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National Institute of Business Management Chennai - 020 FIRST SEMESTER EMBA/ MBA Subject : Principles of Economics Attend any 4 questions. Each question carries 25 marks (Each answer should be of minimum 2 pages / of 300 words)

1.

Write an essay on the main purposes of how economics work, and the relations between the main economic players and institutions.

2.

Describe developed, undeveloped and developing Economies.

3.

All economies face three fundamental or basic central economic problems. What are they. Explain.

4.

Define price elasticity of demand and explain the formula for calculating price elasticity?

5.

Describe the advantages of a Socialist Economy.

6.

Explain the defects of Capitalism.

25 x 4=100 marks

3.All economies face three fundamental or basic central economic problems. What are they. Explain. Fundamental Problems of an Economy From the study of the essential processes of an economy, it would appear that some fundamental problems arise whatever the type of the economy. An economy exists because of two basic facts: Firstly human wants for goods and services are unlimited; and secondly, productive resources with which to produce goods and services are scarce. Wants being unlimited and our resources being limited, we cannot satisfy all out wants. That being so, an economy has to decide how to use its scarce resources to give the maximum possible satisfaction to the members of the society. In doing so, an economy has to solve some basic problems called Central Problems of an economy, which are: (i) WHAT to Produce. (ii) HOW to Produce. (iii) FOR WHOM to Produce. Whatever the type of the economy or economic system, these problems have to be solved somehow. Whether it is a capitalist economy of the U.S.A. or a socialist economy of the U.S.S.R. or a mixed economy of India, every economy has to make decisions in regard to what, how and for whom to produce. These problems are basic and fundamental for all economies.However, different economies may solve these problems differently. For instance, the socialist economy of Soviet Russia tackles these problems in a different way from that of capitalist America. We shall now explain each of the above three problems in some detail.

(i) WHAT to Produce: The problem ‘what to produce’ can be divided into two related questions. First, which goods are to be produced and which not; and second, in what quantities those goods, which the economy has decided to produce, are to be produced. If productive resources were unlimited we could produce as many numbers of goods as we liked and, therefore, the question “What goods to be produced and what not” would not have arisen. But because resources are in fact

scarce relative to human wants, an economy must choose among different alternative collections of goods and services that it should produce. If the Society decides to produce particular goods in a larger quantity, it will have to withdraw resources from the production of some other goods. Further, an economy has to decide how much resources should be allocated for the production of consumer goods and how much for capital goods. In other words, an economy has to decide the respective quantities of consumer goods and capital goods to be produced. The choice between consumer goods and capital goods involves the choice between the present and the future. If the society decides to produce more capital goods, some resources will have to be taken away from the production of consumer goods and. therefore, the production of consumer goods would have to be cut down. But greater amount of capital goods would make possible the production of larger quantities of consumer goods in the future. Thus, we see that some current consumption has to be sacrificed for the sake of more consumption in the future.

(ii) HOW to Produce: The problem of ‘how to produce’ means which combination of resources is to be used for the production-of goods and which technology is to be made use of in production. Once the society has decided what goods and services are to be produced and in what quantities, it must then decide how these goods shall be produced. There are various alternative methods of producing a good and the economy has to choose among them. For example, cloth can be produced either with automatic looms or with power looms or with handlooms. Fields can be irrigated (and hence wheat can be produced) by building small irrigation works like tube-wells and tanks or by building large canals and dams. Therefore, the economy has to decide whether cloth is to be produced by handlooms or power looms or automatic looms. Similarly, it has to decide if the irrigation has to be done by minor irrigation works or by major works. Obviously, it is a problem of the choice of production techniques. Different methods or techniques of production would use different quantities of various resources. For instance, the production of cloth with handloom would make use of more labbur and less capital. Production by handloom is, therefore, called labour-intensive technique of production. Production of cloth with power loom or automatic loom would

utilise less labour and more capital. Production with power looms is, therefore, called capital-intensive technique of producing cloth. Thus, the economy has to choose whether it wants to use for production labour-intensive methods or capital-intensive methods of production. Obviously, the choice between different methods would depend on the factor-supply situation and the prices of the factors of production. The criterion, it is obvious, must be the cost of production- It is well known that the resources are scarce. But some resources are more scarce than others. It is in society’s interest that those methods of production are employed that make the greatest use of the relatively plentiful resources or, conversely, economies are much as possible on the relatively scarce resources.

