Managerial Economics(For Batch 2003 and Earlier) - 2

Q3. State and explain the Law of Variable Proportion.
Answer:
The law is about the production function (relationship between input and output) with one factor variable keeping quantity of other factor fixed i.e. by bringing about the changes in proportion between variable factor and the fixed factor. This law is very important in the economics and it is supported by empirical evidence particularly in the agricultural sector. The law of a\variable proportion is stated by various economists in the following manner:
By F.Benham: “As the proportion of one factor in a combination of factors is increased after a point, first the marginal and then the average product of that factor will diminish.”
By G.J. Stigler: “As equal increments one input are added, the inputs of other productive services being held constant, beyond a certain point the resulting increments of product will decrease i.e. the marginal product will diminish”.

Thus, it is observed that the law refers to three aspects:
Behavior of output
Quantity of one factor is increased keeping quantity of other factors fixed
Marginal product and average product eventually declines.

ASSUMPTIONS
1. The state of technology remains unchanged. If there is an any improvement in technology, then marginal and average product may rise instead of diminishing.
2. Alteration or variation in various factor proportion is done by varying some inputs i.e. some inputs must be kept fixed. This law does not apply when all factors are varied.
3. The law is also based on the assumption that there is a possibility of varying the proportions in which the various factors can be combined to produce a product. If factors were used in fixed proportion then the increase in one factor would not lead to any increase in the output that means the marginal product of a factor is zero.
There are three stages of law of variable proportion namely”
Stage of increasing returns where marginal productivity increases
Stage of decreasing returns where marginal productivity decreases
Stage of negative returns where marginal productivity becomes negative.

THREE STAES OF LAW OF VARIABLE PROPORTION
As shown in figure, X-axis is measured the quantity of the variable factor and on the Y-axis are measured the total product, average product and the marginal product. As the variable factor is increases, we can see its effect on the total, average and marginal productivity of a product changes. The behavior of these total, average and marginal products of the variable factor consequent on the increase in its amount can be seen through three stages which are as follows;



Stage-I
Increasing returns:
In this stage, total product to a point increases at an increasing rate. In the fig. From the origin to the point F, slope of the total TP is increasing. I.e. Upto point F total product curve increases at an increasing rate. The point F where the total product stops increasing at an increasing rate and starts increasing at a diminishing rate is called as the point of inflexion where corresponding vertically to this point of inflexion marginal productivity is maximum. Upto the point F marginal product MP rises. The average product curve rises through out the first stage Upto the point S. It is notable that the marginal product in this stage increases but in later part it starts declining but remains greater than the average product so that the average product continues to rise.

Stage-2
Stage of diminishing returns:
In this stage, the total product increases but at a stage both the marginal product and the average product of the variable factor are diminishing but are positive. At point M marginal product of the variable factor is zero, which is corresponding to the highest point H of the total product curve TP.

Stage-3
Stage of negative returns:
In this stage, the total product declines and therefore the TP curve slopes downward. As a result, marginal product of a variable factor is negative and the marginal product curve MP goes below X-axis. Average product curve therefore declines. The stage is called the stage of negative returns. Since the marginal product of the variable factor is negative during this stage.


EXPLANATION OF THE VARIOUS STAGES:

Increasing returns: As more and more units of variable factors are added to constant quantity of fixed quantity of fixed factor then fixed factor gets more intensively & effectively utilized and production increases at a rapid rate.
The variable factor i.e. no. Of workers increase as a firm expands its product. A worker contributes three pairs of whose per day to the firm’s output. The total product reaches seven pairs of shoes per day when the second worker contributes to the production. Fuller utilization of machine is possible due to the addition of a variable factor. One worker cannot take full advantage of the capabilities of machinery. When the second worker joint it is possible to use the full potential of the machinery. More over increasing returns can also be attributed to the principle of division of labor or specialization of work.

Diminishing returns: The peculiar features of this stage are that the marginal product falls through out the stage and finally touches to zero. Corresponding vertically is the point H, which is the highest point of the TP curve. Where stage two ends.

