SMU

ASSIGNMENT
SEMESTER – 1
MB0026

MANAGERIAL ECONOMICS

SUBMITTED BY:
KOYEL DATTA
ROLL# -520961515
 SET - 1
Q1. The demand function of a good is as follows:
Q1=100-6P1-4P2+2P3+0.003Y
WHERE P1 and Q1 are the price and quantity values of good 1
P2 and P3 are the prices of good 2 and good 3 and Y is the income of the consumer. The initial
values are given:
P1 =7
P2 =15
P3 =4
Y=8000
Q1 =30
You are required to:
Using the concept of cross elasticity determine the relationship between good 1 and others
Determine the effect on Q1 due to a 10 % increase in the price of good 2 and good

Answer:- Cross elasticity can be defined as the proportionate change in the quantity demanded of a
particular commodity in response to a change in the price of another related commodity.

a) Cross elasticity between good 1 and product 2 = (dQ1/dP2)*(P2/Q1)

Cross elasticity between good 1 and product 3 = (dQ1/dP3)*(P3/Q1)

Taking the differentiation of the equation:

dQ1/dP2 = -4
dQ1/dP3 = 2

Putting the values in the elasticity equation:

Cross elasticity between good 1 and product 2 = (dQ1/dP2)*(P2/Q1)

= (-4) * (P2/Q1)
= (-4) * (15/30)
= -2

Cross elasticity between good 1 and product 3 = (dQ1/dP3)*(P3/Q)

= (2) * (P3/Q1)
= (2) * (4/30)
= 0.267

b) As per the cross elasticity equation:

E = % Change in demand of product A / % Change in price of product B

% Change in demand of product A = E * % Change in price of product B

Putting the values from

% Change in demand of product A due to 10 % increase of good 2 = -2 * 10
= -20%
% Change in demand of product A due to 10 % increase of good 3 = 0.267 * 10 =
2.67%
Q2. What are the factors that determine the Demand curve? Explain.

Answer: - Demand is the quantity of a good buyers wish and are able to purchase at each conceivable
price over a given period of time. Law of demand says, when the price of a good rises, the quantity
demanded will fall, other things being equal. Quantity demanded – the amount of a good that a
consumer is willing and able to buy at a given price over a given period of time.

DEMAND CURVE: DEFINITION

 Demand schedule for an individual economic agent is a table reflecting different quantities that an
agent is willing and able to buy at a various prices over a given period of time

 Market demand schedule is a table showing the different total quantities of a good that consumers
are willing and able to purchase over a given period of time

 Demand curve is a graph showing the relationship between the price of a good and the quantity of
the good demanded over a given period of time. Graph curve that normally slopes downward
towards the right of the chart (except for a Giffen good, where it slopes toward the left), showing
quantity of a product (good or service) demanded at different price levels. Customarily, the price
is plotted on vertical ('Y') axis and quantity on the horizontal ('X') axis, and it is assumed that (in
the short run) income levels, price of substitutes, and customer preferences, remain unchanged.
Demand curves of the individual products are aggregated to give a market demand curve and,
when drawn together with the supply curves, show the equilibrium price at the intersection of the
two curves.

Factors that shift demand curve:

 Causes of shifts in demand

 Changes in disposable income
 Changes in taste and fashion (changes in preferences) - tastes and preferences are assumed to be
fixed in the short-run. This assumption of fixed preferences is a necessary condition for
aggregation of individual demand curves to derive market demand.
 The availability and cost of credit
 Changes in the prices of related goods (substitutes and complements)
 Population size and composition
 Expectations
 Change in education level
 Change in the geographical situation of buyers - in the basic model there are no barriers to entry
and consumers and factors of production possess instantaneous mobility.
 Change in climate or weather - e.g. The demand for umbrellas increases when rain is predicted.
However, this illustrates the constant shifting from practice to theory and back where the
assumptions of the model are relaxed whenever necessary or convenient. A basic assumption of
the standard model is that all economic factors have perfect knowledge so a consumer would
never leave home without an umbrella on days when it rained.
Q3. A firm supplied 3000 pens at the rate of Rs 10. Next month, due to a rise of in the price to 22 rs
per pen the supply of the firm increases to 5000 pens. Find the elasticity of supply of the pens?