(iii) For Whom to Produce: Once the problems of ‘what’ and ‘how’ to produce are solved, the goods are then produced. Because the resources and the resulting output of goods are limited, the third basic economic decision, which must be taken, is ‘for whom to produce’. ‘For whom to produce’ means how the national product is to be distributed among the members of the society. In other words, for whom to produce means that should get how much of the total amount of goods and services produced in the economy. Thus, the third problem is the problem of sharing of the national product. Distribution of the national product depends on the distribution of national income. Those people who have larger incomes would have larger capacity to “buy goods and hence will get greater share of goods and services Problems of Efficiency and Growth: Besides the three fundamental problems explained above, there are two other problems of an economy to which economists of today attach considerable importance. They are the problems of efficiency and growth of the economy. Now a word about each of them. Efficiency of Resource-use: A very important question that can be asked about the working of an economy is: Are the resources being used efficiently? Since resources are scarce, it is obviously desirable that they should be most efficiently used, i.e., the production and distribution of the national product should be efficient. Production is said to be efficient, if it is not possible to produce more of one good without reducing the output of any other goods in the economy. Similarly

the distribution is efficient if it is not possible to make any one person/persons better off without making any other person/persons worse off through any redistribution. Growth of Productive Capacity: It is also important to know whether the productive capacity, of an economy is increasing, static or declining. The increase in productive capacity of an economy over time is called economic growth. Obviously, for under-developed economies, their basic problem is how to accelerate the pace of their economic growth. Even developed countries would not like to rest on their oars. In fact, it has been observed that they are able to achieve higher annual rate of growth than the under-developed ones. The problem of growth is thus not peculiar to the under-developed countries, but is of importance to all countries, whether developed or undeveloped, whether free-market or centrally planned.

Solution of the Fundamental Economic Problems in a Capitalist Economy: It is the price mechanism that helps in the solution of the fundamental problems of the economy. Price mechanism means a set of equilibrium price of individual commodities and factors of production determined through the forces of demand and supply in the various markets. The main problems, are what to produce, how to produce and for whom to produce. In all these cases, price is the indicator of the direction of profitable investment. Those commodities will be produced for which demand prices are high and are therefore profitable to produce; those techniques or factors of production will be employed which cost less as indicated by the prices of factors and the commodities will be produced for those sections of the people who have good incomes and are in a position to pay their price. Hence, in a free capitalist economy, it is the price mechanism which solves the central problems of the economy. Price-mechanism establishes an equilibrium price ‘both in the commodity market and in the factor market. Equilibrium prices in the commodity markets and fact markets are determined through the forces of demand and supply in the various markets.

4.Define price elasticity of demand and explain the formula for calculating price elasticity? Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price, ceteris paribus. When the price elasticity of demand for a good is relatively inelastic (-1 < Ed < 0), the percentage change in quantity demanded is smaller than that in price. Hence, when the price is raised, the total revenue increases, and vice versa. In the earlier discussion we were able to understand the relationship between demand and price. Recapitulating the discussion briefly, The Law of Demand states that Other things remaining the same the demand for a commodity increases when its price falls and it decreases when its price increases. Thus according to the law of demand there is an inverse relationship between price and quantity demanded, other things remaining the same. These other things which are assumed to be constant are taste or preference of the consumer, income of the consumer, prices of related goods etc .If these factors undergo a change, then the inverse relationship may not hold good. However we also observe that for commodities like salt or rice we do not notice much of a change in demand whereas in case of goods like Air conditioners, Cars etc even with a small change there is substantial increase in demand. The Law of demand while stating the relationship between demand and price mentions only the direction of change in demand but does not mention anything about the magnitude of the change which is very essential in decision making process for the producer and Government. For example: "If I lower the price of my product, will the sale increase?" "If I raise the price, will it affect my profit?" “If sales tax rate is increased will it have an effect on the revenue collection?" are questions that need to be answered. This information as to how much or to what extent the quantity demanded of a good will change as a result of a change in its price is provided by the concept of Elasticity of Demand. Elasticity of Demand refers to the degree of responsiveness of quantity demanded to the changes in the determinants of demand . There are mainly three quantifiable determinants of demand:1. Price of the Good 2. Income of the Consumer 3. Price of the Related Goods

Types of Elasticity Of Demand As we have seen above there are three quantifiable determinants of demand, Hence elasticity of demand can be of three types 1. Price Elasticity of Demand 2. Income Elasticity of Demand 3. Cross Elasticity of Demand 4.

