Unit Marks
1. Introduction 4
2. Consumer Behaviour and Demand 13
3. Producer Behaviour and Supply 23
4. Forms of Market and Price determination 10
5. National income and related aggregates 15
6. Determination of income and employment 12
7. Money and Banking 8
8. Government Budget and the economy 8
9. Balance of Payments 7
CBSE SAMPLE PAPERS 2008
SAMPLE PAPER 1
SAMPLE PAPER 2

Chapter 1: INTRODUCTION
Que. What is economics about?
Ans. Economics is about making choices in the presence of scarcity.

Que. What is meant by "economic problem”?
Ans. Economic problem is the problem of choice of the manner in which scarce resources with alternative uses are disposed off.

Que. What is the main cause of economic problem? Or
Mention the main cause which gives rise to economic problems. Or
Why do economic problems arise?
Ans. Scarcity of resources in relation to unlimited wants is the main cause which gives rise to economic problems.

Que. What is meant by scarcity in economics?
Ans. In economics, scarcity means lesser availability of resources in relation to unlimited wants of society.

Que. Discuss the subject matter of economics.
Ans. The subject matter of economics is divided under two broad branches i.e. (1) Micro-economics (2) Macro-economics.
(1) Microeconomics is the study of particular firm, particular household. Individual price, wages, income, industry and particular commodity. Thus, It is a study of a particular unit rather than all the units combined. Micro economic theory deals with the problem of allocation of resources
(2) Macro economics theory is that part of economics which studies the overall average and aggregates of the system, such as total production., total consumption, total saving, and total investment. Thus macro economics is the study of overall phenomena as a whole rather than its individual parts.

Que. What do you mean by economizing the use of resources?
Ans. Economizing the resources means making best use of available resources because they are limited in relation to our requirements.

Que. What are the central problems of an economy and why do they arise?
Ans. Following are the central problems of an economy:
(i) What to produce
(ii) How to produce
(iii) For whom to produce
Central problems of an economy arise due to scarcity of resources in relation to unlimited wants.

Que. Discuss the central problems of an economy.
Or Explain briefly three central problems of an economy.
Ans. Following are the central problems of an economy:
(1) What to produce - Human wants are unlimited and resources are limited to satisfy human wants. The question arises which commodities should be produced and in what quantity.
(2) How to produce - This problem is related to the choice of technique for producing a commodity. An economy has to choose between labour intensive technique and capital-intensive technique. Every method has its own advantages and disadvantages. The economy has to decide about technique of production on the basis of cost labour and capital.
(3) For whom to produce - Problem of "for whom to produce" means how the national product i.e., national income is to be distributed among the factors of production that helped to produce it. It is rent, wages, interest and profits, which determine the distribution of goods among the various individuals in the society. The important view has been that each individual should get income equal to the contribution he makes to the national production.

Que. What do you mean by the production possibilities of an economy?
Ans. The collection of all possible combinations of the goods and services that can be
produced from a given amount of resources and a given stock of technological knowledge is called the production possibility set of the economy.

Que. What is Production Possibility Curve? Or
What is a production possibility frontier?
ANS. PRODUCTION POSSIBILITY CURVE (PPC)
Production Possibility Curve may be defined as a curve which shows the various combinations of two goods that can be produced in any economy with a given amount of resources and technology. PPC also known as Production Possibility Frontier (PPF) and Transformation curve.
Assumptions- While drawing PPC we assume-
1. Only Two types of goods – cloth and wheat produced
2. Productive resources remain fixed
3. Full employment of productive resources –No unemployment of resources
4. No change in technology

Que. Draw a Production Possibility Curve with the help of imaginary schedule.
Ans. It is assumed that there are only two types of goods – cloth and wheat. The resources of economy can be alternatively used in both the commodities. If the production of a commodity is increased then the production of the other commodity will be decreased. Following table shows the production possibilities of production.

Production
Possibilities Cloth Wheat
A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0

From the above table and figure it is clear that when production of cloth increases then production of food decreases and it will give concave shape of PPC because opportunity cost are increasing.

PPC and Productivity Efficiency
ALL points on PPC curve like A,B,C,D,E, and F show that goods and services produced at least cost and no resource is wasted and the economy is ‘Productively Efficient’.

Que. Define opportunity cost in relation to PPC.
Ans. Opportunity cost may be defined as the value of the next best alternative. It is also called ‘foregone cost’ and ‘Trade off ‘. In the context of PPC since there are only two goods, therefore opportunity cost of producing one good is in terms of sacrifice made of the other good. PPC is downward sloping because more production of one good is associated with less of the other good.





Que. Why PPC is Concave to the origin?
PPC - Concave to the origin- due to Increasing opportunity cost-
PPC looks concave to the origin because of increasing marginal opportunity cost. The increasing marginal opportunity cost means that for additional unit of a good, the sacrifice of unit of other good goes on increasing. Principle of increasing opportunity cost that makes the PPC concave to the origin or makes bowed-out shape. PPC may be straight line if opportunity cost is constant. PPC is negative sloped not due to increasing opportunity cost but due to ‘scarcity’ because at any point of time we have limited resources.

Que. Show on a PPC
(i) Under utilization of resources
(ii) Growth of resources
Ans. When an economy produces on PPC, it means that there is no unemployment and all the resources are being used efficiently. But if an economy operates inside the PPC then there is unemployment or underemployment and/or inefficient use of resources.

In the figure given below point ‘U’ inside the PPC indicate under utilization of resources. In other words economy would not be utilizing its resources fully. Point ‘S’ indicate that an economy could not produce with the given resources and technology. If economy moving from ‘U’ to ‘A’ and ‘B’ points, its indicates resources which were lying unutilized are now being utilized fully.

Economic Growth and shift in PPC
When an economy produced at PPC curve it is ‘productively efficient’. But there is also scope of progress and one PPC can shift to another PPC on the right, It indicates Economic Growth. PPC can shift to the right or economic growth are possible in the following circumstances-
1. Improvement in overall technology
2. Greater capital formation
3. Increase in population growth / labour force

In the above figure PPC curve shift from ‘PP’ to ‘P1P1’it indicates economic growth. Sometimes PPC may shift inward when earthquake destroying resources of the country.


Que. What does a rightward shift in production possibility curve indicate?
Ans. A rightward shift in production possibility curve indicates the situation of growth of resources under which an economy can produce more of both the goods.


Que. An economy always produces on, but not inside, a PPC." Defend or refute.
Ans. An economy does not always produce on a PPC. PPC shows the possibilities of producing rent combinations of two goods. When an economy produces on PPC, it means that there is no unemployment and all the resources are being used efficiently. But in practical life, these two conditions not apply. If there is unemployment and/or inefficient use of resources, an economy will operate inside PPC. Hence, the given statement is refuted.

Que. Define a Centrally planned economy. State its features.
Ans. In a Centrally planned economy, all material means of production i.e. land, capital and mines etc. are owned by the whole community represented by the STATE. All the members being entitled to the benefits from the fruits of such socialised planned production on the basis of equal rights. State decides the size and direction of the investment. The state works for the welfare of the society and profit motive is not important for it.
Characteristics: -The following are its main characteristics
(a) Collective ownership of means of production
(b) Economic equalities
(c) Social welfare.
(d) Lack of competition
(e) Elimination of exploitation.

Que. Define a Capitalist or Market economy. State its features.
Ans. Market economy is one in which the factors of production are privately owned and managed and in which production takes place on the initiative for private profits. It is a free economy in which government interference is not found.
Characteristics: -The following are its main characteristics
(i) Right of Private Property
(ii) Freedom of Enterprise
(iii) Freedom of choice by consumers
(iv) Profit Motive
(v) Competition
(vi) Price mechanism
(vii) Inequalities of Income

Que. Define a Mixed economy. State its features.
Ans. An economic system which contains element of both private and public sectors is called mixed economy. It permits coexistence of controlled and market economy.
Features: -
(i) Coexistence of both private and public sectors.
(ii) Planned Economy
(iii) Balanced regional development
(iv) Dual system of pricing


Que. Distinguish between a centrally planned economy and a market economy.
Ans.
Basis of difference Centrally Planned Economy
Market Economy

Definition In a Socialist economy, all material means of production are owned by the whole community represented by the STATE. Market economy is one in which the factors of production are privately owned and managed and in which production takes place on the initiative for private profits.
Owner ship of factors of production State (Govt.) owns all the factors of production/ Factors of production are privately owned.
Objective Social Welfare Private Profit

Price Determination By the Govt. By Market Mechanism.

Examples China U.S.A., U.K. GERMANY Etc



Que. Define Micro Economics. State its variables.
Ans. Microeconomics is the study of particular firm, particular household. Individual price, wages, income, industry and particular commodity. Thus, It is a study of a particular unit rather than all the units combined. Micro economic theory deals with the problem of allocation of resources. Under micro economics we study-
(i) Theory of product pricing
(ii) Theory of Consumer behavior
(iii) Theory of Factor pricing
(iv) Study of a firm
(v) Location of an industry
Example of Micro economics
(a) Lock out in TELCO
(b) Finding the causes of failure of X and co.

Que. Define Macro Economics. State its variables.
Ans. Macro economics theory is that part of economics which studies the overall average and aggregates of the system, such as total production., total consumption, total saving, and total investment. Thus macro economics is the study of overall phenomena as a whole rather than its individual parts. Macro economics deals with growth and development of resources. Under macro economics we study: -
(i) Theory of National Income and output
(ii) Theory of Employment
(iii) Theory of Money
(iv) Theory of General Price Level
(v) Theory of Economic Growth and Development
(vi) Theory of International Trade.
Example of Macro economics
(a) Per capita income of India.
(b) Under employment in agricultural sector.
(c) Total savings in India.
(d) Determining the GNP of India.
(e) Identifying the causes of inflation in India.
(f) Analyse the causes of failure of industry in providing large-scale employment.
(g) The national economy's annual rate of growth
(h) Increase in the corporate income tax rate will affect the national unemployment.
Note: - It should be noted that micro and macro economics are interdependent

Que. Distinguish between microeconomics and macroeconomics.
Ans.
Micro - economics Macro- economics
1. It studies economic relationship or economic problems at the level of an individual- an individual firm ,an
individual household or an individual consumer.
1. It studies economic relationship or
economic problems at the level of the
economy as a whole.

2It is basically concerned with
determination of output and price for an individual firm or industry.

2.It is basically concerned with determination
of aggregate output and general price level in the economy as a whole.

3. Study of microeconomics assumes
that macro variable remain constraint.

3. Study of macroeconomics assumes that
macro variables remain constraint.
4. Market mechanism plays a significant role in the context of microeconomics
problems, like the problem of product pricing or facture pricing. 4. Government plays a significant role in the context of macroeconomic problems like the problems of unemployment, poverty and inflation.

Que. What do you understand by positive economic analysis?
Ans. Positive economic analysis states ‘what is’ and not ‘what ought to be’. or it makes a real description of an economy. It does not pass value judgments. Any one with the limited amount of money may use it for buying liquor and not milk.
Example of positive economic analysis
(a) Planned economies allocate resources via government departments.
(b) Most transitional economies have experienced problems of falling output and rising prices.
(c) There is a greater degree of consumer sovereignty in the market.

