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Q-1 Distinguish between a firm and an industry.

Explain the equilibrium of a firm and


industry under perfect competition.
Ans: Difference between firm & industry:
Firm:
Any business unit organized under one ownership and management is called a firm. The firm may
be organized as a sole proprietorship, partnership or a joint stock

company. The form of

organization can be anything. It is necessary that the business should be owned and managed by
one management.
According to Miller, Firm is an organisation that buys and hires resources and sells goods and
services. Lipsey has defined as firm is the unit that employs factors of production to produce
commodities that it sells to other firms, to households, or to the government.
A firm is usually a corporate company that controls a number of chains in the industry it is
operating within. Several firms can operate in one industry to ensure that there is always
competition to keep prices reasonable and stop the market becoming a monopoly, which is where
one firm is in charge of the whole industry. Sometimes, a firm is not necessary within the
industry and independent chains and retailers can enter straight into the market without a firm
behind them, although this is risky. This is because one of the advantages of having a firm
behind you is that it is a safeguard against possible bankruptcy because the firm can support
the chain that it owns.
Industry:
An industry is a group of firms dealing in the same line of business.

The ownership and

management of each firm may be different, but since all firms are engaged in the production of
the same commodity, they are collectively called as industry.
Industry is a group of firms producing standardized products in a market. According to Lipsey,
Industry is a group of firms that sells a well defined product or closely related set of
products.
Example: Swadeshi Mills in Mumbai is a firm dealing in textiles. Similarly, Shriram Mills is
another firm & other firm is Kohinoor Mills dealing in textiles.
But when we take into account all the textiles firms in India we describe them collectively as
the cotton textile industry of India.
Similarly we can say about automobile industry, in which there are companies like HONDA,
HYUNDAI, MARUTI, FORD, AUDI, PORSCH, BMW, TOYOTA, etc.
An industry is the name given to a certain type of manufacturing or retailing environment. For
example, the retail industry is the industry that involves everything from clothes to computers,
anything in the shops that get sold to the public. The retail industry is very vast and has many

sub divisions, such as electrical and cosmetics. More specialized industries deal with a specific
thing. The steel industry is a more specialized industry, dealing with the making of steel and
selling it on to buyers.
Equilibrium of a firm and industry under perfect competition :
Conditions of Equilibrium of the Firm and Industry
A firm is in equilibrium when it has no propensity to modify its level of productivity. It requires
neither extension nor retrenchment. It wants to earn maximum profits in by equating its
marginal cost with its marginal revenue, i.e. MC = MR. Diagrammatically, the conditions of
equilibrium of the firm are
(1) the MC curve must equal the MR curve.
This is the first order and essential condition. But this is not a sufficient condition which may
be fulfilled yet the firm may not be in equilibrium.
(2) The MC curve must cut the MR curve from below and after the point of equilibrium it must
be above the MR.
This is the second order condition. Under conditions of perfect competition, the MR curve of a
firm overlaps with the AR curve. The MR curve is parallel to the X axis. Hence the firm is in
equilibrium when MC = MR = AR.

FIGURE (1)
figure (1), the MC curve cuts the MR curve first at point X. It contends the condition of MC =
MR, but it is not a point of maximum profits for the reason that after point X, the MC curve is
beneath the MR curve. It does not pay the firm to produce the minimum output OM when it can

earn huge profits by producing beyond OM. Point Y is of maximum profits where both the
situations are fulfilled.
Amidst points X and Y it pays the firm to enlarges its productivity for the reason that its MR >
MC. It will nevertheless stop additional production when it reaches the OM1 level of
productivity where the firm fulfils both the circumstances of equilibrium. If it has any plants to
produce more than OM1 it will be incurring losses, for its marginal cost exceeds its marginal
revenue beyond the equilibrium point Y. The same finale hold good in the case of straight line
MC curve and it is presented in the

FIGURE (2).

An industry is in equilibrium, first when there is no propensity for the firms either to leave or
either industry and next, when each firm is also in equilibrium. The first clause entails that the
average cost curves overlap with the average revenue curves of all the firms in the industry.
They are earning only normal profits, which are believed to be incorporated in the average cost
curves of the firms. The second condition entails the equality of MC and MR. Under a perfectly
competitive industry these two circumstances must be fulfilled at the point of equilibrium i.e.
MC = MR.
(1) AC = AR
(2) AR = MR. Hence MC = AC = AR. Such a position represents full

equilibrium of the industry.

Short Run Equilibrium of the Firm and Industry

Short Run Equilibrium of the Firm


A firm is in equilibrium in the short run when it has no propensity to enlarge or contract its
productivity and needs to earn maximum profit or to incur minimum losses.
The short run is a period in which the firm can vary its productivity by changing the erratic
factors of production. The number of firms in the industry is fixed since neither the existing
firms can leave nor new firms can enter it.