The third stage is set in by hiring 3rd worker who adds only 3 pairs of shoes per day as compared to 4v pairs per day added by the 2nd worker. Total product increases but the gain from third worker is not as great as gain from second worker. Once the point is reached at which variable factor is sufficient to ensure full utilization of fixed factor, then further increase in variable factor will cause MP as well as AP to fall because fixed factor has not become inadequate relative to the quantity of variable factors. In stage two-fixed factor is scarce as compared to variable factor. According to Joe Robinson famous economist, the factors of production are imperfect substitutes for on another, the stage of diminishing returns occurs. Fixed factor is scarce and variable factor is in abundance. If some factors are available that are perfect substitutes of fixed factor then fixed factor would not have remained scarce. The paucity of fixed could have been made up by such perfect substitutes. If one of the variable factors added to the fixed factor were perfect substitute deficiency of fixed could have been made up but elasticity of substitute between factors is not infinite, substitution is not possible and diminishing returns occur.

3. Negative returns: Under this stage, marginal product falls below “X” axis i.e. negative because total product starts falling. In this example this is set in by hiring 6th worker. The total product falls from 13 pairs of shoes per week to 12 pairs of shoes per week. The large number of variable factors impairs the efficiency of the fixed factor. The excessive variable factor as compared to less fixed factor results in a fall of total output. In such a situation, a reduction in the units of the variable factor will increase the total output.

Q4. Define ‘Business Cycle’. Explain various phases of business cycle.

Answer
Definition of A Business or Trade Cycle

The term “trade cycle” in economies refers to the wave-like fluctuations in the aggregate economic activity. Particularly in employment, output and income. In other words, trade cycles are ups and downs in economic activity. A trade cycle is defined in various ways by different economists. For instance, Mitchell defined trade cycle as a fluctuation in aggregate economic activity. According to Heberler, ‘The business cycle in the general sense may be defined as on alternation of periods of prosperity and depression, of good and bad trade.’

Keynes, points out that ‘A trade cycle is composed of periods of good trade characterized by rising prices and low unemployment percentages, altering with periods of bad trade characterized by tolling prices and high unemployment percentages.’ Keynes, thus, stresses two indices namely, prices and unemployment, for measuring the upswing and downswing of the business cycles.

PHASES OF BUSINESS CYCLES
The ups and downs in the economy are reflected by the fluctuations in aggregate economic magnitudes, such as. Production, investment, employment, prices, wages, bank credits. etc. The upward and downward movements in these magnitudes show different phases of a business cycle. Basically there are only two phases in a cycle, viz., prosperity and depression. But considering the intermediate stages between prosperity and depression, the various phases of trade cycle may be enumerated as follows: -
1) Expansion
2) Peak
3) Recession
4) Trough
5) Recovery and expansion.

The five phases of a business cycle have been presented in the figure below.

The figure showing phases of Business Cycle

1) Prosperity Expansion and Peak
The prosperity phase is characterized by rise in the national output, rise in consumer and capital expenditure rise in the level of employment. Inventories of both input and output increase. Debtors find it more and more convenient to pay off their debts. Bank advances grow rapidly even thought bank rate increases. There is general expansion of credit. Idle funds find their way to productive investment since stock prices increase due to increase in profitability and dividend. Purchasing power continues to flow in and out of all kinds of economic activities. So long as the conditions permit, the expansion continues, following the multiplier process.

In he later stages of prosperity, however inputs start falling short of their demand. Additional workers are hard to find. Hence additional workers can be obtained by bidding a wage rate higher than the prevailing rates. Labor market becomes seller’s market. A similar situation appears also in other input markets. Consequently, input prices increase rapidly leading to increase in cost at production. As a result. Prices increase and overtake the increase in output and employment. Cost of living increases at a rate relatively higher than the increase in household income. Hence consumers, particularly the wage earners and fixed income class. Review their consumption. Consumer’s resistance gets momentum. Actual demand stagnates or even decreases. The first and most pronounced impact falls on the demand for new houses, flats and apartments. Following this, demand for cement, iron and steel, construction-labor tends to halt, this trend subsequently appears in other durable goods industries like automobiles. refrigerators, furniture, etc. This marks reaching the Peak.