Que. What do you understand by normative economic analysis?
Ans. Normative economic analysis refers to “What ought to be” or it makes an assessment of an activity and offers advice.
Example of normative economic analysis
(a) Reducing inequality should be major priority for mixed economy
(b) Changing the level of interest rates is a better way of managing the economy than using taxation and government expenditure.
(c) Govt. ought to guarantee that farmer’s income will not fall if harvest is poor.

Note: The positive and the normative issues involved in the study of the central economic problems are very closely related to each other and a proper understanding of one is not possible in isolation to the other.
.


CHAPTER II: Theory of Consumer Behaviour

Que. What do you mean by the budget set of a consumer? (NCERT)
Ans. The budget set is the collection of all bundles of goods that a consumer can buy with his or her income at the prevailing market prices.

Que. What do you mean by the budget constraint of a consumer?
Ans. A consumer can buy any bundle of goods which costs less than or equal to the income he has. It is called the consumer’s budget constraint.

Que. What is budget line?
Ans. The budget line represents all bundles which cost the consumer his or her entire income. The budget line is negatively sloping.

Que. Explain why the budget line is downward sloping.
Ans. As the income of the consumer is limited so if the consumer wants to have one more unit of good 1, he can do it only if he gives up some amount of the other good. The budget line measures the rate at which the consumer is able to substitute good 1 for good 2 when he spends his entire budget.


Que. A consumer wants to consume two goods. The prices of the two goods are Rs 4 and
Rs 5 respectively. The consumer’s income is Rs 20.
(i) Write down the equation of the budget line.
(ii) How much of good 1 can the consumer consume if she spends her entire income on that good?
(iii) How much of good 2 can she consume if she spends her entire income on that good?
(iv) What is the slope of the budget line?

Ans. (i) The equation of the budget line is p1x1 +p2x2 ≤M. Where p1 = price of good 1, x1 =quantity of good 1, p2 = Price of good 2 , x2 = quantity of good 2 and M = Income of the consumer.
(ii) If she spends her entire income on the good 1 the consumer can consume 5 units of that good. ( Rs. 20/4)
(iii) If she spends her entire income on the good 2 the consumer can consume 4 units of that good. ( Rs. 20/5)
(iv) The budget line is downward sloping.

Que.. How does the budget line change if the consumer’s income increases but the prices remain unchanged?
Ans. If there is an increase in the income, the vertical intercept increases, and hence, there is a parallel outward shift of the budget line.


Que. How does the budget line change if the consumer’s income decreases but the prices remain unchanged?
Ans. If there is a decrease in the income, the vertical intercept decreases, and hence, there is a parallel inward shift of the budget line.

Que. How does the budget line change if the price of good 1 decreases by a rupee but the price of good 2 and the consumer’s income remain unchanged?
Ans. If the price of good 1 decreases, the consumer can now purchase more of good 1 due to increase in purchasing power hence, the absolute value of the slope of the budget line decreases and hence, the budget line becomes flatter.


Que. How does the budget line change if the price of good 1 increases by a rupee but the price of good 2 and the consumer’s income remain unchanged?
Ans. If the price of good 1 increases, the consumer can now purchase less of good 1 due to decrease in purchasing power hence, the absolute value of the slope of the budget line increases hence, the budget line becomes steeper.

Que. What happens to the budget set if both the prices as well as the income double?
Ans. If both the prices as well as the income double the budget set will remain unchanged.

Que Suppose a consumer can afford to buy 6 units of good 1 and 8 units of good 2 if she spends her entire income. The prices of the two goods are Rs 6 and Rs 8 respectively. How much is the consumer’s income?
Ans. M = p1x1 +p2x2
= 6x6 + 8x8 = Rs. 100
Consumer’s income= Rs. 100

Que. Suppose a consumer wants to consume two goods which are available only in integer units. The two goods are equally priced at Rs 10 and the consumer’s income is Rs 40.
(i) Write down all the bundles that are available to the consumer.
(ii) Among the bundles that are available to the consumer, identify those which
cost her exactly Rs 40.
Ans. (i) The bundles that this consumer can afford to buy are: (0, 0), (0, 1), (0, 2), (0, 3), (0, 4), (1, 0), (1, 1), (1, 2), (1, 3), (2, 0), (2, 1), (2, 2), (3, 0), (3, 1) and (4, 0).
(ii) Among the bundles, (0, 4), (1,3), (2, 2), (3, 1) and (4, 0) cost exactly Rs 40 and all the other bundles cost less than Rs 40.

Que. What does point below the Budget Line represent?
Ans. Any point below the budget line represents a bundle which costs less than the consumer’s income.


Que. What are the assumptions of preferences of the consumer?
Ans. Followings are are the assumptions of preferences of the consumer
1. Well-defined preferences: - It is generally assumed that the consumer has well-defined preferences to the set of all possible bundles. She can compare any two bundles. In other words, between any two bundles, she either prefers one to the other or she is indifferent to the two.
2. Ranking of Preferences:-It is assumed that the consumer can rank the bundles in order of her preferences over them.
3. Taste and preference: - It is assumed that the consumer chooses his consumption bundle on the basis of his tastes and preferences over the bundles in the budget set.
4. Monotonic Preferences: - A consumer’s preferences are monotonic if and only if between any two bundles, the consumer prefers the bundle which has more of at least one of the goods and no less of the other good as compared to the other bundle.
5. Substitution between Goods: - Consider two bundles such that one bundle has more of the first good as compared to the other bundle. If the consumer’s preferences are monotonic, these two bundles can be indifferent only if the bundle having more of the first good has less of good 2 as compared to the other bundle.
6. Diminishing Rate of Substitution: - The consumer’s preferences are assumed to be such that she has more of good 1 and less of good 2, the amount of good 2 that she would be willing to give up for an additional unit of good 1 would go down. The amount of good 1 increases, the rate of substitution between good 2 and good 1 diminishes. Preferences of this kind are called convex preferences.

Que. Explain the concept of indifference curve with the help of an example and diagram.
Ans. INDIFFERENCE CURVE (IC): - An IC is the curve, which represents all those combinations of two goods, which give same satisfaction to the consumer. Following table and diagram shows different combination of X and Y which give same satisfaction to the consumer.
Combination Good X Good Y
A 1 12
B 2 6
C 3 4
D 4 3

Que. What is shape of the Indifference Curve? Why it is so?
Ans. Indifference curves are always convex to the origin. The rate of substitution between good 2 and good 1 is called the marginal rate of substitution (MRS). If the preferences are monotonic, then if more and more of one commodity (X) is substituted for another (Y), the consumer is willing to part with less and less of the commodity being substituted (i.e.Y). This is called law of diminishing rate of substitution. Thus, monotonicity of preferences implies that the indifference curves are downward sloping and convex to the origin.



Que. What is Indifference Map?
Ans. The consumer’s preferences over all the bundles can be represented by a family of indifference curves as shown in Figure . This is called an indifference map of the consumer. Monotonicity of preferences imply that between any two indifference curves, the bundles on the one which lies above are preferred to the bundles on the one which lies below thus A higher indifference curve represents a higher level of satisfaction than lower IC.


Que. Explain Utility function.
Ans. Utility function assigns a number to each and every available bundle in a way such that between any two bundles if one is preferred to the other, the preferred bundle gets assigned a higher utility number, and if the two bundles are indifferent, they are assigned the same utility number.

Que. Explain consumer equilibrium under IC analysis. Or Explain the concept of optimal choice of the consumer.
Ans. It is generally assumed that the consumer is a rational individual. From the bundles, which are available to her, a rational consumer always chooses the one, which she prefers, the most.

Her preferences over the available bundles can usually be represented by an indifference map. The rational consumer’s problem is to move to a point on the highest possible indifference curve given her budget set.

The optimum (most preferred) bundle of the consumer would be on the budget line.

Consumer’s equilibrium can be understood with the help of IC MAP and BUDGET LINE.

To show which combination of two goods X and Y the consumer will buy to be in equilibrium we bring his indifference map and budget line together.

Consider the figure given below in which consumer’s indifference map together with the price line ‘PL’ is depicted.



Good X is measured on the X-axis and good Y is measured on the Y-axis. With given money to be spent and given prices of the two goods, the consumer can buy any combination of the goods which lies on the price line PL. In order to maximize his satisfaction the consumer will try to reach the highest possible indifference curve.

The highest indifferences curve to which the consumer can reach is the indifference curve to which the price line is tangent. Any other possible combination would either lie on a lower indifference curve or would be unattainable.

Que. Define the term demand.
Ans. Demand refers to the quantity of a good or service that consumers are willing and able to purchase at various prices during a period of time.

Que. What is consumer demand function?
Ans. The consumer’s demand function for a good gives the amount of the good that the consumer chooses at different levels of its price when the other things remain unchanged. The consumer’s demand for a good as a function of its price can be written as
q = d(p)
Where q denotes the quantity and p denotes the price of the good.

Que. What is demand schedule?
Ans. Demand Schedule: Demand schedule is a numerical tabulation showing quantity that is demanded at given prices. Demand schedule and curve may be two types:
(a) Individual demand schedule: It shows the quantity of the commodities that one consumer will buy at selected prices.

Price of ‘X’ (Rs.) Quantity of ‘X’
1 50
2 40
3 30
4 20
5 10

This above table and curve below shows an inverse relationship between price and quantity demanded, if other things being equal.


(b) Market demand schedule: When we add the individual demands for various schedules we get market demand schedule.

Price of ‘X’ (Rs.) A B C Total Market Demand
1 50 40 10 100
2 40 35 5 80
3 30 30 3 63
4 20 25 2 47
5 10 20 1 31

It indicates that market demand have also inverse relationship between price and quantity demanded.






Que. What is Demand Curve?
Ans. The graphical representation of the demand function is called the demand curve.



Que. Explain the determinants of demand.
Or
Explain the factors that can affect demand for a commodity.
Ans. Following factors demand of a commodity.
1. Price of the commodity (P): Other things being equal, demand of a commodity is inversely related to its price because when price increases then demand decreases and when price decreases then demand increases.
2. Price of related commodities (Pr): Related commodities are of two types:
(a) Complementary goods: Complementary goods are those goods, which are consumed together, or simultaneously e.g. tea and sugar, automobiles and petrol, pen and ink. There is an inverse relation between change in price of one complement and demand of other complementary good. Other things being equal, a fall in the price of one will cause the demand of other to rise and vice versa.
(b) Substitutes or competing goods: Substitutes are those goods which can be used in place of one another e.g. tea and coffee, ink pen and ball pen. There is positive relation between change in price of one substitute and demand of other substitutes good i.e. a fall in the price of one leads to a fall in the quantity demanded of its substitute and vice-versa.
3. Income of the household (Y):
(a) Other things being equal, in case of Normal / Luxury goods demand for goods increases with increase in household’s income and vice versa. So there is positive relation.
(b) In case of Inferior Goods increase in income decrease the quantity demanded. So there is inverse relation
(c)In case of Necessaries as the income of household increases, the demand for necessaries also increases in the beginning and becomes income inelastic (constant) thereafter.
4. Tastes and preference of consumers (T): A positive change in the tastes and preference shall lead to an increase in demand and vice-versa. Fashion can also affect demand and Goods, which are more in fashion command higher demand than goods which are out of fashion. ‘Demonstration effect’ plays also an important role in affecting demand for a product.
5. Future Expectations about price (E): If there is future expectation about rise in price then at present demand rises and if there is future expectation about fall in price then at present demand falls. For example in share market it happens.
6. Other factors (O):
(a) Size of population: Generally larger the size of population of a country, more will be the demand for commodities and vice versa
(b) Composition of population: If the number of children is large, demand for toys and biscuits will be high, similarly, if there are more old people, goods such as sticks and artificial teeth etc. will be in more demand.
(c) Distribution of income: While equitable distribution of the income in the community leads to increase in consumption so APC (Average Propensity to Consume) will rise, an unequal distribution of income brings a fall in the quantity demanded so consumption decreases so APC will fall.
Que. Explain the Law of demand with the help of a demand schedule and demand curve.
Ans. Law of Demand states “other things being equal, there is an inverse relationship between price and quantity demanded of a commodity i.e. if the price of a commodity falls, the quantity demanded of it will rise and if the price of the commodity rises, its quantity demanded will decline. The Law is based upon certain assumptions, which are:
1. No change in Price of related goods.
2. No change in consumer’s income.
3. People’s taste and preference remains unchanged.
4. There are no expectations of future changes in the price.
5. The law may not apply in the goods, which has the prestige value.
The Law of Demand can be illustrated with the help of the demand schedule and the demand curve.