Answer:- Of course, consumption is not the only thing that changes when prices go up or down.
Businesses also respond to price in their decisions about how much to produce. Economists define the
price elasticity of supply as the responsiveness of the quantity supplied of a good to its market price.

More precisely, the price elasticity of supply is the percentage change in quantity supplied divided by the
percentage change in price.

Suppose the amount supplied is completely fixed, as in the case of perishable pen brought to market to be
sold at whatever price they will fetch. This is the limiting case of zero elasticity, or completely inelastic
supply, which is a vertical supply curve.

At the other extreme, sat that a tiny cut in price will cause the amount supplied to fall to zero, while the
slightest rise in price will coax out an indefinitely large supply. Here, the ratio of the percentage change in
quantity supplied to percentage change in price is extremely large and gives rise to a horizontal supply
curve. This is because the polar case of infinitely elastic supply.

Between these extremes, we call elastic or inelastic depending upon whether the percentage change in
quantity is larger or smaller than the percentage change in price.
Price elasticity of demand is a ratio of two pure numbers, the numerator is the percentage change in the
quantity demanded and the denominator is the percentage change in price of the commodity. It is
measured by the following formula:

Ep = Percentage change in quantity demanded/ Percentage changed in price

Applying the provided data in the equation:
Percentage change in quantity demanded = (5000 – 3000)/3000
Percentage changed in price = (22 – 10) / 10

Ep = ((5000 – 3000)/3000) / ((22 – 10)/10) = 1.2

Q4. Briefly explain the profit-maximization model?

Answer: - Profit maximization is the process by which a firm determines the price and output level that
returns the greatest profit. There are several approaches to this problem. The total revenue–total cost
method relies on the fact that profit equals revenue minus cost, and the marginal revenue–marginal cost
method is based on the fact that total profit in a perfectly competitive market reaches its maximum point
where marginal revenue equals marginal cost.

Basic definitions
Any costs incurred by a firm may be classed into two groups: fixed cost and variable cost. Fixed costs
are incurred by the business at any level of output, including zero output. These may include
equipment maintenance, rent, wages, and general upkeep. Variable costs change with the level of
output, increasing as more product is generated. Materials consumed during production often have
the largest impact on this category. Fixed cost and variable cost, combined, equal total cost.
Revenue is the total amount of money that flows into the firm. This can be from any source,
including product sales, government subsidies, venture capital and personal funds. Marginal cost
and revenue, depending on whether the calculus approach is taken or not, are defined as either the
change in cost or revenue as each additional unit is produced, or the derivative of cost or revenue
with respect to quantity output. It may also be defined as the addition to total cost as output
increase by a single unit. For instance, taking the first definition, if it costs a firm 400 USD to
produce 5 units and 480 USD to produce 6, the marginal cost of the sixth unit is approximately 80
dollars, although this is more accurately stated as the marginal cost of the 5.5th unit due to linear
interpolation. Calculus is capable of providing more accurate answers if regression equations can
be provided.

Total cost-total revenue method

Profit Maximization - The Totals Approach

To obtain the profit maximising output quantity, we start by recognizing that profit is equal to total
revenue (TR) minus total cost (TC). Given a table of costs and revenues at each quantity, we can either
compute equations or plot the data directly on a graph. Finding the profit-maximizing output is as simple
as finding the output at which profit reaches its maximum. That is represented by output Q in the
diagram.

There are two graphical ways of determining that Q is optimal. Firstly, we see that the profit curve is at its
maximum at this point (A). Secondly, we see that at the point (B) that the tangent on the total cost curve
(TC) is parallel to the total revenue curve (TR), the surplus of revenue net of costs (B,C) is the greatest.
Because total revenue minus total costs is equal to profit, the line segment C,B is equal in length to the
line segment A,Q.
Computing the price at which to sell the product requires knowledge of the firm's demand curve. The
price at which quantity demanded equals profit-maximizing output is the optimum price to sell the
product.

