Managerial Economics

1. 1
QUESTION 1- Economic stability implies avoiding fluctuations in economic activities. It is
important to avoid the economic and financial crisis. The challenge is to minimize the
instability without affecting productivity, efficiency, employment. Find out the
instruments to face the challenges and to maintain an economic stability.
ANS
Economic stability: Promoting economic stability is partly a matter of avoiding economic and
financial crisis. A dynamic market economy necessarily involves some degree of instability, as
well as gradual structural change. The challenge for policy makers is to minimize this instability
without reducing the ability of the economic system to raise living standards through increasing
productivity, efficiency and employment. Economic stability is fostered by robust economic and
financial institutions and regulatory frameworks.
Instruments of Economic Stability
1. Monetary Policy
 Monetary policy deals with the total money supply and its management in an
economy.
 Monetary policy is a part of the overall economic policy of a country. It is
employed by the government as an effective tool to promote economic stability
and achieve certain predetermined objectives.
 Monetary policy is essentially a program of action undertaken by the monetary
authorities, generally the central bank, to control and regulate the supply of
money with the public, and the flow of credit with a view to achieving economic
stability and certain predetermined macroeconomic goals.
 In a narrow sense Monetary policy is concerned with administering and
controlling a country’s money supply including currency notes and coins, credit
money, level of interest rates and managing the exchange rates.
 In a broader sense, monetary policy deals with all those monetary and non-
monetary measures and decisions that affect the total money supply and its
circulation in an economy. It also includes several non-monetary measures like
wages and price control, income policy, budgetary operations taken by the
Government which indirectly influence the monetary situations in an economy.
 Monetary policy basically deals with total supply of legal tender money, i.e.,
currency notes and coins, total amount of credit money, level of interest rates,
exchange rate policy and general liquidity position of the country.
 Monetary policy is passive when the central bank decides to abstain deliberately
from applying monetary measures.
 Monetary policy is active when the central bank makes use of certain
instruments to achieve the desired objectives.
 Monetary policy is positive when it promotes economic activities and it is
negative when it restricts or curbs economic activities.

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 The objectives may be manifold in relation to the general economic policy of a
nation. The various objectives may be interrelated, interdependent and mutually
complementary to each other.
2. Fiscal Policy
 Fiscal policy is an important part of the overall economic policy of a nation. It is
being increasingly used in modern times to achieve economic stability and
growth throughout the world.
 The term ‘fisc’ in English language means ‘treasury’ and the policy related to
treasury or government exchequer is known as fiscal policy.
 Fiscal policy is a package of economic measures of the Government regarding
public expenditure, public revenue, public debt or public borrowings. It concerns
itself with the aggregate effects of government expenditure and taxation on
income, production and employment.
 Fiscal policy is concerned with the manner in which all the different elements of
public finance, while still primarily concerned with carrying out their own duties
(as the first duty of a tax is to raise revenue), may collectively be geared to
forward the aims of economic policy.
 Fiscal policy as an instrument to fight depression and create full employment
conditions is much more effective than monetary policy since it affects the level
of effective demand directly, while monetary policy attempts to do it only
indirectly.
3. Physical policy or Direct Controls.
 Direct controls are imposed by government to ensure proper allocation of scarce
resources like food, raw materials, consumer goods and capital goods.
 Monetary and fiscal controls will have a general impact on the economy while
physical controls can be employed to affect specific scarcity areas.
 Direct controls are used generally to tide over a situation of shortage or surplus
and, to avoid large fluctuations in the prices of essential commodities.
Investments in certain fields and foreign trade are regulated through licensing,
fixing of quotas, import controls, export controls and export promotion.

