrease in the demand for fuel,

hence an in ward shift of the demand curve.

An increase in the price of the substitute. If the price of X for example increases, consumers will

consume the next substitute to that product Y.This will lead to the shift of the demand curve

outwards of commodity Y despite the constant price.

Question 2.

Prefect competition describes a market in which there are many buyers producing

homogeneous goods chasing many sellers who have perfect knowledge about the market. In

other words, it is a market characterized by the fact that no single film has influence on the price

of the product. all firms in this market are price takers and prices are determined through the

interplay of the forces of demand and supply. Examples of firms that operate in this market

include the bakery industry, stationery, and building industry.

On the contrary, oligopolistic competition refers to a market situation characterized by a

few sellers who are chasing many buyers. Such sellers are aware of the actions of the other and

therefore a high degree of dependence. Examples of firms that operate in this market include

petroleum firms, telecommunication firms and cigarettes.

In a bid to contrast the two market situations, it is important to take the following factors into

consideration;

The degree of freedom of entry and exit. Under perfect completion, there is a high degree of

freedom of entry and exit. Firms are free to enter the market when profits are realized and free to

exit when the begin incurring losses.

On the other hand, under oligolpolistic competition, there is restricted entry and exit. In such a

market the firms are well established and usually enjoy dominance over the market. It therefore

becomes rather difficult for new entrants to establish them selves in such a market.
 Price determination. Under perfect completion, prices are determined through the market

forces of demand and supply. This therefore leaves companies under such a market with no

authority over price determination. In this case therefore, firms are price takers.

On the contrast, under oligopolistic competition, prices are determined through formal

arrangements called cartels. In other instances there is price leadership, where the dominant firm

that enjoys benefits of large scale production sets prices that are followed by all other firms. For

example shell in the petroleum industry. Firms here are therefore price makers.

Size of the firm. Under perfect competition, there are many firms but of small both in size

and scope. This therefore makes even formation of such small firms much easier and it increases

the level of competition in the market.

On the other hand, under oligopolistic competition the number of firms in the market is small.

But the size of each firm is big. This makes the market share of each firm sufficiently large to

dominate the market.

Question 3.

Pricing Policy refers to the policy of setting the price of the product of produces and services by

the management after taking into account of various internal and external factors, forces and its

own business. It involves fixing of prices as a major function of current business management.

Here management takes into account the various forms of pricing, like skimming and penetration

pricing.

Objectives of Policing Policy include the following;

Profit maximization in the short term. In the short run, a firm not only should be able to recover

its total costs, but also should get excess revenue over cost. Here management may adopt

skimming pricing to recover costs in the short run and later adopt penetrative pricing technich to

maintain and attract more customers.

Profit optimization in the long run is another objective of any pricing policy. Optimum profits

refer to the most desirable level of profit. Hence in the long run, firms follow a pricing policy

that does not scare away customers but also maintains the minimum level of profits that are

required for the firm to remain in business.

Price stabilization is another objective of pricing. The prices as far as possible should not

fluctuate too often. It’s only a Stable price policy that can instill confidence in customers. A

stable price policy also ensures the steady and persistent growth of any business concern.

Facing competitive situation is also an objective of pricing. Wherever companies are aware of

specific competitive products, they try to match the prices of their products with those of their
rivals to expand the volume of their business. A fair pricing policy also helps firms in meeting

competition and to prevent it.

Capturing the market. In order to achieve this goal, sometimes the firm does fix a lower price for

its products and this may lead to a loss in the short term. it may however prove beneficial in the

long run especially in markets that are price sensitive.

Target profit on the entire product line irrespective of profit level of individual products. A

rational pricing policy should keep in view the entire product line and maximum total revenue

from sales of all products. In a product line, a few products are regarded as less profit earning

products and offers are considered as more profit earning hence, a proper balance in pricing is

required.

Explaining the utility of full cost pricing in public works contracts in India

This method of pricing involves a general practice under which public works contractors, add

afair percentage of profit margin to the average variable cost (AVC).The formular for setting this

price is : P = AVC+AVC (m)

Where AVC is average variable cost, and (m) = mark-up percentage, and AVC (m) = gross profit

margin. Thus

AVC (m) = AFC + NPM

The procedure for arriving at AVC and price fixation may be summarized as follows.

The first step in price fixation is to estimate the average variable cost. For this the firm has to

ascertain the volume of its output for a given period of time, usually one accounting or fiscal

year.
The next step is to compute the total variable cost (TVC) of the standard out put. The TVC

includes direct cost. These costs added together give the total variable cost. The AVC is then

obtained by dividing the total variable cost (TVC) by the standard out put (q), i.e,

AVC = TVC/Q

After AVC is obtained, a mark-up of some percentage of AVC is added to it as profit margin and

the price is fixed. While determining the mark-up, such contractors always take into account

what the market will bear and the competition in the market.