Marginal cost-marginal revenue method

Profit Maximization - The Marginal Approach

If total revenue and total cost figures are difficult to procure, this method may also be used. For each unit
sold, marginal profit equals marginal revenue minus marginal cost. Then, if marginal revenue is greater
than marginal cost, marginal profit is positive, and if marginal revenue is less than marginal cost,
marginal profit is negative. When marginal revenue equals marginal cost, marginal profit is zero. Since
total profit increases when marginal profit is positive and total profit decreases when marginal profit is
negative, it must reach a maximum where marginal profit is zero - or where marginal cost equals
marginal revenue. This is because the producer has collected positive profit up until the intersection of
MR and MC (where zero profit is collected and any further production will result in negative marginal
profit, because MC will be larger than MR). The intersection of marginal revenue (MR) with marginal
cost (MC) is shown in the next diagram as point A. If the industry is competitive (as is assumed in the
diagram), the firm faces a demand curve (D) that is identical to its Marginal revenue curve (MR), and this
is a horizontal line at a price determined by industry supply and demand. Average total costs are
represented by curve ATC. Total economic profits are represented by area P,A,B,C. The optimum
quantity (Q) is the same as the optimum quantity (Q) in the first diagram.

If the firm is operating in a non-competitive market, minor changes would have to be made to the
diagrams. For example, the Marginal Revenue would have a negative gradient, due to the overall market
demand curve. In a non-competitive environment, more complicated profit maximization solutions
involve the use of game theory.
Maximizing revenue method

In some cases a firm's demand and cost conditions are such that marginal profits are greater than zero for
all levels of production. In this case the Mπ = 0 rule has to be modified and the firm should maximize
revenue. In other words the profit maximizing quantity and price can be determined by setting marginal
revenue equal to zero. Marginal revenue equals zero when the marginal revenue curve has reached its
maximum value = topped out. An example would be a scheduled airline flight. The marginal costs of
flying the route are negligible. The airline would maximize profits by filling all the seats. The airline
would determine the p-max conditions by maximizing revenues.

Mathematical Example

A promoter decides to rent an arena for concert. The arena seats 20,000. The rental fee is 10,000. The
arena owner gets concessions and parking and pays all other expenses related to the concert. The
promoter has properly estimated his demand to be Q = 40,000 - 2000P. What is the profit maximizing
ticket price?

Because the promoter’s marginal costs are zero the promoter maximizes profits by charging a ticket price
that will maximize revenue. Total revenue equals price, P, times quantity, Q or PQ = (40,000 - 2000P)P =
40,000P - 2000(P)2. Total revenue reaches it maximum value when marginal revenue is zero. Marginal
revenue is the first derivative of the total revenue function so

MR ‘ = 40,000 - 2(2000)P = 40,000 - 4000P

MR’ = 0

40,000 - 4000P = 0

4000P = - 40,000

P = 10

Profit = TR -TC

Profit = [40,000P - 2000(P)2] - 10,000

Profit = [40,000(10) - 2000(10)2] - 10,000

Profit = 400,000 - 200,000 - 10,000

Profit = 190,000

What if the promoter had charged 12 per ticket?

Q = 40,000 - 2000P.
 Q = 40,000 - 2000(12)

Q = 40,000 - 24,000 = 16,000 (tickets sold)

Profits at 12:

Q = 16,000(12) = 192,000 - 10,000 = 182,000

Changes in fixed costs and profit maximization

A firm maximizes profit by operating where marginal revenue equal marginal costs. A change in fixed
costs has no effect on the profit maximizing output or price. The firm merely treats short term fixed costs
as sunk costs and continues to operate as before. This can be confirmed graphically. Using the diagram
illustrating the total cost total revenue method the firm maximizes profits at the point where the slope of
the total cost line and total revenue line are equal. A change in total cost would cause the total cost curve
to shift up by the amount of the change. There would be no effect on the total revenue curve or the shape
of the total cost curve. Consequently, the profit maximizing point would remain the same. This point can
also be illustrated using the diagram for the marginal revenue marginal cost method. A change is fixed
cost would have no effect on the position or shape of these curves.

• What if the arena owner in the example above triples the fee for the next concert but all other
factors are the same. What price should the promoter now charge for tickets in light of the fee
increase?

The same price of $10. The fee is a fixed cost which the promoter should consider as a sunk cost and
simply ignore it in calculating his profit maximizing price. The only effect is that the promoter’s profit
will be reduced by $20,000.

Markup pricing

In addition to using methods to determine a firm’s optimal level of output, a firm can also set price to
maximize profit. The optimal markup rules is:
(P - MC)/P = 1/ -Ep

or

P = (Ep/1 + Ep) MC

Where MC equals marginal costs and Ep equals price elasticity of demand. Ep is a negative number.
Therefore, -Ep is a positive number.