Price elasticity of Demand Concept Of Elasticity of demand Alfred Marshall introduced the concept of elasticity in 1890 to measure the magnitude of percentage change in the quantity demanded of a commodity to a certain percentage change in its price or the income of the buyer or in the prices of related goods .In this section we look at the sensitivity of demand for a product to a change inthe product's own price.Since Price Elasticity of Demand is predominantly used in economic analysis it is alternatively referred to as Elasticity of Demand. Definition Price Elasticity of demand is the degree of responsiveness of demand to a change in its price.In technical terms it is the ratio of the percentage change in demand to the percentage change in price. Thus, Ep = Pecentage change in quantity demanded/Percentage change in price In mathematical terms it can be represented as: Ep =(∆q/∆p) (p/q) From the definition it follows that 1. when percentage change in quantity demanded is greater than the percentage change in price then, price elasticity will be greater than one and in this case demand is said to be elastic. 2. when percentage change in quantity demanded is less than the percentage change in price then, price elasticity will be less than one and in this case demand is said to be inelastic. 3. when percentage change in quantity demanded is equal to the percentage change in price then price elasticity will be equal to one and in this case demand is said to be unit elastic. Since the Elasticity of Demand is less than one Demand is inelastic . In other words we can say

that for a 14% increase in price ,demand has declined only by 4% . The negative sign indicates the inverse relationship between demand and price.

Diagrammatic representation Of Price Elasticity Of Demand

Determinants Of Price Elasticity Of Demand 4. There are number of factors which determine the price elasticity of demand. Let us consider some of these factors. 5. Firstly if close substitutes are available then there is a tendency to shift from one product to another when the price increases and demand is said to be elastic. For example, demand for two brands of tea. If the price of one brand A increases then the demand for the other brand B increases. In other words greater the possibility of substitution greater the elasticity. 6. Secondly how much of the income is spent on a commodity by the consumer. Greater the proportion of income spent on the commodity greater will be the elasticity. 7. Thirdly the number of uses to which the commodity can be put is important factor determining elasticity. If the commodity can be put to many uses then the elasticity will be greater. 8. Fourthly if two commodities are consumed jointly then increase in the price of one will reduce the demand for both. 9. Fifthly time element has an important role to play in determining the elasticity of demand . Demand is more elastic if time involved is long. In the short run , it is difficult to substitute one commodity for another. 10. Sixthly Cost of switching between different products and services.There may be significant transaction costs involved in switching.In this case demand tends to be relatively inelastic.For example ,mobile phone service providers may include penalty clauses in their contracts. 11. Seventhly Who makes the payment, Where the purchaserdoes not directlypay for the goodthey consume, such as perks enjoyed by employees,demand is likely to be more inelastic. 12. Finally Brand Loyalty,An attachment to a certain brand either out of tradition or because of propriety barriers can override sensitivity to price changes, resulting in more inelastic demand.

Measurement of Elasticity of Demand i. Percentage Method . i. Point Elasticity Method. ii. Total Outlay Method. iii. Arc Elasticity. Let us discuss each of these measures in detail.

6.Explain the defects of Capitalism. 

Capitalism is an economic system in which capital goods are owned by private individuals or businesses. The production of goods and services is based on supply and demand in the general market (market economy), rather than through central planning (planned economy or command economy). The purest form of capitalism is free market or laissez-faire capitalism, in which private individuals are completely free to determine where to invest, what to produce or sell, and at which prices to exchange goods and services, without check or controls. Most modern countries practice a mixed capitalist system of some sort that includes government regulation of business and industry.

Turbo Capitalism Refers to an unregulated form of capitalism with financial deregulation, privatisation and lower tax on high earners. Turbo capitalism involves:    

Absence of regulation for banking /finance system. This encourages banks to take risks and pursue profit through complex financial derivatives rather than basic principles of attracting deposits and lending. Less regulation on abuse of monopoly power. Lower income tax and lower capital gains tax giving greater rewards to high income earners. An unregulated labour market, where it is easy to hire and fire workers, and very limited regulation about working conditions.

