Role of Government in the Economy

Government is an institution which plays an important role in all types of

economic system. The role of government in all types of economic system is
very essential in present situation. By using its power, government can
enact the law to regulate different economic activities. The Government
intervenes, the activities of private firm by using various specific
policies, such as industrial policy, commercial policy, labour policy,
environment policy etc. In primitive societies, the government role was
neglected. They believed that the government is best which governed least.
They preferred the minimum role of government. Their economic ideas were
based on laissez-fair doctrine, which means the system of economic liberty.
In nineteen century in England "that government was considered the best
which does the least". Due to this government control and the role in the
economy had declined. In laissez-fair economy there was rapid economic
growth and on the other the evils, such as unequal distribution of income
and wealth, monopolistic exploitation, exploitation of unskilled labour.
Consequently, the role of government again began to increase all over the
world. After World War I, Russian revolution which lead to the abolition
most private property and put state in control through central planning of
all economic activities. During the period of 1929 33, there occurred
Great Depression in the capitalist countries which caused huge unemployment
of labour and other resources in those countries and as a result level of
national income fell down. Due to depression many factories were closed and
factories which were working were also not being used to their full
productive capacity. As a result, unemployment, low income, low production
was created. Since World War II most of the economists had taken increasing
public sector as the natural and essential factor of development. The
objectives like economic efficiency, growth, macroeconomic stability,
poverty alleviation, equal distribution of income, provision of public of
goods cannot be achieved only through private agencies. During the period of
1967s there was re-emergence of private interest views in public sector. In
this way controversy about the role of government has not subsided. Many
research has been made regarding government involvement has hindered or
facilitate in economic sector.
The Government, Culture and Geography,
taken as the basic pillars of economic
for governments role mainly due to
governments role is important in
following reasons:

Environment and Natural Resources are

growth. Economists point out the need
the market failure. It is therefore
the economy mainly because of the

a) Providing public goods such as rule of law, effective regulation and

development of physical infrastructure.
b) Managing positive externalities such as those emanating from the
investment in education, health, and research, and the negative ones such
as the effect of the pollution.
c) Controlling and monitoring monopoly, and
d) Managing the coordination failure occurring in the private sector
A number of world economies that were at the same level with their
neighbouring economies in terms of education, health, per capita income and
natural resources some five decades ago, have been successful in attaining
significantly higher level of economic development because of the
governments role. Countries like Sri Lanka, Botswana, China, and South
Africa have proved that significant progress could be achieved even in a
short period mainly due to the qualitative improvements in and effectiveness

of the government's role. The Human Development Report 2003 highlights that
Sri Lanka had increased life expectancy of her people from 46 years to 58
years during 1946 to 1953. Botswana was able to increase the primary school
enrolment rate from 46 percent to 89 percent during 1970 through 1985. China
successfully reduced the poverty rate from 33 percent to 18 percent in the
decade of 1990's. And South Africa was able to reduce the number of people
lacking access to clean drinking water from 15 million to 7 million only in
a period of 4 years during 1997 through 2001. In the background of these
theories and instances, Nepals need of the hour is to develop a far-sighted
vision to ensure an effective state mechanism, even taking into account the
experiences of other economies, that facilitates in attaining higher level
of economic growth.
Source: David N. Weil, Economic Growth (2005) and UNDP Human Development
Report (2003)
According to World Bank Report, 1988, government was involvement mainly on
public goods, defence, diplomacy, macroeconomic management, justice, legal
matters and infrastructure like social, physical, education, health,
transportation, and environment protection.

Regulatory and Promotional Role of the Government

Any country's the prosperity and obstacles of economic growth results from
activities of government. That means, government plays important role in
economic activities. In free market economies government plays important
activities. It has to perform role to prevent market failure. As we know
that market does not yield economically efficient outcome every time as the
result market fails to operate. In free market economy government has
designed activities to stimulate and assist private enterprise and to
regulate or control business practices so that their operations are
consistent with the public interest. There are various forms of government
regulation especially to regulate the activities of private firms.
a) Industrial products are subject to operating regulations, governing
plant and pollutant emission, product packaging and labelling, worker
safety and health etc.
b) Financial Regulations; Banks and Financial Institutions are subject to
both the government as well as the control made by the Central Bank
for financial soundness.
A. Rational for Regulation
1) Economic Consideration; and
2) Political Consideration
1. Economic Consideration
Economic consideration is related to the cost and efficiency implications of
various regulatory methods. From economic view point a given mode of
regulation or change in regulatory policy is desirable to the extent that
benefit exceeds the cost. Political consideration relate to equity rather
than efficiency. Economic consideration has an important role in formulating
regulatory policy. In fact, it is due to market imperfection that need of
regulation in production and marketing activities was felt. If unregulated,

the market
failure.