In English the rule is that the size of the markup is inversely related to the price elasticity of demand for a
good.

MPL, MRPL and profit maximization

The general rule is that firm maximizes profit by producing that quantity of output where marginal
revenue equals marginal costs. The profit maximization issue can also be approached from the input side.
That is, what is the profit maximizing usage of the variable input? To maximize profits the firm should
increase usage "up to the point where the input’s marginal revenue product equals its marginal costs". So
mathematically the profit maximizing rule is MRPL = MCL The marginal revenue product is the change in
total revenue per unit change in the variable input assume labor. That is MRP L = ∆TR/∆L. MRPL is the
product of marginal revenue and the marginal product of labor or MRPL = MR x MPL.
• Derivation:
MR = ∆TR/∆Q

MPL = ∆Q/∆L

MRPL = MR x MPL = (∆TR/∆Q) x (∆Q/∆L) = ∆TR/∆L

There are various factors that contribute to the maximization of profits of a firm. Some of them are
listed below:-

 Pricing and business strategies of rival firms and its impact on the working of the given firm.
 Aggressive sales promotion policies adopted by rival firms in the market.
 Without inducing the workers to demand higher wages and salaries leading to rise in operation
costs.
 Without resorting to monopolistic and exploitative practices inviting government controls and
takeovers.
 Maintaining the quality of the product and services to the customers.
 Taking various kinds of risks and uncertainties in the changing business environment.
 Adopting a stable business policy.
 Avoiding any sort of clash between short run and long run profits in the business policy and
maintaining proper balance between them.
 Maintaining its reputation, name, fame and image in the market.
 Profit maximization is necessary in both perfect and imperfect markets. In a perfect market, a
firm is a price-taker and under imperfect market it becomes a price-searcher.

Assumptions of the model:-

The profit maximization model is based on three important assumptions. They are as follows:-

 Profit maximization is the main goal of the firm.

 Rational behavior on the part of the firm to achieve its goal of profit maximization.
 The firm is managed by owner-entrepreneur
Q5. What is Cyert and March’s behavior theory? What are the demerits?

Answer: - Cyert and March’s behavior makes an attempt to explain the behavior of inter group conflicts
and their multiple objectives in an organization. Basically, this theory explains the usual and normal
behavior of different groups of people who work in an organization having mutually opposite goals.

Cyert and March explain how complicated decisions are taken in big industrial houses under various
kinds of risks and uncertainties in an imperfect market in the background of limited data and information.
The organizational structure, goals of different departments, behavioral pattern and internal working of a
big and multi-product firm differs from that of small organizations. The various kinds of internal conflicts
and problems faced by these organizations. They also explain how there are certain common problems
faced by similar organizations in an industry and their effects on internal working of each individual
organization and their decision making process.

Cyert and March consider that a modern firm is a multi-product, multi-goal and multi-decision making
coalition business unit. Like a coalition government, it is managed by a number of groups. The group
consists of share holders, managers, workers, customers, suppliers, distributors, financiers, legal experts
and so on. Each group is independent by itself and has its own set of objectives and they try to maximize
their individual benefits.

Cyert and March points out the goals of a business organization would depend upon the multiple
objectives of each group and their collective demands. Demands of each group would depend on their
aspirations levels, expectations, actual performance of the organization, bargaining power of each group,
past success in their demands, etc.

As all of them change over a period of time, the demands of each group would all of them change over a
period of time, the demands of each group would also undergo changes. If actual performance and
achievements of the organization is much better than expected aspirations and target level, in that case,
there will upward revision in their demands and vice-versa.

Thus, there is a strong linkage between the expected and actual demand of each group in the organization,
past success and future environment. Each group makes an attempt to achieve its demand in its own way.

Cyert and March are of the opinion that out of several objectives a firm has five important goals.
They are:-

Production goal: Production is to be organized on the basis of demand in the market. Neither there should
be over production nor under production but just that much to meet the required demand in the market,
avoid excess capacity, over utilization of capital assets, lay-off of workers etc.

Inventory goal: Inventory refers to stock of various inputs. In order to ensure continuity in production and
supply, certain minimum level of inventory has to be maintained by a firm. Neither there should be
surplus stock or shortage of different inputs. Proper balance between demand and supply should be
maintained.

