Introduction to Engineering Economics

Dept of CSE | IV YEAR | VIII SEM HS T81 | ENGINEERING ECONOMICS AND MANAGEMENT | UNIT 1
1 |Prepared By : Mr. PRABU.U/AP |Dept. of Computer Science and Engineering | SKCET |
UNIT I
Introduction – Micro Economics – Macro Economics – Economic Decisions and
Technical Decisions – Demand and Supply Concepts – Elasticity of Demand – Cost of
Products – Price of Products – Break-Even Analysis – Nature of Functioning of Money –
National Income – GNP and Savings – Inflation and Deflation Concepts
1.1 INTRODUCTION
Economics
Economics is a science which deals with introduction and consumption of goods
and services distribution for the welfare of humans.
Economy, the attainment of an end(product/good/service) at low cost in terms
of human effort, has always been associated with engineering.
Engineering economics
Engineering economics deals with the methods that enable an individual to take
economic decisions with minimized cost and maximum benefit to business
organization.
1. Defining Managerial Economics
Managerial Economics is the study of directing resources in a way that it most
efficiently achieves the managerial goals.
Spencer and Siegelman have defined managerial economics as "The integration
of economic theory with business practice for the purpose of facilitating decision-
making and forward planning by management".
2. Nature of Managerial/ Engineering Economics
Macro Economic Conditions
Macro economic conditions are the economic environment in which the firm
operates. The nature of this environment is broad and almost always decisions of the
firm are made within broad framework.
Micro Economic Analysis
Unlike the macro economic conditions which talk about broad
environment(external) of the firm, micro economic analysis deals with the problems of
an individual firm, industry or consumer etc.
3. Factors influencing Managerial decisions
The following are the factors influencing managerial decisions
i) Technological Factor
ii) Internal and External Environmental Factor
A firm is a unit engaged in production of goods and services. The term firm
includes all those enterprises which are related with the production not only of goods
but also of services.

i) Technological Factor
 In economic analysis the technological factor is held constant for convenience
sake which is not true in the real life situation. Technology is never stagnant and
it always changes, improvements are made all the time in the existing
technology.
 The competitors will be adopting these technologies and improve upon their
profit over nights. New technologies will help the firm to provide better
product/services for the consumer, one may save huge amount of money
through cost reduction by introducing new technology.
ii) Internal and External Environmental Factor
 Any economic decisions taken by the manager should consider both the internal
and the external environmental factors of the firm.
 A manager, dictated by the internal requirement to increase the profits may be
willing to raise the price of a product but the competition need not do so. This
automatically gives the competitor a competitive advantage over this firm.
 Similarly if the manager decides to cut price to win over the competition,
government rules and regulation may not allow to do so because this firm may
become monopoly after some time since the competition may die out and the
consumer's will be affected in the long run.
4. Scope of Managerial Economics
Managerial Economics has close connections with economic theory, statistics,
mathematics, operations research and theory of decision making. The following aspects
constitute the scope of managerial economics
i) Objectives of a business firm
The objectives of a business firm may be varied. Apart from generating profits a
firm has many other objectives like being a market leader, being a cost leader, being a
price leader, achieving superior efficiency, achieving superior quality, achieving
superior customer responsiveness etc.
ii) Demand analysis and forecasting
Demand analysis and forecasting helps in analyzing the market factors
influencing the firm's product and thus provides guidance in manipulating the demand
to produce profits. Thus demand analysis and forecasting have an important place in
managerial economics.
iii) Cost Analysis
An element of cost uncertainty exists because all the factors determining costs
are not always known and controllable. If a detailed cost analysis and estimation is
done, the firm can move upon effective profit management.
iv) Production Management
When a manager organizes and plans the firm's production functions ie., when
he tries to convert raw materials to finished product, he faces a number of economic
problems. He should arrive on the most profitable decision with regard to the efficient
use of resources available with the firm and in scheduling the output.
v) Supply Analysis
Supply analysis deals with the various aspects of supply of a commodity. Certain
important aspects of supply analysis are supply schedule, curves and function, elasticity
of supply, law of supply and its limitations and factors influencing supply.

vi) Pricing decisions and Policies
A firm's profitability and success greatly depend on the pricing decisions and the
pricing policies of the firm. Pricing also depends on the environment in which the firm
operates, competitions, customers etc.
vii) Profit management
Profits are influenced by various factors such as cost of production, revenues and
other factors both internal and external to the firm. Profits are hard to predict. This is
chiefly because of the uncertainty of future. This aspect of uncertainty makes profit
planning and measurement a difficult area in managerial economics.
viii) Capital Budgeting and Investment Decisions
To realize the profits predicted by the organization, a capital allocation is one of
the fundamental decisions which the firm takes. These decisions usually involve huge
sums and amount of resources. Once a decision is made to invest, they cannot be easily
reversed. The future success or failure greatly depends on investment decisions made
today.
ix) Decision theory under uncertainty
Most of the decisions taken by the managers are done under uncertainty.
Uncertainties pertaining to demand, cost, profit etc prevail most of the time when
decisions are made.
x) Competition
Competition in any product category is inevitable. Competition is all pervasive
and a ever present constant. All decisions made by managers will have to take the
element of competition into consideration.
1.2 MICRO ECONOMICS
Microeconomics is the study of particular markets, and segments of the
economy. It looks at issues such as consumer behaviour, individual labour markets, and
the theory of firms.
1. Subject Matter/ Scope of Microeconomics
Microeconomics: Micro Economics is concerned with the following topics :-
i)Commodity Pricing: Prices of individual commodities are determined by market
forces of demand and supply. So micro economics makes demand analysis (individual
consumer behaviour) and supply analysis (individual producer behaviour).
ii)Factor Pricing: Land, labour, capital and entrepreneur, all factors contribute in
production process. So they get rewards in the form of rent, wages, interest and profit
respectively. Micro economics deals with determination of such rewards i.e. factor
prices. So micro economics is also called as 'Price Theory' or 'Value Theory'.
iii)Welfare Theory: Micro economics deals with optimum allocation of available
resources and maximisation of social welfare. It provides answers for 'What to
produce?', 'When to produce?', 'How to produce?' and 'For whom it is to be produced?'.
In short, Micro economics guides for utilizing scarce resources of economy to maximize
public welfare.
2. Characteristics / Features of Microeconomics
i)Nature of Analysis: In micro economics, the behaviour of individual consumers and
producers in detail is analysed. It is study of subject matter from particular to general.
ii)Method: Micro economics divides the economy into various small units and every
unit is analysed in detail. It is a slicing method.

iii)Scope: Micro economic analysis involves product pricing, factor pricing and theory of
welfare.
iv)Application: Both theoretically and practically, micro economics is useful in
formulating various policies, resource allocation, public finance, international trade, etc.
v)Nature of Assumptions: Assumption of Ceteris Paribus is always made in every micro
economic theory. It means theory is applicable only when 'other things being same'.
3. Uses/ Importance/ Advantages of Microeconomics
i)Individual Behaviour Analysis: Micro economics studies behaviour of individual
consumer or producer in a particular situation.
ii)Resource Allocation: Resources are already scare i.e less in quantity. Micro
economics helps in proper allocation and utilization of resources to produce various
types of goods and services.
iii)Price Mechanization: Micro economics decides prices of various goods and services
on the basis of 'Demand-Supply Analysis'.
iv)Economic Policy: Micro economics helps in formulating various economic policies
and economic plans to promote all round economic development.
v)Free Enterprise Economy: Micro economics explain operating of a free enterprise
economy where individual has freedom to take his own economic decisions.
vi)Public Finance: It helps the government in fixing the tax rate and the type of tax as
well as the amount of tax to be charged to the buyer and the seller.
4. Disadvantages/ Limitations of Microeconomics
i)Unrealistic Assumptions: Micro economics is based on unrealistic assumptions,
especially in case of full employment assumption which does not exist practically. Even
behaviour of one individual cannot be generalised as the behaviour of all.
ii)Inadequate Data: Micro economics is based on the information dealing with
individual behaviour, individual customers. Hence, it is difficult to get correct
information. So because of incorrect data Micro Economics may provide inaccurate
results.
iii)Ceteris Paribus: It assumes that all other things being equal (same) but actually it is
not so.
1.3 MACRO ECONOMICS
Macro economics deals not with individual quantities as such but with
aggregates of these quantities, not with individual incomes but with the national
Income, not with individual prices but with the price level, not with Individual outputs
but with the national output.
1. Importance of Macroeconomics
 It is helpful in understanding the functioning of a complicated economic system.
It also studies the functioning of global economy. With growth of globalisation
and WTO regime, the study of macro-economics has become more important.
 It is very important in the formulation of useful economic policies for the nation
to remove the problems of unemployment, inflation, rising prices and poverty.
 Through macro-economics, the national income can be estimated and regulated.
The per capita income and the people’s living standard are also estimated
through macro-economic study. It explains the fluctuations in national income,
per capita income, output and employment.

