Price Mechanism

In economics, a price mechanism is the manner in which the profits

of goods or services affects the supply and demand of goods and services, principally by the price
elasticity of demand. A price mechanism affect both buyer and seller who negotiate prices. A price
mechanism, part of a market system, comprises various ways to match up buyers and sellers. Price
mechanism is a mechanism where price plays a key role in directing the activities of producers,
consumers, resource suppliers. An example of a price mechanism uses announced bid and ask prices.
Generally speaking, when two parties wish to engage in trade, the purchaser will announce a price he
is willing to pay (the bid price) and seller will announce a price he is willing to accept.

Under a price mechanism, if demand increases, prices will rise, causing a movement along the
supply curve.

For example: the oil crisis of the 1970s drove oil prices dramatically upwards, which in turn caused
several countries to begin producing oil domestically.

A price mechanism affects every economic situation in the long term. Price Mechanism plays a vital
role in determining prices in a capitalist economy. An example of the effects of a price mechanism in
the long run involves fuel for cars. If fuel becomes more expensive, then the demand for fuel would
not decrease fast but eventually companies will start to produce alternatives such as biodiesel fuel and
electrical cars. A price mechanism is a system by which the allocation of resources and distribution of
goods and services are made on the basis of relative market price. There are two important elements
of price mechanism – 1.
PRICES - prices are essence of price mechanism. price mechanism works through prices in a free
enterprise economy, where all goods and services carry price tags with them. a whole set of prices
prevail in such an economy. goods and services are available at a price because it involves cost in
producing these goods and services. consumers have to pay some prices if they want to buy some
goods like food, clothes, etc. producers are willing to sell goods and services only if they get the
appropriate price. 2. MARKET - forces of demand and supply operate within the framework of
market. market constitute an integral part of the price mechanism A market means a system or a set-
up in which the buyers and sellers of the commodity are able to interact and communicate with each
other and strike a deal, i.e., price and the quantity to be bought and sold.

Demand & Supply Equilibrium

Equilibrium is the state in which market supply and demand balance each other, and as a result,
prices become stable. Generally, an over-supply of goods or services causes prices to go down,
which results in higher demand. The balancing effect of supply and demand results in a state of
equilibrium.
The equilibrium price is where the supply of goods matches demand. When a
major index experiences a period of consolidation or sideways momentum, it can be said that the
forces of supply and demand are relatively equal and that the market is in a state of equilibrium.

Example of Equilibrium:

A store manufactures 1,000 spinning tops and retails them at $10 per piece. But no one is willing buy
them at that price. the store reduces To pump up demand, their price to $8. There are 250 buyers at
that price point. In response, the store further slashes the retail cost to $5 and garners five hundred
buyers in total. Upon further reduction of the price to $2, one thousand buyers of the spinning top
materialize. At this price point, supply equals demand.
Hence $2 is the equilibrium price for the spinning tops.

What Is the Law of Supply and Demand?

The law of supply and demand is a theory that explains the interaction between the sellers of a
resource and the buyers for that resource. The theory defines what effect the relationship between the
price of the product the willingness people to either buy or sell the product.
Generally, as price increases people are willing to supply more and demand less and vice versa
when the price falls.

Understanding the Law of Supply and Demand

The law of supply and demand, one of the most basic economic laws, ties into almost all economic
principles in some way. In practice, people's willingness to supply and demand a good determines the
market equilibrium price, or the price where the quantity of the good that people are willing to supply
just equals the quantity that people demand. However, multiple factors can affect both supply and
demand, causing them to increase or decrease in various ways.

Concept of Elasticity and its Application

What Is Elasticity?

Elasticity is a measure of a variable's sensitivity to a change in another variable, most commonly this
sensitivity is the change in price relative to changes in other factors. In business and economics,
elasticity refers to the degree to, consumers which individuals or producers change their demand or
the amount supplied in response to price or income changes. It is predominantly used to assess the
change in consumer demand as a result of a change in a good or service's price.

How Elasticity Works?

When the value of elasticity is greater than 1.0, it suggests that the demand for the good or service is
affected by the price. A value that is less than 1.0 suggests that the demand is insensitive to price, or
inelastic. Inelastic means that when the price goes up, consumers’ buying habits stay about the same,
and when the price goes down, consumers’ buying habits also remain unchanged.If elasticity is zero it
is known as perfectly inelastic. If elasticity
= 0, then it is said to be 'perfectly' inelastic, meaning its demand will remain unchanged at any
price. There are probably no real-world examples of perfectly inelastic goods. If there were, that
means producers and suppliers would be able to charge whatever they felt like
and consumers would still need to buy them. The only thing close to a perfectly inelastic good
would be air and water, which no one controls.

Elasticity is an economic concept used to measure the change in the aggregate quantity demanded
for a good or service in relation to price movements of that good or service. A product is considered
to be elastic if the quantity demand of the product changes drastically when its price increases or
decreases. Conversely, a product is considered to be inelastic if the quantity demand of the product
changes very little when its price fluctuates.

For example, insulin is a product that is highly inelastic. For diabetics who need insulin, the demand
is so great that price increases have very little effect on the quantity demanded.
Price decreases also do not affect the quantity demanded; most of those who need insulin aren't
holding out for a lower price and are already making purchases.

The price elasticity of demand is the percentage change in the quantity demanded of a good or
service divided by the percentage change in the price. The price elasticity of supply is the percentage
change in quantity supplied divided by the percentage change in price.

Demand and Supply Theory is essential for an understanding of economics.