activities

itself

creates

inefficiency

or

waste

and

market

Market failure is mainly two types

a) Failure by market structure
In order to achieve the economically efficient outcome there must be many
producers and consumers within each market. This condition is unfulfilled in
some market such as water power, telecommunication etc. If these sectors are
allowed for private sectors natural monopoly situation come to exist. They
may exploit the consumers by charging higher prices and reduces the volume
of output and earn excessive profit. Under such situation market does not
yield economically efficient outcomes and creates the situation of market
failure.
b) Failure by incentive
Second kind of market failure is due to lack of incentive. The market
failure due to presence of externalities is known as incentive failure.
Production of the firms and consumption of individuals are interdependent of
each other. Differences between social and private costs or benefit are
called externality. Pollution caused in the water supply in the lower part
of the city by the carpet factory situated in the upper part of the city and
Plantation of trees in the certain part of the community benefits the
community as a whole are the examples of negative and positive
externalities.
2. Political Consideration
In formulating regulatory policy, political manifesto of the ruling party
and the opposition parties needs to be taken into consideration for
political consensus and commitments. From political viewpoint there are two
reasons for regulation:
a) Preservation of consumer sovereignty
The preservation of consumer's choice or consumer sovereignty is an inherent
aspect of democracy. Consumers have free to decision regarding to their
consumption. This is possible only in the competitive market. In competitive
market price is set at minimum point of LAC curve in the long run. Therefore
monopoly market regulatory policy can be valuable tool to restore control
over the price and quality decision making process to the public.
b) Limit concentration of economic and political power
In a democratic society it is not desirable to have economic and political
power concentrated in limited group. It is regarded that the economic and
political power remains linked with one another. Economically active power
oriented persons usually are seen interfering in political activities as
well. Therefore, the development of large structures is prevented through
regulatory policy. The aim of the government is equitable distribution of
wealth and income. For the purpose government should interfere in the
market.
B. Promotional Role

In the free enterprises economy, the major role of government is to promote

private sector participation. To promote private sector, government has to
develop physical infrastructure such as transport, energy, development of
irrigation, telecom networking. The social and economic overheads created by
the government help private business at least in two ways:
a) Economic growth
The building of economic and social overhead accelerates the pace of
economic growth. Economic growth enlarges the size of market to the
advantage of private business through a sustained increase aggregate demand.
b) External economies
The adequate supply of economic and social overhead creates external
economies which reduces the private cost of production. The social, economic
overhead created by the government helps the growth of private business,
facilitating acquisition of inputs such as labour, raw material, skilled
labour.

GOVERNMENT RESPONSE TO MARKET FAILURE

Market failure refers to a market that fails to provide efficient outcomes

for the society. In other words, market works efficiently only when there
exist perfect competition or when exclusion principle could be applied in
the free market.
Exclusion principle requires that, those who do not pay for as goods should
be excluded from its consumption and those who derive any benefit from goods
should bear its cost. According to Pappas and Herschey "market failure can
be described as the failure of a system of market institutions to sustain
socially desirable activities or to eliminate undesirable ones."
In free market economy the main responsibility of the government is to
prevent the market from failure. Market failure can be summarized in two
ways:
1) Market failures due to incentive or incentive failure
2) Market failures due to structure or structure failure
1) Market failure due to incentive or incentive failure
The market failure due to the presence of externalities is known as
incentive failure. The free market mechanism does not function effectively
when exclusion principle is not applicable. Exclusion principle requires
that, those who do not pay for as goods should be excluded from its
consumption and those who derive any benefit from goods should bear its
cost.
But in the complex world there are many such goods and services where even
people do not use goods and services are bearing cost in terms of loss of
welfare, and even though people do not pay for the goods they are benefited
by the goods and services. Such situations are called externalities. The
market mechanism does not compensate or charge those who are affected by
externalities.