3. 3
QUESTION 2 - Explain any eight macroeconomic ratios.
ANS
Macroeconomics is that branch of economics, which deals with the study of aggregative or
average behavior of the entire economy.
Macroeconomics ratios:
1) Saving income ratio:
Excess of income over expenditure is saving. The saving function can be easily derived
by subtracting spending from income. Hence, S = Y–C
where S = saving, Y = income and C = consumption. It is a function of income.
S = f [Y]. It implies that there is a direct relationship between the two. Higher the income,
higher would be the savings and vice-versa. The saving-income ratio indicates the
amount of savings made out of a given level of income. In the above example, saving
income ratio is 1:0.2. The consumption income ratio and saving income ratio enable a
business to plan its production schedule and derive sales forecasts.
2) Value added output ratio:
 Value added output is the difference between the value of output produced and
the value of inputs employed.
 It is a ratio of increase in the quantity of inputs employed and the corresponding
increase in the output obtained.
 It is very much necessary to find out the difference between the value of inputs
used and the output obtained. This will help in deciding whether to increase the
employment of additional factor input units in the production process.
3) Consumption income ratio:
Y= C + S. Out of a given income (Y); people can either spend or save (S), or they can
consume (C) their entire income. Hence, C = Y–S.
In other words, it tells us about the percentage of consumption out of a given level of
income.
This can be expressed as C = f [Y] where C = consumption, Y = income and f = function.
Consumption is an increasing function of income. Higher the income, higher would be
the consumption and vice-versa. There is a direct relationship between the two. For
example, out of Rs. 100, a person can consume Rs. 80, and save Rs 20. In this case,
the consumption income ratio is 1:0.8. This ratio helps business personnel to forecast
his/her sales in the market.
4) Capital labor ratio:
 This ratio indicates the proportion of two factor inputs.
 It tells us the ratio between the numbers of laborers required for a given amount
of capital invested in any business.

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 This ratio is useful to work out the least cost combination by substituting one
factor input to another.
 This ratio can be expressed as
K/L where K=capital and L= labor
5) Input- output ratio:
 This ratio explains the relationship between two variables of inputs and outputs.
 Input-output ratio indicates the quantity of inputs employed and the quantity of
outputs obtained.
 It is also called as production function in economics. Production is purely
physical in nature and as such, the ratio between inputs and outputs is
determined by technology, availability of equipments, labor, materials, etc. It can
be expressed in the form of a mathematical equation.
Q = f [ L,N,K -------- etc]
where Q = quantity of output per unit of time and, L,N,K etc are different factor
inputs like land, capital, labor, etc which are used in the production process.
Thus, the rate of output is a function of the factor inputs L,N,K etc, employed by
the firm per unit of time. The knowledge of production function would help a
producer to work out the most ideal combinations to maximize output and
minimize cost.
6) Land’s share of income:
 Land is one of the primary factors of production. It is a free gift of nature.
 It is an immovable factor input. The landlord supplies this factor input and earns
income in the form of rent.
 Land’s share of income indicated, by the percentage of income earned by the
landlord in the form of rent, out of total national income is called as land’s share
of income.
 It indicates the level of rent and the ability of the landlords to earn their income.
7) Capital share of income:
 Capital is a very powerful and important input in the production process. Capital
is described as the lifeblood of all economic activities. Without adequate capital,
no economic activity can be undertaken.
 Capital as a factor of production is earning interest as its income in the total
national income generation.
 Capital’s share of income indicated, by the percentage of income earned by
capital in the form of interest, out of total national income is called as capital’s
share of income
8) Cash income ratio:
 A bank is a commercial institution based on business principles.

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 Its main objective is to make profits. This depends on its portfolio management. A
bank has to keep adequate amount of cash in order to meet the requirements of
its customers.
 How much deposits it will keep in the form of liquid cash and how much money it
will lend and invest on various assets will depend on its CRR. This ratio helps the
banker to know the income earning capacity during a financial year.
 The cash - income ratio tells us the amount of cash, held by a bank in liquid form
and the percentage of income earned during an accounting year through its
investments.
 This ratio gives us information about the income-earning capacity of an
institution during an accounting year.