(c) Demand Curve: Graphical presentation of demand schedule is known as demand curve. The Law of Demand can also be explained through the demand curve.


(Individual demand curves) (Market demand curve)

Both individual and market demand curves slopes downward from left to right indicating an inverse relationship between price and quantity demanded. Market demand curve is horizontal summation of individual demand curves.

Que Explain the concept of Adding up Two Linear Demand Curves.
Ans. Consider, for example, a market where there are two consumers and the demand
curves of the two consumers are given as
d1(p) = 10 – p
and d2(p) = 15 – p
Furthermore, at any price greater than 10, the consumer 1 demands 0 unit of the good, and similarly, at any price greater than 15, the consumer 2 demands 0 unit of the good. The market demand can be derived by adding equations. At any price less than or equal to 10, the market demand is given by 25 – 2p, for any price greater than 10, and less than or equal to 15, market demand is 15 – p, and at any price greater than 15, the market demand is 0.

Que. Suppose there are two consumers in the market for a good and their demand functions are as follows:
d1(p) = 15 – p for any price less than or equal to 15, and d1(p) = 0 at any price greater than 15.
d2(p) = 30 – 2p for any price less than or equal to 15 and d1(p) = 0 at any price greater than 15.
Find out the market demand function.
Ans. To get market demand function we have to add the two equations
d1(p) = 15 – p
d2(p) = 30 – 2p

d2(p) = 45 – 3p


At any price less than or equal to 15, the market demand is given by 45 – 3p, for any price greater than 15, and less than or equal to 30, market demand is 30 – 2p, and at any price greater than 30, the market demand is 0.


Que. Explain the rational for the law of demand. Or why does demand curve slope downwards?
Ans. The demand curve slopes downwards due to the following reasons
(1) Substitution effect: When the price of a commodity falls, it becomes relatively cheaper than other substitute commodities. This induces the consumer to substitute the commodity whose price has fallen for other commodities, which have now become relatively expensive. As a result of this substitution effect, the quantity demanded of the commodity, whose price has fallen, rises.
(2) Income effect: When the price of a commodity falls, the consumer can buy more quantity of the commodity with his given income, as a result of a fall in the price of the commodity, consumer’s real income or purchasing power increases. This increase induces the consumer to buy more of that commodity. This is called income effect.
(3) Number of consumers: When price of a commodity is relatively high, only few consumers can afford to buy it, And when its price falls, more numbers of consumers would start buying it because some of those who previously could not afford to buy may now afford to buy it, Thus, when the price of a commodity falls, the number of its consumers increases and this also tends to raise the market demand for the commodity.

Que. Write the equation for Linear demand curve.
Ans. A linear demand curve can be written as
d(p) = a – bp; 0 ≤p ≤ a/b
= 0; p > a/b
where a is the vertical intercept, –b is the slope of the demand curve. At price 0, the demand is a, and at price equal to a/b , the demand is 0.



Que. What does the slope of demand curve measure?
Ans. The slope of the demand curve measures the rate at which demand changes with respect to its price. In the following demand curve for a unit increase in the price of the good, the demand falls by b units.


Que.State the exceptions to Law of Demand.
Ans. Following are the important exceptions to Law ofpemand :

(i) Giffen goods - Law of Demand does not apply to "giffen" goods which have direct price-demand relationship. Examples of such goods are dalda ghee and coarse grain.
(ii) Conspicuous goods - Some consumers measure the utility of a commodity by its price, For example, diamonds are demanded more at high price. Higher the price of diamonds, higher is the prestige attached to them and hence higher is the demand for them.
(iii) Conspicuous necessities - Law of Demand does not apply to the goods which have become necessities of life due to constant use. For examples, television sets, coolers, cooking gas etc.
(iv) Future expectations about prices: It has been observed that when price are rising, households expecting that the prices in the future will be still higher, tend to buy larger quantities of commodities. For example, when there is a expectation that prices of share would rise in future, then demand for the same rises at present.
(v) Ignorance effect: Generally, it is assumed that household has perfect knowledge about price and quality of goods. However, in practice, a household may demand larger quantity of a commodity even at a higher price because it may be ignorant of the ruling price of the commodity.

Que. Explain the concept of expansion and contraction of demand.
Ans. When due to change in price alone demand for a commodity changes, it is called movement along the demand curve. Movements of two types-

(a) Expansion in Demand / Increase in Qty. demand / Downward movement on the same demand curve: Rise in demand due to fall in price is called Expansion of demand.
(b) Contraction of Demand / Decrease in Qty. demand / Upward movement along the same demand curve: - Fall in demand due to rise in its price is called Contraction of demand. In other words contraction of demand is the result of increase in the price of good concerned.



(CONTRACTION OF DEMAND) (EXPANSION OF DEMAND)
Que. Explain the concept of increase and decrease of demand.
Ans. When due to change in factors other than price, demand for a commodity changes. It is called shifting. Shifting is of two types.
(a) Increase in Demand / Rightward shift in the demand curve: When there is increase in demand due to change in factors other than price; it is called increase in demand.

Causes of increase in demand
1. Rise in price of substitutes.
2. Fall in price of a complement good.
3. Rise in income.
4. Taste and preference favour of commodity.
5. Increase in population.
6. Same price and increase in demand or same demand and increase in price.


(b) Decrease in Demand / Leftward shift in demand curve: - When decrease in demand is due to change in factors other than price it is called decrease in demand.

Causes of Decrease in demand:
1. Fall in price of substitutes.
2. Rise in price of a complement
3. Fall in income
4. Taste and preference against the commodity
5. Decrease in population
6. Same price and decrease in quantity demanded or same demand and decrease in price.


Que. Differentiate between movement along the demand curve and shifting of demand curve.
Ans. Difference between Movement and Shifting:
1. Movement along the demand curve indicates change in quantity demanded due to change in price and a shifting indicates that there is change in demand due to change in factors other than price.
2. Movement is also called ‘change in quantity demanded’ and which includes expansion and contraction of demand. Shifting is also called ‘change in demand’ which includes increase and decrease in demand.
3. Change in Qty. demanded represents movement upwards or downwards on the same demand curve and ‘change in demand’ represents shifts of demand curve to the right or left.


Que. Explain the concept of Elasticity of demand.
Ans. Elasticity of demand (Ed) is the percentage change in quantity demanded divided by the percentage change in one of the variables on which demand depends, these variables are P, Pr, Y, T, E, O. Price elasticity of demand usually referred to as elasticity of demand.

Que. What is Price elasticity of demand?
Ans. Price elasticity of demand is measured as percentage change in quantity demanded divided by the percentage change in price, other things remaining equal.

Percentage Change in Quantity demanded %∆Q
Ed= --------------------------------------------- or -------------
Percentage Change in Price %∆P

EP = ∆Q ÷ ∆P
Q P

EP = ∆Q x P
∆P Q
Where EP= Price elasticity Q = Quantity
P = Price ∆ = Change
For example

1. As the price of ‘X’ increases by 5%, and demand falls by 8%. What is the elasticity of demand for ‘X’ commodity?

Elasticity of demand for X = Percentage change in quantity demanded of X
Percentage change in price of X
8%
Ep = -------- = 1.6 or say Ep > 1
5%
2. Originally, a product was selling for Rs. 10 and the quantity demanded was 1000 units. The product price changes to Rs. 14 and as a result the quantity demanded changes to 600 units. Calculate the price elasticity.
EP = ∆Q x P
∆P Q

∆Q = 400 ∆P = 4
P = 10 Q = 1000

400 10
Ep = ---- X ---- = 1 or say E = 1
4 1000

Que. Consider the demand for a good. At price Rs 4, the demand for the good is 25 units. Suppose price of the good increases to Rs 5, and as a result, the demand for the good falls to 20 units. Calculate the price elasticity.

Ans. EP = ∆Q x P
∆P Q

∆Q = 5(25-20) ∆P = 1(5-4)
P = 4 Q = 25


5 4
Ep = ---- X ---- = 0.8 or say E < 1
1 25

Que. Suppose the price elasticity of demand for a good is – 0.2. If there is a 5 % increase in the price of the good, by what percentage will the demand for the good go down?

Ans. Percentage Change in Quantity demanded
Ed= ---------------------------------------------
Percentage Change in Price

Percentage Change in Quantity demanded
-0.2 = ---------------------------------------------
5%
%∆Q = 0.1%

Que. Explain Elasticity along a Linear Demand Curve.
Ans. Let us consider a linear demand curve q = a – bp.
EP = ∆Q x P
∆P Q
Note that at any point on the demand curve, the change in demand per unit change in the price ∆q/∆p = –b. Substituting the value of ∆q/∆p in ed formula we obtain
eD = – b. p/q = – bp/a–bp

it is clear that the elasticity of demand is different at different points on a linear demand
curve. At p = 0, the elasticity is 0, at q = 0, elasticity is ∞. At p = a/2b , the elasticity is 1, at any price greater than 0 and less than a/2b , elasticity is less than 1, and at any price greater than a/2b , elasticity is greater than 1. The price elasticities of demand along the linear demand curve given by equation are depicted in Figure .



Que.. Consider the demand curve D (p) = 10 – 3p. What is the elasticity at price 5/3 ?
Ans. The linear equation is p/q = – bp/a–bp
Here, a = 10, b = 3 and P= 5/3
eD = – bp/a–bp
= -3x5/3
10 -3x5/3
= -1


Que. What are different types of price elasticites of demand.
Ans. Degrees / Types / Coefficient of Price elasticity of Demand are as follows
1. Perfectly elastic demand (Ed=): It is a situation in which demand of a commodity continuously change without any change in price. It means demand of commodity is perfectly flexible in case of perfectly elastic demand. In perfectly elastic demand, the demand curve will be horizontal.
2. More than unitary elastic demand (Ed>1) :-It refers to a situation by which percentage change in demand of a commodity is higher than percentage change in price of that commodity. It is also called elastic demand. For ex. change in price is 10% but change in demand is 20%, then 20% / 10% = 2 (E>1)
3. Unit elastic demand (Ed=1): - When percentage change in demand of a commodity is equal to percentage change in price. For ex. change in price is 10% but change in demand is 10%, then 10% / 10% = 1 (E = 1)
4. Less than unit elastic demand (Ed<1): - When percentage change in demand of a commodity is less than percentage change in price. For ex. change in price is 10% but change in demand is 7%, then 7 % / 10% = .70 (E<1)
5.Perfectly inelastic demand (Ed=0):- When price of commodity does not influence demand of that commodity that situation is called perfectly inelastic demand. In perfectly inelastic demand curve, the demand curve will be vertical. In other words if regardless of change in its price, the quantity demanded of a good remain unchanged, then the demand curve for the good will be vertical.