Thus, collective action is needed by the government to charge those benefit

from and compensate those who suffer from externalities. In order to prevent
the market from failure, government response to incentive failure in two
ways:
A) Consumption externality; and
B) Production externality
A) Consumption externality
In traditional economics, consumption is supposed to be independent, but in
reality, consumption of an individual is not independent. It is affected by
external environment. For Example: those who smoke in a bus reduce the
utility of those who do not smoke. Externalities may arise from either
consumption or production
Consumption externalities are of two kinds:
a) Positive externality in consumption; and
b) Negative externality in consumption.
a) Positive externality in Consumption
The consumption externality occurs if the welfare of the person is affected
by the consumption pattern of other person. In other words, if an individual
gets satisfaction with out incurring any cost. It is the case of positive
externality. For example when individual paint his house, it increases the
beauty of the whole society. Consumption decision of one, others receive
value without paying compensation.
b) Negative externality in consumption
An external diseconomy of consumption arises when the purchase and
consumption of goods or services results in disutility for people not
involved in the transaction. For example, when an individual use loud
speaker to listen the radio, it adversely affects the students who is
planned to appear an examination.
In both cases, there is difference between social cost and private cost. In
case of positive externality in consumption social value is grater than
private values. In case of negative externality in consumption social cost
is greater than private cost. The environment pollution is the glaring
example of negative externality. If firm discharge polluted water in the
river, swimming fishing comes to a halt. If the firm pulls water from the
river is not available to others. People bear the cost in terms of social
welfare without using the product or service. In this sense, government
charges compensate made to firm.
B) Production externalities
Production externality is also divided in the following two parts.
a) Positive externality in production; and
b) Negative externality in production.
a) Positive externality in production
An external economy of production arises when an increase in the firm's
production results in some benefit to society or another firm. As for

example construction of high way reduces the transportation cost of the

firm, the research conducted by government benefit all the firms etc, are
the positive externality in production. Other examples of positive
externalities in production are:
i)
ii)

Training program of on firm increases the supply of skilled labour

for all the firms.
If a person increases the apple trees the output of honey producers
automatically increases.

If we introduce the external economy, it reduces the cost of production, In

this time, quality production id OQ1 is greater than OQ, the output without
external economy.
PMC

SMC

Price

D
O

Q1

b) Negative externality in production

Negative externality in production arises when expansion of the firm's
production results in adverse effects (social cost) that are not paid for by
the firm and are therefore not reflected in the prices of its production.
For example:
i)
ii)

Price

iii)

The water pollution created by carpet industry cost on society

Factory vehicles produces air pollution and imposes cost in the
society
The factory car, plane, pollutes air by discharging smoke and
create noise pollution by creating loud noise
PMC
Y
SMC

D
O
Q Q1
X
When there are negative externalities PMC curve lies below SMC curve. i.e.
social cost is greater than private cost.
Government Responses in incentive failure
In order to prevent the market form failure, positive externalities should
be increased. Market does not have any mechanism to encourage such

activities. Government should take the following steps to prevent market

failure:
Grant patents; and
Provide operating subsidies
Patent
Patents are a government grant of exclusive right to produce, use or sell
and inventions or ideas for a specified period of time. They are essentially
a limited grant of legal monopoly power designed to encourage inventions and
innovation. Patents arose response to the fact that a firm which develops an
important technological breakthrough cannot begin to reap the full benefits
of its efforts if other firms can freely begin making the new product or
using the new production process without having to compensate the
originator. Without patent rights and protection, few firms would devote
resources to research, and the economy would obtain few of the benefits
which flow from such research efforts.
Advantages
i)
Patent is necessary incentive to induce the business firms to work more
and invest in new and creative projects.
ii)
The inventions are disclosed soon due to the patent act. Consequently,
since there is sooner dissemination of information, it facilitates other
inventions.
Disadvantages
i)
There are some perversions of the patent law that directly effects
competition. Controlling output, dividing markets, fixing prices are
some perversions due to patent right.
ii)
ii) Since patent system enables the inventors to get a great part of the
social benefit from their innovation although patent system is
ineffective. Thus it encourages imitations.
Government apathy leads to flower patent theft
More than 342 species of indigenous flowering plants grow in Nepal,
according to a survey made by Ministry of Forest and Land Conservation but
the government has not taken any initiative to register the patents of these
plants. The result is people from other countries come here and take away
Nepals plants and register those under their own countries patents.
Floriculture Association of Nepal (FAN) president Ghacchadar Karki said
there are more than 342 species identified but as they are yet to be
registered at the international level it is boosting patent theft.
We recently heard one of our local plants known as Jamuney Mandro has got
its patent registered by Japan. Actually, it is a rare plant grown in
Kathmandu Valley, said Karki.
It is useless to identify our local species if we fail to protect their
identity in our country.
He added that if the authorised bodies were active for patent registration
of plants available in our country, the floriculture business would have
bloomed to phenomenal proportions. The plants available in our forests can

