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Four Phases of the Business Cycle

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Q 1 Define the term Business Cycle and also explain the phases of business or trade cycle in brief?

Ans: The business cycle is the periodic but irregular up-and-down movements in economic activity, measured by fluctuations in real GDP and other macroeconomic variables.Diagram of Business Cycle (or Trade Cycle) :-


The business cycle starts from a trough (lower point) and passes through a recovery phase followed by a period of expansion (upper turning point) and prosperity. After the peak point is reached there is a declining phase of recession followed by a depression. Again the business cycle continues similarly with ups and downs.

Explanation of Four Phases of Business Cycle

1. Prosperity Phase : Expansion or Boom or Upswing of economy.When there is an expansion of output, income, employment, prices and profits, there is also a rise in the standard of living. This period is termed as Prosperity phase.The features of prosperity are :- High level of output and trade, High level of effective demand, High level of income and employment, Rising interest rates, Inflation, Large expansion of bank credit, Overall business optimism.

2. Recession Phase: from prosperity to recession (upper turning point).

The turning point from prosperity to depression is termed as Recession Phase.

During a recession period, the economic activities slow down. When demand starts falling, the overproduction and future investment plans are also given up. There is a steady decline in the output, income, employment, prices and profits. The businessmen lose confidence and become pessimistic (Negative). It reduces investment. The banks and the people try to get greater liquidity, so credit also contracts. Expansion of business stops, stock market falls. Orders are cancelled and people start losing their jobs. The increase in unemployment causes a sharp decline in income and aggregate demand. Generally, recession lasts for a short period.

3. Depression Phase : Contraction or Downswing of economy.When there is a continuous decrease of output, income, employment, prices and profits, there is a fall in the standard of living and depression sets in.

The features of depression are :- Fall in volume of output and trade, Fall in income and rise in unemployment,Decline in consumption and demand, Fall in interest rate, Deflation, Contraction of bank credit, Overall business pessimism.In depression, there is under-utilization of resources and fall in GNP (Gross National Product). The aggregate economic activity is at the lowest, causing a decline in prices and profits until the economy reaches its Trough (low point).

4. Recovery Phase : from depression to prosperity (lower turning Point).

The turning point from depression to expansion is termed as Recovery or Revival Phase.During the period of revival or recovery, there are expansions and rise in economic activities. When demand starts rising, production increases and this causes an increase in investment. There is a steady rise in output, income, employment, prices and profits. The businessmen gain confidence and become optimistic (Positive). This increases investments. The stimulation of investment brings about the revival or recovery of the economy.Thus we see that, during the expansionary or prosperity phase, there is inflation and during the contraction or depression phase, there is a deflation.

Q2. Monopoly is the situation there exists a single control over the market producing a commodity having no substitutes with no possibilities for anyone to enter the industry to compete. In that situation, they will not charge a uniform price for all the customers in the market and also the pricing policy followed in that situation?

Ans: A market structure characterized by a single seller, selling a unique product in the market. In a monopoly market, the seller faces no competition, as he is the sole seller of goods with no close substitute.In a monopoly market, factors like government license, ownership of resources, copyright and patent and high starting cost make an entity a single seller of goods. All these factors restrict the entry of other sellers in the market. Monopolies also possess some information that is not known to other sellers.

Characteristics of monopoly: Only one single seller in the market, There is no competition, There are many buyers in the market, The firm enjoys abnormal profits, The seller controls the prices in that particular product or service and is the price maker, Consumers don’t have perfect information, There are barriers to entry. These barriers many be natural or artificial, The product does not have close substitutes.

Advantages of monopoly

Monopoly avoids duplication and hence wastage of resources.

Due to the fact that monopolies make lot of profits, it can be used for research and development and to maintain their status as a monopoly.

Monopolies may use price discrimination which benefits the economically weaker sections of the society. Monopolies can afford to invest in latest technology and machinery in order to be efficient and to avoid competition.