The term ‘turbo capitalism’ was coined in 1989 by Edward Lattwak, a senior fellow at the Center for Strategic and International Studies, in his book “Turbo-Capitalism: Winners and Losers in the Global Economy“, (New York, 1999). It reflected on the changes to capitalist societies such as US and UK since 1980. The 1980s were a period of financial deregulation, privatisation and tax cuts for the wealthy. Arguably, this led to rising income inequality and also the financial deregulation played a key role in the unsustainable credit bubble of 2001-2007. Turbo capitalism could also be referred to as: Unrestrained capitalism or free market capitalism

Responsible Capitalism Responsible capitalism is essentially a free market economy, but with a degree of government regulation to avoid the excesses and inequalities of capitalism. Responsible capitalism would involve:  

An extensive welfare state to protect those who are unemployed or on low incomes. A progressive tax system with high earners paying a higher % of their income to fund government spending.

  

Most industries would be in the private sector, but, the government might take responsibility for areas with substantial positive externalities and social benefits like health care, education, public transport. A willingness to regulate monopolies and protect rights of workers. Responsible capitalism is similar to concepts of social market economy

Popular Capitalism Recently, the Conservative leader David Cameron, spoke about his wish for ‘popular capitalism’. Presumably this is to take benefits of capitalism, but to make sure everyone benefits from economic growth. This would involve a degree of redistribution and guarantees of a certain social welfare safety net. Presumably popular capitalism would be willing to impose greater regulation on the finance sector to prevent excess risk taking and growing inequality. But, when politicians use such terms, there is always a degree of ‘vagueness’. As much as anything it is an attempt to appeal to a wider political audience. ‘Popular capitalism’ could really mean whatever you want it to.

Crony Capitalism A term used to refer to the situation where business success is related to strategic influences with civil servants, politicians and those in authority. It could be used to refer to situations in early twentieth century US where business leaders had to buy off politicians in return for favours (e.g. in popular media: Citizen Kane). Arguably a degree of ‘crony capitalism occurs in countries like China, South Korea and Latin America. The power of the Mafia in Italy is also an example of ‘crony capitalism’

Advanced Capitalism A term used to refer to societies where capitalism is firmly established. There is widespread acceptance of status quo, and little political activism over fundamental political issues. In advanced capitalism, consumerism is important. There is likely an established welfare state to overcome the worst of the excesses of capitalism.

State Capitalism State capitalism occurs when state owned industries play a key role within the market economy. Under state capitalism, the government also plays a key role in planning, for example deciding to invest in transport and communication. To some extent, China has become a model of state capitalism. Private firms play a key role, but the government also plays a key role in planning energy, transport and the Chinese government influences monetary policy and exchange rate policy. The difference between state capitalism and state socialism is that under state socialism there is no room for private enterprise and competition.

Merits and Demerits of Capitalistic System Merits of Capitalistic System: The main merits of this system are: (i) Economic Freedom: The foremost advantage of this system is that everybody enjoys’ economic freedom as one can spend one’s income according to one’s wishes. Producers have complete freedom to invest in any business or trade. (ii) Automatic Working: Another advantage according to classical economists is an automatic system. Equilibrium point is automatically come with the forces of demand and supply. (iii) Variety of Goods and Services: All the basic decisions of what to produce, how to produce and for whom to produce are taken by producers. Every producer gives attention to consumers’ taste and preferences. Hence, there are large variety of goods and services; produced in the economy. (iv) Optimum Use of Resources: All natural resources are used to their optimum level as production is undertaken with a sole purpose: of earning profit and no scope for wastages at all. (v) Efficient Producer: There is very tough I competition among entrepreneurs. They always encouraged to produce best quality of products. Thus, technical development will lead to increase in higher productivity as well as efficiency. (vii) Incentive to efficient: In this system, incentives are given to the efficient workers in cash or kind. This means every worker should get reward according to his ability. Hence, workers will try to work more and more, therefore, total output will also increase. (viii) New Inventions: In this type of economy, there is ample scope of new invention. To get more profit every producer takes initiative to develop new techniques in production.