Que. Explain the relationship between Elasticity of demand and Expenditure.
Ans. The expenditure on a good is equal to the demand for the good multiplied by its price. The price of a good and the demand for the good are inversely related to each other. Whether the expenditure on the good goes up or down as a result of an increase in its price depends on how responsive the demand for the good is to the price change.
Case 1.Increase in the price of a good.
1. If the percentage decline in quantity is greater than the percentage increase in the price, the expenditure on the good will go down.
2. If the percentage decline in quantity is less than the percentage increase in the price, the expenditure on the good will go up.
3. If the percentage decline in quantity is equal to the percentage increase in the price, the expenditure on the good will remain unchanged.
Case 2.Decline in the price of the good.
1. If the percentage increase in quantity is greater than the percentage decline in the price, the expenditure on the good will go up.
2. On the other hand, if the percentage increase in quantity is less than the percentage decline in the price, the expenditure on the good will go down.
3. If the percentage increase in quantity is equal to the percentage decline in the price, the expenditure on the good will remain unchanged.
Summary
1. The expenditure on the good would change in the opposite direction as the price change if and only if the percentage change in quantity is greater than the percentage change in price, i.e. if the good is price-elastic.
2. The expenditure on the good would change in the same direction as the price change if and only if the percentage change in quantity is less than the percentage change in price, i.e., if the good is price inelastic.

Que. Suppose the price elasticity of demand for a good is – 0.2. How will the expenditure on the good be affected if there is a 10 % increase in the price of the good?
Ans. Since the good is price inelastic The expenditure on the good would change in the same direction as the price change.

Que.Suppose there was a 4 % decrease in the price of a good, and as a result, the expenditure on the good increased by 2 %. What can you say about the elasticity of demand?
Ans. The expenditure on the good would change in the opposite direction as the price change if and only if the percentage change in quantity is greater than the percentage change in price, i.e. if the good is price-elastic.

Que Explain the factors which affect elasticity of demand.
Ans. FACTORS AFFECTING / DETERMINANTS OF ELASTICITY OF DEMAND-
(1) Availability of substitutes: If a commodity have more close substitutes, have more elastic demand. And, if a commodity have less substitutes, have inelastic demand. For example Coca cola, Pepsi have close substitutes so demand tends to be elastic. Other commodities such as salt have inelastic demand.
(2) Position of a commodity in the consumer’s budget: Generally, greater the proportion of income spent on a commodity, the greater will be its elasticity of demand and vice-versa. The demand for goods like salt, matches, buttons, etc. tends to be highly inelastic because consumer spend small part of his income. On the other hand, demand for goods like clothing tends to be elastic since consumer spends high part of his income.
(3) Nature of the commodity: In general, luxury goods are price elastic while necessities are price inelastic. Thus while the demand for televisions is relatively elastic the demand for necessity e.g. food and housing, is inelastic.
(4) Number of uses: The more the possible uses of a commodity the greater will be its price elasticity and vice versa. To illustrate, milk has several uses. If its price falls, it can be used for a variety of purposes like preparation of curd, cream, ghee and sweets. But if its price increases, its use will be restricted only to essential purposes.
(5) Consumer habits: If a consumer is habitual consumer of a commodity no matter how much its price change, the demand for the commodity will remain inelastic.

