managerial economics syed

MBA Information Systems – Principles of Management P a g e | 1

Enrollment No.: MBISMCT11118178

MBA Information Systems 1st Year - Assignment Annamalai University

2: Managerial Economics

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Question #3: Explain how inflation will affect the economy of a country with suitable examples.

Answer:-

What is Inflation?

Everyone is familiar with the term “Inflation” as rising prices. This means the same thing as fall in the value of money. Inflation is a monetary ailment in an economy and it is defined by economists in so many ways. When there is persistent and appreciable rise in the general level or average prices, we have inflation. Economists have defined inflation as follows

Based on “phenomenon of rising prices”“State in which the value of money is falling, i.e., the prices are rising.” – Crowther“I define inflation as substantial rise in prices.” – Harry G. Johnson“Inflation is a persistent and appreciable rise in the general level or average of prices.” – Gardner Ackley

Based on “Monetary phenomenon”“Inflation is always and everywhere a monetary phenomenon.” – Friedman“Too much money chasing too few goods.” – Coulborn“Issue of too much currency.” – Hawtrey “Inflation is too much money and deposit currency, that is, too much currency in relation to the physical volume of business being done." – Kemmerer

All these definitions indicate one basic phenomenon in the economy. Too much of money in circulation compared to too little goods produced leading to extraordinary increase in prices. It should be noted that inflation is not all about high prices, but it is a persistence increase in prices to an abnormal extent.

Keynesian ViewWhile increase in volume of money is responsible for rise in the price level, Keynes related inflation and rise in prices as follows

a) It comes into existence after the stage of full employment.b) Rise in prices may be accomplished by increase in production.c) Rise in prices not accompanied by increase in production.

Keynes defined inflation as a phenomenon of full employment. According to him, inflation is the result of the excess of aggregate demand over the available aggregate supply and true inflation starts only after full employment. So long, there is unemployment, employment will change in the same proportion as the quantity of money and when there is full employment, and prices will change in the same proportion as the quantity of money.



Keynes does not deny that prices may rise even before full employment, mainly due to the existence of certain bottlenecks in the expansion of output. However, he termed such a rise in prices as semi-inflation. It is the true inflation (after full employment), which poses a real threat to the economy and is to be worried about. Hence in Keynesian sense, inflation refers to a rise in the price level after full employment is reached.But in an underdeveloped country, the term “inflation” cannot be used in the Keynesian sense.For Example: In a country like India, we can witness “inflation” and “unemployment” existing side by side. Abnormal rise in prices and persistent rise in prices is not an indication of prosperity and that the country is moving towards full employment. On the other hand, the backlog of unemployment is mounting up year by year.

Types of Inflation

Based on different considerations and categories which result in inflation, it can be classified as follows

1. On the Basis of SpeedOn the basis of speed or rapidity with which prices increase, inflation is divided into (a) Creeping inflation. (b) Walking inflation. (c) Running inflation. (d) Galloping inflation or Hyper-inflation.a. Creeping inflation as name itself suggests, is slow-moving and very mild. The rise in

prices will be perceptible but spread over long period of time. This type of inflation is not dangerous to the economy. Economists consider this type of inflation as favorable for development and preventing stagnation. This has attracted attention in some countries for example: Germany and USA.

b. Walking inflation takes place when creeping inflation takes momentum. In this case, the rise in prices becomes more marked and it is danger signal.

c. Running inflation will have sharp and vigorous rise in prices.d. In the case of Galloping or Hyper-inflation, the prices will not only rise sharply but

they rise in fits and starts. This type of inflation is dangerous to the economy and cannot be controlled easily. It ruins fixed middle income group for example: First World War Germany.