2. Issues involved in Macroeconomics
The main issues which are addressed in macro economics are in brief as under:
i)It helps in understanding the determination of income and employment: Late J.M.
Keynes laid great stress on macro-economic analysis. He, in his revolutionary book,
“General Theory of Employment Interest and Money” brought drastic changes in
economic thinking. He explained the forces or factors which determine the level of
aggregate employment and output in the economy.
ii) Determination of general level of prices: Macro economic analysis answers
questions as to how the general price level is determined and what is the importance of
various factors which influence general price level.
iii) Economic growth: The macro-economic models help us to formulate economic
policies for achieving long run economic growth with stability. The new developed
growth theories explain the causes of poverty in under developed countries and suggest
remedies to overcome them.
iv) Macro economics and business cycles: Macro economics causes of fluctuations in
the national income are analysed. It has also been possible now to formulate policies for
controlling business cycles i.e., inflation and deflation.
v) International trade: Another important subject of macro-economics is to analyse the
various aspects of international trade in goods, services and balance of payment
problems, the effect of exchange rate on balance of payment etc.
vi) Income shares from the national income: Mr. M. Kalecki and Nicholas Kelder, by
making departure from Ricardo theory, has presented a macro theory of distribution of
income. According to these economists, the relative shares of wages and profits depend
upon the ratio of investment to national income.
vii) Unemployment: Another macroeconomic issue , is to explain the causes of
unemployment in the economy. Stagflation ‘is another important issue of modern
economics. The Keynesian and post Keynesian economists are putting lot of efforts in
explaining the causes of cyclical unemployment and high unemployment coupled with
inflation and suggesting remedies to counteract them.
viii) Macro Economic Policies: Fiscal and monetary policies affect the performance of
the economy. These two major types, of macroeconomic policies are central in macro
economic analysis of the economy.
ix) Global Economic System: In macro economic analysis, it is emphasized that a
nation’s economy is a part of a global economic system. A good or weak performance of
a nation’s economy can affect the performance of the world economy as a whole.
1.4 ECONOMIC DECISIONS AND TECHNICAL DECISIONS
Decision-making is a process of selecting a particular course of action from
among a number of alternatives.
1.Steps in the Process of Managerial Decision-Making
Simply speaking, there are two broad steps in the process of managerial decision-
making:
1. Identification of alternative courses of action, and
2. The selection of a particular course of action.
Let us assume that four alternative courses of action are available to the
decision-maker. The identification of these alternative courses of action for the
accomplishment of a predetermined target or objective is the first step in this decision-
making process. Now, the problem is to select a particular course of action or to make a
decision which is likely to be best suited for achieving the targeted goal.

Step I: Identification of alternative courses of action
At the next step, the decision-maker after making a thorough evaluation of those
alternative courses of action, selects a particular course of action (say, Action D) for
achieving its target.
Step II: Selection of a particular course of action
In this flow-chart, it is assumed that the decision-maker chooses only one course of
action. But in actual practice, the decision-maker may select multiple course of actions
or a combination of two or more actions. However, the essential nature of decision-
making process remains the same.
2. Uncertainty in decision-making: If everything can be predicted or estimated
accurately, the decision-making process would be very simple. However, in most cases,
the outcome of a decision cannot be controlled by the decision-maker. As a result, some
elements of uncertainty remain present in the decision-making process. In that case, the
decision-maker tries to estimate the probable outcome of each alternative course of
action.
Such uncertainty arises because of various reasons:
(i) Unpredictable movements of market demand for any product;
(ii) Unforeseen changes in the input prices both in home market and world market
(when the inputs are required to be imported);
(iii) Unforeseen changes in the tax policy, export-import policy, licensing policy, etc., of
the government;
(iv) Unpredictable political and social environment (say, sudden break out of any social
or political tension);
(v) Unpredictable changes in the preference pattern of the consumers;
(vi) Unpredictable behaviour of the domestic and foreign investors (that may affect the
fund-raising move of a firm); etc.
3. Refer 1.1 (3)
1.5 DEMAND CONCEPTS
Demand indicates the quantities of products(goods/service) which firm is
willing and financially able to purchase at various prices, holding other factors constant.
1. Types/ Categories of Demand
Some of the important way of categorizing demand are
(a) Demand for consumer's goods and producer's goods.
(b) Demand for perishable(non-durable) goods and non-perishable(durable) goods.
(c) Derived demand and Autonomous demand.
(d) Firm's demand and Industry demand.
(e) Demand by Total market and by market segments.
2. Determinants of Demand
The demand for a commodity depends on the individual's desire and capability
to purchase it. Apart from the desire to purchase, there are many other factors which
influence the purchase of a product. They are known as demand determinants.

Demand Determinants
General Factors Factors related to luxuries
& durables
Factors related to market
demand
1. Price of the Product 1. Consumer's expectation
of future prices
1. Population
2. Income of the Customer 2. Consumer's expectation
of future income
2. Social, Economic,
Geographic & Demographic
distribution of consumers
3. Tastes and Preference of the
Customer
4. Price of related goods
3. Law of Demand
The relation of price to quantity demand/sales is known as the law of demand.
Law of demand states that the higher the price is, the lower the demand is and vice
versa, holding other factors as constant.
Demand Schedule
In economics, the relationship between prices and sales/demand which may also
be called the price-quantity relationship. The below table shows the demand schedule
Price of one T-Shirts Quantity sold/
Demanded per year
Rs. 5 20,000 Units
Rs. 10 15,000 Units
Rs. 15 10,000 Units
Rs. 20 5,000 Units
Demand Curve
The more realistic way of drawing the demand curve(market-demand curve) is
shown in the below. Here the curve 'D' slopes downwards from left to right indicating
that when the price of a product rises, the demand decreases. This kind of slope which
shows inverse relationship is also called as a 'Negative Slope'.
Price
(Rs.)
20
15
10
5 D
0 Quantity Sales
5,000 10,000 15,000 20,000
The price quantity relation can be expressed as demand being a function of price D=f(p)

4. Demand Function
A demand function states the dependence relationship between the demand for a
product or service and the factors or variables affecting it. This relationship can be
symbolically represented as
Dx= f(Px , Ps , Pc , I, Y, T, A, U)
Where Dx is the demand for product X
Px is the price of that product X
Ps is the price of substitutes for X
Pc is the price of complements of X
I is the customer's income
Y is level of household income
T is the customer's tastes and preference
A is the effect of advertising
U denotes other determinants of demand for X
5. Individual Demand and Market Demand
Individual Demand
The quantity of a product demanded by an individual purchaser at a given price
is known as individual demand.
Market Demand
The total quantity demanded by all the purchasers together is known as the
market demand.
6. Consumption Function
Consumption function is the relationship of total expenditure on consumption to
total income.
7. Production Consumption Function
This function can be defined as the relationship between the total income of the
consumer and sales of particular products. It means that when there is a change in
income there is a change in the demand for particular products.
8. Purpose/ Types of Demand Forecasting
There are two types of forecasting: Short-run forecast and Long-run forecast
Short-run forecast
In short-run forecast, the prime focus is on the seasonal patterns. Such forecasts
help in preparing suitable sales policies and proper scheduling of output to avoid over
stocking or delays in meeting orders, both of these costly.
Long-run forecast
Long-run forecasts help in proper capital planning. Taking into consideration the
demand for a product over a long period of time, managers plan to invest the capital in
new machinery, recruit new manpower etc.
9. Steps Involved in Demand Forecasting
The following are the necessary steps which will ensure a good forecast
1. Identify and clearly state the objectives of forecasting-short term or long term,
market or industry as a whole etc.
2. Select appropriate methods for forecasting. The selection of an appropriate method
for forecasting depends on the objectives of forecasting. Different objectives will use
different tools.