It has been argued that certain relationships exist between price and quantity demanded and supplied,
other things remaining constant. But if price changes, by how much does quantity demanded or
supplied change? It could be that a large price increase/decrease will have little effect of quantity
demanded or supplied.
On the other hand, a small price increase/decrease might result in a substantial change in demand or
supply. Theoretically it is impossible to say exactly what will happen in cases like these. Each
product may have a different price-quantity reaction. It is a matter for economists to collect evidence
and calculate this relationship.
However, theoretical economists can provide a useful guidance for studying this relationship.
Elasticity is a measure of the relationship between quantity demanded or supplied and another
variable, such as price or income, which affects the quantity demanded or supplied.

Marginal Utility
Marginal utility is the added satisfaction that a consumer gets from having one more unit of a good or
service. The concept of marginal utility is used by economists to determine how much of an item
consumers are willing to purchase. Positive marginal utility occurs when the consumption of an
additional item increases the total utility. On the other hand, negative marginal utility occurs when the
consumption of one more unit decreases the overall utility.
Economists use the idea of marginal utility to gauge how satisfaction levels affect consumer
decisions. Economists have also identified a concept known as the law of diminishing marginal
utility. It describes how the first unit of consumption of a good or service carries more utility than
later units.
 Marginal utility is useful in explaining how consumers make choices to get the most benefit
from their limited budgets. In general, people will continue consuming more of a good as long as the
marginal utility is greater than the marginal cost. In an efficient market, the price equals the marginal
cost. That is why people keep buying more until the marginal utility of consumption falls to the price
of the good.
The law of diminishing marginal utility is often used to justify progressive taxes. The idea is that
higher taxes cause less loss of utility for someone with a higher income. In this case, everyone gets
diminishing marginal utility from money. Suppose that the government must raise $20,000 from
each person to pay for its expenses. If the average income is $60,000 before taxes, then the average
person would make $40,000 after taxes and have a reasonable standard of living.
In economics, marginal cost is the change in the total cost that arises when the quantity produced
is incremented by one unit; that is, it is the cost of producing one more unit of a goods. Intuitively,
marginal cost at each level of production includes the cost of any additional inputs required to
produce the next unit. At each level of production and time period being considered, marginal costs
include all costs that vary with the level of production, whereas other costs that do not vary with
production are fixed and thus have no marginal cost. For example, the marginal cost of producing an
automobile will generally include the costs of labor and parts needed for the additional automobile but
not the fixed costs of the factory that have already been incurred. In practice, marginal analysis is
segregated into short and long-run cases, so that, over the long run, all costs (including fixed costs)
become marginal. Where there are economies of scale, prices set at marginal cost will fail to cover
total costs, thus requiring a subsidy. Marginal cost pricing is not a matter of merely lowering the
general level of prices with the aid of a subsidy; with or without subsidy it calls for a drastic
restructuring of pricing practices, with opportunities for very substantial improvements in efficiency
at critical points.
Production Process:Output Decision,Revenue Cost and Profit
Maximisation
The business firm is basically a producing unit it is a technical unit in which inputs are
converted into output for sale to consumers, other firms and various government departments.

Production is a process in which economic resources or inputs (composed of natural resources like
land, labour and capital equipment) are combined by entrepreneurs to create economic goods and
services (also referred to as outputs or products). In traditional economics, the term ‘production’ is
used in a broad sense. It refers to the provision of goods and services for sale in the market with a
view to satisfying human needs and wants.
In managerial economics, however, the term is used in a narrow sense to refer to the processes of
physical transformation of resources, such as the transformation of iron ore into steel or the
production and assembly of components into a finished car.

This definition surely includes other and equally vital forms of transformation such as that of
location, whereby the finished car is moved from the factory to the showroom of the dealer from
whom it can be purchased. Here we concerned with production in the narrow sense of physical
transformation, with particular reference to economic problems connected with production in the
factory.

The production system can be seen as consisting of three elements – inputs, the production process
and outputs. In reality, the outputs are the starting point of the operation inasmuch as they must be
considered in the light of the market possibilities.

Inputs take the form of labour of all types, the required raw materials and sources of energy. All
these involve cost outlays. Thus the theory of cost and theory of production are interrelated. In fact,
the former is derived from the latter.

The production system can be shown as a continuous, smooth flow of resources through the process
ending in an outflow of a homogeneous product or two or more products (in fixed or variable
proportions).

Time also plays a very important role in the theory of production. We usually draw a distinction
between the short run and the long-run. The distinction is not based on any time period but is made
on the basis of the possibility of factor substitution.

In the short run, it is assumed that some factors (such as capital or plant size) remain fixed and
others are variable. In the long run, it is assumed that all factors are variable. From this we drive the
proposition that the short run costs are partly fixed and partly variable; in the long run all costs are
variable.

Finally, in traditional economics it is assumed that the techniques of production are ‘given’. But in
managerial economics, however, it is assumed that there are usually various alternatives open to the
manager from which one has to selected.

Types of Production Process

Four types of production

There are 4 different types of productions which are most commonly used. Which type of production
should be used by the company depends on the type of product being
manufactured, the demand of the product as well as the supply of raw materials. Taking these factors
into consideration, below are the 4 types of Production.

1) Unit or Job type of production

This type of production is most commonly observed when you produce one single unit of a product.
A typical example of the same will be tailored outfits which are made just for you or a cake which is
made just like you want it.

Example of Unit type of production

It is one of the most common types of products used because it is generally used by small
businesses like restaurants, individual products providers or individual services providers.

It is also a type of production used by very premium companies like Harley Davidson, or Dell.
Harley Davidson actually has a lot of accessories which can be customized, and which suit the
individual. Same ways, you can design your own DELL laptop on their website with the given
specifications.