2. On the Basis of Inducementa. Deficit-induced inflation: This is caused by the adoption of unbalanced budgetary

policies. The government would resort to deficit financing which means government spending in excess of its revenue receipts.

b. Wage-induced inflation: This denotes a rise in prices due to an increase in money wages. A small general increase in the price level may induce the labor organizations to clamor for more wages or any change in monetary or fiscal policies if the government resulting in increase of price level will make the laborers demand more wages.

c. Profit-induced inflation: This occurs on account of increase in the profits of



manufacturers. This is possible when there is general increase in the price level or an increase in the price level of new capital goods.

3. On the Basis of TimeEmergencies like war or preparations for war will create inflationary conditions in the economy. Sudden launching of war will strain the economy, as all the factor resources have to be pooled for war purposes. The government would resort to deficit-financing and there will be massive expansion of money supply for producing materials and ammunition for war, besides food for defence personnel and also for the people. Besides war, the post-war period will also breed inflation due to rehabilitation and development work undertaken by the government to set right the war-torn economy. Thus inflation can be classified as war-time inflation and post-war inflation and inflation due to development activities.

4. On the Basis of Extent of CoverageIn this category inflation can be classified as a. Economy wide: It signifies inflation of a very comprehensive nature covering the

entire economy. No section of the economy will be left untouched by the rising prices and the impact will be felt by the nation as a whole.

b. Sporadic: It is partial in character and sectional in nature. It occurs only in specified sectors or sections of the economy due to abnormal but temporary shortage of some specific goods. The defect may not be fundamental but only superficial.For Example: increase in prices of food products as a result of crop failure in the season.

c. Open Inflation: Means price rise will be uninterrupted. If it is allowed to have its own way will reach to dizzy heights as in case of Germany, Austria during the 20s.

d. Suppressed Inflation: Occurs when government controls and prevents goods prices and money wages from rising, so the excess demand is not reduced but suppressed.

5. Based on causesBased on two important forces demand and cost, which would create inflation are classified as followsa. Demand-Pull inflation: This type of inflation occurs when there is excess demand

force acting in the economy leading to rise in prices. It emerges when the aggregate demand exceeds the level of full employment output. Keynes calls this as bottleneck inflation. Generally, demand-pull inflation occurs due to heavy government expenditure either for financing war or financing development projects.

b. Cost-Push inflation: When there is an increase in the cost of production of goods and services, it is likely that cost-push inflation will occur. Increase in cost of production mainly occurs due to an increase in the employee’s wages.For Example: OPEC reduces oil supply; prices are artificially driven up and result in higher prices at the pump. This Type of Inflation is also known as Supply shock inflation.



Effects of Inflation

Inflation has good as well as bad effects on the economy. In the initial stages, mild inflation may create an all-round expansion of business activity and this proves beneficial to the economy. Inflation is good up to the stage of full employment. But the trouble is that the rise in prices is not uniform throughout the economy and there may be distortions due to inflation causing many imbalances. Let’s see effects of inflation on various sections of the society

i. On producers: Inflation is a period of boom and prosperity for the producing classes. All businessmen, traders, speculators gain during inflation because of (a) windfall profits and (b) appreciation in the value of their stock. Normally, there is a time-lag between a rise in the prices of commodities and rise in the cost of production. Prices of goods increase at faster rate during the period of inflation and the cost of production lags behind as wages, interest, insurance etc. are almost fixed. This gives enormous scope for windfall gain. Further, with the fall in the value of money, businessmen try to appreciate the value of their stock. Thus, inflation is a blessing in disguise to the business class at the initial stages.

ii. On Working Class: Working class suffer during inflation, as their wages do not rise proportionately with the rise in prices and cost of living. These days workers of the organized group do not suffer much as they react faster during the inflation. Whereas other unorganized groups like self employed and agriculture labours find it very difficult during inflation. The condition is equally distressing for those workers, who have little bargaining power from their organizations.

iii. On fixed income groups: This is the worst hit class during inflation. People living on past savings, fixed interest, on investments, pensioners, salaried class like teachers and government employees find inflation and rising in prices very agonising, as their fixed purchasing power decline in the face of mounting cost of living. This class of people, called the middle income group, which form the bulk of the society become the worst sufferers.