micro economics

INTRODUCTORY MICROECONOMICS
UNIT-I
PRODUCTION POSSIBILITIES CURVE
The production possibilities (PP) curve is a graphical medium of highlighting the central problem of
'what to produce'. To decide what to produce and in what quantities, it is first necessary to know what
is obtainable. The PP curve shows the options that are obtainable, or simply the production
possibilities.
What is obtainable is based on the following assumptions:
1. The resources available are fixed.
2. The technology remains unchanged.
3. The resources are fully employed.
4. The resources are efficiently employed.
5. The resources are not equally efficient in production of all products. Thus if resources are
transferred from production of one good to another, the cost increases. In other words
marginal opportunity cost increases.
The last assumption needs explanation because it determines the shape of the PP curve. If this
assumption changes, the shape changes.
Efficiency in production means productivity i.e. output per unit of an input. Let the input be worker.
Suppose an economy produces only two goods X and Y. Suppose a worker is employed in
production of X because he is best suited for it. The economy decides to reduce production of X
and increase that of Y. The worker is transferred to Y. He is not that efficient in production of Y as
he was in X. His productivity in Y will be low, and so cost of production high.
The implication is clear. If the resources are transferred from one use to another, the less and less
efficient resources will be transferred leading to rise in the marginal opportunity cost which is
technically termed as marginal rate of transformation (MRT). What is MRT?
Marginal Rate of Transformation (MRT)
To simplify, let us assume that only two goods are produced in an economy. Let these two goods be
guns and butter, the famous example given by Samuelson. The guns symbolize defense goods and
butter, the civilian goods. The example, therefore, symbolizes the problem of choice between civilian
goods and war goods. In fact it is a problem of choice before all the countries of the world.
Suppose if all the resources are engaged in the production of guns, there will be a maximum amount
of guns that can be produced per year. Let it be 15 units (one unit may be taken as equal to 1000, or
one lakh and so on). At the other extreme suppose all the resources are employed in production of
butter only. Let the maximum amount of butter that can be produced is 5 units. These are the two
extreme possibilities. In between there are others if the resources are partly used for the production
of guns and partly for production of butter. Given the extremes and the in-between possibilities, a
schedule can be prepared. It can be called a production possibilities schedule. Let the schedule be:
2
Production Possibilities Schedule
Possibilities Guns Butter MRT = Guns
(units) (units) Butter
A 15 0 -
B 14 1 1G : IB
C 12 2 2G : IB
D 9 3 3G : IB
E 5 4 4G : IB
F 0 5 5G : IB
In the table the possibility A is one extreme. The society devotes all the resources to guns and
nothing to butter. Suppose the society wants one unit of butter. Since resources are limited and fully
and efficiently employed, to produce one unit of butter some of the resources engaged in production
of guns have to be transferred to the production of butter. Let the resources worth one unit of gun are
enough to produce one unit of butter. This gives us the second possibility with MRT = 1G/IB. Now
suppose that the society wants another unit of butter. This requires transfer of more resources from
the production of guns. Now we require transfer of resources worth 2 units of guns to produce one
more unit of butter. The MRT rises to 2G/IB. MRT rises because now less efficient resources are
being transferred. In this way MRT goes on rising.
We can now define MRT in general terms. MRT is the ratio of units of one good sacrificed to produce
one more unit of the other good.
MRT = Units of one good sacrificed____ = Guns
More units of the other good produced Butter
Or, MRT is the rate at which the quantity of output of one good is sacrificed to produce on more unit
of the other good.
Production Possibility Curve
By converting the schedule into a diagram, we can get the PP
curve. Refer to the figure I which is based on the PP schedule.
Butter's production is shown on the x-axis and that of guns on the
y-axis.
We can measure MRT on the PP curve. For example MRT
between the possibilities C and D is equal to CG/GD. Between D
and E it is equal to DH/HE, and so on.
3
Diagrammatically, the slope of the PP curve is a measure of the MRT. Since the slope of a concave
curve increases as we move downwards along the curve, the MRT rises as we move downwards
along the curve.
Characteristics
A typical PP curve has two characteristics:
(1) Downward sloping from left to right
It implies that in order to produce more units of one good, some units of the other good must
be sacrificed (because of limited resources).
(2) Concave to the origin
A concave downward sloping curve has an increasing slope. The slope is the same as MRT.
So, concavity implies increasing MRT, an assumption on which the PP curve is based.
Can PP curve be a straight line.
Yes, if we assume that MRT is constant, i.e. slope is constant.
When the slope is constant the curve must be a straight line. But
when is MRT constant? It is constant if we assume that all the
resources are equally efficient in production of all goods.
Note that a typical PP curve is taken to be a concave curve
because it is based on a more realistic assumption that all
resources are not equally efficient in production of all goods.
Does production take place only on the PP curve?
Yes and no, both. Yes, if the given resources are fully and
efficiently utilized. No, if the resources are underutilized or
inefficiently utilized or both. Refer to the figure 3.
On point F, and for that matter on any point on the PP curve
AB, the resources are fully and efficiently employed. On point
U, below the PP curve or any other point but below the PP
curve, the resources are either underutilized or inefficiently
utilised or both. Any point below the PP curve thus highlights
the problem of unemployment and inefficiency in the economy.
4
Can the PP curve shift?
Yes, if resources increase. More labor, more capital goods,
better technology, all mean more production of both the goods.
A PP curve is based on the assumption that resources remain
unchanged. If resources increase, the assumption is broken, and
the existing PP curve is no longer valid. With increased resources
there is a new PP curve to the right of the existing PP curve.
It can also shift, to the left if the resources decrease. It is a rare
possibility but sometimes it may happen due to fall in population,
due to destruction of capital stock caused by large scale natural
calamities, war, etc.
5
UNIT-II
CONSUMER'S EQUILIBRIUM
Introduction
A consumer is one who buys goods and services for satisfaction of wants.
The objective of a consumer is to get maximum satisfaction from spending his income on various
goods and services, given prices.
We start with a simple example. Suppose a consumer wants to buy a commodity. How much of it
should he buy? One of the approaches used for getting an answer to this question is 'utility' analysis.
Before using this approach, we would like to familiarize ourselves with some basic concepts used in
this approach,
Concepts
The term utility refers to the want satisfying power of a commodity. Commodity will possess utility
only if it satisfies a want. Utility differs from person to person, place to place, and time to time.
Marginal Utility is the utility derived from the last unit of a commodity purchased. It can also be
defined as the addition to the total utility when one more unit of the commodity is consumed.
Total Utility is the sum of the utilities of all the units consumed.
As we consume more units of a commodity, each successive unit consumed gives lesser and lesser
satisfaction, that is marginal utility diminishes. It is termed as the Law of Diminishing Marginal Utility.
The following utility schedule will make the Law clear.
Units of a commodity Total (utils) Utility Marginal (utils) Utility
1 4 4 (=4-0)
2 7 3 (=7-4)
3 9 2 (=9-7)
4 10 1 (=10-9)
5 10 0 (=10-10)
6 9 -1 (=9-10)
Here we observe that as more units are consumed marginal utility declines. This is termed as the
law of diminishing marginal utility. The law states that with each successive unit consumed the
utility from it diminishes.
Assumptions
The utility approach to consumer's equilibrium is based on certain assumptions.
6
1. Utility can be cardinally measurable, i.e. can be expressed in exact units.
2. Utility is measurable in monetary terms
3. Consumer’s income is given
4. Prices of commodities are given and remain constant.
Equilibrium
(a) One commodity case
Suppose the consumer wants to buy a good. Further suppose that price of goods is Rs. 3 per unit.
Lel the utility be expressed in utils which are measured in rupees. We are given the marginal utility
schedule of the consumer.
Quantity Price Marginal Utility
1 3 8
2 3 7
3 3 5
4 3 3
5 3 2
When he purchases the first unit, the utility that he gets is 8 utils. He has to pay only
Rs. 3/- for it. Will he buy the 1st unit? Obviously, yes, because he gets more than what he gives.
Similarly, we compare the utility received from other units with the price paid. We find that he will buy
4 units. At the 4th unit, MU equals price. If he buys the 5th unit, he is a looser because the utility that
he gets is 2 utils and what he has to pay is Rs. 3. Therefore, the consumer will maximize his satisfaction
by buying 4 units of this commodity. The condition for maximization of satisfaction if only one
commodity is purchased then is:
MU = Price.
(b) Two commodities case
Suppose a consumer consumes only two goods. Let these goods be X and Y. Given income
and prices (Px and Py), the consumer will get maximum satisfaction by spending his income in such
a way that he gets the same utility from the last rupee spent on each good. This is satisfied when
MUx = MUy = M.U. of a rupee spent on a good.
Px Py
We can show that in order to maximise satisfaction this condition must be satisfied. If it is not satisfied
what difference will it make. Suppose the two ratios are:
MUx > MUy
Px Py
7
It means that per rupee MUx is higher than per rupee MUy. It further means that by transferring one
rupee from Y to X, the consumer gains more utility than he looses. This prompts the consumer to
transfer some expenditure from Y to X. Buying more of X reduces MUx, Px remaining unchanged,
MUx/Px, i.e. per rupee MUx, is also reduced. Buying less of Y raises MUy. Py remaining unchanged
it raises, per rupee MUy. The change continues till per rupee MUx becomes equal to per rupee MUy.
In other words :
MUx = MUy = per rupee MU
Px Py
CONCEPTS OF DEMAND AND DEMAND SCHEDULE
Demand for a good is the quantity of that good which a buyer is willing to buy at a particular price,
during a period of time.
Demand schedule is a tabular presentation showing the different quantities of a good that buyers
of that good are willing to buy at different prices during a given period of time.
Demand schedule of a commodity
Price (Rs. per unit) Quantity demanded (in units)
50 50
40 100
30 150
20 200
10 250
This schedule indicates that more is purchased as price falls. This inverse relationship between
price and quantity demanded, other thing remaining the same is called the law of demand.
RELATIONSHIP BETWEEN PRICE ELASTICITY OF DEMAND AND TOTAL EXPENDITURE
At this stage of learning it is sufficient to know the following about this relationship:
1. When demand is elastic, a fall (rise) in the price of a commodity results in increase (decrease)
in total expenditure on it. Or, when a fall (rise) in the price of a commodity results in increase
(decrease) in total expenditure on it, its demand is elastic.
2. When elasticity is unitary, a fall (rise) in the price of the commodity does not result in any
change in total expenditure on it, or when a fall (rise) in price results in no change in total
expenditure then its elasticity is unitary.
3. When demand is inelastic, a fall (rise) in the price of a commodity results in a fall (rise) in total
expenditure on it, or when a fall (rise) in the price of a commodity results in decrease (increase)
in total expenditure on it, its demand is inelastic.
8
Unit III
PRODUCER’S BEHAVIOUR AND SUPPLY
Meaning of supply
Supply means the quantity of a commodity which a firm or an industry is willing to produce at
a particular price, during a given time period.
Law of supply
This law states that 'other things remaining the same', an increase in the price of a commodity
leads to an increase in its quantity supplied. Thus, more of a commodity is supplied at higher prices
than at lower prices.
This law can be explained with the help of a supply schedule and curve.
A supply schedule is a table which shows the quantities of a commodity supplied at various
prices during a given time period.
Supply Schedule Supply Curve
Price (Rs.) Supply (Units)
1 100
2 200
3 300
As the price increases from Re. 1 to Rs. 3, the supply also rises from 100 units to 300
units, in response to the rising price. What is the basis of the law of supply? Other things remaining