Features of Unit production or Job Production

 Depends a lot on skill

 Dependency is more on manual work than mechanical work
 Customer service and customer management plays and important role

2) Batch type of Production

It is one of the types of production most commonly used in consumer durables, FMCG or other such
industries where there are large variety of products with variable demands. Batch production takes
place in batches. The manufacturer already knows the number of units
he needs to a manufacturer and they are manufactured in one batch.

So, if a manufacturer has the shortage of Product X and 100 units of this product is consumed in one
month, then the manufacturer can give orders for batch production of 100 units of Product X.

Example of Batch production

LG has many different types of home appliance products in its portfolio. It has to manufacture all
these different variants of the same type of product. There would be 10-20 types of mixer grinders
alone in the product portfolio of LG home appliances. Thus, a company like LG manufactures these
variants via Batch production.

First, one type of mixer will be manufactured completely and then the second type will be
manufactured. They are manufactured on the basis of demand. Depending on demand, the batch
production can produce the number of units required in one batch.

The batches may be as small as 10 units or they may be as large as 1 lakh units of the same products.
However, as long as there is a defined quantity of product which has to be manufactured before
moving on to the next item in the list, it is known as batch production.
Examples of batch production include FMCG like Biscuits, confectionaries, packaged food items etc. It
is used in Medicines, Hardware, Consumer durables and many such industries.
Features of Batch production

 Production is done in batches

 The total number of units required is decided before the batch production starts
 Once a batch production starts, stopping it midway may cost a huge amount to the
company.
 Demand plays a major role in a batch production. Example – seasonality of products.

3) Mass Production or Flow production

One of the best examples of mass production is the manufacturing process adopted by Ford. Mass
production is also known as flow production or assembly line production. It is one of the most
common types of products used in the automobile industry and is also used in industries where
continuous production is required.

An Assembly line or mass production plant typically focus on specialization. There are multiple
workstations installed and the assembly line goes through all the workstations turn by turn. The work
is done in a specialized manner and each workstation is responsible for one single type of work. As a
result, these workstations are very efficient and production due to which the whole assembly line
becomes productive and efficient.

Products which are manufactured using mass production are very standardized products. High
sophistication is used in the manufacturing of these products. If 1000 products are manufactured
using mass production, each one of them should be exactly the same. There should be no deviation
in the product manufactured.

Features of Mass Production

 Mass production is generally used to dole out huge volumes of the product
 It is used only if the product is standardized
 Demand does not play a major role in a Mass production. However, production capacity
determines the success of a mass production.
 Mass production requires huge initial investment and the working capital demand is huge too.

4) Continuous production or Process production

There is a lot of confusion between mass production and continuous production. It can be
differentiated by a single element. The amount of mechanical work involved. In Mass production,
both machines and humans work in tandem. However, in continuous production, most of the work is
done by machines rather than humans. In continuous production, the production is continuous,24×7
hours, all days in a year.

A good example of the Continous production is brewing. In brewing, the production goes on 24 hours
a day and 365 days a year. This is because brewing takes a lot of time and production is important. As
a result, there is a continuous input of raw materials such as malt or water, and there is continuous
output in the form of beer or other alcoholic drink. The key factor in this is that the brewing and
fermentation process itself is time-consuming, and the maximum time is spent in the fermentation
which is a continuous process.

There are many chemicals which are manufactured in the form of a continuous process due to the
huge demand across the world. Similarly, the Plastic industry is known to adopt the continuous
production methodology where production can go continuously for weeks or
months depending on the demand. Once the production starts, you only need to feed in the raw
material, and the machines turn out the finalized products.

Features of Continuous production

 Majority of the work is done by machines rather than humans

 Work is continuous in nature. Once production starts, it cannot be stopped otherwise it will
cause huge loss.
 A very controlled environment is required for continuous production.

As a business owner, you want your organization to grow and ultimately flourish. But how,
exactly, do you facilitate that? Do you try to sell a lot of items to create an abundance of
revenue, or do you try and become as profitable as possible? And what approach is the best
one to take for your business? Typically, businesses prioritize the maximization of either
profits or revenues, but these two strategies don’t have to be mutually exclusive. They serve
different purposes in business; revenue maximization can be beneficial in the short-term, but
profit maximization is a long-term strategy intended to promote lasting business success. You
can use a combination of both of these methods to reach your own specific goals, but,
depending on what you want to accomplish, one strategy might be better for your business than
the other.

REVENUE MAXIMIZATION
Revenue maximization is the theory that if you sell your wares at a low enough price, you will
increase the revenue you bring in by selling a higher total volume of goods. However, maximized
revenue does not equate with maximized profits, as you may have to sell your goods at a loss to get
them off of your shelves. If you choose this strategy, your goal is to increase volume of goods sold,
not the profit you make off of selling those goods.

Revenue Maximization Pros

Naturally, there are a number of advantages that come from maximizing revenue without focusing on
profits, otherwise business owners would never use this strategy. Revenue maximization is a simple
way to increase your customer base. By having tantalizingly low prices, you can bring in customers
who typically wouldn’t spend money on your products or draw them away from your higher-priced
competitors. Revenue maximization is also a useful way to avoid issues with your supply chain,
quickly increase your cash flow, and improve your overall business operations. You can employ this
strategy to sell off excess inventory, which can help move products that aren’t selling well, get rid of
seasonal goods, and make room for products that you expect to sell for a larger profit. A trustworthy
inventory management software solution can help you identify which products are best-suited for
this method, allow you to keep track of how much inventory is going out, and know how much room
you have for new goods.