Demerits of Capitalistic System: According to Karl Marx, “Capitalism contains the seeds of its own destruction.” The main demerits of this system are given below: (i) Labour Exploitation: The main defect of capitalism is the exploitation of labour. Labourers get less wages in comparison to their working hours. The wages less than their marginal productivity are not sufficient for their livelihood. (ii) Class Struggle: A lion’s share of income and resources is controlled by the upper sections of the society, while others remain deprived of the basic amenities of life. Thus, the entire society is divided between ‘haves and ‘have not’s. Hence, the continuous class struggle spoils the health environment of the economy. (iii) Wasteful Competition: Capitalism is a wasteful competition. A lot of money is spent on advertisement and publicity for pushing the sale of the commodity. Its burden ultimately is borne by the poor consumers in the form of increased price. (iv) Threat of Over-Production: The production is made on a large scale which cannot be changed in a short period. Therefore, under capitalism, fear of over-production always exists. The Great Depression of 1930s in USA is an example of it. (v) Economic Fluctuations: Being automatic in nature, capitalist economy always faces the problem of economic fluctuations and unemployment. This means the state of instability and uncertainty, (vi) Unbalanced Growth: All the resources are put only to those channels where there is maximum profit. Other sectors of the economy are neglected. As there is no check on the economic system, the growth is unbalanced in nature. (vii) No Welfare Activities: In capitalism, the sole motive is maximum profit, but not the public welfare. Variety of goods are produced according to market demand, not for any welfare activity.

5.Describe the advantages of a Socialist Economy. A socialist economic system is characterized by social ownership and democratic control of the means of production, which may mean autonomous cooperatives or direct public ownership; wherein production is carried out directly for use.

Merits and Demerits of Socialist Economy Merits of Socialist Economy: (i) No Labour Exploitation: There is only one class in a socialistic economy hence there is no question of exploitation. There are no concept of strikes and lock-outs. Everybody works in a well-knit family way. (ii) Proper Utilisation of Resources: Under this economy, all types of natural resources are utilized in a most organized manner. Its main objective is to exploit these resources for the welfare of society. (iii) No Wasteful Advertisement: The government is virtually the owner of almost every sector. Hence, all the individual producers are also more according to the plan targets. Therefore, the competition among the producers is almost nil. Hence, very less money is spent on wasteful advertisement. (iv) Proper Planning: In order to solve various problems, which arise from time to time, there is proper economic plan in this type of economy. Thus, with the help of economic plans socialist economy will adopt the balanced development strategy. (v) No Cyclical Fluctuations: Under socialist economy, no cyclical fluctuations are found. It means economy faces no boom, depression, unemployment or over production etc. Economic stability is maintained by the government on the basis of economic planning.

(vi) Social Welfare: The aim of socialist economy is to maximize social welfare of the society. It provides equal opportunities of employment to all individual according to their abilities. (vii) Rapid Economic Development: The Central Planning Authority is the main figure in a socialist economy. It coordinate the natural, human and physical resources to attain economic progress of the country. In turn it accelerates the path of tremendous progress and people enjoy higher standard of living. (viii) Most Suitable to Developing Countries: This type of economic system is most suitable to the needs of developing countries as all means of production are controlled by the government. Demerits of Socialist Economy: Economists like Robbins, Maurice Dobb, Georg Halm etc. have criticised the socialist economy on the following grounds: (i) Loss of Consumer Sovereignty: A consumer has no choice of his own, he acts as a mere slave under this system. Government produces goods and services keeping in view the needs of the people. (ii) Less Democratic: Socialist economy is always less democratic as it possesses no element of freedom. It is also like government dictatorship. (iii) No Automatic Functioning: Under this system, no automatic function in system exists at all. It is the Central Authority, i.e., government, that governs the country according to its own interest. (iv) Evils of Bureaucracy In socialist economy, all economic activities are controlled by the government. Thus, they develop all evils of bureaucracy like favouritism, delay, corruption and other sue evils, (v) Rigid Economy: Socialist economy is very rigid and not susceptible to change according to requirements. Hence people work like a machine and never get any incentive to work.

(vi) Burden on Government: All the economic activities are performed by the Central Authority on behalf of the government. Hence, it is overburdened with daily activities and, therefore, it gets very less time to think and plan for the economic prosperity of the economy. (vii) Expenditure on Planning: In fact, planning is a long process in a socialist economy. This expenditure is unnecessarily wasteful and a burden on the national economy.