3. Identify the variables affecting the demand for the product and express them in
appropriate form.
4. Gather the relevant data to represent the variables.
5. Determine the most probable relationship between the dependent variable and the
independent variables through the use of statistical techniques.
6. Prepare the forecast and interpret the results. Interpretation of the analysis of the
data is usually done by the management.
1.6 SUPPLY CONCEPTS
The supply of a product means " the amount of that product which producers are
able and willing to offer for sale at a given price".
The market supply of goods, generally depend on many factors such as
1. Input prices (raw materials price, production cost etc).
2. Technology.
3. Government regulation.
4. Competition.
5. substitutes in production.
6. Taxes.
7. Producer expectation.
1. Supply Schedule
A supply shedule is a tabular representation of the data on the quantity supplied
by the manufaturers to the market at various prices of the good(product).
Price (Rs.) Supply/ Output of Firm X
1 0
3 100
5 300
7 500
2. Supply Curve
Supply Curve is the graphical representation of the supply schedule. The market
supply curve (or just supply curve) summarizes the total quantity all producers are
willing and able to produce at different alternatives prices, holding other factors such as
competition, technology, government factors, taxes etc that affect supply as constant.
3. Law of Supply
Law of supply is other factors remaining the same, as the price of a commodity
rises, its suppy increases; and as the price of a commodity falls, its supply declines. Thus
the quantity supplied is directly proportional to the price.
The relationship between the supply and price can be represented algebraically
and is called the supply function. The supply function can be written as
∫ Sx = f(Px, FT, FI, Rp, W, E, N)
Where:
Sx = Supply of product x
Px = Price of product x
FT = Factor of technology affecting supply
FI = Factor of input prices affecting supply
Rp = Related product price
W = Influence of weather, strikes and other short run forces

E = Expectation about future prospects for prices, costs, sales and the state of economy.
N= Number of firms in the market (Competitions)
4. Limitations of Law of Supply
Some of the limitations are
i) Future prices
ii) Agricultural outputs
iii) Factors other than the price not remaining constant
iv) Case of subsistence farmers
5. Supply Shift
Variables that affect the position of the supply curve are called the supply
shifters. These include
i) Price of inputs
ii) Level of technology
iii) Government regulation
iv) Competition of number of firms
v) Taxes
vi) Producer expectation
vii) Substitutes in production
Price
(Rs.) S1
20 Decrease in Supply S
15 S2
10
5 Increase in supply
0 Quantity Supplied
5,000 10,000 15,000 20,000
Figure 1.1: Market Equlibrium

6. Market Equilibrium
The market equilibrium comes at that price and quantity where the supply and
demand are in balance. At this point, the amount (price and quantity) that buyers want
to buy is just equal to the amount (price and quantity) that sellers want to sell. At
equilibrium, price and quantity tend to stay the same, as long as other things remain
equal. See figure 1.1
7. Elasticity of Supply
Elasticity of supply can be defined as "the degree of responsiveness of supply to a
given change in price". The formula to find the elasticity of supply is
es =
es =
Where
Q1 is the quantity supplied before price change
Q2 is the quantity supplied after price change
P1 is the Original Price
P2 is the New Price
For example , Consider a firm X supplying 500 units of its output at a price of Rs.5
each. When the price increases to Rs.10, the quantity supplied increases to 800
units. Then the elasticity of supply will be
es = = = = 0.6
8. Types of Elasticity of Supply
There are five types of supply elasticity. They are
i) Perfectly / Infinite Elastic Supply (es=∝)
Perfectly elastic supply is one which the supply is present only at one price.
Y
Price
P S
0 X
Quantity

ii) Perfectly Inelastic Supply (es=0)
In case of perfectly inelastic supply, it is one in which the quantity supplied does
not change as price changes.
Y
Price
P
0 X
d Quantity
iii) Unitary Elastic Supply (es=1)
When the quantity of a product supplied to the market changes in the same
proportion as the change in price, the product is said to have unitary elastic supply. A
unitary elastic supply is a straight line passing through the origin.
Y
S
Price
0 X
Quantity
iv) Relatively Elastic Supply (es>1)
Here the supply starts only after a certain price 'P'. Below this price there is no
supply and above this price the supply changes in the same proportion as the change in
price.
Y
S
Price
P
0 Quantity X

v) Relatively inelastic Supply (es<1)
Relatively inelastic supply is one in which manufacturers supply their product
even at a very low price. But once the price increases the supply also increases.
Y
S
Price
0 Quantity X
9. Cross elasticity of supply
The cross elasticity of supply measures the change in quantity supplied of one
commodity (say 'Coffee') when the price of another commodity (say 'Tea') changes. This
can be expressed as
esc =
1.7 ELASTICITY OF DEMAND
Elasticity of demand is defined as 'the percentage change in quantity demanded
caused by one percent change in the demand determinant under consideration, while
other determinants are held constant. This can be represented as
e =
e =
e =
Where
Q1 = Quantity demanded before the change in the demand determinant
Q2 = Quantity demanded after the change in the demand determinant
Z1= Status of the demand determinant before change
Z2= Status of the demand determinant after change
The various elasticities are
1. Price elasticity of demand
2. Income elasticity of demand
3. Cross elasticity of demand
4. Promotional elasticity
5. Expectations elasticity of demand
1.7.1 Price elasticity of demand
Price elasticity of demand can be defined as "the degree of responsiveness of
quantity demanded to a change in price"

ep =
ep =
Where
Q1 is the quantity demanded before price change
Q2 is the quantity demanded after price change
P1 is the Original Price
P2 is the New Price
1. Types of price elasticity
Price elasticity are generally classified into the following categories
i) Price elastic demand (ep=∝)
There is no need for reduction in price to cause an increase in demand. If this be
the case, a firm can sell all the quantity it wants at the prevailing price, but the firm can
sell none at all at even a slightly higher price. Here the demand curve is horiontal.
Y
Price
P D
0 X
Quantity Demanded
ii) Absolutely inelastic demand or Perfectly inelastic demand (ep=0)
Absolutely inelastic demand is where a change in price howsoever large, causes
no change in the quantity demanded of a product. Here, the shape of the demand curve
is vertical.
Y
D
Price
X
0 Quantity Demanded

iii) Unit elasticity of demand(ep=1)
Unit elasticity is where a given proportionate change in price causes and equal
proportionate change in the quantity demanded of the product. The shape of the
demand curve here is that of a rectangular hyperbola.
Y
Price
D
0 X
Quantity Demanded
iv) Relatively elastic demand (ep>1)
It is where a reduction in price leads to more than proportionate change in
demand. Here the shape of the demand curve is flat.
Y
Price
P1
P2
D
0 Q1 Q2 Quantity Demanded X
v) Relatively in elastic demand(ep<1)
It is where a decline in price leads to less than proportionate increase in demand.
Here the shape of the demand curve is steep.
Y

1.7.2 Income elasticity of demand
Income elasticity of demand may be defined as the degree of responsiveness of
quantities demanded to a given change in income. This can be measured by the
following expression
ei =
ei =
Where
Q1 is the quantity demanded before the change in income
Q2 is the quantity demanded after the change in income
I1 is the income before the change (in income) or previous income before change
I2 is the income after the change (in income) or new income before change
To illustrate the income elasticity of demand, let us consider an example. Suppose
if a consumer's income is Rs.2000 /- per month and he buys 10kgs of fruits per
month and if his income goes upto Rs.2500 /- per month and he buys 15kg of
fruits per month, the income elasticity demand is calculated as follows:
ei =
ei = = 1.8
1. Types of Income Elasticity
There are few possible income elasticities which are given below
i) High Income Elasticity(ei>1)
Here the quantity demanded for a product increases by a larger perecentage
than the percentage increase in income of the consumer or vice versa.
Y
Income
D
I1
I2
X
0 Q1 Q2 Quantity Demanded

ii) Unitary Income Elasticity(ei=1)
Here the percentage change in the quantity demanded by a customer is equal to
the percentage change in income.
Y
Income
D
I1
I2
X
iii) Low Income Elasticity (ei<1)
Income elasticity is said to be low if the relative change in quantity demanded is
less than the relative change in income. The low income elasticity is less than one.
Y
Income
D
I2
I1
X
iv) Zero Income Elasticity(ei=0)
Here a change in income will have no effect on the quantities demanded. Here
the ei=0.
Y
Income
D
0 X
Quantity Demanded

v) Negative Income Elasticity
As increase in income may lead to a reduction in the quantities demanded for
certain products. For example when income increases moped users will move on to
motor bikes
Y
Income
D
I2
I1
X
vi) Positive Income Elasticity
Here an increase in income may lead to an increase in the quantities demanded.
For most goods, the income elasticity of demand is positive. This is similar to high
income elasticity.
1.7.3 Cross Elasticity of Demand
The effect of change in price of related products upon the demand for a
particular product may be determined by measuring the cross elasticity of demand. For
example, cross elasticity of demand may attempt to find the change in demand for tea
when there is a change in price for coffee.
ec =
ec =
Where
Qx1 is the quantity demand for product x, before the price change in product y
Qx2 is the quantity demand for product x, after the price change in product y
Py1 is the Original price for product y
Py2 is new price after the change in pricing of product y
Y
Price C (Unrelated goods)
A (Substitutes)
B (Complements)
X
Quantity Demanded for a product