iv. On Distribution: Inflation has bad effect on distribution too. Since rise in price and rise in income may not be uniform in all sectors and sections of the economy there will be distortions and imbalances causing bottlenecks in distribution and fluctuation in production and effective distribution. For instance, during inflation the price of industrial goods go up rapidly and prices of agriculture produce are not so flexible. The returns of farmers diminish and their economic condition deteriorates due to mounting cost of commodities and industrial product which they must buy. The net result will be that some classes enjoy the benefits of inflation while others suffer from it.

v. On debtors and creditors: During the inflationary period the debtors (borrowers) gain much while creditors (lenders) lose heavily. When prices rise, the real value of money falls and the debtors have to pay money which has less purchasing power. This will be beneficial to debtor while the creditor will be getting back amount whose value of purchasing power has declined.

vi. On Government: The government too will be affected by the inflation. The public sector undertaking may have to raise the expenditure level due to a fall in the value of money.



Alternatively they would cut the size of the projects and programmes to meet with the original budgeted expenditure. On other hand government will be benefited during inflationary period, as it is a largest borrower as we have in the case of debtors.

vii. Social Consequence: If inflation is persistent and severe, it has baneful influence on society. It makes rich richer and poor poorer. There is an all-round frustration among the salaried and fixed income groups. The producing and trading classes gain at the expense of salaried fixed income groups. Thus there is transference of income from poor to rich. Due to enormous rise in prices and scarcity of essential commodities, there is black-marketing, hoarding and profiteering. Inflation becomes social menace and political problem if necessary steps are not taken.

Effects of inflation on Economy of a country

Inflation and the economy of a country are closely related. The effect on the economy of any country is not immediate or it does not affect the economy overnight. There is a cumulative effect. Several such changes build up to bring about a big change. The economy of a country is affected by inflation in a number of ways.Inflation and the economy both influence all the major macroeconomic indicators of a country. The various macroeconomic indicators include the following:

Gross domestic product or GDP Producer price index (industrial) Consumer price indices Industrial production Capital Investment Agricultural production Export Import Demography Debt

Inflation not only affects the macroeconomic indicators, it affects the living standards of the people. The exchange rates of all currencies also change. This in turn influences trade. When exchange rates are affected, the interest rates cannot be far behind.Inflation and its effect on economy are enormous. In other words, all events are interlinked and the entire economic cycle gets upset.

For Example: 1. The mortgage crisis of 2007 in USA could best illustrate the ill effects of inflation.

Housing prices increases substantially from 2002 onwards, resulting in a dramatic decrease in demand.

2. India after independence has had a more stable record with respect to inflation than most other developing countries. Since 1950, the inflation in Indian economy has been in single digits for most of the years, as shown in the following table



Period Avg. Inflation rate1950-1960 2.00%1960-1970 7.20%1970-1980 8.50%

In early 2007, in India, the inflation rate, as measured by the wholesale price index (WPI), hovered around 6-6.8%, well above the level of 5-5.5% that would have been acceptable to the Reserve Bank of India (RBI), the country's central bank. On February 15, 2007, the inflation rate reached a two-year high of 6.73%. In the past, the main cause of high inflation in India used to be rises in global oil prices. However, in early 2007, the chief component of the inflation was the increase in the prices of food articles - caused by increased demand as well as supply constraints. According to analysts, the increased demand was due to high economic growth and increased money supply, while stagnant agricultural productivity was behind the supply constraints.

Apart from the rise in prices of food articles, fuel and cement prices too recorded high increases. The Government of India, together with the RBI, took several measures to contain inflation. For example, the RBI increased the Cash Reserve Ratio (CRR) and repo rates in an effort to check money supply; the Government of India reduced import duties on several food products and cut the price of diesel and petrol.