be used through tissue culture for higher production. This can increase the
export of Nepals flowers, said Karki.
Though the country is rich in bio-diversity, the lack of government
initiative force FAN to import flowering and non-flowering plants from other
countries.
Huge quantities of flowering and non-flowering plants are imported from
Kalimpong and Kolkata while more than Rs. 1 million is spent on buying
motherplants of certain flowers from abroad, Karki said.
According to him, for festivals huge quantities of cut flowers are imported
from India during winter seasons while mother-plants are imported mainly
from Cambodia.
Investigations are still on about the number of species of flowering plants
and nonflowering plants available at high altitudes, according to the
Ministry of Forest and Land Conservation.
We need special package programmes such as priority for investments to
encourage the floriculture business in Nepal, and Karki.
Currently, there a number of nurseries involved in selling flowers that are
imported from other countries but not those which are available in the
countrys forests.
Exports of foreign plants cannot make us feel proud, at least not until we
are able to sell our own floral products in the international market, said
Karki.
There is also a number of non-flowering plants which if recognized can be
brought for business in the local market. According to Karki, about 75
percent of plants both flowering and non-flowering plants are imported from
foreign countries.
There are around 500 registered floriculturists under FAN but only 350 are
participating actively. There are around 600 flower farms and nurseries in
35 districts.
Around 4000 people are directly involved in floriculture while the number of
temporary workers getting employed during peak seasons is double that.
Subsidies
Government also responds to external economies of production by providing
subsidies to private business firms. These subsides can be indirect, as in
the case of government construction and maintenance of highways used by the
trucking industry. They can also take the form of such direct payments as
special tax treatments and governmentprovided low-cost financing.
Investments tax credits allowed for certain types of business investments
and the depletion allowances provided to promote resources extraction
industries are examples of tax subsides given in recognition of production
externalities which provide benefits to society. The external economies
associated with locating a major manufacturing facility in an industrial
park have given rise to local government financing of such facilities. The
low-cost financing is thought to provide compensation for the external
benefits provided.

Often market creates negative externalities. Government use taxes along with
direct operating requirement and controls to correct for the external
diseconomies in the market place.
Operating control
Just as government attempts to correct for the market failures associated
with external economies, it also works to remedy problems associated with
external diseconomies. One of the primary tools of government policy in this
area is the imposition of operating controls that limit the activities of
firms.
What kind of operating controls are imposed on business firms? Controls over
environmental pollution immediately come to mind, but businesses are also
subject to many other kinds of constraints. For example:
Federal legislation sets limits for automobiles safety standards; and firms
handling food products, drugs and other substances that could harm consumers
are constrained under various labour laws and health regulations: Included
are provisions related to noise levels, noxious gases and chemicals, and
safety standards.
Anti-discrimination laws designed to protect minority groups and women also
cause some firms to modify their hiring and promotional policies.
Wage and price controls, imposed at various times in the past in attempts to
reduce high rates of inflation, restrict the freedom of firms in setting
prices and affect the usage of resources throughout the economic system.
Numerous other constraints have been imposed on firms. Rather than attempt
to enumerate all of them, it will prove more useful to specify the value of
economic analysis in determining the impact of direct controls over the
activities of firms.
Operating right grant
Government exercises the following measures as operating right grant:
a) Government controls media such as radio, television broadcasting right to
provide quality services to the public.
b) Government
through
institutions.

central

bank

control

banking

and

financial

c) In order to get the operating right for higher secondary school and
college, firm must fulfil certain conditions such as minimum amount of
deposits, qualified faculty number physical facilities etc.
Tax policies
Taxes are used to control the negative externalities created by market. Tax
policies are designed to limit the undesirable activities of private firm.
Pollution taxes, effluent charges, fines etc are common examples of tax
policies. For example government fines to those who do not fallow the
traffic rules such as wearing of helmet wearing of safety belt etc.