1.7.4 Advertising Elasticity of Demand or Promotional Elasticity
Advertising elasticity of demand may be said as the measure of the
responsiveness of demand to changes in advertising or other promotional expenses.
The formula to measure this elasticity is
ea =
ea =
Where
Q1 is the demand before advertising
Q2 is the demand after advertising
A1 is the original advertising activity
A2 is the new advertising activity
1.7.5 Expectations Elasticity of Demand
This elasticity of expectations, say that the demand for a product is affected not
only by the current price but also by the expected future price. The expectations
elasticity may be calculated using the formula
ea =
ea =
Where
Pe1 and Pe2 are expected price
Pc1 and Pc2 are the current price
1.8 COST OF PRODUCTS
The cost of product has numerous components. Some components directly
contribute to the cost while some others indirectly contribute to the cost of a product.
Cost is the money spent (directly or indirectly) on producing and selling a product to
the customers.
The cost of a product starts from the raw materials (procuring, transporting,
preparing the raw material) through production costs (labor, power, machinery etc) till
selling (Selling costs include the cost in maintaining outlets, providing advertisements,
salary to sales people, incentives to trade etc) the product to the customer.
1.8.1 Concepts / Classification / Types of Costs
The following are the some of the main cost concepts or cost types. They are
i) Actual Costs and Oppurtunity Costs
Actual costs(or acquisition costs or outlay costs) are the costs which a firm
incurs for producing or acquiring a product or a service. As example, for this is the cost
on raw materials, labor, rent, interest etc. These are also called as absolute costs.
Oppurtunity costs(or alternative) of a good or a service is measured in terms of
revenue or benefit which could have been generated or earned by employing that good
or service in some other alternative use.

ii) Incremental costs (Differential Cost) and Sunk Costs
Incremental cost is the additional cost due to a change in the level or nature of
business activity. The change may take several forms. For example addition of a new
product line, increase in the present production rate, changing the distribution channel,
adding new machinery, replacing a machine by a better machine etc.
Sunk costs are the costs that are not altered by a change in quantity produced
and cannot be recovered. One example of sunk cost is the depreciation of equipments.
iii) Explicit costs (Out of pocket cost) and Implicit Costs (Book cost)
Explicit or paid out costs are those expenses which are actually paid by the firm
(paid out costs). These costs appear in the accounting records of the firm. The amount
paid out as rent, wages, utility expenses etc.
Implicit costs or imputed costs are theoritical costs in the sense that they go
unrecognized by the accounting system.
iv) Paid costs and Future costs
Paid costs are the actual costs incurred in the past and are generally contained in
the financial accounts. The measurement of past cost is essentially a record keeping
activity and is a passive function as far as mangerial decision making is concerned.
Future costs are costs that are expected to occur in some future period. Their
actual incurrence is a forecast and management of future cost is an estimate.
v) Accounting costs and Economic costs
Accounting costs are the acutal outlay costs. These costs point out how much
expenditure has already been incurred on a particular process or on production as such.
Economic cost relate to the future. Economic costs are used in managerial
decision making.
vi) Private Costs and Social Costs
Private costs are those which are actually incurred or provided for the business
activity by an individual or the business firm.
Social costs on the other hand, are the total costs to the society on account of
production of a good. For example, a business firm decides to expand its business into
chemical industry.
vii) Direct cost and Indirect cost
Direct cost or traceable costs or assignable cost are the ones that have direct
relationship with a unit of operation like a product, a process or a department of the
firm.
Indirect costs or non-traceable costs or common or non-assignable costs are the
costs whose course cannot be easily definitely traced to the plant, a product, a process
or a department.
viii) Controllable costs and non-controllable costs
Controllable costs are those which are capable of being controlled or regulated
by the managers and it can be used to assess the manager's effeciency in controlling the
cost in his department.
Non-controllable costs are those which cannot be subjected administrative
controls and supervision.

ix) Replacement costs and original costs (Historical cost)
Replacement costs are the costs that the firm incurs if it wants to replace or
acquire the same assets now.
Original costs or the historical costs are the costs paid for assets such as land,
building, cost of plant, equipment and materials etc at the price paid originally for them.
x) Shutdown cost and abandonment cost
Shutdown cost are the cost which the firm incurs if it temporarily stops its
operation. For example firm may have to stop operation for maintenance purpose or
machine fault.
Abandonment costs are the cost of retiring altogether a fixed asset from use.
xi) Urgent cost and postponable cost
Urgent costs are the costs the firm must incur so that the operations of the firm
continue. The cost of material, labor, fuel etc fall in this category.
Those costs whose postponement does not affect the operational efficiency of the
firm are known as postponable costs.
xii) Business cost and full cost
Business cost are the ones which are known in the profit and loss account for
legal and tax purposes.
Full costs are the sum of oppurtunity costs and normal profits.
xiii) Fixed cost and Variable cost
Fixed costs remain constant in total regardless of changes in volume of
production (output) up to a certain level of output.
Total variable costs varies in direct proportion to the changes in volume. ie., If
the volume of production is less, then the total variable cost is proportionally less and if
the volume of production is high the total variable cost is proportionally high.
xiv) Short-run costs and Long run costs
Short-run costs is defined as a period in which the supply of atleast one of the
inputs cannot be changed by the firm. For example, inputs like building, machinery
cannot be changed by the firm whenever it desires so.
Long-run is defined as a period in which all inputs can be varied as desired. Thus
in short-run some inputs(like the factory installations) are fixed and some inputs are
variable(like the level of capacity utilization) and in the long-run, all inputs are variable.
xv) Incremental cost and Marginal cost
Both incremental cost and marginal cost are closely related. The similarities and
the differences between these two must be well understood.
1. Marginal cost deals with unit by unit output whereas incremental cost is not
restricted to a unit change. It rather deals with a whole batch of output.
2. Marginal cost is the amount added to total cost by a unit increase in output.
Incremental cost is related to change in any number of units of output or even a change
in the quality of the output.
xvi) Average cost and Marginal cost
Average cost AC =

Average fixed cost (AFC) =
Average variable cost (AVC) =
1.8.2 Determinant of Cost
The cost of production of goods depends on number of factors. These factors may
differ from industry to industry and all may not be applicable to all firms. Some of the
important cost determinants are
1. Level of output
2. Price of inputs
3. Size of plant
4. Output Stability
5. Production lot size
6. Level of capability utilization
7. Technology
8. Learning Effect
9. Breadth of product range
10. Geographical location
1.8.3 Cost Output Relationships
There are two aspects in the study of cost-output relations, they are
1. Cost-output relationship in short-run
2. Cost-output relationship in long-run
1. Cost-output relationship in short-run
The cost output relationship in the short-run can be studied in terms of
i) Average fixed cost and output
ii) Average variable cost and output
iii) Average total cost and output
2. Cost-output relationship in long run
There is no fixed cost in long-run since the firm has sufficient time to fully
replace its manufacturing facilities. The long-run costs would refer to the cost of
producing different levels of output by changing the size of the plant or scale of
production.
i) Usefulness of Long run average cost (LAC) curve
Firms may not be interested in achieving the minimum cost output for a given
plant. The LAC curve helps the organization to determine the size of the plant to be
adopted for producing the given output.
ii) Economies and diseconomies of large scale
Marshall classified the economies and diseconomies of large scale production
into two types. They are
External economies are those which are available to all the firms in an industry.
These economies arise from the expansion in the size of an industry-involving an
increase in the number and size of the firms engaged in it.
Internal economies are the economies which are available to a particular firm
and gives it an advantage over other firms enaged in the production of same products in
the industry. The varous factors at contribute to internal economies or diseconomies of
a firm are