All firms use standardized factors of production

Firms are of diverse competence

Cost curves of firms are dissimilar from each other

All firms sell their produces at the equal price ascertained by demand and supply of the
industry so that the price of each firm, P (Price) = AR = MR

Firms produce and sell various volumes

The short run equilibrium of the firm can be described with the helps of marginal study and
total cost revenue study.

Marginal Cost, Marginal Revenue analysis During the short run, a firm will produce only
its price equals average variable cost or is higher than the average variable cost (AVC).
Furthermore, if the price is more than the averages total costs, ATC, i.e. P = AR > ATC
the firm will be earning super normal profits. If price equals the average total costs, i.e.
P = AR = ATC the firm will be earning normal profits or break even.

If price equals AVC, the firm will be incurring losses. If price drops even a little below
AVC, the firm will shut down since in order to produce it must cover at least its AVC
through short run. So during the short run, under perfect competition, affirm is in
equilibrium in all the above mentioned stipulations.

Super normal profits The firm will be earning super normal profits in the short run
when price is higher than the short run average cost.

Normal Profits - The firm may earn normal profits when price equals the short run
average costs.

Total Cost Total Revenue Analysis The short run equilibrium of the firm can also be
represented with the help of total cost and total revenue curves. The firm is able to
maximize its profits when the positive discrimination between TR and TC is the
greatest.

Short Run Equilibrium of the Industry


The term Equilibrium implies a state of balance or rest. In economics, it refers to a position or
situation from which there is no incentive to change. At the equilibrium point, an economic unit is
maximizing its benefits or advantages. Hence, always there will be a tendency on the part of
each economic unit to move towards the equilibrium condition. Reaching the position
of equilibrium is a basic objective of all firms. In the short period, time available is too short
and hence all types of adjustments in the production process are impossible. As plant capacity is
fixed, output can be increased only by intensive utilization of existing plants and machineries or
by having more shifts. Fixed factors remain the same and only variable factors can be changed
to expand output. Total number of firms remains the same in the short period. Hence, total
supply of the product can be adjusted to demand only to limited extent. In the short run, price
is determined in the industry through the interaction of the forces of demand and supply. This
prices is given to the firm. Hence, the firm is a price taker and not price maker. On the basis of
this price, a firm adjusts its output depending on the cost conditions. An industry under perfect
competition in the short run, reaches the position of equilibrium when the following conditions
are fulfilled
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.
An industry is in equilibrium in the short run when its total output remains steady there being no
propensity to enlarge or contract its productivity. If all firms are in equilibrium the industry is
also in equilibrium. For full equilibrium of the industry in the short run all firms must be earning
normal profits.
But full equilibrium of the industry is by sheer accident for the reason that in the short rum
some firms may be earning super normal profits and some losses. Even then the industry is in
short run equilibrium when its quantity demanded and quantity supplied is equal at the price
which clears the market.
Long Run Equilibrium of the Firm and Industry
Equilibrium of the firm in the long run

A competitive firm reaches the equilibrium position when it maximizes its profits. This 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 price. 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 profits 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. In the
case of the industry, E is the position of equilibrium at which LRS = LRD, indicating OR as the
equilibrium price and OQ as the equilibrium quantity demanded and supplied. In case of firm P
indicates the position of equilibrium. At P, LMR = LMC and LMC curve cuts LMR curve from
below. At the
same point P the minimum point of LAC is tangent to LAR curve. Hence
,LAR = LAC

Equilibrium of Industry in the Long run


In the long run industry is in equilibrium when all competitive firms are earning normal profit.
There is no tendency for the new firm to enter or for the old to leave the industry. In the short
run an industry cannot obtain an equilibrium position because some firms learn normal profit
while the others suffer a loss. Therefore an industry can only be in equilibrium in the long run
because all the firms are in stable position and earning normal profit.

It is an important condition for the industry equilibrium that price which is determined
according to aggregate demand and supply that must be equal to the AR = MF = AC = MC of each
firm. There is also an optimum allocation of resources and goods are provided to the consumers
at the lowest possible price.
We can explain the equilibrium of the industry by the following diagram.

According to the above diagram out put is measured along OX and Cost/Revenue along OY. Firm
"A" is in equilibrium at the point "K" where its MC = AC and MR = AR. So firm is earning a normal
profit. Firm "B" is in equilibrium at the point "E" and "C" is at the point "R".
All the three firms in the industry are earning normal profit because their MC = AC = MR = AR =
Price. So industry itself in equilibrium position.

Q-2 Give a brief description of


a.Implicit and Explicit cost
b.Actual and opportunity cost

Ans: (a) Implicit Cost:


The firm uses resources which the firm itself owns. The costs of self owned resources which
are employed by the firm are non-expenditure or implicit costs, like salary of proprietor,
interest of on the entrepreneurs own investment, rent on own land used by the firm.