the same, an increase in price results in higher profits for the producer. The higher the price of the
commodity, the greater are the profits earned by the firms and the greater is the incentive to
produce more. Similarly when the price falls, profits decline, resulting in a decrease in quantity
supplied of the commodity. Thus the price and quantity supplied of a commodity are directly
related, other things remaining the same.
‘Change in supply’ versus ‘change in quantity supplied’
(‘shift of supply curve’ versus ‘movement along a supply curve’)
The supply of a commodity depends on its own price and 'other factors' like input prices,
technique of production, prices of other goods, goals of the firm, taxes on the commodity etc.
Movement along a supply curve
The law of supply states the effect of a change in the own price of a commodity on its supply,
other things remaining constant. The supply curve also carries the same assumption. Thus when
other factors influencing supply do not change, and only the own price of the commodity changes, the
9
change in supply takes place along the curve only. This is what movement along a supply curve
means. A movement from one point to another on the same supply curve is also referred to as
a change in quantity supplied”.
In figure 7, OQ is the quantity supplied at price OP. When the price rises
to OP1 the quantity supplied increases to OQ1. Thus there is an upward
movement along the supply curve from point A to B. It is extension of
supply.
Similarly, when the price of a commodity falls from OP to OP2, there is a
decrease in quantity supplied from OQ to OQ2 and thus a downward
movement along the supply curve from A to C. It is contraction of supply.
Movements along the supply curve are caused by a change in the own
price of the good only, other things remaining the same.
Shifts of the supply curve
When supply changes due to changes in factors other than the own price of the commodity, it
results in a shift of the supply curve. This is also referred to as a “change in supply”.
An ‘increase’ in supply means more of the commodity is supplied at the same price. As a
result the supply curve shifts to the right.
In figure 8, at price OP the previous supply was OQ which
increased to OQ1. This also means that OQ units can now be supplied
at a lower price OP1 with the new supply curve S1S1.
An ‘increase’ in supply can take place due to many reasons. For
example, if the input prices fall or there is an improvement in technology,
it will enable producers to produce and sell more at the same price
resulting in a rightward shift of the supply curve.
A decrease in supply means less of the commodity is supplied at
the same price, than previously. As a result, the supply curve shifts
inwards to the left.
In figure 9, at price OP, previously OQ units were supplied which
decreased to OQ1. This also means that OQ units can now be supplied
at a higher price OP1 with the new supply curve S1S1.
10
Shifts of the supply curve of a good are caused by a change in any one or more of the
'other factors' affecting supply, own price remaining unchanged. For example, if the input
prices fall or there is a decrease in the prices of other related commodities, the producers
supply more at the same price resulting in a rightward shift of the supply curve.
PRODUCER'S EQUILIBRIUM
The primary objective of a producer is to earn maximum profits. Profit is the difference between
total revenue and total cost. At that level of output, he is in equilibrium at which he is earning maximum
profit, and he has no incentive to increase or decrease his output. If he produces less than this he
does not maximize total profits. Similarly, if produces beyond this, total profits decline. Thus the
producer is in a 'state of rest' only at the level of output at which the difference between the total
revenue and total cost of production is maximum i.e total profits are maximum.
(NOTE : How does a producer reach equilibrium under different market conditions is not discussed
at this stage of learning).
RELATIONSHIP BETWEEN MARGINAL COST (MC) AND AVERAGE COST (AC)
The relationship between marginal cost and average cost is an arithmetic relationship. To understand
this relationship let us take a numerical example.
The table A shows the marginal costs, total costs and average costs at different levels of output.
Table A
Output Total cost Marginal cost Average cost
(Units) (Rs.) (Rs.) (Rs.)
(1) (2) (3) (4)
1 60 60 60
2 110 50 55
3 162 52 54
4 216 54 54
5 275 59 55
Column 1 shows the level of output.
Column 2 shows the total cost of producing different levels of output.
Column 3 shows the increase in total cost resulting from the production of one more unit of output.
(It is called marginal cost. Thus MCn = TCn - TCn-1, where n and n-1 are levels of output).
Column 4 shows the average cost at different levels of output (ACn = TCn )
n
11
This table shows that :
1. Average cost falls only when marginal cost is less than average cost. Upto the third unit of
output, the marginal cost is less than the average cost and average cost is falling. When 2
units are produced the marginal cost is Rs. 50 which is less than the previous average cost
(Rs.60), now average cost falls from Rs. 60 to Rs. 55. When 3 units are produced, the marginal
cost is Rs. 52 which is less than the average cost of 2 units (Rs. 55) so once again the
average cost falls from Rs. 55 to Rs. 54.
2. Average cost will be constant when marginal cost is equal to average cost. When 4 units are
produced, average cost does not change (It is Rs. 54 when 3 units are produced and remains
Rs. 54 when 4 units are produced) because marginal cost (Rs. 54) is equal to average cost
(Rs. 54).
3. Average cost will rise when marginal cost is greater than average cost. When 5 units are
produced average cost rises from Rs. 54 to Rs. 55, because the marginal cost (Rs. 59) is
greater than the average cost (Rs. 54).
This relationship between marginal cost and average cost is a generalized relationship and holds
good in case of the marginal and average values of any variable, be it revenue or product etc.
In the box a simple proof of the relationship is given : This is for reference only
For Reference only
Suppose AC falls. Then :
TCn < TCn-1
n n-1
Multiplying both sides by n we get,
TCn < TCn-1 x n
n-1
TCn < TCn-1 x (1 + 1 )
n-1
TCn < TCn-1 + TCn-1
n-1
TCn - TCn-1 < TCn-1
n-1
Since the left hand side is MC, and the right hand side is AC, it proves that
MC < AC
Thus a fall in average cost means marginal cost is less than average cost. It can similarly be proved
that a rise in average cost means, marginal cost is greater than average cost and a constant average
cost means marginal cost is equal to average cost.
The relationship between marginal cost and average variable cost is similar to the relationship between
marginal cost and average cost because marginal cost is not affected by fixed cost.
(For proof see box which is for reference only)
12
MCn = TCn - TCn-1
= [TFCn + TVCn] - [TFCn-1 + TVCn-1]
Since TFCn and TFCn are equal
MCn = TVCn - TVCn-1
LAW OF VARIABLE PROPORTION IN TERMS OF TP AND MP CURVES.
(i) In terms of TP
As more and more units of variable factor are employed with fixed factor, total product initially
increases at an increasing rate then increases at decreasing rate and ultimately starts decreasing.
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On the TP curve in the diagram, upto point A, TP is increasing at an increasing rate. If more than 3
units of variable factor are employed, total product still increases till 7units are employed but this
increase is at a diminishing rate. If beyond 7 units of variable factor are employed then TP starts
falling. These are the three respective phases of the law.
(ii) In terms of MP
MP increases upto 3 units. This is phase 1. MP falls after 3 units but is positive upto 7 units.
This is phase 2. MP continues to fall but is negative after 7 units. This is phase 3. Therefore, in
phase 1 the MP curve is upward sloping; downward sloping but above the X-axis in phase 2; and
downward sloping but below the X-axis in phase 3.
(Note that TP is convex in phase 1; concave in phase 2; and downward sloping in phase 3. This is
how we can identify the three phases.)
Returns to Scale
Introduction
This topic is a part of study of production function. A production function is an expression of
quantitative relation between change in inputs and the resulting change in output. It is expressed as
:
Q = f (i1, i2 ......in)
Where Q is output of a specified good and i1, i2 ….in are the inputs usable in producing this good. To
simplify let us assume that there are only two inputs, labour (L) and capital (K), required to produce
a good. The production function then takes the form :
Q = f (K,L)
In microeconomics, conventionally, we study two aspects of relation between inputs and output. One
aspect is : in what manner the change takes place in output of a good, if only one of the inputs
required in producing that good is increased, i.e. other inputs kept unchanged? The manner of
change in output is summed up in the law of variable proportions which you have already studied.
The second aspect is : in what manner the output of a good changes, if all the inputs required in
producing that good are increased simultaneously and in the same proportion. This aspect is
technically termed as returns to scale, and is the subject matter of this study. The word 'return' refers
to the change in physical output. The word 'scale' refers to the scale of operation expressed in terms
of quantum of inputs employed.
Meaning
Returns to scale means the manner of change in physical output caused by the increase in all
the inputs required simultaneously and in the same proportion. Elaborating, suppose one unit of
capital and one unit of labour (1K + 1L), produce 100 units of output. Further suppose that both the
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inputs are doubled, i.e. 2K + 2L. The point of interest is : will output increase by just 100%; by more
than 100%, or by less than 100%. There is no unique answer. All the three states are possible. The
three states are respectively called Constant Returns to Scale (CRS), Increasing Returns to Scale
(IRS) and Decreasing Returns to Scale (DRS). Let us first illustrate the three states and then explain
reasons.
Constant Returns to Scale (CRS)
Suppose 1K+1L produce 100 units of output, and 2K+2L produce 200 units of output. It is
100 percent increase in inputs leading to just 100 percent increase in output. This manner of change
in output is called CRS.
Increasing Returns to Scale (IRS)
Suppose 1K+1L produce 100 units of output and 2K+2L produce 250 units of output. It is 100
percent increase in inputs in leading to 125 percent increase in output. This manner of change in
output is called IRS.
Decreasing Returns to Scale (DRS)
Suppose 1K+1L produce 100 units of output, and 2K+2L produce 180 units of output. It is
100 percent increase in inputs leading to only 80% increase in output. This manner of change in
output is called DRS.
Which of the above states actually results depends to a great extent on the type of technology
used. There are technologies which result in IRS from the beginning and continue upto a large output
level. Similarly, there are technologies leading to CRS almost throughout. There can also be
technologies leading to DRS from the very beginning.
Besides, it is also possible that a technology is such that it gives IRS in the beginning, followed
by CRS and then DRS. For example:
Returns to Scale
Inputs %change Output %change Returns to scale
1K+1L - 100 - -
2K+2L 100% 250 125% IRS
3K+3L 50% 375 50% CRS
4K+4L 33.3% 450 20% DRS
Why do IRS arise?
There are two possible reasons:
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1. More division of labour
Division of labour means subdividing a task into many small sequential operations, with each
worker (or a group of workers) assigned each operation. A single worker, instead of doing all the
operations, concentrates on only one operation and specializes. This raises efficiency of the worker.
Returns to scale means increasing the number of workers along with other inputs. More
workers mean more division of labour. If one task can be divided into 20 small operations, with each
worker assigned only one operation, the worker becomes an expert in the operation he is assigned.
Efficiency increases and so the production. In business circles, the division of labour type production
is called assembly line production.
2. Use of specialized machines
More capital means more capital goods and bigger capital goods. Fully automatic machines
can replace the semi-automatic or the hand operated machines. Bigger machines can be used in
place of small machines. Bigger capital goods can be used in place of smaller capital goods. It is
a common knowledge that a double size capital input may produce more than double the output.
Let us take an interesting example.
Suppose a firm needs a wooden box to store goods. Suppose initially the firm goes in for
1'x1'x1' (LxBxH) size box. Let us see the input requirement and the resulting output. Let the wood
be the only input required. A box has 6 sides. Each side requires 1 sq. ft. of wood (=1'x1'). Then
the input requirement = 1'x1'x6 = 6 sq.ft.