Revenue Maximization Cons

Revenue maximization is not a perfect way to run your business. The primary issue with utilizing
this type of strategy is that it works well only in the short-term. Your business can sacrifice profits
for revenue for a little while, but will collapse if you take this approach for long periods of time.
Because many business owners forgo making a profit to increase revenue, this is an unsustainable
practice for long-term business success. It must be done incrementally and very strategically to
leverage the benefits without it becoming a losing proposition.
PROFIT MAXIMIZATION
Generally speaking, most successful businesses primarily operate under a profit maximization model.
Profit maximization is similar to revenue maximization, but differs greatly in its financial intention:
the goal of profit maximization is not to increase the volume of goods sold, but to
increase the amount of money earned from selling those goods. It’s not simply about
selling your wares at a higher price point or generating cash flow, but also involves making money
off of your investment in materials, labor, and other expenses. This is a long-term strategy that not
only sustains a company, but helps foster its growth.

Profit Maximization Pros

Businesses maximize their profits to make money, which is not only a benefit, but something all
companies need to survive. This is the “default” state of any organization, so to speak, and it should
be your primary, long-term goal if you want to see your business flourish. Profit maximization is a
necessity to both the survival and growth of your business.

Profit Margin Cons

Though profit maximization is an essential strategy for businesses, there are still disadvantages
to using this model. First and foremost, it’s difficult to get started with this method, as you have
to build up the perception of value of this item and get people to actually purchase it. However,
this can easily be remedied by using a loss leader strategy, wherein you purposefully sell a
particular item below its cost to attract customers. Theoretically, customers then purchase other
products at full-price and on which you can make a profit. Of course, you will not make any
profits if customers only purchase the loss leader item, so there is some risk to using this strategy
to help drive profits. Prioritizing a profit maximization strategy when your inventory is
overstocked can also be tricky. Overstocking is one of many common mistakes with inventory
management; when you expect that certain items will move quickly, it can be an effective way
to satisfy customer demand, but when business is slow, it can lead to a huge loss in net profits.
In this situation, it’s likely better to focus on maximizing revenue instead.

Market Structure
Market Structure in economics, depicts how firms are differentiated and categorised based on types
of goods they sell (homogenous/hetergenous) and how their operations are affected by external
factors and elements. Market structure makes it easier to understand the characteristics of diverse
markets.

Types of Market Structures

A variety of market structures will characterize an economy. Such market structures

essentially refer to the degree of competition in a market.

There are other determinants of market structures such as the nature of the goods
and products, the number of sellers, number of consumers, the nature of the product or service,
economies of scale etc. We will discuss the four basic types of market structures in any economy.
One thing to remember is that not all these types of market structures actually exist. Some of them are
just theoretical concepts. But they help us understand the principles behind the classification of market
structures.

1] Perfect Competiton
In a perfect competition market structure, there are a large number of buyers and sellers. All the
sellers of the market are small sellers in competition with each other. There is no one big seller with
any significant influence on the market. So all the firms in such a market are price takers.

There are certain assumptions when discussing the perfect competition. This is the reason
a perfect competition market is pretty much a theoretical concept. These assumptions are as follows,

 The products on the market are homogeneous, i.e. they are completely identical
 All firms only have the motive of profit maximization
 There is free entry and exit from the market, i.e. there are no barriers
 And there is no concept of consumer preference

2] Monopolistic Competition
This is a more realistic scenario that actually occurs in the real world. In monopolistic competition,
there are still a large number of buyers as well as sellers. But they all do not sell
homogeneous products. The products are similar but all sellers sell slightly differentiated
products.

Now the consumers have the preference of choosing one product over another. The sellers can also
charge a marginally higher price since they may enjoy some market power. So the sellers become
the price setters to a certain extent.

For example, the market for cereals is a monopolistic competition. The products are all similar
but slightly differentiated in terms of taste and flavours. Another such example is toothpaste.

3] Oligopoly
In an oligopoly, there are only a few firms in the market. While there is no clarity about the number
of firms, 3-5 dominant firms are considered the norm. So in the case of an oligopoly, the buyers are
far greater than the sellers.

The firms in this case either compete with another to collaborate together, They use their market
influence to set the prices and in turn maximize their profits. So the consumers become the price
takers. In an oligopoly, there are various barriers to entry in the market, and new firms find it
difficult to establish themselves.

4] Monopoly
In a monopoly type of market structure, there is only one seller, so a single firm will
control the entire market. It can set any price it wishes since it has all the market power.
Consumers do not have any alternative and must pay the price set by the seller.
Monopolies are extremely undesirable. Here the consumer loose all their power and market
forces become irrelevant. However, a pure monopoly is very rare in reality.

Monopolistic Market

Definition: Monopolistic competition is a market structure which combines elements of

monopoly and competitive markets. Essentially a monopolistic competitive market is one
with freedom of entry and exit, but firms can differentiate their products. Therefore, they
have an inelastic demand curve and so they can set prices. However, because there is
freedom of entry, supernormal profits will encourage more firms to enter the market
leading to normal profits in the long term.
A monopolistic competitive industry has the following features:

 Many firms.
 Freedom of entry and exit.
 Firms produce differentiated products.
 Firms have price inelastic demand; they are price makers because the good is
highly differentiated
 Firms make normal profits in the long run but could make supernormal profits in
the short term
 Firms are allocatively and productively inefficient.

Output Determination under Perfect Competition Monopoly

Perfect competition refers to a market situation where there are a large number of buyers
and sellers dealing in homogenous products.

Moreover, under perfect competition, there are no legal, social, or technological

barriers on the entry or exit of organizations.