.
Question 4.

A consumption function states the relationship between consumption and income. The total

demand for consumer goods and services accounts for the largest proportion of the aggregate

demand in an economy and plays a crucial role in the determination of national income. The total

household consumption expenditure in an economy depends on the total current disposable

income of the people.

According to Lord Keynes, the consumption function stems from a fundamental law of

psychology. The law states that propensity to consume decreases with increase in real income.

When real income of a society increases in the short run, its total consumption increases but not

by an equal amount of increase in income

As income increase the wants of the people get satisfied and as such when income increases they

save more than what they spend.

As consumption expenditure progressively diminishes when income increases, a gap between

income and expenditure arises.

This tendency is so does replied in people’s habits, customs and the psychological set up that it is

difficult to change in the short run. Hence, it is impossible to raise the propensity to consume of

the people so as to increase the national output, income and employment.

Increasing the volume of investment in an economy can only fill up the gap between income and

consumption.

Te relationship between income and consumption is measured by the average and marginal

propensity to consume

Average propensity to consume (APC) explains the relationship between total consumption and

total income.

Thus, APC = Total consumption

Total income

Marginal propensity t consume (MPC) is the there mental change in consumption as a result of a

given increment in income.

When income increases, APC as well as MPC declines but the decline in MPC is greater than

APC.As income goes down, MPC falls and APC also falls but at a slower rate. If MPC is rising,

the APC will also be rising although at a slower rate.

I support the fact that increased income in the hands of BPO and IT industry employees has

affected the APC and MPC. In the short run, the MPC and APC will increase in the same

direction but later in the long run the APC will decline and MPC will follow suit.
Question. 5

According to Harry Johnson, monetary policy is a policy employing central bank’s control of the

supply of money as an instrument of achieving the objectives of general economic policy. It is

essentially a programme of action undertaken by the monetary authorities generally the central

bank, to control and regulate the supply of money with the public and the flow of credit with a

view to achieving predetermined macroeconomic goals.

Generally objectives of monetary policy include;

Neutral Money policy. Money should be natural in its effects on prices, income, output and

employment. If money supply is stabilized and money becomes neutral the price level will vary

inversely with the productive power of the economy.

Price stability. A policy of price stability checks fluctuations and smoothens production and

distribution, keeps the value of money stable, prevent artificial scarcity or property, makes
economic calculations possible, introduces and element of certainty, eliminates soci0-economic

disturbances, ensure equitable distribution of income and wealth, secure social justice and

promote economic welfare.

Exchange rate stability. In order to have smooth and unhindered international trade and free flow

of foreign capital in to a country, it becomes imperative for a country to maintain exchange rate

stability.

Control of trade cycles. Here monetary authorities help to control the operations of trade cycles

and ensure economic stability by regulating total money supply effectively.

Full employment. Deliberate efforts one to be made by the monetary authorities to ensure

adequate supply of financial resources to exploit and utilize resources on the best possible

manner so as to raise the level of aggregate effective demand in the economy.

Equilibrium in the balance of payment. Monetary authorities here have to take appropriates

monetary measures like deflation, exchange depreciation, devaluation, exchange control, current

account and capital account convertibility, regulate credit facilities and interest rate structures

and exchange rates etc.

QUESTION 6.

A business cycle refers to the periodic booms and slumps in economic activities. The ups and

downs in the economy are reflected by the fluctuations in aggregate economic magnitudes,

including productions, investment, employment, prices wages, and bank credits. The upward and

downward movements in these magnitudes show different phases of business cycles.

The business cycle can be represented in the diagram below:

 Boom peak

Boom Full
employment line

Recession

Recovery
depression

Recession

Number of years

The full employment line shows the growth of the economy when there are no business cycles.

the various phases of business cycles are shown by the line of cycle which moves up and down
the steady growth line. Let us try to emphasize the important features of the various phases of

this business cycle, and also the causes of turning points.

The period of prosperity. This is characterized by the expansion and boom .the prosperity phase

is characterized by a rise in the national out put, rise in consumer and capital expenditure, rise in

the prices of raw materials and finished goods, and the rise in the level of employment. There is

general expansion of credit and idle funds find their way to productive investment since stock

prices increase due to increase in profitability and dividend. All this usually occur in the short

run. In the later stages of prosperity, however, inputs start falling short of their demand and

additional workers are hard to find and therefore for one to get labour, he has to pay heavily for

it. When all this happens, prices of all factor inputs rise leading to an increase in the cost of

living which is not followed with a corresponding increase in incomes. This is usually raises the

cost of living to the peak.