1. Labour economies and diseconomies
2. Technical process economies and diseconomies
3. Managerial economies and diseconomies
4. Marketing economies and diseconomies
5. Financial economies and diseconomies
6. Diversification in output economies and diseconomies
7. Diversification of market economies and diseconomies
8. Risk spreading economies and diseconomies
1.8.4 Estimation of cost-output relationship
There cost output relationship can be estimated through the following three
ways
i) Accounting method
ii) Engineering method
iii) Econometric method
i) Accounting method
Accounting method calls for estimating the cost output relationship by
classifying the total cost into fixed, variable and semi variable costs. These components
are estimated separately. The average variable cost, the ranges of output within which
the semi variable cost is fixed and the amount of fixed cost are determined on the basis
of inspection and experience.
ii) Engineering method
The engineering estimate of the cost output relationship is got by estimating the
physical units of various input factors like plant size, consumption of material, man-
hours and other inputs for a given output.
iii) Econometric method
Econometric takes economic models and tests them through statistical trials. The
results are then compared and contrasted against real-life examples.
1.9 PRICE OF PRODUCTS
Price is the source of revenue for the firm and it decides the health of the firm.
Price also gives an image to the product.
1.9.1 Price determinants
i) Objectives of business
The fundamental objective of a firm is to survive in the business and then thrive.
The pricing strategy adopted by a firm is very much influenced by these factors. Thus
the basic guide to pricing is the firm's objectives. Other business objectives include the
competitive position in the market, achieving the market leadership, growth of the firm,
maintenance and control of ownership and ultimately profits.
ii) Competition
To come out with a pricing policy that will be advantages to the firm, managers
require a perfect understanding of the competitive environment in which the firm is
placed. Usually when a seller cuts his selling price, soon other competitors also follow
suit.
iii)Product and Promotional Strategies
When a marketing strategy is formulated for a product, the four components
considered are the

1. Product itself (quality of product, utility value of product to consumers, varieties,
available etc)
2. Pricing
3. Promotion activities and
4. Distribution of products through the channel to the consumer
Marketibility of a product is equally affected by all these factors. Thus the pricing policy
depends on all these factors.
iv) Nature of price sensitivity
We know that many factors contribute to the increase of price sensitivity, but
managers should not ignore the factors that minimize price sensitivity when designing
pricing strategies.
v) Influence of middlemen
Middlemen are the ones who stock the finished product of the manufacturer to sell it to
the customers. These are also called the channel for distribution. Many a times the
interests of the manufacturer and middle man are conflicting.
vi) Routinization of price
This strategy of pricing relies on the tried and trusted pricing strategies which
the organization has followed all along.
(a) Number of pricing decisions made: If a organization has huge number of products
and if none of the products provide a substantial portion of the sale or profit then it
becomes costly for the organization to have an analysis on each of the products and
formulate a price structure.
(b) Speed of pricing decision: If a company, for many reasons is time pressed to come
out with pricing strategies at the earliest then they use mechanical formula such as
predetermined markup on full cost etc. These have advantage of speed but the
advantages of flexibility, adaptability is all lost.
(c) Quality of available information: A firm relies on the data of cost and demand to
fix its pricing policies. If the data available on demand and cost are highly accurate the
pricing policy adopted tends to be more accurate and useful.
(d) Competitive market: If the firm is operating in a highly competitive market, the
firm will have little choice for price discretion. This is because any change in the pricing
may lead to price wars.
vii) Government Regulation
In order to safegaurd the interests of the public the government acts on their
behalf to prevent the abuse of the monopolistic power and collusion among business.
The government formulates policies and enacts law to control prices which may be
against the interest of the public.
1.9.2 Objectives of Pricing Policy
i) Profit Maximization: Profits ensure that the organization will move on to be a viable
business in future. Firm should set a price such that it enhances the sale of the entire
product line rather than yield profit from only one product.
ii) Long term welfare of the firm: The pricing policies must be decided such that, the
sale of product from the firm is for over a long period of time and that it retains
customers for their life time.

iii) Facing competition: The other objective of the pricing policy is to face competition.
The pricing policy must fit into diverse competitive situations and ensure a place for the
organization in the market.
iv) Flexibility to economic changes: Pricing policies must be able to be flexible to vary
prices to meet the changes in the economic conditions affecting the various consumer
industries.
v) Satisfying the rate of returns: Pricing should help achieve a satisfactory rate of
return for the organization
1.9.3 Pricing Methods
The main pricing practices can be classified into three broad categories. They are
i) Cost oriented pricing, which include
(a) Cost plus pricing or full cost pricing
(b) Marginal cost pricing or incremental or direct cost pricing
(c) Target pricing or rate of return pricing
(d) Programme pricing
ii) Competition oriented pricing, which are
(a) Going rate pricing
(b) Loss leader pricing
(c) Customary pricing
(d) Price leadership pricing
(e) Trade association pricing
(f) Cyclical pricing
(g) Imitative pricing
(h) Turnover pricing
iii) Pricing based on other economic consideration
(a) Administered pricing
(b) Dual pricing
(c) Price discrimination or differential pricing
1.9.4 Price determination under different market structures
The various types of market structures are based on the four basic models such
as
1. Pricing under perfect competition
The key conditions for perfect competition are as follows
i) There are large number of undifferentiated buyers and sellers, each of which is
"small" relative to market.
ii) Each firm in the market produces a homogeneous(identical) product.
iii) Buyers and sellers have perfect information.
iv) There are no transaction costs
v) There are many competitors (whether sellers or buyers) each acting independently.
vi) The market price must be flexible and must rise and fall in response to the changing
conditions of demand and supply.
vii) There are no entry barriers or exit barriers to any of the firm in the market.
2. Pricing under Monopoly
Monopoly refers to a situation where a single firm serves an entire market for a
good for which there are no close substitutes

Main features of monopoly
1. There is only one seller of a particular good or service
2. Rivalry from the producers of substitutes is absent or insignificant
3. The monopolist is in a position to set the market price himself.
3. Pricing under oligopoly
Oligopoly refers to a situation where there are relatively few large firms in an
industry. No explicit number of firms is required for oligopoly, but the number usually is
some where between two and ten. The products the firms offer may be either identical
or differentiated. An oligopoly composed of only two firms is called a 'Duopoly'.
Main features of oligopoly
1. Sellers are few in number.
2. Any of them is of such a size that an increase or decrease in his output will
appreciably affect the market price. The size of each seller's output in relation to the
total supply is the test.
3. Each seller knows his competitor individually in the market.
i) Classification of oligopoly
1. Pure or perfect oligopoly
2. Differentiated or imperfect oligopoly
3. Open and closed oligopoly
4. Collusive and competitive oligopoly
5. Partial and full oligopoly
6. Syndicated and organized oligopoly
1.9.5 Price Discrimination
Price discrimination is said to exist when the same product is sold at different
prices to different buyers at the same time.
1. Conditions when price discrimination is possible
The necessary conditions which must be present for the implementation of price
discrimination are the following
(i) Difference in price elasticities
Depending on the preference of the buyer, their income, their location and the
case of availability of substitutes, the product has different elasticity with different
customers.
(ii) Market segmentation
For price discrimination with different customers in different markets, it must be
possible to divide the market into sub markets with different price elasticities of the
customers.
(iii) Effective separation of sub-markets
There must be effective separation of the different market segments, in the sense
that no reselling can take place from the low price market and the high price market.
(iv) Legal sanctions for price discrimination
In certain cases firms have a legal sanction for price discrimination. This is quite
commonly found in cases where there are the price is administered by the government
like in elasticity where common buyers pay a lesser price and industrial users pay a
higher fare.