In perfect competition, sellers and buyers are fully aware about the current market price of a
product. Therefore, none of them sell or buy at a higher rate. As a result, the same price
prevails in the market under perfect competition.

Under perfect competition, the buyers and sellers cannot influence the market price by
increasing or decreasing their purchases or output, respectively. The market price of
products in perfect competition is determined by the industry. This implies that in perfect
competition, the market price of products is determined by taking into account two market
forces, namely market demand and market supply.

In the words of Marshall, “Both the elements of demand and supply are required for the
determination of price of a commodity in the same manner as both the blades of scissors are
required to cut a cloth.” As discussed in the previous chapters, market demand is defined
as a sum of the quantity demanded by each individual organizations in the industry.

On the other hand, market supply refers to the sum of the quantity supplied by individual
organizations in the industry. In perfect competition, the price of a product is determined at
a point at which the demand and supply curve intersect each other. This point is known
as equilibrium point as well as the price is known as equilibrium price. In addition, at this
point, the quantity demanded and supplied is called equilibrium quantity. Let us discuss
price determination under perfect competition in the next sections.

Demand under Perfect Competition:

Demand refers to the quantity of a product that consumers are willing to purchase at a
particular price, while other factors remain constant. A consumer demands more quantity
at lower price and less quantity at higher price. Therefore, the demand varies at different
prices.

Equilibrium under Perfect Competition:

As discussed earlier, in perfect competition, the price of a product is determined at a point
at which the demand and supply curve intersect each other. This point is known as
equilibrium point. At this point, the quantity demanded and supplied is called equilibrium
quantity.

Figure-3 shows the equilibrium under perfect competition:

In Figure-3, it can be seen that at price OP1, supply is more than the demand. Therefore,
prices will fall down to OP. Similarly, at price OP2, demand is more than the supply.
Similarly, in such a case, the prices will rise to OP. Thus, E is the equilibrium at which
equilibrium price is OP and equilibrium quantity is OQ.
 Inflation
Inflation refers to the rise in the prices of most goods and services of daily or common use,
such as food, clothing, housing, recreation, transport, consumer staples, etc. Inflation
measures the average price change in a basket of commodities and services over time. The
opposite and rare fall in the price index of this basket of items is called ‘deflation’. Inflation
is indicative of the decrease in the purchasing power of a unit of a country’s currency. This is
measured in percentage.

The purchasing power of a currency unit decreases as the commodities and services get
dearer. This also impacts the cost of living in a country. When inflation is high, the cost of
living gets higher as well, which ultimately leads to a deceleration in economic growth. A
certain level of inflation is required in the economy to ensure that expenditure is promoted
and hoarding money through savings is demotivated.

Inflation is a quantitative measure of the rate at which the average price level of a basket
of selected goods and services in an economy increases over some period of time. It is
the rise in the general level of prices where a unit of currency effectively buys less than it
did in prior periods. Often expressed as a percentage, inflation thus indicates a decrease
in
the purchasing power of a nation’s currency.

Types of inflation by rate of increase

Creeping inflation (1-4%)

When the rate of inflation slowly increases over time. For example, the inflation rate rises
from 2% to 3%, to 4% a year. Creeping inflation may not be immediately noticeable, but if the
creeping rate of inflation continues, it can become an increasing problem.

Walking inflation (2-10%)

When inflation is in single digits – less than 10%. At this rate – inflation is not a major
problem, but when it rises over 4%, Central Banks will be increasingly concerned.
Walking inflation may simply be referred to as moderate inflation.

Running inflation (10-20%)

When inflation starts to rise at a significant rate. It is usually defined as a rate

between 10% and 20% a year. At this rate, inflation is imposing significant costs on the
economy and could easily start to creep higher.
Galloping inflation (20%-1000%)

This is an inflation rate of between 20% up to 1000%. At this rapid rate of price increases,
inflation is a serious problem and will be challenging to bring under control. Some
definitions of galloping inflation may be between 20% and 100%. There is no universally
agreed definition, but hyperinflation usually implies over 1,000% a year.

Hyperinflation (> 1000%)

This is reserved for extreme forms of inflation – usually over 1,000% though there is no
specific definition. Hyperinflation usually involves prices changing so fast, that it becomes a
daily occurrence, and under hyperinflation, the value of money will rapidly decline.

Causes of Inflation
Rising prices are the root of inflation, though this can be attributed to different factors. In
the context of causes, inflation is classified into three types: Demand-Pull inflation, Cost-
Push inflation, and Built-In inflation.

Demand-Pull Effect
Demand-pull inflation occurs when the overall demand for goods and services in an
economy increases more rapidly than the economy's production capacity. It creates a
demand-supply gap with higher demand and lower supply, which results in higher
prices. For instance, when the oil producing nations decide to cut down on oil
production, the supply diminishes. This lower supply for existing demand leads to a
rise in price and contributes to inflation.

Additionally, an increase in money supply in an economy also leads to inflation. With more
money available to individuals, positive consumer sentiment leads to higher spending. This
increases demand and leads to price rises. Money supply can be increased by the monetary
authorities either by printing and giving away more money to the individuals, or
by devaluing (reducing the value of) the currency. In all such cases of demand increase, the
money loses its purchasing power.

Cost-Push Effect
Cost-push inflation is a result of the increase in the prices of production process inputs.
Examples include an increase in labor costs to manufacture a good or offer a service or
increase in the cost of raw material. These developments lead to higher cost for the
finished product or service and contribute to inflation.