Sales goal: There should be adequate sales in any organization to earn reasonable amounts of profits. In
order to create demand, sales promotion policies may be adopted from time to time.

Market-share goal: Each firm has to make consistent effort to increase its market share to compete
successfully with other firms and make sufficient profits.
Profit goal: This is one of the basic objectives of any firm. The very survival and success of the firm
would depend upon the volume of profits earned by it.

The above mentioned objectives also would undergo changes over a period of time in the background of
modern business environment. Hence, decision making would become complex and complicated.

The demerits are as follows:-

• The theory fails to analyze the behavior of the firm but it simply predicts the future expected
behavior of different groups.
• It does not explain equilibrium of the industry as a whole.
• It fails to analyze the impact of the potential entry of the new firms into the industry and the
behavior of the well established firms in the market.
• It highlights only on short run goals rather than long run objectives of an organization. Thus,
there are certain limitations to this theory.
Q6. What is Boumal’s Static and Dynamic?

Answer: - The model highlights that the primary objective of a firm is to maximize its sales rather than
profit maximization. It states that the goal of the firm is maximization of sales revenue subject to a
minimum profit constraint. The minimum profit constraint is determined by the expectations of the share
holders. This is because no company can displease the share holders. Maximization of sales does not
mean maximization of physical sales but maximization of total sales revenue. Hence, the managers are
more interested in increasing the sales rather than profit. The basic philosophy is that when sales are
maximized automatically profits of the company would also go up.

Prof. Boumal has developed two models. The first is static model and the second one is the dynamic
model.

The Static model:-

The model is based on the following assumptions:-

 The model is applicable to a particular time period and the model does not operate at different
periods of time.
 The firm aims at maximizing its sales revenue subject to a minimum profit constraint.
 The demand curve of the firm slope downwards from left to right.
 The average cost curve of the firm is U-shaped one.

Sales Maximization (dynamic model):-

Many changes take place which affects business decisions of a firm. In order to include such changes,
Boumal developed dynamic model. This model explains how changes in advertisement expenditure, a
major determinant of demand, would affect the sales revenue of a firm under severe competitions.

This model is based on certain assumptions. They are as follows:-

• Higher advertisement expenditure would certainly increase sales revenue of a firm.

• Market price remains constant.
• Demand and cost curves of the firm are conventional in nature.

Under competitive conditions, a firm in order to increase its volume of sales and sales revenue would go
for aggressive advertisements. This leads to a shift in the demand curve to the right. Forward shift in
demand curve implies increased advertisement expenditure resulting in higher sales and sales revenue. A
price cut may increase sales in general. But increase in sales mainly depends on whether the demand for a
product is elastic or inelastic. A price reduction policy may increase its sales only when the demand is
elastic and if the demand is inelastic; such a policy would have adverse effects on sales.

Hence, to promote sales, advertisements become an effective instrument today. It is the experience of
most of the firms that with an increase in advertisement expenditure, sales of the company would also go
up. A sales maximizer would generally incur higher amounts of advertisement expenditure than a profit
maximizer. However, it is to be remembered that amount allotted for sales promotion should bring more
than proportionate increase in sales and total profits of a firm. Otherwise, it will have a negative effect on
business decisions.
By introducing, a non-price variable into this model, Boumal makes a successful attempt to analyze the
behavior of a competitive firm under oligopoly market conditions. Under oligopoly conditions as there
are only a few big firms competing with each other either producing similar or differentiated products,
would resort to heavy advertisements as an effective means to increase their sales and sales revenue.
 SET - 2

Q.1 What is pricing policy? What are the internal and external factors of the policy?

Answer:

Pricing Policies:- Pricing Policies refer to the policy of setting the price of the product or product &
services by the management after taking into account of various internal and external factors, forces
and its own business objectives. The decision of pricing is very important in any business. Price once
fixed is never permanent. It needs to be reviewed and revised according to the market conditions.