2. Degrees of price discrimination
Pigon distinguishes between different types of price discrimination in the
following three ways
(a) Price discrimination of the first degree
(b) Price discrimination of the second degree
(c) Price discrimination of third degree
3. Objectives of Price discrimination
1. The firm's aim at maximization of their revenue by appropriating consumer's surplus.
2. When inventories accumulate above the desired levels, the firms generally resort to
price reduction for a short span of time or for a group of buyers.
3. If the firm is having some unutilized capacity, it may charge lower price from the
buyers who may help in its utilization.
4. Firms also charge different prices for the same product at different time frames.
1.9.6 Other Pricing Strategies
1. Stay out pricing
2. Psychological pricing (or odd number and round number pricing)
3. Skimming price strategy
4. Penetration pricing
5. Premium pricing policy
6. Price out Pricing
7. Fraction below competition pricing
1.9.7 The Profit Maximization Rule
Consider an output level less than Q in the figure, say Q1. Here the revenue R1 is
greater than the cost C1. Thus for any such output, MR>MC. This means that if the firm
expands output, it will add more to its revenues than to its costs, thus increasing profit.
But once the firm reaches the point Q, it has no further incentive to increase output. This
is because beyond the point Q, you will find from the graph that the cost becomes very
high than the revenues ie., MR<MC. Thus, by increasing the output beyond the point
Q(where MR=MC), the firm will add more to its costs than to its revenues, thus reducing
the profit. Hence, the profit maximization output occurs at the point Q where MR=MC.

The opposite case is illustrated in the below figure where the condition MC=MR
does not give the profit maximizing output. Here in fact the firm can increase profit by
increasing output beyond the point Q, since MR>MC for the levels of output beyond Q.
1.10 BREAK-EVEN ANALYSIS
Break even analysis involves the study of revenues and costs of a firm in relation
to its volume of sales and it specifically involves in the determination of that volume at
which the firm's cost and revenue will be equal. A break even analysis indicates at what
level, cost and revenue are in equilibrium.
1.10.1 Break Even Point (BEP)
Break even point(BEP) may be defined as that point of activity (sales volume) at
which the total revenues equal the costs and the net income is zero. It is the point of
zero profit. This is also known as no profit no loss point.
1.10.2 Determination of the Break Even Point
Break even point can be determined either in terms of physical units (products)
to be produced or in terms of money(sales value in rupee).
Q - Physical output of the firm
QBEP - Output at BEP
BEP - Break Even Point
P- Price per unit or average revenue
TR - Total Revenue = P x Q
TFC - Total Fixed Cost
TVC - Total Variable Cost = Q x AVC
TC - Total Cost = TFC + TVC
AF - Average Fixed Cost (or fixed cost per unit)
AVC - Average Variable Cost (or variable cost per unit)
ACM or CMP - Contribution Margin Unit = Selling price - Average Variable Cost
ACM = P - AVC (CMP may also be called as Average Contribution Margin)
TCP - Total Contribution Profit = TR - TVC
= P x Q - Q x AVC
= Q(P-AVC)
TNP - Total Net Profit = TR - TC

i) Break Even Point in terms of Quantity
QBEP =
ii) Break Even Point in terms of Sales Value
SBEP =
iii) Break Even Point as Percentage of Capacity
Percent BEP = x 100
1.10.3 Objectives of Break Even Analysis
The main objective of break-even analysis is to find the cut-off production
volume from where a firm will make profit. Let
s = selling price per unit
v = variable cost per unit
FC = fixed cost per period
Q = volume of production
The total sales revenue (S) of the firm is given by the following formula:
S = s x Q
The total cost of the firm for a given production volume is given as
TC = Total variable cost + Fixed cost
= v x Q + FC
The linear plots of the above two equations are shown in Figure. The intersection
point of the total sales revenue line and the total cost line is called the break-even point.
The corresponding volume of production on the X-axis is known as the break-even sales
quantity. At the intersection point, the total cost is equal to the total revenue.
This point is also called the no-loss or no-gain situation. For any production
quantity which is less than the break-even quantity, the total cost is more than the total
revenue. Hence, the firm will be making loss.
For any production quantity which is more than the break-even quantity, the
total revenue will be more than the total cost. Hence, the firm will be making profit.
Profit = Sales – (Fixed cost + Variable costs)
= s x Q – (FC + v x Q)

The formulae to find the break-even quantity and break-even sales quantity
The contribution is the difference between the sales and the variable costs. The
margin of safety (M.S.) is the sales over and above the break-even sales. The formulae to
compute these values are

1.11 NATURE OF FUNCTIONING OF MONEY
Money
Money is "anything that is generally acceptable as a means of exchange and that
at the same time acts as a measure and as a store value"
1.11.1 Function/ Performance of Money
1. Money is the medium of exchange
Money acts as a intermediary between the buyer and the seller. Buyer gives
money and gets the product, seller receives the money and gives the product.
2. It is the measure of value
It is the unit in which the value of goods and services are measured.
3. Money is a standard of deferred payments
Money has helped the borrowing and lending activities to become much simpler.
4. Money is a store of purchasing power
Now saving has become possible because it can be stored and later used. So now
people can accumulate wealth.
5. Money is a basis of credit
The money has become the base for credit system, without which it cannot be
run successfully.
6. Money gives liquidity to capital
Since money is highly liquid any type of transaction can be carried out at any
point of time.
1.11.2 Advantages of Money
1. Money has made purchases very simpler and easier.
2. People can postpone their purchases if they feel the price is high and it will fall in the
future.
3. It helps manufacturers in exactly calculating their cost of production and they can
clearly find out which cost to reduce and to what extent it has to be reduced.
4. Money has transformed savings to investment, the savings of invidual can be given to
the company to make their investments.
5. It helps to improve trade.
6. Money has made future transaction possible.
7. Money helps to raise standard of living.
8. Money is a measure of social welfare.
9. Money makes accounting and budgeting possible.
10. The liquid nature of money adds mobility to capital.
1.11.3 Evils of Money
The evils of money can be classified under two heads. They are
i) Economic Evils
1. Money gives rise to trade cylces which mean we will face boom and as well as
recession, which gives rise to instability in the economy because of which people are
affected.
2. Now as lending and borrowing is possible, companies may borrow more money than
they require and this will lead to over production. This is going to harden the growth of
economy.
3. The value of money keeps on changing the hinders the growth of trade and industry.

ii)Social Evils
1. It is responsible for the decline of spiritualism in modern society
2. It is prime reason for the greediness and acquistiveness among people
3. It is the prime reason for the growth of fraud, theft, murders etc.
4. This is the reason why a few set of people exploit other set of people.
1.11.4 Value of Money
The value is given by
V=
Where V- value of money
Pg - General Price level
Prof. Crowther has found out three standards based on which the value of money can be
calculated. They are
1. Wholesale standard
The value of money is determined under this method by taking the prices of the
commodities traded in the wholesale market as the base. This value is called as the
wholesale value of money.
2. Retail or consumption standard
The value of money determined under this method takes the prices at which the
goods and services are purchased by the average family consumption purpose as the
base. This value is called as the retail value of money.
3. Labour Standard
For the calculation the rate at which the wage is paid to the labour for a days
work in kept as the base. So this can be called as the labour value of money.
1.11.5 Measurement of changes in value
The changes in the value is given by the changes in the general level of prices
over a period of time. The changes in the general level of prices can be measured by
using index numbers.
Method of preparing the index are
i) Choice of base year
ii) Choice of goods and services
iii) Finding the price of goods and services
iv) Represent price in percentage
v) Find out the average
1.12 NATIONAL INCOME
National income is the flow of goods and services produced in an economy over a
period of one year. It has been defined by various economists in different ways.
Definition: National income is defined by Marshall as 'the labor and capital of a country
acting upon its natural resources, produce annually a certain net aggregate of
commodities-material and immaterial including services of all kinds'.
The National Income Committee of India has defined national income in a very
simple way. It says "National Income estimate measures the volume of commodities and
services turned out during a given period, counted without duplication".