6. 6
QUESTION 3 - Define Inflation and explain the types of inflation.
ANS
Inflation is commonly understood as a situation of substantial and rapid increase in the level of
prices and consequent deterioration in the value of money over a period of time. It refers to the
average rise in the general level of prices and fall in the value of money.
The types of inflation are:
 Creeping Inflation
 When the rise in prices is very slow (less than 3%) like that of a snail or creeper it is
called creeping inflation.
 Walking Inflation
 When the rise in prices is moderate (in the range of 3 to 7%) and the annual inflation rate
is of single digit it is called walking inflation.
 It is a warning signal for the government to control it before it turns into running inflation.

 Running Inflation
 When the prices rise rapidly at a rate of 10 to 20% per annum it is called running
inflation. Such inflation affects the poor and middle classes adversely.
 Its control requires strong monetary and fiscal measures; otherwise, it can lead to
hyperinflation.
 Hyperinflation
 Hyperinflation is also called by various names like jumping, runaway, or galloping
inflation. During this period, prices rise very fast (double or triple digit rates) at a rate of
more than 20 to 100% per annum and become absolutely uncontrollable. Such a
situation brings a total collapse of the monetary system because of the continuous fall in
the purchasing power of money.
 Demand-pull Inflation
 The total monetary demand persistently exceeds the total supply of goods and services
at current prices so that prices are pulled upwards by the continuous upward shift of the
aggregate demand function.
 It arises as a result of an excessive aggregate effective demand over aggregate supply
of goods and services in a slowly growing economy. Supply of goods and services will
not match the rising demand.
 The productive ability of the economy is so poor that it is difficult to increase the supply at
a quicker rate to match the increase in demand for goods and services. When exports
increase, the money income of people rises. With excess money income, purchasing
power, demand, and prices move in the upward direction.
 Cost-push Inflation
 Prices rise on account of increasing cost of production. Thus, in this case, rise in
price is initiated by growing factor costs. Hence, such a price rise is termed as ‘cost-
push’ inflation as prices are being pushed up by rising factor costs.

7. 7
QUESTTION 4 - Define Fiscal Policy and the instruments of Fiscal policy
ANS
 The term ‘fisc’ in English language means ‘treasury’ and the policy related to treasury or
government exchequer is known as fiscal policy.
 Fiscal policy is a package of economic measures of the Government regarding public
expenditure, public revenue, public debt or public borrowings.
 It concerns itself with the aggregate effects of government expenditure and taxation on
income, production and employment. In short, it refers to the budgetary policy of the
government.
 Fiscal policy is an important part of the overall economic policy of a nation. It is being
increasingly used in modern times to achieve economic stability and growth throughout
the world.
The instruments of fiscal policy are :
1) Public revenue:
 It refers to the income or receipts of public authorities.
 It is classified into two parts - tax-revenue and non-tax revenue.
 Taxes are the main source of revenue to a government. There are two types of
taxes. They are direct taxes such as personal and corporate income tax, property
tax, expenditure tax, and indirect taxes such as customs duties, excise duties,
sales tax (now called VAT).
 Administrative revenues are the bi-products of administrate functions of the
government. They include fees, license fees, price of public goods and services,
fines, escheats and special assessment.
2) Public expenditure policy:
 It refers to the expenditure incurred by the public authorities like central, state
and local governments.
 It is of two kinds: development or plan expenditure and non-development or non
plan expenditure.
 Plan expenditure includes income-generating projects like development of basic
industries, generation of electricity, development of transport and
communications and construction of dams.
 Non-plan expenditure includes defense expenditure, subsidies, interest
payments and debt servicing changes.
3) Public debt or public borrowing policy:
 All loans taken by the government constitutes public debt. It refers to the
borrowings made by the government to meet the ever-rising expenditure.
 It is of two types, internal borrowings and external borrowings.
4) Deficit financing:
 It is an extraordinary technique of financing the deficits in the budgets.

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 It implies printing of fresh and new currency notes by the government by running
down the cash balances with the central bank.
 The amount of new money printed by the government depends on the absorption
capacity of the economy.
5) Built in stabilisers or automatic stabilisers (BIS):
 The automatic or built-in stabilisers imply automatic changes in tax collections
and transfer payments or public expenditure programmes so that it may reduce
the destabilizing effect on aggregate effective demand.
 When income expands, automatic increase in taxes or reduction in transfer
payments or government expenditures will tend to moderate the rise in income.
 On the contrary, when the income declines, tax falls automatically and transfers
and government expenditure will rise and thus built-in stabilisers cushion the fall
in income.