An implicit cost results if the person who at first foregoes the satisfaction in the search of an
activity and is not rewarded by money or another form of payment. The implicit cost begins and
ends with foregoing the benefits and satisfaction. When an organization or owner uses its own
equity for company's well-air then that cost is considered as implicit cost.

Example of implicit cost - Goodwill


A cost that is represented by lost opportunity in the use of a company's own resources,
excluding cash. The implicit cost for a firm can be thought of as the opportunity cost related to
undertaking a certain project or decision, such as the loss of interest income on funds, or
depreciation of machinery used for a capital project.
Implicit costs can also be thought of as intangible costs that are not easily accounted for.
Implicit cost cannot be traded and therefore cannot be counted in terms of money.
For example, the time and effort that an owner puts into the maintenance of the company,
rather than working on expansion, can be viewed as an implicit cost of running the business. In
corporate finance decisions, implicit costs should always be considered when coming to a
decision on how to allocate resources.
Explicit Cost :
The money payment, which a firm makes to those outsiders who supply labour services, raw
materials, transport services, electricity etc. are called explicit costs. Thus explicit costs are
out-of pocket costs i.e payments made for resources purchased or hired by firm.
Explicit cost can be counted in terms of money whereas explicit cost is a direct tangible cost.
An Explicit cost is a business expense accounted cost that can be easily identified such as wage,
rent and materials. Explicit costs gives clear and evident cash outflows from business that
decreases its end result profitability. This cost directly affects the revenue. Intangible
expenses such as goodwill and amortization are not explicit expense because these expenses
don't show clear effects on a business's revenue and expenses.
Explicit cost can be counted in terms of money. Explicit cost is a direct tangible cost
For example, wages paid to employees, rent payments, and utility bills and the cost of materials
that go into the production of goods. With these expenses, it is easy to see the source of the
cash

outflow

and

the business

activities

to

which the

expense is attributed.

(b) Actual Cost:


The cost a company pays or is paid for a good or service. The actual cost may be more or less
than the estimated cost. For example, a car shop may estimate that repairs will cost Rs.1700,
but the actual cost may in fact be Rs.2000. One often is not informed of the actual cost until it
is incurred.
Actual costs are those costs, which a firm incurs while producing or acquiring a good or service
like raw materials, labour, rent, etc.
Example: Suppose, we pay Rs. 150 per day to a worker whom we employ for 10 days, then the
cost of labour is Rs.1500.The economists called this cost as accounting costs because
traditionally accountants have been primarily connected with collection of historical data (that

is the costs actually incurred) in reporting a firms financial position and in calculating its taxes.
Sometimes the actual costs are also called acquisition costs or outlay costs.
Opportunity cost:

The cost of passing up the next best choice when making a decision.
Opportunity cost is useful when evaluating the cost and benefit of choices. It often is
expressed in non-monetary terms. The cost of an alternative that must be forgone in order to
pursue a certain action. Put another way, the benefits one could have received by taking an
alternative action.
For example - if one has time for only one elective course, taking a course in microeconomics
might have the opportunity cost of a course in management. By expressing the cost of one
option in terms of the foregone benefits of another, the marginal costs and marginal benefits of
the options can be compared.

For example - if an asset such as capital is used for one purpose, the opportunity cost is the
value of the next best purpose the asset could have been used for. Opportunity cost analysis is
an important part of a company's decision-making processes.
Example - The opportunity cost of going to college is the money you would have earned if you
worked instead. On the one hand, you lose four years of salary while getting your degree; on the
other hand, you hope to earn more during your career, thanks to your education, to offset the
lost wages.

Example - if a gardener decides to grow carrots, his or her opportunity cost is the alternative
crop

that

might

have

been

grown

instead

(potatoes,

tomatoes,

pumpkins,

etc.)

In both cases, a choice between two options must be made. It would be an easy decision if you
knew the end outcome; however, the risk that you could achieve greater "benefits" (be they
monetary or otherwise) with another option is the opportunity cost.

Q-3 A Firm Supplied 3000 pens at the rate of Rs10.Next month ,due to a rise of in the
price to 22 rs per pen the supply of the firm increases to 5000 pens. Find the elasticity
of supply of the pens.
Ans : Price elasticity of demand is a ratio of two pure numbers the numerator is the percentage
change in the quantity demanded and the denominator is the percentage change in price of the
commodity. it is measured by the following Formula:
Ep=Percentage change in quantity demanded /Percentage changed in applying the provided data
in the equation :
Percentage changed in price=(22-10)/10
Ep={(5000-3000)/3000}/{(22-10)/10}
=1.2

Q-4 What is monetary policy? Explain the general objectives and measurements of
monetary policy?
Ans: Introduction:
Objectives of Monetary Policy
The objectives of a monetary policy in India are similar to the objectives of its five year plans.
In a nutshell planning in India aims at growth, stability and social justice. After the Keynesian
revolution in economics, many people accepted significance of monetary policy in attaining
following objectives.
1.