1. Gross National Product (GNP)
GNP is defined as the total value of final goods and services produced by the
residents of the country during a given period of time, including net income from
abroad(exports).
GNP= Domestic product - Imports + Exports
2. Net National Product (NNP)
The total output of final good consists of both consumption goods and capital
goods. In modern round about methods of production, machinery gets worn out. This
has to be replaced. The share of GNP which is kept aside for replacing worn out capital
equipment is called 'capital consumption allowance'. To arrive at the NNP, capital
consumption allowance should be deducted from GNP.
Therefore, NNP=GNP- Depreciation.
3. Net National income at factor cost
It is slightly different from GNP and NNP. National income at factor cost is the
total of all incomes earned by the owner of production for their contribution of land,
capital and entrepreneurial ability.
4. Personal Income
Personal income may be defined as the current incomes of persons and
households from all services. This is the income before personal taxes are deducted.
Personal income = National income - Corporate taxes - undistributed profits - social
security contribution and transfer payments.
5. Disposable income or disposable personal income
All personal income is not at the disposal to be spent on consumption.
Individuals have to pay personal direct taxes to the government. They are free to spend
only after the payment of taxes. The income which individuals have at their disposal
after the payment of personal taxes is called the disposable income. It is that part of the
income which is spent on consumption.
Diposable personal income = personal income - personal direct taxes.
6. Diposable personal outlay
The disposable personal income may be spent fully or individuals may save.
What remains after saving is called the personal outlay. Disposable income is equal to
cosumption and saving.
Disposable outlay = Disposable income - savings.
7. Real income
Since National income does not reveal the real state of economy, the concept of
real income has been used. To find out the real income of the economy, a base year is
selected and the price level of that year is assumed to be 100. In order to estimate the
real income, the following formula is used.
Real income = x 100
1.12.1 Methods of measuring national income
The estiamtes of national income provide economists with a powerful tool for
analyzing an economy's performance. The concept of national income has three
interpretations. It represents total receipts, total expenditure equal to these receipts
and total value of production.
Based upon these three interpretations of income, there are three methods of
measuring national income namely
1. Census of Production method or production method
2. Income method

3. Expenditure method
1. Census of production method or Production method
This method views national income from the output side. The production
method is also known as total product method or goods flow method or net input
method or simply output method. In India it is also known as inventory method.
In this method, the economy is classified into three sectors namely - Industrial
sector, Direct Services Sector and Foriegn Transaction Sector where international
payments are considered.
2. Income method
This method is also called factor income method, factor share method, income
distribution method or national income by distributive shares method. In this method,
the national income is calculated from the distribution side.
According to this method, national income is obtained by totalling all the
incomes, according to the various factors of production used in producing national
product. Thus the national income is calculated for example by adding up the rent of
land, wages and salaries of employees, profit of enterpreneurs, interest on capital and
income of self employed people.
3. Expenditure method
This method is also called 'flow of product approach' and in India it is called as
outlay method. National Income under this method is arrived at by adding up all the
expenditure made on the goods and service during a specific period. It includes
expenditure on new investments, on replacement of old capital and inventory or raw
materials, manufactured and semi-manufactured goods.
4. Value added method
The difference between the value of output and input at each stage of production
is called the value addition. By summing such value added for all industries in the
economy, GNP can be found out.
5. Difficulties in calculating National Income
1. Measurement of national income is not limited to the terrritorial boundaries of the
country. we include the income of all the residents of a country even if they are abroad.
this becomes difficult.
2. Income generaed through illegal activities is not included in national income. this
resuts in a diminution of national income .
3. Services rendered free of charge are not included in GNP.by leaving out these services
,NI will be less.
4. There is dfficulty in deciding about the nature of goods and services to be included in
national income.
5. Capital gans and losses are not included in GNP as they are not the results of current
economic activities.
6. Another difficulty arises with regard to the public services rendered by the
government services rendered by military, judiciary system, administrative services are
difficult to measure and account.

6. Importance of National Income Analysis
National income statistics are of immense use for economy. as profeesor cairn
cross points out, it provides an index of economic activity and instrument of econoic
planning.
1. National income accounting indicates the growth of the economy in terms of income
and output. it also shows the functioning and performance of the economy. by analysing
the statistics on industrial production, inventories, wages rates, consumer spending,
money supply etc, the working of the economy can be understood.
2. National income statistics helps the policy makers to frame policies to achieve full
employment and rapid economic growth.
3. The trends in national income help in economic planning. sector wise distribution of
outlay and determination of targets are based on national income statistics.
4. From national income statistics, the regional distribution of income can be analyzed,
on the basis of which measures can be adopted to remove inequalities in income
distribution.
1.13 INFLATION
Inflation is defined by crowther as a state in which the value of money is falling
i.e. prices are rising.
1.13.1 Types of Inflation
Economists have classified inflation into various types.
1. On the basis of Speed
This classification is made on the basis of the speed with which the prices
increase in the economy. They are,
i) Creeping Inflation
This is slow moving and a very mild inflation. when prices rise appx. by 2%
annually. There is creeping inflation which does not disrupt the economic balance.
ii) Walking Inflation
When the rise in prices becomes more pronounced there exists walking inflation
in the economy. roughly speaking , the price level under walking inflation rises appx. by
5% annually.
iii) Running Inflation
The rate of incease of price level gets further accelerated under running inflation
when prices rise by more than 10% a year.
iv) Galloping Inflation
In the case of galloping or hyperinflation, the price rises every minute and there
is no upward limit to which the price level may rise in course of time. Keynes has
referred to this type of inflation as the true inflation which occur after the point of full
employment. under this, price level rises appx. to 16% every year.

2. Inflation on the Basis of Inducement
Here the inflation is classified on the basis of the factors which cause this
phenomenon.
i) Deficit-induced Inflation
This is caused by the adoption of deficit budget of the government. The
government of an underdeveloped economy may resort to deficit financing to finance its
deelopmental plans. this may result in a rising price level.
ii) Wage induced Inflation
This denotes a rise in price due to an increase in money wages. when the
workers organize themseves into powerful trade unions and force the employers to
increase their wages, the evitable
iii) Profit induced Inflation
This occurs on account of increase in the profit margins of the producers.
Enterpreneurs are induced to invest more when mangerial efficiency of capital exceeds
the rate of interest.
v) Scarcity induced Inflation
When the supply of money does not increase but the supply of goods decreases
an account of natural calamities, the prices show an upward trend.
vi) Ratchet Inflation
When the prices in the excess demand sector increases, they are not allowed to
fall in the deficient demand sectors due to resistance from industrialists and trade
unions. The net is a rise in general price level.
vii) Currency Inflation
This type of inflation generally occurs at times of war when the supply of money
exceeds the aviable output of goods and services.
viii) Credit Inflation
Some times the government encourages an expension of credit which inevitably
results in an inflationary rise in the price level.
ix) Sectoral Inflation
In this case the rise in price may be restricted to a particular sector of economy.
For example, agricultural production suffering serious set back at times of drought will
make the agricultural product dearer and the prices go up.
3. Inflation on the basis of extent of coverage
i) Open Inflation
When the government takes no steps to check the rise in price level, inflation is
said to be opne inflation.
ii) Repressed Inflation
Inflation may be said to be repressed inflation when the government actively
intervenes to check the rise in price level by resorting to price control and rationing
scares items in the economy.

iii) Comprehensive Inflation
Comprehensive inflation occurs when the prices of all commodities register a
rise in the economy and the impact is felt by the nation as a whole.
iv) Sporadic Inflation
In sporadic inflation, the prices of a few commodities may rise on account of
certain production bottle necks. For example there would be an increase in price of food
products as a result of crop failure of the season.
4. Inflation on the basis of time
i) Peace time inflation
Peace time inflation very often during a period of planned economic
development in an underdeveloped economy. This type of inflation is the result of
increased government expenditure on ambitious developmental projects in the
economy.
ii) War time inflation
War time inflation arises when the increase in the output of goods and service do
not keep pace with the expansion of money supply during a period of war in a country.
iii) Post war inflation
Post war inflation is more rapid than war time inflation because the pent up
demand finds an over expression on the relaxation of price and physical controls by the
government.
5. Inflation based on its extent
Inflation can also be classified based on its extent as partial inflation and full
inflation.
i) Partial inflation
The price level consequent upon the expansion of money supply in the pre-full
employment stage is referred to as partial inflation.
ii) Full inflation
In full inflation , the increase in the supply of money after the point of full
employment does not increase output and employment but leads to a sharp un-
interrupted rise in the price level. If the supply of money continues to increase so much
even after the point of full employment , then the prices rise so high and the entire
economy will collapse with dangerous economic and political consequence for the
country.
1.13.2 Causes of Inflation
Broadly speaking , there are two main causes of inflation.
(i) An increase in effective demand and
(ii) An increase in production costs.
The former gives rise to demand – pull inflation, while the latter leads to cost-push
inflation.
1. Demand –Pull inflation
Demand pull inflation or excess demand inflation is described as “too much
money chasing too few goods”. The concept of simple quantity theory of money states
that prices rise in proportion to increase in money supply when the economy is
operating at full employment level.
As the quantity of the money increases , the rate of interest will fall and consequently
investment demand increase.