The RBI also chose not to intervene when the Indian Rupee rallied against the US Dollar between March 2007 and May 2007. The decision not to intervene was based on the idea that a stronger Rupee would bring down the cost of imports, which, in turn, would help reduce domestic prices of goods. Though the measures taken by the GoI were targeted at inflation, some analysts feared that some of these measures, especially the ones leading to higher interest rates, might induce recession in the Indian economy. There were others who felt that letting the Rupee rise would not only have a negative effect on the bottom lines of companies that earn a substantial percent of their profits from exports, but also impact the long-term competitiveness of Indian exports.

Inflation in India a menace a few years ago is at a 30 year low. The inflation ended at a low of 0.61% in the week ended May 9, 2009 this after reaching a 16 year high of 12.91 % in August 2008, bringing in a sigh of relief to policymakers. Following diagram illustrates latest inflation rates in India



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Question #4: Explain pricing methods and which method will be suitable in present age?

Answer:-

Need for Pricing Methods

There are many practical pricing methods adopted by the firms, based on different considerations. While fixing the price, the firm is guided by some objectives such as, profit maximisation, sales maximisation, establishing a favourable image with the public or limiting competition, etc. Every firm sets certain objectives and tries to accomplish them.

Formulating price policy and adopting a particular pricing method is often a critical factor in the successful operation of a business organization. Even though the basic problem of pricing is the same for all firms (i.e. Costs, Competition, Demand, and Profit), the optimum mix of these factors varies according to the nature of the products markets and the overall objective of the firm. Thus, the job for the management is to develop and adopt an appropriate pricing method that meets the needs of the company.

Pricing Methods

Generally businessmen prefer a pricing procedure which is easy to implement and requires only few assumptions on demand. The various pricing methods usually employed by businessmen areMethods Based on Cost

1. Cost-Plus or Full-Cost pricing2. Target pricing or pricing for a rate of return3. Marginal pricing

Methods Based on Competition and Market4. Going-rate pricing5. Customary pricing6. Differential pricing

Methods Based on Cost

1. Cost-Plus or Full-Cost pricing:The full-cost pricing method is generally adopted by many of the firms for its simplicity and ease. This method is also called Cost-plus pricing, Margin pricing and Mark-up pricing. Under this method, the price is set to cover all costs (material, labour and overhead) and predetermined percentage for profit. Which means the selling price of the product is computed by adding percentage to the average total cost of the product . The percentages added to the cost are called margins or mark-ups. These percentages



vary from firm to firm and product to product in the same firm. Firms using this method should take the following costs into consideration

Variable and fixed production costs Variable and fixed selling and administrative costs

The mark-up of profit is determined based on variety of considerations. It may be based on common tradition laid down in particular business or it may be determined by trade associations or guide lines if any provided by the government.

For example: The fixed costs to produce an item are Rs300000, the variable costs add up to Rs100000, and the estimated number of units to be produced is 50,000. Add Rs100000 to Rs300000, divide by 50000, and the true unit cost equals Rs8. If the desired return on sales is 20%, divide Rs8 by 1 minus .20, and the cost-plus price for this item will be Rs10.

Advantagesa. It helps in setting fair and plausible prices.b. It is easy for application by all types of firms.c. This method safeguards the interest of the firm against risks due to uncertain

demands.d. It economical for decision making.e. If adopted by all businessmen, it may help protect the firms against price wars or

self damaging price competition and at the same time it provides flexibility to adjust price based on variation of costs.

f. This method is best while dealing with uncertainty and ignorance.Drawbacks

a. Totally ignores influence of demand.b. Fails to reflect the forces of competition adequately.c. Cost is regarded the main factor influencing the price.d. Undue importance is given for the precision of allocating of costs.e. This method is based on circular reasoning. Which means price determines

quantity demanded; price charged is dependent upon cost per unit and the cost, in turn, depends upon the quantity demanded.

f. It ignores marginal or incremental cost and uses average cost instead.In spite of drawbacks this method is useful in product tailoring, custom design products, monopsony buying and public utility buying.