Rapid Economic Growth

2. Price Stability

3. Exchange Rate Stability


4. Balance of Payments (BOP) Equilibrium
5. Full Employment
6. Neutrality of Money
7. Equal Income Distribution
These are the general objectives which every central bank of a nation tries to attain by
employing certain tools (Instruments) of a monetary policy. In India, the RBI has always aimed
at the controlled expansion of bank credit and money supply, with special attention to the
seasonal needs of a credit.
The objectives of monetary policy in detail:1.

Rapid Economic Growth: It is the most important objective of a monetary policy. The
monetary policy can influence economic growth by controlling real interest rate and its
resultant impact on the investment. If the RBI opts for a cheap or easy credit policy by
reducing interest rates, the investment level in the economy can be encouraged. This
increased investment can speed up economic growth. Faster economic growth is possible
if the monetary policy succeeds in maintaining income and price stability.

2. Price Stability: All the economics suffer from inflation and deflation. It can also be
called as Price Instability. Both inflation are harmful to the economy. Thus, the
monetary policy having an objective of price stability tries to keep the value of money
stable. It helps in reducing the income and wealth inequalities. When the economy
suffers from recession the monetary policy should be an 'easy money policy' but when
there is inflationary situation there should be a 'dear money policy'.
3. Exchange Rate Stability: Exchange rate is the price of a home currency expressed in
terms of any foreign currency. If this exchange rate is very volatile leading to frequent
ups and downs in the exchange rate, the international community might lose confidence
in our economy. The monetary policy aims at maintaining the relative stability in the
exchange rate. The RBI by altering the foreign exchange reserves tries to influence the
demand for foreign exchange and tries to maintain the exchange rate stability.
4. Balance of Payments (BOP) Equilibrium: Many developing countries like India suffer
from the Disequilibrium in the BOP. The Reserve Bank of India through its monetary
policy tries to maintain equilibrium in the balance of payments. The BOP has two aspects
i.e. the 'BOP Surplus' and the 'BOP Deficit'. The former reflects an excess money
supply in the domestic economy, while the later stands for stringency of money. If the
monetary policy succeeds in maintaining monetary equilibrium, then the BOP equilibrium
can be achieved.

5. Full Employment: The concept of full employment was much discussed after Keynes's
publication of the "General Theory" in 1936. It refers to absence of involuntary
unemployment. In simple words 'Full Employment' stands for a situation in which
everybody who wants jobs get jobs. However it does not mean that there is a Zero
unemployment. In that senses the full employment is never full. Monetary policy can be
used for achieving full employment. If the monetary policy is expansionary then credit
supply can be encouraged. It could help in creating more jobs in different sector of the
economy.
6. Neutrality of Money: Economist such as Wicksted, Robertson has always considered
money as a passive factor. According to them, money should play only a role of medium
of exchange and not more than that. Therefore, the monetary policy should regulate the
supply of money. The change in money supply creates monetary disequilibrium. Thus
monetary policy has to regulate the supply of money and neutralize the effect of money
expansion. However this objective of a monetary policy is always criticized on the ground
that if money supply is kept constant then it would be difficult to attain price stability.
7. Equal Income Distribution: Many economists used to justify the role of the fiscal policy
are maintaining economic equality. However in recent years economists have given the
opinion that the monetary policy can help and play a supplementary role in attainting an
economic equality. Monetary policy can make special provisions for the neglect supply
such as agriculture, small-scale industries, village industries, etc. and provide them with
cheaper credit for longer term. This can prove fruitful for these sectors to come up.
Thus in recent period, monetary policy can help in reducing economic inequalities among
different sections of society.
Instruments of monetary policy:
(A) Quantitative Instruments or General Tools
The Quantitative Instruments are also known as the General Tools of monetary policy. These
tools are related to the Quantity or Volume of the money. The Quantitative Tools of credit
control are also called as General Tools for credit control. They are designed to regulate or
control the total volume of bank credit in the economy. These tools are indirect in nature and
are employed for influencing the quantity of credit in the country. The general tool of credit
control comprises of following instruments.
1. Bank Rate Policy (BRP)
The Bank Rate Policy (BRP) is a very important technique used in the monetary policy for
influencing the volume or the quantity of the credit in a country. The bank rate refers to rate
at which the central bank (i.e RBI) rediscounts bills and prepares of commercial banks or
provides advance to commercial banks against approved securities. The Bank Rate affects the
actual availability and the cost of the credit. Any change in the bank rate necessarily brings out
a resultant change in the cost of credit available to commercial banks. If the RBI increases the
bank rate than it reduce the volume of commercial banks borrowing from the RBI. It deters
2