Disadvantages of monopoly

Poor level of service, No consumer sovereignty, Consumers may be charged high prices for low quality of goods and services, Lack of competition may lead to low quality and out dated goods and services.

Price Discrimination : It is the ability to charge different prices to different individual.

Need for price discrimination: increase output and profit. Buying pattern of individuals will be different. Increase the economic welfare.

Eg: Air tickets, movie tickets , discount coupons etc.

multiple types of price discrimination:

  • First-degree price discrimination is an attempt by the seller to leave the price unannounced in advance and charge each customer the highest price they would be willing to pay for the purchase.
  • A business may benefit by offering different prices to those who purchase in larger volumes because either they can increase their profit with the increased volume sales or their costs per unit decrease when items are purchased in volume. Businesses can create alternative pricing methods that distinguish high-volume buyers from low-volume buyers. This is second-degree price discrimination.
  • Third-degree price discrimination is differential pricing to different groups of customers. One justification for this practice is that producing goods and services for sale to one identifiable group of customers is less than the cost of sales to another group of customers. For example, a publisher of music or books may be able to sell a music album or a book in electronic form for less cost than a physical form like a compact disc or printed text.

Q3 Fiscal policy is a package of economic measures of the government regarding public expenditure, public revenue, public debt or borrowings. It is very important since it refers to the budgetary policy of the government. Explain the fiscal policy and its instruments in detail?

Ans: 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.

instruments of Fiscal Policy are Automatic Stabilizer and Discretionary Fiscal Policy:

  1. 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\u2013Tax on individual(direct tax) and tax on commodity (indirect tax or commodity tax).

a) 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-

  1. 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.
  2. 2 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.
  3. 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.

b) Indirect Tax Or consumpyion tax: tax which is iimposed on every unit of product .

Q4 Explain the various methods of forecasting demand?

Ans : Economic forecasting is the process of making predictions about the economy. Forecasts can be carried out at a high level of aggregation—for example for GDP, inflation, unemployment or the fiscal deficit—or at a more disaggregated level, for specific sectors of the economy or even specific firms.

Methods of forecasting demand:


For many goods, the length of the product cycle is shrinking. Not only does this make it more difficult to build a historical database, it accentuates the need to forecast correctly. Computer technology makes it possible to adjust pricing instantly and to modify sales promotions on the run. Without accurate historical information to measure the impact of price changes, the business owner may be forced to experiment. Sales performance of other goods with similar product attributes may serve as proxies for a current product with no track record.

Trend Analysis

If you have historical data -- or if you can create it from related products -- trend analysis is the first step in demand forecasting. Plotting sales over time will reveal the presence of a sales trend if one exists. If there are aberrations -- “hiccups” in the trend -- you can look for explanations, which could include price, weather or demographic changes. If you are proficient with spreadsheet programs, you can chart data points and insert a trend line over the data. A more sophisticated approach is using least squares regression analysis which can also be done with standard spreadsheet software.

Qualitative Forecasting

A more subjective approach uses expert opinions to predict demand. Especially useful when there is a lack of historical data, relying on the collective opinion of experts makes sense. Begin with an analysis of the marketplace, reviewing the economic conditions. Obtain as much information about competitors’ performance as you can. Then gather opinions from a variety of sources within your business. Include the owner, sales manager, accountant, attorney and any others whose opinion you value. If you wish, you can get outside opinions as well. Qualitative forecasting is based on the consensus view of your panel as you digest and aggregate their opinions.

Forecasting with Economic Indicators

Depending on the products you sell and the customers who buy them, basing your demand forecast on one or more economic indicators may be an effective method. This style of demand forecasting works better with industrial buyers rather than retail. First, find the indicators that relate to your business. For example, small businesses in construction-related work can look to housing starts, building permits, loan applications and interest rates for solid indicators of the future. Businesses in agriculture can find clues to the future from farm income, interest rates and weather forecasts. The Departments of Commerce and Agriculture release statistics on an ongoing basis. Agricultural Extension Services and other state agencies provide complementary data

Q5 Define monopolistic competition and explain its characteristics?