STRUCTURE FAILURE
Competitive market benefits society by reducing the price and improving the
efficiency of resource allocation, thus, government's priority action should
be to enhance competition. There should be enough sellers and buyers in the
market to get the beneficial effect of competition or there should be at
least the possibility of the easy entry of new firms. If such condition is
not fulfilled, it is considered as the market failure due the market
structure. Depending on the nature of a particular industry, for example:
market of water, electricity, telephone, a monopoly or oligopoly may
develop, possibly resulting in too little production and excess profits.
Such condition is considered natural monopoly.
Natural Monopoly
In some industries, economies of scale operate (i.e. the long run average
cost curve may fall) continuously as output expands, so that a single firm
could supply the entire market more efficiently than any number of smaller
firms. Such large firm supplying the entire market is called natural
monopoly. Examples of natural monopolies are public utilities like
electricity,
gas,
water,
local
transportation
companies
etc.
The
characteristic of natural monopoly is:
that the firms' long-run average cost curve is still declining even the
firm supplies the entire market.
The monopoly is that, the natural result of such firm will have lower cost
per unit than other smaller firms. This will give the firm, market power to
drive the smaller firms out of the business.
To avoid this, governments usually exercises two methods for controlling
monopolistic situation:
a) Control over market structure
b) Direct control
a) Control over market structure
Anti-trust laws are design to decrease industrial
prevent collusion among oligopolistic firms.

concentration

and

to

Antitrust Law
In the late nineteenth century a movement toward industrial consolidation
developed in the United States. Industrial growth was rapid, and because of
economies of scale, an oligopolistic structure emerged in certain
industries. Pricing reactions became apparent to industry leaders, who
concluded that higher profits could be attained through cooperation rather
than through competition. As a result, voting trusts were formed, whereby
the voting rights to the stocks of the various firms in an industry were
turned over to a trust, which then managed the firm and sought to reach a
monopoly price/output solution. The oil and the tobacco trusts of the 1880s
are well-known examples.
Although profitable to the firms, the trusts were socially undesirable, and
public indignation resulted in the passage of the first significant

antitrust measure in 1890, the Sherman Act. Other important legislation

subsequently passed includes the Clayton Act (1914) and the Federal Trade
Commission Act (1914), the RobinsonPatman Act (1936), and the Celler AntiMerger
Act
(1950).
Each
of
these
acts
was
designed
to
prevent
anticompetitive actions, actions whose impact is more likely to reduce
competition than it is to lower costs by increasing operating efficiency. IN
this section we present a brief chronology of major antitrust legislation.
Sherman Act
The Sherman Act of 1890 was the first federal antitrust legislation. In
substance, it was brief and to the point. Section 1 forbade contracts,
combinations, or conspiracies in restraint of trade (then an offence at
common law), and Section 2 forbids monopolization. Both sections could be
enforced by civil courts decrees or by criminal proceedings, with the guilty
liable to fines or jail sentences.
Despite some landmark decisions against the tobacco, powder, and Standard
Oil trusts, enforcement proved to be sporadic. Moreover, the Sherman Act was
alleged to be too vague. On the one hand, business people claimed not to
know what was illegal; on the other, it was widely felt that the Justice
Department was ignorant of monopoly-creating practices and did not bring
suit against them until it was too late and monopoly was a fait accompli.
In 1974 the Sherman Act was amended to make violations felonies rather than
misdemeanours. That statue also increased the maximum penalties that could
be levied. Instead of $50,000 against a corporation and $50,000 and one year
in prison against an individual, the act now provides for $1,000,000 maximum
fines against corporations and up to $1,000,000 fines and three years
imprisonment for individuals. In addition to the criminal fines and prison
sentences, firms and individuals violating the Sherman Act face the
possibility of triple-damage civil suits from those injured by the antitrust
violation.
Despite its shortcomings, the Sherman Act remains one of the government's
main weapons against anticompetitive behaviour. IN February of 1978 a
federal judge imposed some of the stiffest penalties in the history of U.S.
anti trust actions o eight firms and eleven of their officers who were
convicted of violating the Sherman Act. These convictions for price fixing
in the electrical wiring devices industries resulted in fines totalling
nearly $900,000 and jail terms for nine of the eleven officers charged.
Clayton Act and Federal Trade Commission Act
Congress passed two measures in 1974 that were designed to further overcome
weakness in the Sherman Act the Clayton Act and the Federal Trade
Commission (FTC) Act. The principal features of these are summarized below.
Enforcement
The Federal Trade Commission Act established and funded
the FTC for the expressed purpose of initiating actions to prevent and
punish antitrust violations.
Mergers
Voting trusts that lessened competition were prohibited by the
Sherman Act, but interpretation of the act did not always prevent on
corporation form acquiring the stock of other, competing firms and then
merging them into itself. Section 7 of the Clayton Act prohibited such
mergers if they were found to reduce competition. Either the Anti-trust
Division of the Justice Department or the FTC can bring suit under Section