banks from further credit expansion as it becomes a more costly affair. Even with increased
bank rate the actual interest rates for a short term lending go up checking the credit
expansion.
On the other hand, if the RBI reduces the bank rate, borrowing for commercial banks will be
easy and cheaper. This will boost the credit creation. Thus any change in the bank rate is
normally associated with the resulting changes in the lending rate and in the market rate of
interest. However, the efficiency of the bank rate as a tool of monetary policy depends on
existing banking network, interest elasticity of investment demand, size and strength of the
money market, international flow of funds, etc.
In simple words, Bank rate is that rate which is charged by Central bank for issue loan to the
member banks. By changing it, central bank can control the credit.
(a) If Central bank increases this bank rate, all commercial banks will increase their interest
rate by this loan become costly and flow of fund in the form of credit will decrease.
(b) If central bank wants to expand credit, then Central bank will decrease bank rate, after this
commercial bank can get advance and loan at cheap rate and by this way, they also decrease
their interest rate. After this flow of cash in the form of loan will increases.
2. Open Market Operation (OMO)
The open market operation refers to the purchase and/or sale of short term and long term
securities by the RBI in the open market. This is very effective and popular instrument of the
monetary policy. The OMO is used to wipe out shortage of money in the money market, to
influence the term and structure of the interest rate and to stabilize the market for
government securities, etc. It is important to understand the working of the OMO. If the RBI
sells securities in an open market, commercial banks and private individuals buy it. This reduces
the existing money supply as money gets transferred from commercial banks to the RBI.
Contrary to this when the RBI buys the securities from commercial banks in the open market,
commercial banks sell it and gets back the money they had invested in them. Obviously the stock
of money in the economy increases. This way when the RBI enters in the OMO transactions, the
actual stock of money gets changed. Normally during the inflation period in order to reduce the
purchasing power, the RBI sells securities and during the recession or depression phase she
buys securities and makes more money available in the economy through the banking system.
Thus under OMO there is continuous buying and selling of securities taking place leading to
changes in the availability of credit in an economy.
3. Variation in the Reserve Ratios (VRR)
The Commercial Banks have to keep a certain proportion of their total assets in the form of
Cash Reserves. Some part of these cash reserves are their total assets in the form of cash.
Apart of these cash reserves are also to be kept with the RBI for the purpose of maintaining
liquidity and controlling credit in an economy. These reserve ratios are named as Cash Reserve
Ratio (CRR) and a Statutory Liquidity Ratio (SLR). The CRR refers to some percentage of
2

commercial bank's net demand and time liabilities which commercial banks have to maintain with
the central bank and SLR refers to some percent of reserves to be maintained in the form of
gold or foreign securities. In India the CRR by law remains in between 3-15 percent while the
SLR remains in between 25-40 percent of bank reserves. Any change in the VRR (i.e. CRR + SLR)
brings out a change in commercial banks reserves positions. Thus by varying VRR commercial
banks lending capacity can be affected. Changes in the VRR helps in bringing changes in the cash
reserves of commercial banks and thus it can affect the banks credit creation multiplier. RBI
increases VRR during the inflation to reduce the purchasing power and credit creation. But
during the recession or depression it lowers the VRR making more cash reserves available for
credit expansion.
Cash reserve ratio is the minimum percentage of the deposit to be kept as reserve by the banks
with central bank. It can be used as the technique of monetary policy. By changing cash reserve
ratio, RBI can contract or expand credit in Indian economy.

If RBI wants to contract credit, and then RBI will increase this ratio. After this all
banks have to keep more fund as reserve with RBI. So, they will decrease the amount of

loan due to decrease the total fund available for enterprises.


If RBI wants to expand credit, then RBI will decrease this ratio, after this all banks
have to keep less fund as reserve with RBI. So, they will issue more credit to public.

B) Qualitative Instruments or Selective Tools:


The Qualitative Instruments are also known as the Selective Tools of monetary policy. These
tools are not directed towards the quality of credit or the use of the credit. They are used for
discriminating between different uses of credit. It can be discrimination favoring export over
import or essential over non-essential credit supply. This method can have influence over the
lender and borrower of the credit. The Selective Tools of credit control comprises of following
instruments.

1. Fixing Margin Requirements


The margin refers to the "proportion of the loan amount which is not financed by the bank". Or
in other words, it is that part of a loan which a borrower has to raise in order to get finance for
his purpose. A change in a margin implies a change in the loan size. This method is used to
encourage credit supply for the needy sector and discourage it for other non-necessary sectors.
This can be done by increasing margin for the non-necessary sectors and by reducing it for
other needy sectors.
Example:- If the RBI feels that more credit supply should be allocated to agriculture sector,
then it will reduce the margin and even 85-90 percent loan can be given.

Marginal requirement is the difference between value of security and actual loan accepted by
bank. Suppose a person wants to take loan of Rs. 80 , we has to give security of Rs. 100 then
marginal requirement is Rs. 100 - Rs. 80 = Rs. 20 .