Built-In Inflation
Built-in inflation is the third cause that links to adaptive expectations. As the price of goods
and services rises, labor expects and demands more costs/wages to maintain their cost of
living. Their increased wages result in higher cost of goods and services, and this wage-
price spiral continues as one factor induces the other and vice-versa.
Theoretically, monetarism establishes the relation between inflation and money supply of an
economy. For example, following the Spanish conquest of the Aztec and Inca empires,
massive amounts of gold and especially silver flowed into the Spanish and other European
economies. Since the money supply had rapidly increased, prices spiked and the value of
money fell, contributing to economic collapse.

Types of Inflation Indexes

Depending upon the selected set of goods and services used, multiple types of inflation
values are calculated and tracked as inflation indexes. Most commonly used inflation
indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).

The Consumer Price Index

The CPI is a measure that examines the weighted average of prices of a basket of goods
and services which are of primary consumer needs. They include transportation, food, and
medical care. CPI is calculated by taking price changes for each item in the predetermined
basket of goods and averaging them based on their relative weight in the whole basket.
The prices in consideration are the retail prices of each item, as available for purchase by
the individual citizens. Changes in the CPI are used to assess price changes associated
with
the cost of living, making it one of the most frequently used statistics for identifying
periods of inflation or deflation. The U.S. Bureau of Labor Statistics reports the CPI on a
monthly basis and has calculated it as far back as 1913.1

The Wholesale Price Index

The WPI is another popular measure of inflation, which measures and tracks the changes
in the price of goods in the stages before the retail level. While WPI items vary from one
country to other, they mostly include items at the producer or wholesale level. For
example, it includes cotton prices for raw cotton, cotton yarn, cotton gray goods, and
cotton clothing. Although many countries and organizations use WPI, many other
countries, including the U.S., use a similar variant called the producer price index (PPI).

The Producer Price Index

The producer price index is a family of indexes that measures the average change in selling
prices received by domestic producers of goods and services over time. The
PPI measures price changes from the perspective of the seller and differs from the CPI
which measures price changes from the perspective of the buyer.

In all such variants, it is possible that the rise in the price of one component (say oil)
cancels out the price decline in another (say wheat) to a certain extent. Overall, each
index represents the average weighted cost of inflation for the given constituents which
may apply at the overall economy, sector or commodity level.
 Unemployment

Unemployment occurs when a person who is actively searching for employment is unable
to find work. Unemployment is often used as a measure of the health of the economy. The
most frequent measure of unemployment is the unemployment rate, which is the number of
unemployed people divided by the number of people in the labor force.

Unemployment is a key economic indicator because it signals the ability (or inability)
of workers to readily obtain gainful work to contribute to the productive output of the
economy. More unemployed workers mean less total economic production will take
place than might have otherwise. And unlike idle capital, unemployed workers still
need to maintain at least subsistence consumption during their period of
unemployment. This means an economy with high unemployment has lower output
without a proportional decline in the need for basic consumption. High, persistent
unemployment can signal serious distress in an economy and even lead to social and
political upheaval.

Types of Unemployment

Frictional unemployment
Frictional unemployment occurs as a result of people voluntarily changing jobs within an
economy. After a person leaves a company, it naturally takes time to find another job.
Similarly, graduates just entering the workforce add to frictional unemployment.
Usually, this type of unemployment is short-lived. It is also the least problematic
from an economic standpoint. Frictional unemployment is a natural result of the fact
that market processes take time and information can be costly. Searching for a new
job, recruiting new workers, and matching the right workers to the right jobs all take
time and effort, resulting in frictional unemployment.

Cyclical unemployment
Cyclical unemployment is the variation in the number of unemployed workers over
the course of economic upturns and downturns, such as those related to changes in
oil prices. Unemployment rises during recessionary periods and declines during
periods of economic growth. Preventing and alleviating cyclical unemployment
during recessions is one of the key reasons for the
study of economics and the purpose of the various policy tools that governments
employ on the downside of business cycles to stimulate the economy.
Structural unemployment
Structural unemployment comes about through technological change in the structure
of the economy in which labor markets operate. Technological changes—such as
the replacement of horse-drawn transport by automobiles or the automation of
manufacturing—lead to unemployment among workers displaced from jobs that are
no longer needed. Retraining these workers can be difficult, costly, and time
consuming, and displaced workers often end up either unemployed for extended
periods or leaving the labor force entirely.

Institutional unemployment
Institutional unemployment is unemployment that results from long-term or
permanent institutional factors and incentives in the economy. Government
policies, such as high minimum wage floors, generous social benefits programs,
and restrictive occupational licensing laws; labor market phenomena, such as
efficiency wages and discriminatory hiring; and labor market institutions, such as
high rates of unionization, can all contribute to institutional unemployment.

What Is a Business Cycle?

"Business cycles are a type of fluctuation found in the aggregate economic activity
of nations…a cycle consists of expansions occurring at about the same time in many
economic activities, followed by similarly general recessions…this sequence of
changes is recurrent but not periodic." That description, from the 1946 magnum
opus by Arthur F. Burns and Wesley C. Mitchell, Measuring Business Cycles,
remains definitive today.1

In essence, business cycles are marked by the alternation of the phases of

expansion and contraction in aggregate economic activity, and the comovement
among economic variables in each phase of the cycle.
Aggregate economic activity is represented by not only real (i.e., inflation- adjusted)
GDP—a measure of aggregate output—but also the aggregate measures of industrial
production, employment, income, and sales, which are the key coincident economic
indicators used for the official determination of
U.S. business cycle peak and trough dates.