The storing capacity of the box is measured by its volume. Then :
Output of the box : 1'x1'x1' = 1 cubic ft.
Let us now see what happens when the size of the box is increased to 2'x2'x2'.
Input requirement = 2'x2'x6 = 24 sq.ft.
Output = 2'x2'x2' = 8 c.ft.
Now compare. Input of the box rises from 6 sq.ft. to 24 sq.ft. i.e. by 300%. Output of the box
rises from 1c.ft. to 8 c.ft., i.e. by 700%. Increasing returns to scale arise.
Remember that it may not go on for ever, i.e. we go on increasing the size and continue to get
IRS. A stage may reach when IRS may give way to CRS or DRS.
Why do DRS arise?
Economists do not find any specific reason. DRS is a puzzle. Why output rises in a smaller
proportion when all inputs are increased? The probable explanation is that the firm finds it difficult
to manage and coordinate the activities arising out of larger scale. The difficulties may lead to wastage,
inefficiency etc. and cause DRS.
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EQUILIBRIUM PRICE UNDER PERFECT COMPETITION
Meaning of equilibrium
Equilibrium, in general terms. implies (a) a balance between the opposite forces and (b) a
state of rest or a situation that has a tendency to persist. Let us take examples to show the application
of these meanings in microeconomics.
Let us take a market situation in which buyers and sellers are negotiating to buy and sell a
good. Both have different prices to offer. But the good will be sold only when both agree to a common
price and a common quantity at that price. If both agree, a market equilibrium is said to emerge.
Note that buyers and sellers have opposite interests. The buyers will like to pay as low a price as
possible. The sellers will like to charge as high a price as possible. Agreement on a common price
and quantity creates a balance between the two opposite interests. This equilibrium price and quantity
has a tendency to persist.
Equilibrium price
Equilibrium price is the price at which the sellers of a good are willing to sell the same quantity
which buyers of that good are willing to buy. We can explain this meaning with the help of market
demand and supply schedule of a good, given below :
Price per unit Market demand Market supply Equilibrium
(Rs.) (units) (units)
1 1000 200 Excess demand
2 800 400 Excess demand
3 600 600 Market Equilibrium
4 400 800 Excess supply
5 200 1000 Excess supply
Refer to the schedule. The market equilibrium is established at a price of Rs. 3 per unit,
because at this price both the market demand and market supply are equal. This is the price
which has a tendency to persist.
Why is not any other price an equilibrium price?
Take, for example, a price less than the equilibrium price. Suppose it is Rs. 2 per unit. At
this price market demand is greater than market supply. It is called an excess demand situation. But
this price cannot persist. It will change. Why?
It is because the buyers will not be able to buy all what they want to buy. The pressure of
excess demand will push the market price up. This will have two effects. Supply will go up because
the producers are willing to supply more at a higher price. Demand will go down because the buyers
are willing to buy less at a higher price. In fact, this is what is required to restore equilibrium. The
tendency of supply going up and demand going down will continue till market supply becomes equal
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to market supply once again and the excess demand becomes zero. This is achieved at Rs. 3 per
unit. The equilibrium is restored.
Let us now take a price higher than the equilibrium price. Suppose it is Rs. 4 per unit. At this
price now the market supply is greater than market demand. It is called an excess supply situation.
Even this price cannot persist. It is because the sellers will not be able to sell all what they want to sell.
The excess supply pressure will push the price downwards. This will have two effects. Supply will go
down and demand will go up. The tendency will continue till market demand becomes equal to
market supply once again, and the price settles at Rs. 3 per unit.
To sum up, the equilibrium price is the price at which market demand equals market supply.
This price has a tendency to persist. If at a price the market demand is not equal to market supply
there will be either excess demand or excess supply and the price will have tendency to change until
it settles once again at a point where market demand equals market supply.
Graphic Presentation
The equilibrium is at E the intersection of supply and
demand curves representing the two schedules given above.
The equilibrium price is Rs. 3 and equilibrium quantity 600 units.
The price higher than Rs. 3, creates excess supply and ultimately
returns to Rs. 3 on account of the effects explained above. The
arrows indicate the tendencies. The price below the equilibrium
price creates excess demand and has a tendency to return to
Rs. 3 per unit on account of the effects explained above and
indicated by the arrows.
Can the equilibrium price change?
Yes, when demand or supply or both increase or decrease. 'Increase', as you know, means
rise in demand or supply due to factors other than the own price of the good. Similarly the term
'decrease' is defined. Graphically, it means shift of demand curve, or supply curve or both. You are
familiar with these terms. You are expected to study the chain effects of shifts in demand and supply
on equilibrium price and quantity.
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UNIT IV
FEATURES OF PERFECT COMPETITION
Introduction
Perfect competition is a state of a market. Anything which facilitates contact between buyers
and sellers constitutes a market. It may be a face to face meeting at some place or simply verbal
negotiations through telephone, internet, etc.
Conventionally, in microeconmoics the markets are classified into these states: perfect
competiton, monopoly, monopolistic competition and oligopoly. There are many criteria of
classification, the number of sellers, similarity of products, availability of information, mobility of firms
and the inputs engaged in the firm, etc. Whatever the criteria the end result is reflected in one thing :
how much influence an individual seller, on his own, is able to exercise on the market. Lower the
influence more the competitive nature of the market it indicates. If the influence of an individual seller
is zero, or virtually zero, the market is said to be perfectly competitive.
Meaning
Perfect competition can be defined either in terms of its characteristic features, or in terms of
the unique end result of these characteristics. Unique in the sense that it is specific to a perfectly
competitive market. In terms of its features, a perfectly competitive is a market where there are
large number of buyers and sellers, the firms produce homogeneous products, the buyers and sellers
have perfect knowledge and the firm are free to entry or make an exit in and out of industry. In terms
of the end result of these features which is unique to this market, a perfectly competitive market is
one in which an individual firm cannot influence the prevailing market price of the product on its own.
Features and their implications
A perfectly competitive market has the following features:
1. Large number of sellers and buyers
Note that 'large number' is not a specifically defined number. However, it has a specific
implication. Let us talk about the large number of sellers first. The words 'large number' imply that
the number of sellers is large enough to render a single seller's share in total market supply of the
product insignificant. It has a further implication. Insignificant share means that if only one individual
firm reduces or raises its own supply, the prevailing market price remains unaffected. The prevailing
market price is the one which was set through the interaction of market demand and market
supply forces, for which all the sellers and all the buyers together are responsible. One single
seller has no option but to sell what it produces at this market determined price. This position of
an individual firm in the total market is referred to as price taker. This is a unique feature of a
perfectly competitive market.
Similarly, the 'large number' of buyers also has the same implication. A single buyer's
share in total market demand is so insignificant that the buyer cannot influence the market price
on his own by changing his demand. This makes a single buyer also a price taker.
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To sum up, the feature 'large number' indicates ineffectiveness of a single seller or a
single buyer in influencing the prevailing market price on its own, rendering him simply a price
taker.
2. The products of all the firms in the industry are homogenous
It means that the buyers treat the products of all the firms in the industry as homogenous. The
products produced by the firms are identical, or treated as identical, or perfectly standardized. The
buyers do not distinguish the output of one firm from that of the other.
The implication of this feature is that since the buyers treat the products as identical they are
not ready to pay a different price for the product of any one firm. They will pay the same price for the
products of all the firms in the industry. On the other hand, any attempt by a firm to sell its product at
a higher price will fail.
To sum up, the 'homogenous products' feature ensures a uniform price for the products of all
the firms in the industry.
3. Perfect knowledge about markets for outputs and inputs.
The firms have all the knowledge about the product market and the input markets. Buyers
also have perfect knowledge about the product market.
Let us take the product market first. The implication of perfect knowledge about the product
market is that any attempt by any firm to charge a price higher than the prevailing uniform price will
fail. The buyers will not pay because they have perfect knowledge. There is no ignorance factor
operating in the market. The sellers do not charge a lower price due to ignorance. The buyers do not
pay a higher price due to ignorance. A uniform price prevails in the market.
As regards the knowledge about the input markets, the implicit assumption is that each firm
has an equal access to the technology and the inputs used in the technology. No firm has any cost
advantage. Cost structure of each firm is the same. All the firms have a uniform cost structure.
Since there is uniform price and uniform cost in case of all firms, and since profits equals cost
less price, all the firms earn uniform profits.
4. Freedom to firms to enter or to leave the industry in the long run
Freedom of entry means that there are no artificial barriers and natural barriers in the way of
a new firm wishing to enter into industry. The artificial barriers may take the form of patent rights,
legal restrictions, etc. The natural barrier may take the form of huge capital expenditure required to
start a new firm, which the firm wishing to enter is not able to arrange.
Freedom of exit means no barriers in the way of a firm deciding to leave the industry.
Government rules, labour laws, loss of huge fixed capital etc. do not come in the way.
The freedom of entry and exit of firms has an important implication. This ensures that no
firm can earn above normal profits in the long run. Each firm earns just the normal profits, i.e.
minimum necessary to carry on business. In Microeconomics, normal profits is treated as an
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opportunity cost, and therefore, counted in calculation of total cost. Since profit equals total revenue
minus total cost, normal profit means zero economic profit. Why? Let us explain.
Suppose the existing firms are earning above normal profits, i.e. positive economic profits.
Attracted by the positive profits, the new firms enter the industry. The industry's output, i.e. market
supply, goes up. The price comes down. New firms continue to enter and the price continues to
fall till economic profits are reduced to zero.
Now suppose the existing firms are incurring losses. The firms start leaving. The industry's
output starts falling, price starts going up, and all this continues till losses are wiped out. The remaining
firms in the industry then once again earn just the normal profits.
Only zero economic profit in the long run is the basic outcome of a perfectly competitive
market.
Average Revenue and marginal revenue curves of a perfectly competitive firm
The forces of market supply (i.e. supply by industry) and market demand (demand by all the
buyers) determine the market price. The firm, being a price taker, adopts this price and is free to sell
any quantity it likes at this price. The price taker feature determines the shape of the firms AR and
MR curves. Refer to the figure -12 b
The figure 12a shows the intersection of demand and supply curves at E determining the
price OP. The figure 12b shows the adoption of price by the price taker firms who are free to sell any
quantity, at this price. This makes the AR curve perfectly elastic and thus parallel to the
X-axis. As per the average marginal relationship, when AR is constant, MR must be equal to AR.
Therefore, AR curve is also the MR curve of the firm.