If RBI wants to contract the credit, this rate will increase suppose, if RBI fixes it as
40%, then customer can get loan of Rs. 60 after giving security of Rs. 100. So trend of

getting loan will decrease.


If RBI wants to expand the credit, this rate will decrease suppose; if RBI fixes it as
10% more people will take loan, if they get Rs. 90 in cash after giving security of Rs. 100.

So, by this way RBI controls credit.


2. Consumer Credit Regulation
Under this method, consumer credit supply is regulated through hire-purchase and installment
sale of consumer goods. Under this method the down payment, installment amount, loan duration,
etc is fixed in advance. This can help in checking the credit use and then inflation in a country.

In case inflation, prices are increased. To control prices central bank contract credit to

reduce the total amount of installment for payment.


In case of deflation, prices are decreased to control prices central bank expand credit
to increase the amount of installment.

3. Publicity
This is yet another method of selective credit control. Through it Central Bank (RBI) publishes
various reports stating what is good and what is bad in the system. This published information
can help commercial banks to direct credit supply in the desired sectors. Through its weekly and
monthly bulletins, the information is made public and banks can use it for attaining goals of
monetary policy.

4. Credit Rationing
Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount
available for each commercial bank. This method controls even bill rediscounting. For certain
purpose, upper limit of credit can be fixed and banks are told to stick to this limit. This can help
in lowering banks credit exposure to unwanted sectors.
RBI has right to create ration of credit under monetary policy. It can be done by following way:

To fix the amount of loan for a particular bank.

To fix Quota for all banks.

To fix Quota for different traders.

5. Moral Suasion
It implies to pressure exerted by the RBI on the Indian banking system without any strict
action for compliance of the rules. It is a suggestion to banks. It helps in restraining credit
during inflationary periods. Commercial banks are informed about the expectations of the
central bank through a monetary policy. Under moral suasion central banks can issue directives,
guidelines and suggestions for commercial banks regarding reducing credit supply for
speculative purposes.
RBI as central bank of country can control credit with moral persuasion. Under this persuasion,
RBI can call a meeting of all commercial bank and give advice in discussion that they should not
give loan for speculative purposes.
6. Control through Directives
Under this method the central bank issue frequent directives to commercial banks. These
directives guide commercial banks in framing their lending policy. Through a directive the
central bank can influence credit structures, supply of credit to certain limit for a specific
purpose. The RBI issues directives to commercial banks for not lending loans to speculative
sector such as securities, etc beyond a certain limit.
7. Direct Action
Under this method the RBI can impose an action against a bank. If certain banks are not
adhering to the RBI's directives, the RBI may refuse to rediscount their bills and securities.
Secondly, RBI may refuse credit supply to those banks whose borrowings are in excess to their
capital. Central bank can penalize a bank by changing some rates. At last it can even put a ban on
a particular bank if it does not follow its directives and work against the objectives of the
monetary policy.

Conclusion:
These are various selective instruments of the monetary policy. However the success of these
tools is limited by the availability of alternative sources of credit in economy, working of the
Non-Banking Financial Institutions (NBFIs), profit motive of commercial banks and undemocratic
nature off these tools. But a right mix of both the general and selective tools of monetary
policy can give the desired results.

Q-5 Explain in brief the relationship between TR,AR,MR, under different market
condition.
Ans:
Total revenue:
The revenue received by a firm for the sale of its output. Total revenue is one of two parts a
firm needs for the calculation of economic profit, the other is total cost. In general, total
revenue is the price received for selling good times the quantity of the good sold at that price.
For a perfectly competitive firm, which receives a single unchanging price for all output sold,
the calculation is relatively easy.

Example: A firm sells 2000 units of commodity at the rate of Rs. 3 per unit, than TR would be
Total revenue = 2000 X 3 = 6000

Average revenue:
Average revenue is the revenue per unit of the commodity sold. Average revenue and price is
the same thing. It is obtained by dividing total revenue by the number of units sold by the
producer.
Example: Suppose a firm's total revenue from the sale of 100 bicycles is
Rs. 1,20,000, average revenue here will be Rs.1200 (1,20,000/100).