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QUESTON 5 - Investment is a part of income which can be used for various purposes. It is
necessary to create employment in an economy and to increase national income. To
understand the benefits of income, study the various types of investment.
ANS
Investment refers to real investment, denoting an addition to real capital assets as well as to the
wealth of the society. There are various kinds of investment like private investment, public
investment, foreign, induced, autonomous, gross, net, etc.
Investment is determined by a number of factors like the rate of interest, marginal efficiency of
capital, level of uncertainty, political environment, rate of growth of population, level of existing stock
of capital, inventions, and consumer’s demand .investment is highly unstable in the short run.
Inducement to invest mainly depends on the rate of interest and the marginal efficiency of capital.
The types of investments are as follows:
I. Private investment
 It is made by private entrepreneurs on the purchase of different capital assets like
machinery, plants, construction of houses and factories, offices, shops, etc.
 It is influenced by MEC and interest rate. It is profit – elastic. Profit motive is the basis
for private investment. Private entrepreneurs would take up only those projects which
yield quick results and generally those that have a small gestation period.
II. Public investment
 It is undertaken by the public authorities like central, state and local authorities.
 It is made on building infrastructure of the economy, public utilities and on social
goods, for example, expenditure on basic industries, defense industries, construction
of multipurpose river valley projects, etc. In this case, the basic criterion and motto is
social net gain, social welfare and not profits.
 The principle of maximum social advantage would govern public expenditure.
 It is also influenced by social and political considerations.
III. Foreign investment
 It consists of excess of exports over the imports of a country. It depends on many
factors such as propensity to export of a given country, foreigner’s capacity to
import, prices of exports and imports, state trading and other factors.
IV. Autonomous investment
 Autonomous investment is another name for public investment.
 The investment, which is independent of the level of income, is called as
autonomous investment.
 Such investments do not vary with the level of income. Therefore it is called
income-inelastic. It does not depend on changes in the level of income,
consumption, rate of interest or expected profit.

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QUESTION 6 - Discuss any two laws of returns to scale with example.
ANS
The concept of returns to scale is a long run phenomenon. In this case, we study the change in
output when all factor inputs are changed or made available in required quantity. An increase in
scale means that all factor inputs are increased in the same proportion. In returns to scale, all the
necessary factor inputs are increased or decreased to the same extent so that whatever the scale of
production, the proportion among the factors remains the same.
1) Diminishing Returns to Scale:
The term 'diminishing' returns to scale refers to scale where output increases in a smaller
proportion than the increase in all inputs.
For example, if a firm increases inputs by 100% but the output decreases by less than
100%, the firm is said to exhibit decreasing returns to scale. In case of decreasing returns to
scale, the firm faces diseconomies of scale. The firm's scale of production leads to higher
average cost per unit produced.
2) Increasing Returns to Scale:
If the output of a firm increases more than in proportion to an equal percentage increase in
all inputs, the production is said to exhibit increasing returns to scale.
For example, if the amount of inputs are doubled and the output increases by more than
double, it is said to be an increasing returns to scale. When there is an increase in the scale
of production, it leads to lower average cost per unit produced as the firm enjoys economies
of scale.
The three laws of returns to scale are now explained with the help of a graph below:

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The figure above shows that when a firm uses one unit of labor and one unit of capital, point a, it
produces 1 unit of quantity as is shown on the q = 1 isoquant. When the firm doubles its outputs by
using 2 units of labor and 2 units of capital, it produces more than double from
q = 1 to q = 3.
So the production function has increasing returns to scale in this range. Another output from quantity
3 to quantity 6. At the last doubling point c to point d, the production function has decreasing returns
to scale. The doubling of output from 4 units of input, causes output to increase from 6 to 8 units
increases of two units only.