7, or mergers can be prevented. IF they have been consummated prior to the

suit, divestment can be ordered.
Interlocking Directorates
The Clayton Act also prevented individuals
form serving on the boards of directors of two competing companies. Two socalled competitors having common directors would obviously not compete very
hard.
Price Discrimination
The Clayton Act made it illegal for a seller to
discriminate prices between its customers (1) unless cost differentials in
serving the various customers justified the price differentials or (2)
unless the lower prices charged in certain markets were offered to meet
competition in the area. The primary concern was that a strong regional or
nation firm might employ selective price cuts in local markets to eliminate
weak firms. Once the competitors in one market were eliminated, monopoly
prices would be charged in the area and the excessive profits could be used
to subsidize cut throat competition in other areas.
Typing Contracts and Related Arrangements
A
firm,
particularly
one
with the patent on a vital process or a monopoly on a natural resource, con
use licensing or other arrangements to restrict competition. One such
procedure is the typing contract, through which a firm ties the acquisition
of one item to an agreement to purchase other items. For example, the
International Business Machines Corporation for many years refused to sell
its business machines. If rented these machines to customers who were
required to buy IBM punch cards and related materials as well as machines
maintenance from the company. This clearly had the effect of reducing
competition in the maintenance and service industry, as well as in the punch
card and related products industry. After the IBM lease agreement was
declared illegal under the Clayton Act, the company was forced to offer its
machines for sale and to cease leasing arrangements that tied firms to
agreements to purchase other IBM materials and services.
IBM Case Study
In 1969, the Justice Department filed suit against IMB under section 2 of
the Sherman Act for monopolizing the computer market, for using exclusive
and trying contracts, and for selling new equipments at below costs. The
government sought the dissolution of IBM. After 13 years of litigation, more
than 104,000 trials transcript pages, $26 million cost to the government
cost to the government (and $300 million incurred by IBM to defend itself),
however, the Justice Department dropped its suit against IBM in 1982. The
reason that the government decided to drop its case against IBM was that
rapid technological change, increased competition in the field of computers,
and changed marketing methods since the filing of the suit had so weakened
the government's case that the Justice Department felt it could not win. IN
1995, IBM was a struggling giant in a highly competitive market rather than
the near monopolist it had been accused of being in 1969. It was only in the
second half of the 1990s that IBM seemed to find its way again.
The Microsoft Antitrust Case
In fall 1998, the U.S. Justice Department sued Microsoft, the world's
largest software company, accusing it of illegally using its Window
operating system near monopoly to overwhelm rivals and hurt consumers.
Specifically, the government accused Microsoft of merging its Web browser
into its Windows operating system in order to crush Netscape Communication
Corporation, its chief competitor in the browser business. By bundling the
browser with Windows and using exclusionary contracts to prevent personal

computer makers form hiding or removing the Microsoft browser, Microsoft

prevented consumers from using rival browsers (particularly Netscape's) and
also discouraged systems other than Windows. Furthermore, the government
accused Microsoft of conducting a campaign to curtail other potential
threats form Intel, Sun Micro system, Apple Computer, and IBM that enabled
Microsoft to extend its power to other areas, such as computer servers and
Internet protocols, thus causing substantial and far-reaching harm to
consumers by stifling competition and innovation in the software industry.
The accusation were backed in court by oral testimonies of 26 witnesses, as
well as thousands of exhibits, including numerous e-mail messages and other
internal corporate records form the previous five years.
Microsoft's response was that the government's case was based on fiction and
fantasy. Microsoft said that no company could have a monopoly in the fast
moving, intensely competitive PC and Internet business and that it faces
many competitive threats from the market place. According to Microsoft,
bundling its Web browser in Windows improved the operating system and
lowered prices to consumers and, in any event, consumers had ample choices,
not least of all from Netscape, which distributed millions of copies of its
browser Navigator during 1998. According to Microsoft, America Online's
purchase of Netscape in early 1999 could restore Netscape to a leading
position in the browser business. The government responds that Microsoft's
illegal actions shattered Netscape's browser business and that AOL had
acquired Netscape mostly for its Internet "portal" site and its server and
e-business products.
On April 4, 2000, the federal district judge trying the case ruled that
Microsoft had violated antitrust laws with predatory behaviour and would
impose penalties and remedial action. There are three possible courses of
remedial action if the judges find Microsoft guilty. The weakest punishment
would be simply to forbid Microsoft from engaging in the future in exclusive
dealings with providers of services on the Internet, and nothing more. This
is possible in view of the fact that Professor Stanley Fisher, the
government's leading economic expert form MIT, stated in court that
consumers "had not suffered any harm form Microsoft's actions to date." The
second option would be to force Microsoft to license Windows to other
companies, which could develop it and sell it in competition with Microsoft.
The most drastic remedy would be to break up Microsoft into two companies
(along the lines of the AT&T decision of 1982), with a company controlling
Windows and another selling its applications products, including the popular
Microsoft Office suite of business software. The Windows Company could
develop its own applications business, and the applications company could
join a rival operating software company and pose a much stronger challenge
to Windows than existing competitors can
b) Direct control
Public utility regulation, which fixes prices at levels designed to prevent
firms from earning monopolistic profit.
Public Utility regulation
According to Lewis and Peterson public utility seems to have two general
features:
i)