PLANNING

Introduction
You have just read about the plans of Gas Authority of India Limited (GAIL), It is one of our leading public sector companies. The plans discussed by the Chairperson, GAIL are real plans of the company and how they would like to go about achieving their objectives. Of course, these are broad statements given by the company and they have to be broken down into steps for implementation. This is an example of a company in the public sector with a nation-wide reach striving to be one of the top companies in India. Further more, every organisation whether it is government-owned, a privately owned business or a company in the private sector requires planning. The government makes five year plans for the country, a small business has it’s own plans, while other companies have big plans, sales plans, production plans. All of them have some plans.
All business firms would like to be successful, increase their sales and earn profits. All managers dream of these and strive to achieve their goals. But to turn these dreams into reality managers need to work hard in thinking about the future, in making business predictions and achieving targets. Dreams can be turned into reality only if business managers think in advance on what to do and how to do it. This is the essence of planning.
Meaning
Planning is deciding in advance what to do and how to do. It is one of the basic managerial functions. Before doing something, the manager must formulate an idea of how to work on a particular task. Thus, planning is closely connected with creativity and innovation. But the manager would first have to set objectives, only then will a manager know where he has to go. Planning seeks to bridge the gap between where we are and where we want to go. Planning is what managers at all levels do. It requires taking decisions since it involves making a choice from alternative courses of action.
Planning, thus, involves setting objectives and developing appropriate courses of action to achieve these objectives. Objectives provide direction for all managerial decisions and actions. Planning provides a rational approach for achieving predetermined objectives. All members, therefore, need to work towards achieving organisational goals. These goals set the targets which need to be achieved and against which actual performance is measured. Therefore, planning means setting objectives and targets and formulating an action plan to achieve them. It is concerned with both ends and means i.e., what is to be done and how it is to be done.
The plan that is developed has to have a given time frame but time is a limited resource. It needs to be utilised judiciously. If time factor is not taken into consideration, conditions in the environment may change and all business plans may go waste. Planning will be a futile exercise if it is not acted upon or implemented.
Do you think from the above we can formulate a comprehensive definition of planning? One of the ways to do so would be to define planning as setting objectives for a given time period, formulating various courses of action to achieve them, and then selecting the best possible alternative from among the various courses of action available.
Importance of Planning
You must have seen in films and advertisements how executives draw up plans and make powerful presentations in boardrooms. Do those plans actually work? Does it improve efficiency? After all why should we plan? These are numerous questions to which we would like to find solutions. Planning is certainly important as it tells us where to go, it provides direction and reduces the risk of uncertainty by preparing forecasts. The major benefits of planning are given below:
(i) Planning provides directions: By stating in advance how work is to be done planning provides direction for action. Planning ensures that the goals or objectives are clearly stated so that they act as a guide for deciding what action should be taken and in which direction. If goals are well defined, employees are aware of what the organisation has to do and what they must do to achieve those goals. Departments and individuals in the organisation are able to work in coordination. If there was no planning, employees would be working in different directions and the organisation would not be able to achieve its desired goals.
(ii) Planning reduces the risks of uncertainty: Planning is an activity which enables a manager to look ahead and anticipate changes. By deciding in advance the tasks to be performed, planning shows the way to deal with changes and uncertain events. Changes or events cannot be eliminated but they can be anticipated and managerial responses to them can be developed.
(iii) Planning reduces overlapping and wasteful activities: Planning serves as the basis of coordinating the activities and efforts of different divisions, departments and individuals. It helps in avoiding confusion and misunderstanding. Since planning ensures clarity in thought and action, work is carried on smoothly without interruptions. Useless and redundant activities are minimised or eliminated. It is easier to detect inefficiencies and take corrective measures to deal with them.
(iv) Planning promotes innovative ideas: Since planning is the first function of management, new ideas can take the shape of concrete plans. It is the most challenging activity for the management as it guides all future actions leading to growth and prosperity of the business.
(v) Planning facilitates decision making: Planning helps the manager to look into the future and make a choice from amongst various alternative courses of action. The manager has to evaluate each alternative and select the most viable proposition. Planning involves setting targets and predicting future conditions thus helping in taking rational decisions.
(vi) Planning establishes standards for controlling: Planning involves setting of goals. The entire managerial process is concerned with accomplishing predetermined goals through planning, organising, staffing, directing and controlling. Planning provides the goals or standards against which actual performance is measured. By comparing actual performance with some standard, managers can know whether they have actually been able to attain the goals. If there is any deviation it can be corrected. Therefore, we can say that planning is a prerequisite for controlling. If there were no goals and standards, then finding deviations which are a part of controlling would not be possible. The nature of corrective action required depends upon the extent of deviations from the standard. Therefore, planning provides the basis of control.
Features of Planning
It the example of Polaris, the company has plans of expansion. Their objective is to increase their capacity so that they can employ 800 more professionals. Their target time is six months. The objective of the current year has also been clearly stated which is to increase capacity by 1500-2000 more professionals. Since planning is the primary function of management they have set their objectives first. Thus, all businesses follows a set pattern of planning. You will be able to find some similarities in the features of planning and what you see in real life. Try and identify those.
The planning function of the management has certain special features. These features throw light on its nature and scope. (i) Planning focuses on achieving objectives: Organisations are set up with a general purpose in view. Specific goals are set out in the plans along with the activities to be undertaken to achieve the goals. Thus, planning is purposeful. Planning has no meaning unless it contributes to the achievement of predetermined organisational goals.
(ii) Planning is a primary function of management: Planning lays down the base for other functions of management. All other managerial functions are performed within the framework of the plans drawn. Thus, planning precedes other functions. This is also referred to as the primacy of planning. The various functions of management are interrelated and equally important. However, planning provides the basis of all other functions.
(iii) Planning is pervasive: Planning is required at all levels of management as well as in all departments of the organisation. It is not an exclusive function of top management nor of any particular department. But the scope of planning differs at different levels and among different departments. For example, the top management undertakes planning for the organisation as a whole. Middle management does the departmental planning. At the lowest level, day-to-day operational planning is done by supervisors.
(iv) Planning is continuous: Plans are prepared for a specific period of time, may be for a month, a quarter, or a year. At the end of that period there is need for a new plan to be drawn on the basis of new requirements and future conditions. Hence, planning is a continuous process. Continuity of planning is related with the planning cycle. It means that a plan is framed, it is implemented, and is followed by another plan, and so on.
(v) Planning is futuristic: Planning essentially involves looking ahead and preparing for the future. The purpose of planning is to meet future events effectively to the best advantage of an organisation. It implies peeping into the future, analysing it and predicting it. Planning is, therefore, regarded as a forward looking function based on forecasting. Through forecasting, future events and conditions are anticipated and plans are drawn accordingly. Thus, for example, sales forecasting is the basis on which a business firm prepares its annual plan for production and sales.
(vi) Planning involves decision making: Planning essentially involves choice from among various alternatives and activities. If there is only one possible goal or a possible course of action, there is no need for planning because there is no choice. The need for planning arises only when alternatives are available. In actual practice, planning presupposes the existence of alternatives. Planning, thus, involves thorough examination and evaluation of each alternative and choosing the most appropriate one.
(vii) Planning is a mental exercise: Planning requires application of the mind involving foresight, intelligent imagination and sound It is basically an intellectual activity of thinking rather than doing, because planning determines the action to be taken. However, planning requires logical and systematic thinking rather than guess work or wishful thinking. In other words, thinking for planning must be orderly and based on the analysis of facts and forecasts.
Limitations of Planning
We have seen how planning is essential for business organisations. It is difficult to manage operations without formal planning. It is important for an organisation to move towards achieving goals. But we have often seen in our daily lives also, that things do not always go according to plan. Unforeseen events and changes, rise in costs and prices, environmental changes, government interventions, legal regulations, all affect our business plans. Plans then need to be modified. If we cannot adhere to our plans, then why do we plan at all? This is what we need to analyse. The major limitations of planning are given below:
(i) Planning leads to rigidity: In an organisation, a well-defined plan is drawn up with specific goals to be achieved within a specific time frame. These plans then decide the future course of action and managers may not be in a position to change it. This judgment
kind of rigidity in plans may create difficulty. Managers need to be given some flexibility to be able to cope with the changed circumstances. Following a pre-decided plan, when circumstances have changed, may not turn out to be in the organisations interest.
(ii) Planning may not work in a dynamic environment: The business environment is dynamic, nothing is constant. The environment consists of a number of dimensions, economic, political, physical, legal and social dimensions. The organisation has to constantly adapt itself to changes. It becomes difficult to accurately assess future trends in the environment if economic policies are modified or political conditions in the country are not stable or there is a natural calamity. Competition in the market can also upset financial plans, sales targets may have to be revised and, accordingly, cash budgets also need to be modified since they are based on sales figures. Planning cannot foresee everything and thus, there may be obstacles to effective planning.
(iii) Planning reduces creativity: Planning is an activity which is done by the top management. Usually the rest of the members just implements these plans. As a consequence, middle manage ment and other decision makers are neither allowed to deviate from plans nor are they permitted to act on their own. Thus, much of the initiative or creativity inherent in them also gets lost or reduced. Most of the time, employees do not even attempt to formulate plans. They only carry out orders. Thus, planning in a way reduces creativity since people tend to think along the same lines as others. There is nothing new or innovative.
(iv) Planning involves huge costs: When plans are drawn up huge costs are involved in their formulation. These may be in terms of time and money for example, checking accuracy of facts may involve lot of time. Detailed plans require scientific calculations to ascertain facts and figures. The costs incurred sometimes may not justify the benefits derived from the plans. There are a number of incidental costs as well, like expenses on boardroom meetings, discussions with professional experts and preliminary investigations to find out the viability of the plan.
(v) Planning is a time-consuming process: Sometimes plans to be drawn up take so much of time that there is not much time left for their implementation.
(vi) Planning does not guarantee success: The success of an enterprise is possible only when plans are properly drawn up and implemented. Any plan needs to be translated into action or it becomes meaningless. Managers have a tendency to rely on previously tried and tested successful plans. It is not always true that just because a plan has worked before it will work again. Besides, there are so many other unknown factors to be considered. This kind of complacency and false sense of security may actually lead to failure instead of success. However, despite its limitations, planning is not a useless exercise. It is a tool to be used with caution. It provides a base for analysing future courses of action. But, it is not a solution to all problems.
Planning Process
Planning, as we all know is deciding in advance what to do and how to do. It is a process of decision making. How do we go about making a plan? Since planning is an activity there are certain logical steps for every manager to follow.
(i) Setting Objectives: The first and foremost step is setting objectives. Every organisation must have certain objectives. Objectives may be set for the entire organisation and each department or unit within the organisation. Objectives or goals specify what the organisation wants to achieve. It could mean an increase in sales by 20% which could be objective of the entire organisation. How all departments would contribute to the organisational goals is the plan that is to be drawn up. Objectives should be stated clearly for all departments, units and employees. They give direction to all departments. Departments/units then need to set their own objectives within the broad framework of the organisation’s philosophy. Objectives have to percolate down to each unit and employees at all levels. At the same time, managers must contribute ideas and participate in the objective setting process. They must also understand how their actions contribute to achieving objectives. If the end result is clear it becomes easier to work towards the goal.
(ii) Developing Premises: Planning is concerned with the future which is uncertain and every planner is using conjucture about what might happen in future. Therefore, the manager is required to make certain assumptions about the future. These assumptions are called premises. Assumptions are the base material upon which plans are to be drawn. The base material may be in the form of forecasts, existing plans or any past information about policies. The premises or assumptions must be the same for all and there should be total agreement on them. All managers involved in planning should be familiar with and using the same assumptions. For example, forecasting is important in developing premises as it is a technique of gathering information. Forecasts can be made about the demand for a particular product, policy change, interest rates, prices of capital goods, tax rates etc. Accurate forecasts, therefore become essential for successful plans.
(iii) Identifying alternative courses of action: Once objectives are set, assumptions are made. Then the next step would be to act upon them. There may be many ways to act and achieve objectives. All the alternative courses of action should be identified. The course of action which may be taken could be either routine or innovative. An innovative course may be adopted by involving more people and sharing their ideas. If the project is important, then more alternatives should be generated and thoroughly discussed amongst the members of the organisation.
(iv) Evaluating alternative courses: The next step is to weigh the pros and cons of each alternative. Each course will have many variables which have to be weighed against each other. The positive and negative aspects of each proposal need to be evaluated in the light of the objective to be achieved. In financial plans, for example, the risk-return trade-off is very common. The more risky the investment, the higher the returns it is likely to give. To evaluate such proposals detailed calculations of earnings, earnings per share, interest, taxes, dividends are made and decisions taken. Accurate forecasts in conditions of certainty/uncertainty then become vital assumptions for these proposals. Alternatives are evaluated in the light of their feasibility and consequences.
(v) Selecting an alternative: This is the real point of decision making. The best plan has to be adopted and implemented. The ideal plan, of course, would be the most feasible, profitable and with least negative consequences. Most plans may not always be subjected to a mathematical analysis. In such cases, subjectivity and the manager’s experience, judgment and at times, intuition play an important part in selecting the most viable alternative. Sometimes, a combination of plans may be selected instead of one best course. The manager will have to apply permutations and combinations and select the best possible course of action.
(vi) Implement the plan: This is the step where other managerial functions also come into the picture. The step is concerned with putting the plan into action i.e., doing what is required. Forexample, if there is a plan to increase production then more labour, more machinery will be required. This step would also involve organising for labour and purchase of machinery.
(vii) Follow-up action: To see whether plans are being implemented and activities are performed according to schedule is also part of the planning process. Monitoring the plans is equally important to ensure that objectives are achieved.
Types of Plans
Based on what the plans seeks to achieve and the method which the plan would like to adopt, plans can be classified as different types — Objectives, Strategy, Policy, Procedure, Method, Rule, Programme, Budget.
Objectives
The first step in planning is setting objectives. Objectives, therefore, can be said to be the desired future position that the management would like to reach. Objectives are very basic to the organisation and they are defined as ends which the management seeks to achieve by its operations. Therefore, an objective simply stated is what you would like to achieve, i.e., the end result of activities. For example, an organisation may have an objective of increasing sales by 10% or earning a reasonable rate of return on investment, earn a 20% profit from business. They represent the end point of planning. All other managerial activities are also directed towards achieving these objectives. They are usually set by top management of the organisation and focus on broad, general issues. They define the future state of affairs which the organisation strives to realise. They serve as a guide for overall business planning. Different departments or units in the organ-isation may have their own objectives.
Objectives need to be expressed in specific terms i.e., they should be measurable in quantitative terms, in the form of a written statement of desired results to be achieved within a given time period.
Strategy
A strategy provides the broad contours of an organisation’s business. It will also refer to future decisions defining the organisations direction and scope in the long run. Thus, we can say a strategy is a comprehensive plan for accomplishing an organisation objectives. This comprehensive plan will include three dimensions, (i) determining long term objectives, (ii) adopting a particular course of action, and (iii) allocating resources necessary to achieve the objective.
Whenever a strategy is formulated, the business environment needs to be taken into consideration. The changes in the economic, political, social, legal and technological envi ronment will affect an organisations strategy. Strategies usually take the course of forming the organisations identity in the business environment. Major strategic decisions will include decisions like whether the organisation will continue to be in the same line of business, or combine new lines of activity with the existing business or seek to acquire a dominant position in the same market. For example, a company’s marketing strategy has to address certain questions i.e., who are the customers? what is the demand for the product? which channel of distribution to use? what is the pricing policy? and how do we advertise the product. These and many more issues need to be resolved while formulating a marketing strategy for any organisation.
Policy
Policies are general statements that guide thinking or channelise energies towards a particular direction. Policies provide a basis for interpreting strategy which is usually stated in general terms. They are guides to managerial action and decisions in the implementation of strategy. For example, the company may have a recruitment policy, pricing policy within which objectives are set and decisions are made. If there is an established policy, it becomes easier to resolve problems or issues. As such, a policy is the general response to a particular problem or situation.
There are policies for all levels and departments in the organisation ranging from major company policies to minor policies. Major company policies are for all to know i.e., customers, clients, competitors etc., whereas minor polices are applicable to insiders and contain minute details of information vital to the employees of an organisation. But there has to be some basis for divulging information to others.
Policies define the broad parameters within which a manager may function. The manager may use his/her discretion to interpret and apply a policy. For example, the decisions taken under a Purchase Policy would be in the nature of manufacturing or buying decisions. Should a company make or buy its requirements of packages, transport services, printing of stationery, water and power supply and other items? How should vendors be selected for procuring supplies? How many suppliers should a company make purchases from? What is the criteria for choosing suppliers. All these answers would be addressed by the Purchase Policy.
Procedure
Procedures are routine steps on how to carry out activities. They detail the exact manner in which any work is to be performed. They are specified in a chronological order. For example, there may be a procedure for requisitioning supplies before production. Procedures are specified steps to be followed in particular circumstances. They are generally meant for insiders to follow. The sequence of steps or actions to be taken are generally to enforce a policy and to attain pre-determined objectives. Policies and procedures are interlinked with each other. Procedures are steps to be carried out within a broad policy framework.
Method
Methods provide the prescribed ways or manner in which a task has to be performed considering the objective. It deals with a task comprising one step of a procedure and specifies how this step is to be performed. The Methods may vary from task to task. Selection of proper method saves time, money and effort and increases efficiency. For imparting training to employees at various level from top management to supervisory, different methods can be adopted. For example for higher level management orientation programmes, lectures and seminars can be organised whereas at the supervisory level, on the job training methods and work-oriented methods are appropriate.
Rule
Rules are specific statements that inform what is to be done. They do not allow for any flexibility or discretion. It reflects a managerial decision that a certain action must or must not be taken. They are usually the simplest type of plans because there is no compromise or change unless a policy decision is taken.
Programme
Programmes are detailed statements about a project which outlines the objectives, policies, procedures, rules, tasks, human and physical resources required and the budget to implement any course of action. Programmes will include the entire gamut of activities as well as the organisation’s policy and how it will contribute to the overall business plan. The minutest details are worked out i.e., procedures, rules, budgets, within the broad policy framework.
Budget
A budget is a statement of expected results expressed in numerical terms. It is a plan which quantifies future facts and figures. For example, a sales budget may forecast the sales of different products in each area for a particular month. A budget may also be prepared to show the number of workers required in the factory at peak production times.
Since budget represents all items in numbers, it becomes easier to compare actual figures with expected figures and take corrective action subsequently. Thus, a budget is also a control device from which deviations can be taken care of. But making a budget involves forecasting, therefore, it clearly comes under planning. It is a fundamental planning instrument in many organisations.
Let us take an example of Cash Budget. The cash budget is a basic tool in the management of cash. It is a device to help the management to plan and control the use of cash. It is a statement showing the estimated cash inflows and cash outflows over a given period. Cash inflows would generally come from cash sales and the cash outflows would generally be the costs and expenses associated with the operations of the business. The net cash position is determined by the cash budget i.e., inflows minus (–) outflows = surplus or deficiency.
The management has to hold adequate cash balances for various purposes. But at the same time, it should avoid excess balance of cash since it gives little or no return. The business has to assess and plan its need for cash with a degree of caution.