Marginal revenue:
Marginal revenue ia a net addition to the total revenue when one more unit of a commodity is
sold.
For example, suppose a firm receives total revenue of Rs. 5,000 from the sales of 10 fans and
Rs.5,480 by selling 11 fans. Here Rs. 480 (5480-5000) will be the marginal revenue from the
sale of the 11th fan. Algebraically, marginal revenue is the addition to total revenue of the firm

Relation between TR, AR and MR


Relation between TR, AR and MR is discussed with reference to different market situations.
Broadly, a producer may encounter either of the two situations:
(a) There is a large number of firms selling a product at a constant price. An individual firm is so
small in the market that it cannot change price of the product. Or, it has no control over price
of the product. Accordingly, to a firm, price is given of course, it can sell any amount of the
product at a given price.
(b) A firm enjoys partial control over price through product differentiation or it has full control
over price because it is a monopoly firm. Accordingly, a firm can plan to increase its sale by
lowering its price.
The basic difference between the two situations is the following:
(a) When a firm has no control over price, it can sell any amount at a given price. Accordingly,
firms demand curve (or AR curve) is a horizontal straight line as in Fig. 1.
(b) When a firm has partial or full control over price, it can sell more of a product only by
lowering its price. Accordingly, its demand curve (or AR curve) slopes downward, showing a
negative relationship between price and output as in Fig. 2.

Fig. 1. Shows that a firm (having no control over price) sells its product at the given price (= OP).
It cannot change the price. Implying that it can sell whatever amount it wishes to sell at the
given price.
Fig. 2. Shows that a firm (having partial or full control over price) can sell more only if it lowers
the price of the product.
We now are discussing the relationship between TR, AR and MR with reference to situation1
(when firms AR curve is a horizontal straight line) and situation2 (when firms AR curve is a
downward sloping curve).
Relationship between TR, AR and MR when firms AR curve (or firms demand curve) is a
horizontal straight line.
When AR is given to a firm, it implies that AR is constant for a firm.
Constant AR implies that MR should also be constant, and equal to AR. This is a mathematical
fact. Because, AR is average value of a series. Average value can remain constant corresponding
to every level of output only when MR (which is additional revenue or additional value) remains
constant corresponding to every level of output. Thus, in case a firm is facing a demand curve
which is a horizontal straight line, it should represent both its AR as well as MR curve.
In case a firm is facing a demand curve which is a horizontal straight line, it should represent
both its AR as well as MR curve. It is a situation when a firm has no control over price and has
to sell its product at the given price.
Now, when AR and MR are constant and are equal to each other, corresponding to every
additional unit of output, a firm should be adding a constant amount to its TR (total revenue).
Thus, firms TR should increase at a constant rate (Note: MR is the rate of TR; constant MR
implies that TR increases at a constant rate). Fig. 3 (a and b) illustrates the behavior of TR, AR
and MR in such a situation.

FIGURE 3
Relationship between TR, AR and MR when firms demand curve slopes downward.
When AR tends to decline corresponding to every next level of output, MR should be declining
even faster. Reason:average value of a series (AR) will decline only when additional value (MR)
declines faster than the average value. Take an illustration, as under:

Output

AR

TR

MR

10

10

10

18

We find that when AR is declining by 1


unit (corresponding to a unit increase

in

24

output), MR is declining by 2 units.


Implying the fact that when AR
declines,

MR

should

be

declining

faster than AR.

(Note: The reader may note the fact that in case AR curve is a straight line and slopes
downward, the slope of MR curve should be twice the slope of AR curve. No proof is required as
it is beyond the scope of the prescribed syllabus.)
Fig. 4 illustrates the relationship between TR, AR and MR when firms demand curve (AR curve)
slopes downward.

Observations:
(i) When marginal revenue curve declines till point M in part B, total revenue is increasing at
diminishing rate as shown by the segment O to B in part A.
(ii) When marginal revenue becomes zero at point M in part B, total revenue is at its maximum
as shown by point B in part A.
(iii) When marginal revenue falls, the average revenue also falls but lies above the marginal
revenue curve. Implying that in a situation of falling price, MR falls even faster.
(iv) After point M, marginal revenue becomes negative. Now total revenue starts diminishing.
(v) A situation of zero AR obviously implies a situation of zero TR. (Zero price situation is not a
general phenomenon, but, of course has examples as in government or charitable hospitals where
medicines are given to the patients at zero price.)
Under perfect market
Under perfect competition, an individual firm by its own action cannot influence the market
price. The market price is determined by the interaction between demand and supply forces. A

firm can sell any amount of goods at the existing market prices. Hence, the TR of the firm
would increase proportionately with the output offered for sales. When the total revenue
increases in direct proportion to the sale of output, the AR would remain constant. Since the
market price of it inconstant without any variation due to changes in the units sold by the
individual firm, the extra output would fetch proportionate increase in the revenue. Hence, MR
& AR will be equal to each other and remain constant. This will be equal to price.

Q-6 What is Business Cycle? Describe the different phases of Business Cycle?
Ans: Introduction:
The recurring and fluctuating levels of economic activity that an economy experiences over a
long period of time. At one time, business cycles were thought to be extremely regular, with
predictable durations, but today they are widely believed to be irregular, varying in frequency,
magnitude and duration.
Business Cycle (or Trade Cycle) is divided into the following four phases :1.