Internal factors which can affect the pricing decisions of the company include suppliers, employees
efficiency, profit margin, production cost and other expenses, brand image and expectations of the
company. Suppliers provide the raw materials to the company and good relations with suppliers can make
the company to buy quality products at reasonable prices. Employees' efficiency can also reduce the costs
of the company and company can charge lower prices. Product cost also determines the prices of the
products because all of the companies have to cover up the product costs. Moreover, image of the
company also plays an important role in the price decisions of the company because a global brand will
usually charge premium prices. On the other hand, the external factors include government policies,
competitors' prices, costs of raw materials, consumers expectations and demand and supply of the
product. Government sets the price floors to save the interest of the borrowers and the sellers, therefore,
government policies should be also take into consideration. Expectations of the consumers or consumer
reservation prices are also considered in the price decisions. Costs of raw materials in the market also
determine the pricing strategies. Moreover, the prices offered by the competitors can also impact the
pricing decisions of the company.

Q.2 Mention three crucial objectives of price policies.

Answer:

Price policy has certain objectives:-

1. To maximize profits:- Every firm tries to maximize their profits. So they should have a price
policy, which fetches them maximum revenue. Every firm should have a price policy keeping the
long run prospects in mind.
2. Price Stability :- Always fluctuating price is not for the goodwill of the company. A stable price
always wins the confidence of customers.
3. Ability to pay :- The price should be fixed according to the ability of consumer to pay; high price
for rich customers and low for poor customers. This can be applied in case of services given by
doctors, lawyers etc.
Q.3 Mention the bases of price discrimination.

Answer:

PRICE DISCRIMINATION - The monopoly seller has the advantage of price discrimination, as he is
the only producer in the market. Price discrimination is charging different price to different buyer for the
same product.

DEGREES OF PRICE DISCRIMINATION

1. First degree price discrimination – It is also called perfect price discrimination, as it involves
maximum exploitation of the consumer in the interest of the seller. It happens when the seller is
able to sell each unit separately and at a different price. Each buyer is made to pay the amount he
is willing to pay rather going without it. The seller will make different bargain with each buyer.
Such type of price discrimination enjoyed by the seller is called first degree price discrimination.
2. Second degree price discrimination – It happens when the monopoly seller will charge separate
price in such a way that the buyer is divided into different groups according to the price elasticity
of demand for his product.
3. Third degree price discrimination – When the seller will be divided into sub-market and charge
different price depending on the output sold in the market and the demand condition of that sub-
market. The seller practising price discrimination between the domestic market and international
market, the seller will charge higher price in the domestic market, where he enjoys monopoly and
charge low price in the international market, where he has to face more competition.

Q.4 What do you mean by the fiscal policy? What are the instruments of fiscal policy? Briefly
comment on India’s fiscal policy.

Answer: Fiscal policy is a policy, which affects aggregate output, employment, saving, investment etc. A
responsible government would contain its expenditure within its revenue and thus making the budget
balanced. The instruments of Fiscal Policy are Automatic Stabilizer and Discretionary Fiscal Policy:

i) Automatic Stabilizer: The tax structure and expenditure are programmed in such a way that there is
increase in expenditure and decrease in tax in recession and decrease in expenditure and increase in tax
revenue in the period of inflation. It refers to built-in response to the economic condition without any
deliberate action on the part of government. It is called built- in- stabilizer to correct and thus restore
economic stability. It works in the following manner:-

Tax revenue: Tax revenue increases when the income increases; as those who were not paying tax go
into the higher income tax bracket. When there is depression, the income decreases and many people fall
in the no-income-tax bracket and the tax revenue decreases.

ii) Discretionary Fiscal Policy: Under this, to stabilize the economy, deliberate attempts are made by the
government in taxation and expenditure. It entails definite and conscious actions.
Instruments of Fiscal Policy: Some important instruments of fiscal policy are:-

1. TAXATION: Taxation is always a very important source of revenue for both developed and
developing countries. Tax comes under two heading –Tax on individual (direct tax) and tax on
commodity (indirect tax or commodity tax).Direct tax includes income tax, corporate tax, taxes on
property and wealth. Indirect tax is tax on the consumptions. It includes sales tax, excise duty and custom
duties. Direct tax structure can be divided into three bases-

a. Progressive tax
b. Regressive tax
c. Proportional tax

Progressive tax: Progressive tax says that higher the level of income, greater the volume of tax
burden you have to bear. This means as income increases, the tax contribution should also
increase. Low income group people pay low tax, whereas the high income group people pay
higher tax.

Regressive tax: It is theoretically possible, though no government implements such tax structure,
because that leads to unequal distribution of income. As your income increases the contribution
through tax decreases. Low income people will pay more and high income people will pay less.