Turning point and recession. In this stage of business cycle demand begin to decrease due to a

high cost of living that does not move in the same direction with peoples incomes. The

employers will however, continue to produce as they will hardly notice the decrease in the

demand. Therefore an imbalance will occur as so much will be produced while a few will be

demanded. This will affect a few industries in the short run , and others begin to feel the pinch

over time.. In the later times employers will react by stopping all the supply chains from

delivering raw materials. Hence in a bid to create the balance between demand and supply, many

employers will lay off casual laborers. here borrowing will begin to decrease, bank credit

shrinks, stock prices decrease, unemployment increases even though there is a fall in the wage

rates. At this stage, the process of recession is complete and the economy enters the phase of

depression.
Depression and trough. During the phase of depression, economic activities slide down their

normal level. The growth rate becomes negative. The level of national income and expenditure

declines rapidly. Prices of consumer and capital goods decline steadily. Workers lose their jobs.

Debtors find it difficult to pay off their bank debts. Demand for bank credits reaches its low ebb

and banks experience mounting of their cash balances. Investment in stock becomes les less

profitable and least attractive. At the depth of depression, all economic activities touch the

bottom and the phase of the trough is reached. Even the expenditure on maintenance is deferred

in view of excess production capacity. Weaker firms are eliminated from the industries. At this

point, the process of depression is complete.

The recovery. As the recovery gathers momentum, some firms plan additional investment; some

undertake renovation programmes, and some undertake both. These activities generate

construction activities in both consumer and capital good sectors. Individuals who had postponed

their plans to construct houses undertake this task now, lest cost of construction should mount.

As a result, more and more employment is generated in the construction sector. As employment

increases despite wage rates moving up ward, the total wage incomes increase at a rate higher

than employment rate. Wage incomes rise and so does the consumption expenditure.

Businessmen realizing a quick return with high profitability, speed up the production machinery.

Over a period, as factors of production become more fully employed wages and other input

prices move upward rapidly, though not uniformly. Investors therefore, select the best of the

alternative investment opportunities. as prices, wages and other factor prices increase, a number

of related developments begin to take place. Businessmen start increasing their inventories,

consumers start buying more and more of durable goods and variety items. With this process
catching up, the economy enters the phase of expansion and prosperity. The cycle is thus

complete.

The major theories of business cycles are explained below:

The pure monetary theory of business cycle. Developed by Hawtrey, the theory believes that the

major cause of business fluctuation is the unstable monetary and credit system. And that the

principle factor affecting the money supply is the credit mechanism. Here the banks expand their

credit mechanism by lowering interest rates, and many business men are able to get loans for

business expansion leading to an up swing in economic growth. As the credit of banks decrease

due to many loan advances, the banks contract the credit mechanism because their cash reserves

are depleted. This leads to a decline in business because business men can not borrow hence

leading to an economic down slump.

The monetary overinvestment theory. Hayek, the pioneer of this theory believes that for the

economy to remain in stable equilibrium, it is necessary that voluntary savings are equal to the

actual investment. And that the total investment is well distributed between various industries

such that each industry produces only as much as is demanded by the consumers. To him

economies fluctuate due to an increase in investment that does not follow a corresponding

increase in savings. This will lead to over investment yet the demand will remain low hence

leading to losses and therefore economic fluctuations.

Schumpeter’s theory of innovation. This theory emphasizes innovation as the major cause of

cyclical fluctuations. According to him innovations force firms to invest heavily and there fore

borrow a lot of money from banks. This increased investment in innovation will eventually lead

to a rise in prices. Other firms will copy the innovation, borrow from banks and this will lead to
an expansion in production and the economy at large. After a certain period production will over

shoot leading to a fall in prices and decrease profitability. Many firms which had borrowed

before begin to pay back to banks leading to a decrease in money supply and prices fall further.

The process of recession begins and continues until equilibrium is once again restored.

Multiplier-accelerator interaction theory of business cycle. Samuelson’s model emphasizes

integrating theory of multiplier with the principle of acceleration .his model shows how

multiplier and accelerator interact with each other to generate income, to increase consumption

and investment demands more than expected and how this causes economic fluctuation. His

theory contends that; exogenous factors like new markets lead to an increase in autonomous

investment. This leads to the multiplier effect. The multiplier effect creates derived investment –

investment due to increase in consumer demand. This is the acceleration of investment. Derived

investment creates multiplier effect leading to acceleration. This is called the multiplier-

acceleration interaction.

These theories may be partly applied to socialist societies like India. For example; Schumpeter’s

innovation theory. When ever there is innovation, production increases as well as competition.

This will force firms to produce at a higher price in the short run leading to emergence of new

firms which may lead to expansion of business activities. Over time prices may lower and

production too. This may lead to a contraction in the economy.

The monetary overinvestment theory may also fair well in India .This is because Indians have a

high level of saving culture. This means that most investments are born fro within. This therefore

creates equilibrium between the level of investment and domestic savings .This therefore creates

economic harmony.