Prosperity Phase : Expansion or Boom or Upswing of economy

2. Recession Phase : from prosperity to recession (upper turning point)


3. Depression Phase : Contraction or Downswing of economy
4. Recovery Phase : from depression to prosperity (lower turning Point)
Diagram of Four Phases of Business Cycle
The four phases of business cycles are shown in the following diagram :-

The business cycle starts from a trough (lower point) and passes through a recovery phase
followed by a period of expansion (upper turning point) and prosperity. After the peak point is
reached there is a declining phase of recession followed by a depression. Again the business
cycle continues similarly with ups and downs.

Explanation of Four Phases of Business Cycle


The four phases of a business cycle are briefly explained as follows :1. Prosperity Phase
When there is an expansion of output, income, employment, prices and profits, there is also a
rise in the standard of living. This period is termed as Prosperity phase.
This is the phase when the business establishes its niche in the market & where the business
owners start to establish their brand identity and generate brand loyalty within their customer
base using sound marketing practices. Although the focus of this stage is to maintain the core
customer group and build trust and goodwill amongst the customers. This stage is marked by a
rise in consumer demand and a consequent requirement of increased inputs in terms of
2

production, manufacturing, and general operations to keep up with the rising sales and continue
growth.
The features of prosperity are:1.

High level of output and trade.

2. High level of effective demand.


3. High level of income and employment.
4. Rising interest rates.
5. Inflation.
6. Large expansion of bank credit.
7. Overall business optimism.
8. A high level of MEC (Marginal efficiency of capital) and investment.
Due to full employment of resources, the level of production is Maximum and there is a rise in
GNP (Gross National Product). Due to a high level of economic activity, it causes a rise in prices
and profits. There is an upswing in the economic activity and economy reaches its Peak. This is
also called as a Boom Period.
2. Recession Phase
The turning point from prosperity to depression is termed as Recession Phase.
During a recession period, the economic activities slow down. When demand starts falling, the
overproduction and future investment plans are also given up. There is a steady decline in the
output, income, employment, prices and profits. The businessmen lose confidence and become
pessimistic (Negative). It reduces investment. The banks and the people try to get greater
liquidity, so credit also contracts. Expansion of business stops, stock market falls. Orders are
cancelled and people start losing their jobs. The increase in unemployment causes a sharp
decline in income and aggregate demand. Generally, recession lasts for a short period.
Thus every business at some point of time undergoes a stage where it experiences a decline in
the sales and an overall unfavorable atmosphere in the market termed as recession. This is
nothing but a period of reduced economic activity, which results in a sharp or considerable
decline in buying, selling, production, and even employment. The company might experience
reduce in profit margins or even loss depending on the market positions. This is the phase where
the company struggles to maintain its existence in the market and trying its level best to equip
itself for a quick recovery.
3. Depression Phase

When there is a continuous decrease of output, income, employment, prices and profits, there is
a fall in the standard of living and depression sets in.
The features of depression are:1.

Fall in volume of output and trade.

2. Fall in income and rise in unemployment.


3. Decline in consumption and demand.
4. Fall in interest rate.
5. Deflation.
6. Contraction of bank credit.
7. Overall business pessimism.
8. Fall in MEC (Marginal efficiency of capital) and investment.
In depression, there is under-utilization of resources and fall in GNP (Gross National Product).
The aggregate economic activity is at the lowest, causing a decline in prices and profits until the
economy reaches its Trough (low point).
4. Recovery Phase
The turning point from depression to expansion is termed as Recovery or Revival Phase.
This is the stage where the business reaches a certain maturity level in terms of the market.
The brand identity and brand image of the business are well established at this stage. The
customer base, investors, and other important business networks are well laid at this point. The
sales are either increasing or at least have reached a considerable regular volume and require
less resources for advertising to enhance sales, however intensive marketing is a must to
enhance the overall market position or at least establish the current market position. This is the
phase where the company would want to branch out into other ventures and dabble with product
innovation. This is the business stage where the profit margins are fairly stable.
During the period of revival or recovery, there are expansions and rise in economic activities.
When demand starts rising, production increases and this causes an increase in investment.
There is a steady rise in output, income, employment, prices and profits. The businessmen gain
confidence and become optimistic (Positive). This increases investments. The stimulation of
investment brings about the revival or recovery of the economy. The banks expand credit,
business expansion takes place and stock markets are activated. There is an increase in
employment, production, income and aggregate demand, prices and profits start rising, and
business expands. Revival slowly emerges into prosperity, and the business cycle is repeated.
Thus we see that, during the expansionary or prosperity phase, there is inflation and during the
contraction or depression phase, there is a deflation.

Conclusion:
These are the four stages of business cycle experienced by every business big or small.
Sometimes the business flourishes and gains maximum profits, while at times the business is on
the verge of a complete breakdown. It is the attitude and the positive perspective of successful
businessmen that keeps every business going through the ups and downs and yet always aiming
for the pinnacle.