Proportional tax: When the tax imposed is irrespective of the income you earn, every income
group, high or low pay the same amount of tax.

2. INDIRECT TAX OR CONSUMPTION TAX: Indirect tax differs from direct tax. Tax which is
imposed on every unit of product is known as lump sum tax. E.g. excise tax and sales tax. Taxes
depending on the value of particular product are called ‘ad valorem tax’ e.g. tax on airline tickets.
A good tax structure has to control and bring stability in economic system. There are few requirement of a
good tax structure. They are –

a. The revenue earned through tax structure should be adequate.

b. The distribution of tax burden should be equal.
c. Administration cost should not be more than revenue earned.
d. Tax burden should be borne by the person who is taxed.

Q.5 Comment on the consequences of environmental degradation on the economy of a community.

Ans: Environmental Degradation

For sustainable economic growth, the environment should be properly preserved and improved. The
stocks may remain constant or it can even rise but the environment resources are the base of the country
and the quality of air, water and land represents the heritage of a nation. The environment damages in the
developing countries are the main concern nowadays. Environmental damages can be in these categories-

Water pollution – the water quality is continuously deteriorating due to contamination from the
industrial waste, by throwing out chemical waste and heavy metal in the river. It is difficult to remove the
pollutants form the water to make it good for drinking purpose. The capacity of the water to preserve the
aquatic life is becoming more and more difficult. The under ground water is also getting affected by the
industrial waste, as they some times get discharged directly into underground water.
Air pollution- Air pollution can be contributed to the three man made sources, industrial production,
vehicles and the energy. Human suffering increases due to the air pollution. Respiratory disorders and
cancers are due to inhalation of polluted air. The vehicle increases the sulpur dioxide concentration in the
air creating breathing problems for the children and affects their neurological developments.

Deforestation- Forest is the most important source to protect environment. They protect soil erosion and
regulate the ecological balance of the nature. They i affect the nature and the climatic condition of the
region. The blind increase in the industrial growth is leading to cutting down of many forest leading to
many serious problems for the human being.

Q.6 Write short notes on the following:

a) Philips curve

Ans: Philips Curve describes the relationship between inflation and unemployment in an economy.
New Zealand-born economist A.W Philips first put this theory forward in 1958 gathered the data of
unemployment and changes in wage levels in the UK from 1861 to 1957. He observed that one stable
curve represents the trade-off between inflation and unemployment and they are inversely/negatively
related. In other words, if unemployment decreases, inflation will increase, and vice versa.

• For example, after the economy has just been in recession, the unemployment level will be fairly
high. This will mean that there is a labor surplus.

• As the economy has just started growing, the aggregate demand (AD) will increase and therefore
leading to an increase in employment. In the beginning, there will be little pressure for a raise in
wages. However, as the economy grows faster and more people are employed, wages will start
rising slowly.

B) Stagflation

Ans: Stagnation + Inflation = Stagflation

Stagnation = Slow or no growth. Inflation = Rises in price.
Stagflation is an economic trend in which inflation and unemployment rise while general growth of the
economy is slow. It can be difficult to correct stagflation, because focusing on one aspect of the problem
can exacerbate other aspects. Many governments try to avoid stagflation through fiscal policy, by
promoting even and healthy growth and attempting to prevent inflation. If stagflation continues long
enough, it will trigger an economic recession and an ultimate self-correction.
Stagflation is when the economy experiences slow GDP growth (stagnation) with high inflation and high
level of unemployment. This occurred in the 1970's in many countries. When the economy is working
normally, slow economic growth reduces demand, which keeps prices low, preventing inflation.
Stagflation can only occur when fiscal or monetary policy sustains high prices, and inflation, despite slow
growth. Stabilization policies to control stagflation.

i. The money supply should be tightened to check inflation.

ii. We can control inflationary wage and price increases with direct controls. Government can limit
increases by law or constrain them through tax policies.
iii. Protect people against the effects of inflation. All wages, including the minimum wage, could be
increased automatically when the Consumer Price Index increases. Government bonds could pay
a fixed real interest rate by adjusting the actual interest rate for inflation.

Stagflation is difficult to control without government controls. Therefore, political will is necessary for
formulating the measures to stop stagflation.