Ans: Monopolistic Competition: A market structure in which several or many sellers each produce similar, but slightly differentiated products. Each producer can set its price and quantity without affecting the market place as a whole.

Monopolistically competitive markets exhibit the following characteristics:

  1. Each firm makes independent decisions about price and output, based on its product, its market, and its costs of production.
  2. Knowledge is widely spread between participants, but it is unlikely to be perfect. For example, diners can review all the menus available from restaurants in a town, before they make their choice. Once inside the restaurant, they can view the menu again, before ordering. However, they cannot fully appreciate the restaurant or the meal until after they have dined.
  3. The entrepreneur has a more significant role than in firms that are perfectly competitive because of the increased risks associated with decision making.
  4. There is freedom to enter or leave the market, as there are no major barriers to entry or exit.
  5. A central feature of monopolistic competition is that products are differentiated. There are four main types of differentiation:
  • Physical product differentiation, where firms use size, design, colour, shape, performance, and features to make their products different. For example, consumer electronics can easily be physically differentiated.
  • Marketing differentiation, where firms try to differentiate their product by distinctive packaging and other promotional techniques. For example, breakfast cereals can easily be differentiated through packaging.
  • Human capital differentiation, where the firm creates differences through the skill of its employees, the level of training received, distinctive uniforms, and so on.
  • Differentiation through distribution, including distribution via mail order or through internet shopping, such as Amazon.com, which differentiates itself from traditional bookstores by selling online.
  1. Firms are price makers and are faced with a downward sloping demand curve. Because each firm makes a unique product, it can charge a higher or lower price than its rivals. The firm can set its own price and does not have to ‘take' it from the industry as a whole, though the industry price may be a guideline, or becomes a constraint. This also means that the demand curve will slope downwards.
  2. Firms operating under monopolistic competition usually have to engage in advertising. Firms are often in fierce competition with other (local) firms offering a similar product or service, and may need to advertise on a local basis, to let customers know their differences. Common methods of advertising for these firms are through local press and radio, local cinema, posters, leaflets and special promotions.
  3. Monopolistically competitive firms are assumed to beprofit maximisers because firms tend to be small with entrepreneurs actively involved in managing the business.
  4. There are usually a large numbers of independent firms competing in the market.

Q6 When should a firm in perfectly competitive market shut down its operation?

Ans Definition of 'Perfect Competition'

A market structure in which the following five criteria are met:

1) All firms sell an identical product;

2) All firms are price takers - they cannot control the market price of their product;

3) All firms have a relatively small market share;

4) Buyers have complete information about the product being sold and the prices charged by each firm; and

5) The industry is characterized by freedom of entry and exit.

Perfect competition is sometimes referred to as "pure competition".

The reason for firm shut down in perfect competition

A perfectly competitive firm is presumed to shutdown production and produce no output in the short run, if price is less than average variable cost. This is one of three short-run production alternatives facing a firm. The other two are profit maximization (if price exceeds average total cost) and loss minimization (if price is greater than average variable cost but less than average total cost).

A perfectly competitive firm guided by the pursuit of profit is inclined to produce no output if the quantity that equates marginal revenue and marginal cost in the short run incurs an economic loss greater than total fixed cost. The key to this loss minimization production decision is a comparison of the loss incurred from producing with the loss incurred from not producing. If price is less than average variable cost, then the firm incurs a smaller loss by not producing that by producing.

One of Three Alternatives: Shutting down is one of three short-run production alternatives facing a perfectly competitive firm. All three are displayed in the table to the right. The other two are profit maximization and loss minimization.

With profit maximization, price exceeds average total cost at the quantity that equates marginal revenue and marginal cost. In this case, the firm generates an economic profit.

With loss minimization, price is greater than average variable cost but is less than average total cost at the quantity that equates marginal revenue and marginal cost. In this case, the firm incurs a smaller loss by producing some output than by not producing any output.

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