2. Target pricing or pricing for a rate of return:This method of pricing is only a refinement of the full-cost pricing. According to this method manufacturer considers a pre-determined target rate of return on capital invested. In the case of full-cost pricing, the percentage of profit is marked up arbitrarily. In the case of rate of return method, the companies determine the average mark-up on costs necessary to produce a desired rate of return on the company’s investment.



In this case the company estimates future sales, future costs, and arrives at a mark-up that will achieve a target return on the company’s investment.

Davis and Hughes have used the following formula to calculate the desired rate of return when a mark-up is applied on cost

Percentage mark-up on cost = Capital employed x Planned rate

of returnTotal annual cost

For Example:Suppose the capital employed by a firm is Rs.6 lakhs and total annual cost id Rs.12 lakhs with a planned rate of return of 20 percent. Then percentage mark-up is = (6/12) * 20 = 10%Now suppose the total cost per unit in the firm is Rs.20 with 10 percent mark-up the selling price would be Rs.22.

In any business price policy is profit oriented. A company cannot blindly stick to the mark-up which has been decided based on the capital employed. Change of costs compels company to revise the prices. To overcome this problem, three different methods are followed

a. Revising the prices to maintain constant percentage mark-up over costs.b. Revising the prices to achieve estimated sales to maintain percentage of profit. c. Revising the prices to achieve a constant rate of return on capital invested

Changed percentage may be computed as belowa. Percentage over cost = Profits / Costsb. Percentage on sales = Profits / Earnings from salesc. Percentage on capital employed = Profits / Capital employed

The major drawback of this procedure is that it ignores demand condition.

3. Marginal Cost PricingUnder marginal cost pricing method, the price of a product is determined on the basis of the marginal or variable costs. In this method fixed costs are totally ignored and only variable costs are taken in to consideration. This is done on the assumption that fixed costs are caused by outlays which are historical and sunk. Their relevance to pricing decision is limited, as pricing decision requires planning the future. Under marginal cost pricing, the objective of the firm is to maximise its total contribution to fixed costs and profit.

For Example:Aircraft flying from Bengaluru to ChennaiTotal Cost (including normal profit) = Rs15,000 of which Rs13,000 is fixed cost*Number of seats = 160, average price = Rs93.75



MC of each passenger = 2000/160 = Rs12.50If flight not full, better to offer passengers chance of flying at Rs12.50 and fill the seat than not fill it at all!

Advantagesa. Marginal cost pricing is highly useful for public utility undertakings. It helps them

in maximising output and better capacity utilization. This is possible only when lowest possible price is charged. The lowest limit is set by marginal cost of the product, which helps in maximising public welfare.

b. This method enables the firms to face competition. This is the reason why export prices are based on marginal costs since international market is highly competitive.

c. This method helps in optimum allocation of resources and as such it is the most efficient and effective pricing technique and it is useful when demand conditions are slack.

d. Marginal cost pricing is suitable for pricing over the life-cycle of a product. Each stage of the life-cycle has separate fixed cost and short-term marginal cost.

In the modern business marginal is cost pricing method is more effective compares to full-cost method due to following two characteristics

I. The prevalence of multi-product, multi-process and multi-maker concerns makes the absorption of fixed costs into product costs is absurd. The total cost of separate products can never be estimated perfectly and satisfactorily, and the optimal relationship between costs and prices will vary substantially both among different products and different markets. In this type of business, proposals to changing the prices in terms of sales and segmentation of the market can be profitability employed only with short-run problems and marginal pricing is the most suitable method of short-run pricing.

II. In business, dominant force is innovation combined with constant technology. The long-run situations are often unpredictable. Hence, short-run marginal cost pricing is most suitable.