A popular misconception is that a recession is defined simply as two consecutive

quarters of decline in real GDP. Notably, the 1960–61 and 2001 recessions did not
include two successive quarterly declines in real GDP.2

A recession is actually a specific sort of vicious cycle, with cascading declines in

output, employment, income, and sales that feed back into a further drop in output,
spreading rapidly from industry to industry and region to region. This domino effect
is key to the diffusion of recessionary weakness across the economy, driving the
comovement among these coincident economic indicators and the persistence of the
recession.
On the flip side, a business cycle recovery begins when that recessionary vicious
cycle reverses and becomes a virtuous cycle, with rising output triggering job gains,
rising incomes, and increasing sales that feed back into a further rise in output. The
recovery can persist and result in a sustained economic expansion only if it becomes
self-feeding, which is ensured by this domino effect driving the diffusion of the
revival across the economy.

Measuring and Dating Business Cycles

The severity of a recession is measured by the three D's: depth, diffusion, and
duration. A recession's depth is determined by the magnitude of the peak-to- trough
decline in the broad measures of output, employment, income, and sales. Its diffusion
is measured by the extent of its spread across economic activities, industries, and
geographical regions. Its duration is determined by the time interval between the peak
and the trough.

Meaning of Trade Cycle:

A trade cycle refers to fluctuations in economic activities specially in
employment, output and income, prices, profits etc. It has been
defined differently by different economists. According to Mitchell,
“Business cycles are of fluctuations in the economic activities of
organized communities. The adjective ‘business’ restricts the
concept of fluctuations in activities which are systematically
conducted on commercial basis.

The noun ‘cycle’ bars out fluctuations which do not occur with a
measure of regularity”. According to Keynes, “A trade cycle is
composed of periods of good trade characterised by rising prices
and low unemployment percentages altering with periods of bad
trade characterised by falling prices and high unemployment
percentages”.

Features of a Trade Cycle:

1. A business cycle is synchronic. When cyclical fluctuations start
in one sector it spreads to other sectors.

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2. In a trade cycle, a period of prosperity is followed by a period of
depression. Hence trade cycle is a wave like movement.

3. Business cycle is recurrent and rhythmic; prosperity is followed

by depression and vice versa.

4. A trade cycle is cumulative and self-reinforcing. Each phase

feeds on itself and creates further movement in the same direction.

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5. A trade cycle is asymmetrical. The prosperity phase is slow and

gradual and the phase of depression is rapid.

6. The business cycle is not periodical. Some trade cycles last for
three or four years, while others last for six or eight or even more
years.

7. The impact of a trade cycle is differential. It affects different

industries in different ways.

8. A trade cycle is international in character. Through international

trade, booms and depressions in one country are passed to other
countries.

Phases of a Trade Cycle.

Generally, a trade cycle is composed of four phases – depression,

recovery, prosperity and recession.

Depression:
During depression, the level of economic activity is extremely low.
Real income production, employment, prices, profit etc. are falling.
There are idle resources. Price is low leading to a fall in profit,
interest and wages. All the sections of the people suffer. During this
phase, there will be pessimism leading to closing down of business
firms.
Recovery:
Recovery denotes the turning point of business cycle form
depression to prosperity. In this phase, there is a slow rise in
output, employment, income and price. Demand for commodities
go up. There is increase in investment, bank loans and advances.
Pessimism gives way to optimism. The process of revival and
recovery becomes cumulative and leads to prosperity.

Prosperity: It is a state of affairs in which real income and

employment are high. There are no idle resources. There is no
wastage of materials. There is rise in wages, prices, profits and
interest. Demand for bank loans increases. There is optimism
everywhere. There is a general uptrend in business community.

However, these boom conditions cannot last long because the forces
of expansion are very weak. There are bottlenecks and shortages.
There may be scarcity of labour, raw material and other factors of
production. Banks may stop their loans. These conditions lead to
recession.

Recession: When the entrepreneurs realize their mistakes, they

reduce investment, employment and production. Then fall in
employment leads to fall in income, expenditure, prices and profits.
Optimism gives way to pessimism. Banks reduce their loans and
advances. Business expansion stops. This state of recession ends in
depression.

Circular Flow of Income in a Four-Sector Economy

Circular flow of income in a four-sector economy consists of

households, firms, government and foreign sector.

Household Sector:
Households provide factor services to firms, government and
foreign sector.
In return, it receives factor payments. Households also receive
transfer payments from the government and the foreign sector.
Households spend their income on:
(i) Payment for goods and services purchased from firms;
(ii) (ii) Tax payments to government;
(iii) (iii) Payments for imports.

Firms:
Firms receive revenue from households, government and the
foreign sector for sale of their goods and services. Firms also receive
subsidies from the government.

Firm makes payments for:

(i) Factor services to households;

(ii) Taxes to the government;

(iii) Imports to the foreign sector.

Government:
Government receives revenue from firms, households and the
foreign sector for sale of goods and services, taxes, fees, etc.
Government makes factor payments to households and also spends
money on transfer payments and subsidies.

Foreign Sector:
Foreign sector receives revenue from firms, households and
government for export of goods and services. It makes payments for
import of goods and services from firms and the government. It also
makes payment for the factor services to the households.
The savings of households, firms and the government sector get
accumulated in the financial market. Financial market invests
money by lending out money to households, firms and the
government. The inflows of money in the financial market are equal
to outflows of money. It makes the circular flow of income complete
and continuous.

