Inflation and efficiency
Inflation
• Inflation is the increase in the general level of prices for
goods and services across the economy over a given
period of time.
• It is the percentage increase in price indices of an
economy.
• It implies that the purchasing power of currency is
falling.
• In India, usually, inflation is calculated by taking the WPI
(wholesale price index) as base but CPI (consumer price
index) can also be used
Calculating inflation
• Formula for calculating Inflation=
(WPI of current year-WPI of previous year)
-------------------------------------------------------- x
100
WPI of previous year
Example 1
• If the CPI is 93 in 2014 and 97 in 2015,
calculate the rate of inflation from 2014 to
2015.
Solution:
Inflation = {(CPI in 2015- CPI in 2014)/ CPI in
2014} x 100 = {(97-93)/93} x 100 = 4.3 %
Example 1 (contd)
• If the CPI is 93 in 2014 and 97 in 2024,
calculate the rate of inflation from 2014 to
2015.
• Solution:
Inflation (total)= {(CPI in 2024- CPI in 2014)/ CPI
in 2014} x 100 = {(97-93)/93} x 100 = 4.3 %
Inflation (annual) =4.3/10= 0.43%
Example 2
a) If the index number of a certain period is 100
what does it indicate?
b) If the index number of a certain period is 120
what does it indicate?
c) If the index number of a certain period is 90 what
does it indicate?
Hint: Base year (reference year) has an index of 100.
Solution 2
a) No inflation. Prices remained constant./ Base
year itself.
b) 20% inflation in comparison to base year.
c) Prices have decreased by 10 % in comparison
to base year.
Reasons for inflation
1. Demand Pull inflation:
Caused by excess demand for products
(Demand > Supply)
Demand pull inflation may happen because of :
Increased money supply (through govt spending)
Increased income
Increase in population
Reasons for inflation (contd)
2. Cost –Push Inflation:
Caused by increased cost of production. Increase cost of
production is a result of:
• Infrastructure bottlenecks which lead to rise in production
and distribution costs.
• Rise in Minimum Support Price (MSP).
• Rise in international prices.
• Hoarding and black marketing.
• Rise in indirect taxes.
• rise in price of strategic products like petroleum and
electricity.
Homework
1. Discuss walking, creeping, galloping and
running inflation?
2. Is inflation good or bad for the economy?
3. List the differences between CPI and WPI?
Efficiency
• To improve demand – supply mechanisms we
need to have efficiency in production and
distribution.
• Efficiency of a system is generally defined as
the ratio of its output to input.
• The efficiency can be classified into technical
efficiency and economic efficiency.
Technical efficiency
• It is the ratio of the output to input of a
physical system. The physical system may be a
diesel engine, a machine working in a shop
floor, a furnace, etc.
• Technical efficiency (%) = (Output /Input) x
100
• Technical efficiency can at max be 100 %
Economic efficiency
• Economic efficiency is the ratio of output to input of
a business system.
• Economic efficiency (%) = (Worth /Cost) x 100
• ‘Worth’ is the annual revenue generated by way of
operating the business and ‘cost’ is the total annual
expenses incurred in carrying out the business.
• For the survival and growth of any business, the
economic efficiency should be more than 100%.
Economic efficiency is also called ‘productivity’.
Some additional cost concepts
Relationship between average cost and
marginal cost
Relationship between average cost and
marginal cost
Relationship between Marginal Cost (MC) and Average Cost ( AC)
• Whenever marginal cost is less than average cost, average cost is falling.
• Whenever marginal cost is greater than average cost, average cost is rising.
• The marginal-cost curve crosses the average cost curve at the efficient scale.
Efficient scale is the quantity that minimizes average cost( point S in above diagram)
• The marginal-cost curve crosses the average cost curve at the minimum of
average cost. MC curve cuts AC curve from below.
Please note: Both Average cost and marginal cost curves are u shaped but MC
reaches its minimum before AC and hence starts to rise before AC.
Numerical example illustrating AC and MC
relationship
Quantity of Output (q) Total Cost MC = TCq – TCq-1 AC = TC/ q
0 20 - -
1 30 10 30
2 38 8 19
3 45 7 15
4 50 5 12.5
5 57 7 11.4
6 (=S) 68 11 11.3
7 80 12 11.45
8 96 16 12
9 114 18 12.7
Capital budgeting
• Capital budgeting is the process in which a
business determines and evaluates potential
expenses or investments that are large in nature.
These expenditures and investments include
projects such as building a new plant or investing
in a long-term venture. Often times, a prospective
project's lifetime cash inflows and outflows are
assessed in order to determine whether the
potential returns generated meet a sufficient
target benchmark, also known as "investment
appraisal”.