The industry provides a product or service of particular importance

either the day to day livelihood or the future growth.

ii)

The nature of the production process is such that competition is seem as

yielding undesirable result such as duplication of facilities.

The
most
common
method
of
monopoly
regulation
is
through
price
control/regulation. The regulated price is such that monopoly recovers its
fixed and variable cost plus an allowed return on investment. The government
exercises price control mechanism for the following results:
Sales volume of the product would increase compare to unrestricted
monopoly condition.
Reduction of the profit of the firm
Level of rate of return on owner's investment will reduce.
The actual output, however, will be determined by the actual demand at the
price set by the regulatory commission.
In order to restrict the firm to operate in an unconstrained monopolist
condition, government/policy maker can exercise several alternatives. Some
alternatives are discussed below:
a) Price at marginal cost;
b) Compromise solution; and
c) Undue price discrimination
Price at marginal cost
One of the measures to control monopoly price is by fixing the price of the
product. In this method, policy makers lets the firms maintain the existing
monopoly position and make them fix price equal to marginal cost. But, for
retaining price level at marginal cost for long time government should
either compensate for loss or provide subsidy to the firm. This situation
can be explained with the help of figure below:

The existence of natural monopoly poses something of a dilemma fro public

policy. One alternative is to let the firm operate as a monopoly. If the
firm faced the

demand curve DD, as shown in the Figure, the monopoly price would be P M and
the quantity, QM. The firm would then earn economic profit, as indicated by
the area of the rectangle PMABC. Compared to marginal cost pricing (i.e.,
setting the price equal to marginal cost), the monopoly pricing scheme would
result in a deadweight loss and also transfer of consumer surplus form
consumers to producers.
If the firm is allow maintaining its monopoly position but regulated to set
the price at marginal cost, it would result in a price of PC and a quantity
of QC. At this level of production there is no deadweight loss because
production is increased until the cost of producing the last unit is equal
to the value of that unit. There is also no transfer of surplus form
consumers to producers. In fact, the problem is quite the reverse. Because
the monopolist is producing in a region of decreasing cost, its marginal
cost is less than its average cost. Being required at marginal cost, the
monopolist is unable to earn a normal return on capital. This is easily seen
by observing that at the output rate QC, the average revenue as shown by the
demand curve is less than the average cost.
Compromise Solution
The most common method for pricing the products of a natural monopoly is the
compromise solution. The nature of the compromise is depicted by the above
figure. A simple description of public utility price regulation is that
price is set equal to average cost. That is, the firm is allowed to charge a
price that allows it to earn no more than a normal return on its capital.
This is shown in the figure by the price, PR, and the quantity, QR. The
regulatory approach is compromise because the price is less than if the firm
were allowed to act as a monopolist. Because the firm earns a normal profit,
there is no need for the subsidy that would be required with marginal cost
pricing. Thus, this mechanism achieves some of the gains form marginal cost
pricing without requiring a subsidy.
Undue Price discrimination
Price discrimination occurs when consumers are charged different prices for
a product and the differences in price cannot be accounted for by cost
differentials. The three requirements for successful price discrimination
are:
that consumers have different demand elasticity,
that markets be separable, and
that the firm has some power over price.
The
telephone
industry
provides
an
example
of
successful
price
discrimination policies by a public utility. Rates for basic telephone
services are higher for business users than they are for residential users.
There is no particular reason to assume that the cost of installing and
maintaining a phone in an office is different form putting one in a kitchen.
There are, however, possible differences in demand elasticity for business
versus home phone customers. Consider the case of a stockbroker. The vast
majority of orders for the purchase or sale of stock come to the broker by
phone. There is no way the business could be conducted without a phone. In
contrast, if there is a neighbour's phone that can be used in an emergency,
it is quite possible to get along without a telephone in one's home. In
economic terms, the stockbroker is said to have more inelastic demand for
telephone service than does the residential customer.