Government in the Macroeconomic: Fiscal Policy

Fiscal policy is the means by which a government adjusts its spending
levels and tax rates to monitor and influence a nation's economy. It is the
sister strategy to monetary policy through which a central bank influences
a nation's money supply. These two policies are used in various
combinations to direct a country's economic goals. Here's a look at how
fiscal policy works, how it must be monitored, and how its implementation
may affect different people in an economy.
KEY TAKEAWAYS

 Fiscal policy is the means by which a government adjusts its spending levels
and tax rates to monitor and influence a nation's economy.
 It is the sister strategy to monetary policy through which a central bank
influences a nation's money supply.
 Using a mix of monetary and fiscal policies, governments can control
economic phenomena.
 Main Objectives of Fiscal Policy in India
 Before moving on the discussion on objectives of India’s Fiscal
Policies, firstly know that the general objective of Fiscal Policy.
 General objectives of Fiscal Policy are given below:
 1. To maintain and achieve full employment.
 2. To stabilize the price level.
 3. To stabilize the growth rate of the economy.
 4. To maintain equilibrium in the Balance of Payments.
 5. To promote the economic development of underdeveloped
countries.

Fiscal policy of India always has two objectives, namely improving

the growth performance of the economy and ensuring social justice
to the people.
 The fiscal policy is designed to achieve certain objectives
as follows:-
 1. Development by effective Mobilisation of Resources: The
principal objective of fiscal policy is to ensure rapid economic
growth and development. This objective of economic growth and
development can be achieved by Mobilisation of Financial
Resources. The central and state governments in India have used
fiscal policy to mobilise resources.
 The financial resources can be mobilised by:-
 a. Taxation: Through effective fiscal policies, the government aims
to mobilise resources by way of direct taxes as well as indirect
taxes because most important source of resource mobilisation in
India is taxation.
 b. Public Savings: The resources can be mobilised through public
savings by reducing government expenditure and increasing
surpluses of public sector enterprises.
 c. Private Savings: Through effective fiscal measures such as tax
benefits, the government can raise resources from private sector
and households. Resources can be mobilised through government
borrowings by ways of treasury bills, issuance of government
bonds, etc., loans from domestic and foreign parties and by deficit
financing.
 2. Reduction in inequalities of Income and Wealth: Fiscal
policy aims at achieving equity or social justice by reducing income
inequalities among different sections of the society. The direct
taxes such as income tax are charged more on the rich people as
compared to lower income groups. Indirect taxes are also more in
the case of semi-luxury and luxury items which are mostly
consumed by the upper middle class and the upper class. The
government invests a significant proportion of its tax revenue in the
implementation of Poverty Alleviation Programmes to improve the
conditions of poor people in society.
 3. Price Stability and Control of Inflation: One of the main
objectives of fiscal policy is to control inflation and stabilize price.
Therefore, the government always aims to control the inflation by
reducing fiscal deficits, introducing tax savings schemes,
productive use of financial resources, etc.
 4. Employment Generation: The government is making every
possible effort to increase employment in the country through
effective fiscal measures. Investment in infrastructure has resulted
in direct and indirect employment. Lower taxes and duties on small-
scale industrial (SSI) units encourage more investment and
consequently generate more employment. Various rural
employment programmes have been undertaken by the
Government of India to solve problems in rural areas. Similarly, self
employment scheme is taken to provide employment to technically
qualified persons in the urban areas.
 5. Balanced Regional Development: there are various projects
like building up dams on rivers, electricity, schools, roads, industrial
 projects etc run by the government to mitigate the regional
imbalances in the country. This is done with the help of public
expenditure.
 6. Reducing the Deficit in the Balance of Payment: some time
government gives export incentives to the exporters to boost up the
export from the country. In the same way import curbing measures
are also adopted to check import. Hence the combine impact of
these measures is improvement in the balance of payment of the
country.

7. Increases National Income: it’s the strength of the fiscal

policy that is brings out the desired results in the economy. When
the government want to increase the income of the country then it
increases the direct and indirect taxes rates in the country. There
are some other measures like: reduction in tax rate so that more
peoples get motivated to deposit actual tax.

8. Development of Infrastructure: when the government of the

concerned country spends money on the projects like railways,
schools, dams, electricity, roads etc to increase the welfare of the
citizens, it improves the infrastructure of the country. A improved
infrastructure is the key to further speed up the economic growth of
the country.

9. Foreign Exchange Earnings: when the central government of the

country gives incentives like, exemption in custom duty, concession
in excise duty while producing things in the domestic markets, it
motivates the foreign investors to increase the investment in the
domestic country.

World Trade Organisation

Created in 1995, the World Trade Organization (WTO) is an international institution that oversees
the global trade rules among nations. It superseded the 1947 General Agreement on Tariffs and
Trade (GATT) created in the wake of World War II.

The WTO is based on agreements signed by the majority of the world’s trading nations. The main
function of the organization is to help producers of goods and services, exporters, and importers
protect and manage their businesses. As of 2019 the WTO has 164 member countries, with Liberia
and Afghanistan the most recent members, having joined in July 2016, and 23 “observer” countries.

The WTO is essentially an alternative dispute or mediation entity that upholds the international
rules of trade among nations. The organization provides a platform that allows member
governments to negotiate and resolve trade issues with other members. The WTO’s main focus is
to provide open lines of communication concerning trade between its members.
For example, the WTO has lowered trade barriers and increased trade among member countries.
On the other hand, it has also maintained trade barriers when it makes sense to do so in the global
context. Therefore, the WTO attempts to provide negotiation mediation that benefits the global
economy.

Once negotiations are complete and an agreement is in place, the WTO then offers to interpret that
agreement in the event of a future dispute. All WTO agreements include a settlement process,
whereby the organization legally conducts neutral conflict resolution.

No negotiation, mediation, or resolution would be possible without the foundational WTO

agreements. These agreements set the legal ground rules for international commerce that the WTO
oversees. They bind a country’s government to a set of constraints that must be observed when setting
future trade policies. These agreements protect producers, importers, and exporters while encouraging
world governments to meet specific social and environmental standards.