2) Turning- Point and Recession
Once the economy reaches the peak, increase in demand is halted. It even starts decreasing in some sectors, for the reason stated above. Producers, on the other band, unaware of this fact continue to maintain their existing levels of production and investment. As a result, a discrepancy between output supply and demand arises. The growth of discrepancy. Between supply and demand is so slow that it goes unnoticed for some time. But producers suddenly realize that their inventories are piling up. This situation might appear in a few industries at the first instance. But later it spreads to other industries also, initially, it might be taken as a problem arisen out of minor maladjustment. But, the persistence of the problem makes the producers believe that they have indulged in ‘over-investment’. Consequently, future investment plans are given up; orders placed for new equipments, raw materials and other inputs are cancelled. Replacement of worn-out capital is postponed. Demand for labor ceases to increase; rather. Temporary and casual workers are removed in a bid to bring demand and supply in balance. The cancellation of orders for the inputs by the producers of consumer goods creates a chain -reaction in the input market, Producers of capital goods and raw materials cancel their orders for their input. This is the turning point and the beginning of recession.

Since demand for inputs has decreased, input prices. E.g. wages, interest etc. show a gradual decline leading to a simultaneous decrease in the incomes of wage and interest earners, This ultimately causes demand recession, Oil the other band, producers lower down the price in order to get rid of their inventories and also to meet their obligations. Consumers in their turn expect a further decrease in price and hence postpone their purchases. As a result the discrepancy between demand and supply continues to grow. When this process gathers speed, it takes the form of irreversible recession. Investments start declining, the decline in investment leads to decline in Income and consumption. The process of reverse of (of negative) multiplier gets underway. (The process is exactly reverse of expansion). When investments are curtailed, production and employment decline resulting in further decline in demand for both consumer and capital goods. Borrowings for investment decreases; bank credit shrinks: share prices decrease; unemployment gets generated along with a fall in wage rates. At this stage, the process of recession is complete and the economy enters the phase of depression.

3) Depression and Trough
During the phase of depression, economic activities slide down their normal level, the growth rate becomes negative. The level of national income and expenditure declines rapidly. Prices of consumer and capital goods decline steadily. Workers lose their jobs. Debtors find it difficult to pay off their debts. Demand for bank credit reaches its low ebb and banks experience mounting of their cash balances. Investment in stock becomes less profitable and least attractive. At the depth of depression, all economic activities touch the bottom and the phase of trough is reached. Even the expenditure on maintenance is deferred in view of excess production capacity. Weaker firms are eliminated form the industries. At this point the process of depression is complete.

How is the process reversed? The factors reverse the downswing varies from cycle to cycle like factors responsible for business cycle vary form cycle to cycle. Generally, the process begins in the labor market. Because of widespread unemployment: workers offer to work at wages less than the prevailing rates. The producers anticipating better future try to maintain their capital stock and offer jobs to some workers here and there. They do so also because they feel encouraged by the halt in decrease in price in the trough phase. Consumers on their part expecting no further decline in price begin to spend on there postponed consumption and hence demand picks up, though gradually.

Besides, there is a self - correcting process within the price mechanism. When prices fall during recession the prices of raw materials and that of other inputs fall faster than the prices of finished products. Therefore, some profitability always remains there, which tends to increase after the trough. Hence the optimism generated in the stock market gets strengthened in the commodity market. Producers start replacing the worn - out capital and making - up the depleted capital stock, though cautiously and slowly. Consequently. Investment picks up and employment gradually increases, following this recovery in production and income, demand for both consumer and capital goods start increasing. Since banks have accumulated excess cash reserves, bank credit becomes easily available and at a lower rate. Speculative increase in prices gives indication of continued rise in levee. For all these reason the economic activities get accelerated. Due to increase in income and consumption. The process of multiplier gives further impetus to the economic activities, and the phase of recovery gets underway. The phase of depression comes to an end over time depending on the speed of recovery.

4) The Recovery
As the recovery gathers momentum, some firms plan additional investment, some undertake renovation programmes, some undertake both. These activities generate construction activities in both consumer and capital good sectors. Individuals who had postponed their plans to construct houses undertake it now, lest cost of construction mounts up. As a result, more and more reemployment is generated in the construction sector, as employment increases despite wage rates moving upward the total wage income increase at a rate higher than employment rate. Wage income rises, so does the consumption expenditure. Businessmen realize quick turn over and an increase in profitability. Hence, they speed up the production machinery.

Over a period, as the factors of production become more fully employed wages and other input prices move upward rapidly. Investors therefore, become discriminatory between alternative investments. As prices, wages and other factor - prices increase, a number of related developments begin to take place. Businessmen start increasing their inventories, consumers start buying more and more of durable goods and variety items. With this process catching up. The economy enters the phase of expansion and prosperity. The cycle is thus complete.