2. Cost –Pull inflation
Cost push inflation or new inflation is mainly caused by wage push and profit
push to prices. It is due to wage increase enforced by unions , profit increase by
employers and sometimes imposition of heavy commodity taxes.
The increase in wages may be caused by powerful trade unions. They press
employers to grant wage increases , considerably in excess of the increase in
productivity of labour, thereby raising the cost of production of commodities.
1.13.3 Effects of Inflation
 Mild inflation caused by an expansion of money supply may actually be good for
the economy particularly when there are unemployed productive resources in
the country.
 But after the point of full employment of productive resources , any expansion of
money supply is bound to result in continuous inflation which shakes the
foundation of the political and the economic stability of the system. The effects
of inflation are many fold.
 When a country as a whole is taken, its effect on production and distribution is
studied.
 On a more micro level , its effect on salaried class , farmers, debtors , credits etc
are studied.
1. Effect of inflation on production
 Hyper inflation has the following adverse effects on the productive activities of
the economy. Hyper inflation discourage savings on the part of the public.
 With reduced savings and capital accumulation , the investment will suffer a
serious setback which may have an adverse effect on the volume of production in
the country.
 The decline in the volume of production may discourage entrepreneurs and
business men from taking business risk in production. This may drive out any
foreign investment in the country.
 Since runaway inflation results in a seller's market, it may lead to serious
deterioration in the quality of goods produces in the country.
2. Effect of inflation on distribution of wealth and income
 Inflation has bad effects on distribution of income and wealth. The impact it
produces on distribution of income and wealth in the society is deep.
 Inflation results in the redistribution of income and wealth in favour of
businessmen , traders and merchants.
 The fixed income groups such as workers, salaried employees, teachers,
pensioners etc suffer on account of inflationary rise in price.
3. Effects of inflation on debtors and creditors
 During inflation , debtors are the gainers while the creditors are the losers.
Debtors, while repaying their debts return less purchasing power to the
creditors than what they had actually borrowed.
 Since e creditors receive less in real terms , they are the losers during this period.
4. Effect of inflation on wage and salary earners
The salary and wages of this group of people do not rise in the same proportion
in which the cost of living rises. Even if the wages and salaries are linked up with the
cost of living index , still the wage and salary earners are adversely affected because
there is often a lag between the rise in price and the rise in wages and salaries.

1.13.4 Control of Inflation
(i) Monetary measures
(ii) Fiscal measures
(iii) Other methods such as wages policy , expansion of output etc.
1. Monetary measures to control inflation
Monetary measures can help in reducing the pressure of demand. These
measures are adopted by the central bank of the country (RBI) to combat inflation
through reduction of money supply and credit.
 Increased rediscount rates.
 Higher reserve requirements
 Consumer credit control.
2. Fiscal measures to control inflation
By adopting suitable measure in public expenditure , taxation , public , borrowing , debt
management and over valuation , the government can effectively curb inflation.
3.Other methods to control inflation
i)Expansion of Output
Inflationary gap arises partly due to the inadequacy of output. A reallocation of
productive resources is suggested to step up the output of essential consumer goods.
ii)Wage Policy
Wage increases may be allowed to workers only if their productivity increases.
iii) Price Control and Rationing
The objective of price control is to lay down the upper limit beyond which the
price of particular commodity would not be allowed to rise.
1.14 DEFLATION DEFINITION AND CAUSES
Deflation is the opposite of inflation . It is essentially a matter of falling prices.
In the words of professor Crowther , “Deflation is the state of the economy where the
value of money is rising or the prices are falling“.
According to professor Pigou , “ Deflation is the state of falling prices which occurs at
the time when the output of the goods and services increases more rapidly than the
volume of money in the economy”.
Deflation refers to the at state of the economy where the supply of money at a particular
time is less than its demand . In other word , the supply of money in the economy is not
sufficient to meet business requirement of the economy.
The fall in the price will be deflationary in the following situation:
1. If the money income diminishes but the output remains constant
2. If the money income diminishes much more rapidly than the output .
3. If the volume of output increases but the money income remains constant
4. If the output increase faster than the money income
5. If the volume of the output increases but the volume of money income diminishes.

1.14.1. Effects of Deflation
i)Producers
Whenever a manufacturer incurs a production cost for the purpose of production, he
has to pay a higher price for it at a time of deflation. But when the product reaches the
market, the manufacturer will be forced to sell his product at a reduces price. As a
result, manufacturer incur heavy losses and curtail employment and output.
ii)Effect on Investors
The fixed investors actually gain by inflation . Their income is constant while the prices
continues to fall as a results of deflation. Hence they are able to buy more goods and
services than before.
iii)Effects of deflation on salaries and labouring class
These two classes of the society gain as a result of deflation . The reason is that it is not
easy to cut the wages and salaries of people with the fall in price and these people in
effect have more money to spend on a already decreasing prices of product.
iv) Effect of deflation on consumers
The consumers are benefited out of deflation . Due to deflation , the purchasing power
of money rises up , enabling the consumers to buy more goods and services than before.
It should be remembered that only the fixed income group of consumers gain to
deflation while the rest of the businesses whose money declines suffer due to deflation.
v)Effect of deflation of debtors and creditors
Creditors gain while debtors lose as a result of deflation. The creditors gain because at a
time of deflation the demand for consumption loans goes up and the creditors can
charge arbitrary rates of interest and whatever amount they receive in the form of
interest carries a higher purchasing power than before.
1.14.2 Other effects of deflation
1. The burden of public debt invariably at time of deflation due to the rise in the value
of money.
2. The tax payers are adversely affected because the real burden of taxation increases at
the time of deflation.
3. It creates a banking crisis in the economy.
4. Deflation generates the expectations of further fall in prices.
5. As more and more workers are rendered unemployed , there is a greater frustration
and discontent among them.
1.14.3 Control of deflation
1. Monetary measures to control deflation:
i) Deficit financing: If a deflationary situation develops in the economy on the account
of expansion of production, then the monetary authority should resort to a policy of
monetary expansion to push up declining price level.
ii)Expansion of credit: At the time of deflation , the central bank as well as the
commercial banks should adopt a policy of credit expansion to promote business and
industry. This policy is known as cheap money policy.
iii)Reduction in interest rate: A the time of deflation , the monetary authority should
cut down the rate of interest mainly to encourage new business enterprise in the
economy.

1.14.4 Fiscal measures to control deflation
i) Increase in public expenditure: At a times of deflation , the government increases
its expenditure on development projects.
ii) Reduction in taxation: To control deflation the government should reduce the
number and the burden of various taxes imposed on commodities.
iii) Redistribution of income and wealth in favour of the poor
iv) Repayment of public debt: The government should repay its past debts to the
people at times of deflation.
v) Grant of subsidies: During deflation, the government should give subsides to
encourage the setting up of new industries for increasing the volume of employment in
the economy.
1.14.5 Other measures to control deflation
i) Price support programs: Farm price support programs , lowering of wages and other
costs will bring about an adjustment between price and cost of production.
ii) Promotion of exports and reduction of import: An increase in exports will go a
long way in solving the problem of over production in the periods of deflation.
iii)Regulation of supply: Attempts should be made to adjust supply with the existing
demand.
1.14.6. Inflation vs Deflation
The consequences of both inflation and deflation are economically bad, socially
undesirable , politically dangerous and normally indefensible .
1. Inflation widens the gap between the rich and poor classes.
2. Inflation is highly demoralizing in character.
3. A moderate inflation may even be good for a depressed economy.
4. Inflation , how-so-ever serious , can be controlled to some extent by the application of
monetary and fiscal measures. Deflation is not be easy to check when it leads to a
depression in the economy.

Introduction to Engineering Economics

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