Limitationsa. Firms may find it difficult to cover up costs and earn a fair return on capital

employed when they follow marginal cost principle in times of recessions when demand is slack and price reduction becomes inevitable to retain business.

b. When production takes place under decreasing costs, marginal cost pricing is unsuitable since MC curve will be below the AC curve and marginal cost pricing is bound to lead to deficits.

c. Marginal cost pricing requires a better understanding of marginal cost technique. Some accountants are not fully conversant with the marginal techniques themselves. Therefore, they are not capable of explaining their use to the management.



In spite of its advantages, due to its inherent weakness of not ensuring the coverage of fixed costs, marginal pricing has not been adopted extensively. It is confined to cases of special orders only.

Methods Based on Competition and Market

4. Going-Rate pricingThis method of pricing conforms to the system of pricing in oligopoly where a firm initiates price changes and other firms in the industry follow the pattern set by the leader. Other firm accepts the leadership. The emphasis here is on the market. Firms make necessary price adjustment to suit the general price structure in the industry. Hence this going-rate pricing method is also called as Acceptance-pricing. Normally, under this method, the industry tries to determine the lowest price that the seller can afford to accept considering various alternatives.

For Example:Going-rate pricing include industries like clothing, automobile, long-playing records, etc., where the products have reached a stage of maturity and where both customers and rival produces have become accustomed to stable price-relationship.

When products are identical, unique selling price will rule. When they are differentiated, prices will form a series, set at discrete intervals.Advantages

a. It helps in avoiding cut-throat competitions among the firms.b. It is a rational pricing method when costs are difficult to measure.c. Going-rate or acceptance pricing is less troublesome and less costly since exact

calculation of costs and demand is not necessary.d. It is suitable to avoid price hazards in oligopoly market.

5. Customary PricingPrice of certain goods becomes more or less fixed for a considerable period of time, not by deliberate action on the seller’s part, but as a result of their having prevailed for a considerable period of time. Only when the costs change significantly, the customary prices of these goods are changed. While changing the customary price, it is necessary to study the pricing policies and practices adopted by the competing firms. Another approach is to effect price change only in a limited market segment and know the customer reaction to decide whether any change would be digested by the market.

Customary price may be maintained even when products are changedFor Example:The new model of a mobile phone may be priced at the same level as the discontinued model. This is usually so even in the face of lower costs. A low price may cause an



adverse reaction on the competitors leading them to a price war as also on the consumers who may think that quality of the new model is inferior. Hence, going along with the old price is the easiest thing to do.

6. Differential PricingIdentical products are priced differently for different types of customers, markets or buying situations. An important aspect of differential price is price discrimination.

Differential pricing enables companies to profit from their customers' unique valuations by offering different customers different prices for the same product.

For Example:At a cinema, customers who paid full price, used coupons, received discounts (senior, student, under 12 and AAA etc.) or purchased prepaid discount passes from Super Market can all be sitting next to each other watching the same movie. Offering this spectrum of prices enables cinemas to maximize profits by serving customers with a variety of different valuations.

Consider the pricing behaviour at an auction. Everyone has the same information and bids on the same item. As prices increase, bidders drop out. Those who drop out are in essence saying, "I know others are willing to pay higher prices, but I just don't value the item as much as they do."

Differential pricing tactics can be grouped as: Requiring customers to jump hurdles (coupons, rebates, sales, price match

guarantees, time in sales cycle, distribution outlet). Customer characteristics (different prices based on where customer lives, readily

available traits such as age, affiliations, purchasing history). Selling characteristics (discounts for volume purchases, bundles, different next

best alternatives). Selling strategy (negotiation, razor/razor blade pricing, metering, and dynamic

pricing).The range of prices created by differential pricing contributes to the pricing windfall with larger margins from higher prices and growth by using discounts to sell to more customers.The end result of implementing these four strategies is a multi-price strategy. By this, I mean a set of publicly known prices and plans for a company's products composed of: (1) a value-based price, (2) new pricing plans, (3) versions, and (4) a range of prices.

managerial economics syed

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