The other conditions for price discrimination are also met in the telephone
industry. Because there is a physical connection between the customer and
the phone company, there is no way low-cost home telephone service can be
resold to a business customer. Also, is the stockbroker does not
interconnect with the local phone company; there is no practical way to have
access to customers calling in orders.
The consequence of price discrimination provides an argument for regulation.
Perhaps government should intervene to protect the commercial user from an
unfair situation. The issue is not one of efficiency, but of fairness. The
presumption is that the monopolist should not be allowed to use its power to
unduly discriminate against some consumers. Although some discrimination may
be acceptable, government intervention may be necessary when that
discrimination becomes excessive. There is no clear definition of the
distinction between due and undue discrimination. In the end, undue price
discrimination is whatever the regulatory commissions or the courts
determine it to be.

Problems of Direct Regulation

a) Uncertainty
Although the concept of price regulation is simple, serious problem exist in
its application to actual regulation of public utilities. First, it is
impossible to determine exactly the cost and the demand scheduled, as well
as the asset base necessary to support a specified level of output.
Utilities also serve several classes of customers, which means that a number
of different demand scheduled with varying price elasticity are involved;
therefore, any number of different rate schedules can be used to produce the
desired profit level. If telephone company profits are too low, should rates
be raised on local calls or on long distance calls? If electric utilities
need more profits, should industrial, commercial, or residential users bear
the burden? An appeal to cost considerations for a solution to this problem
of no avail, because all the services mentioned are joined products, a
factor that makes it extremely difficult, if not impossible, to separate
costs and allocate them to specific classes of customers.
b) Optimal Output
A second problem with price regulation is that regulators can make mistakes
with regards to the optimal output, growth, and service levels. For example,
a telephone utility is permitted to charge excessively high rates, more
funds will be allocated to system expansion, and communication services will
grow at a faster than optimal rate. Similarly, if prices allowed to natural
gas producers are too low, consumers will be encouraged to use gas at a high
rate, producers will not seek new gas supplies, and a shortage of gas will
occur. Too low price structure for electricity will likewise encourage the
use of power but discourage the additional of new generating equipment.
c) Inefficiency
Price regulation can also lead to inefficiency. If the regulated companies
are guaranteed a minimum return on their invested capital, then, provided
demand conditions permit, operating inefficiencies can be offset by higher
prices. This is illustrated in the figure below:

A regulated utility faces the demand curve AR and the marginal revenue curve
MR. If the utility operates at peak efficiency, the average cost curves AC1
will apply. At a regulated price P1, Q1 units will be demanded; cost per unit
will be C1; and profits equal to the rectangle P1P1"C1"C1 will be earned. These
profits are, lets us assume, just sufficient to provide a reasonable return
on invested capital.
Now assume that another company, one with less capable managers, is
operating under similar conditions. Because this management is less
efficient than that of the first company, its cost curve is represented by
AC2. If its price is set at P 1, it too will sell Q1 units, but its average
cost will be C2; its profits will be only P1P1"C 2"C2; and the company will be
earning less than a reasonable rate of return. In the absence of regulation,
inefficiency and low profits go together, but under regulation the
inefficient company can request - and probably be granted - a rate increase
to P2. Here it can sell Q2 units of output, incur an average cost of C3 per
unit, and earn profits of P2P2"C3"C3, resulting in a rate of return on
investment approximately equal to that of the efficient company. We see,
then, that regulation can reduce if not eliminate the profit incentive for
efficiency.
Investment Levels
A fourth problem with regulation is that it can lead to over investment or
under investment in fixed assets. The allowed profits are calculated as a
percentage of the rate base, which is approximately equal to fixed assets.
If the allowed rate of return exceeds the cost of capital, it will benefit
the firm to expand fixed assets and to shift to capital intensive methods
of production. Conversely, if the allowed rate of return is less than the
cost of capital; the firm will not expand capacity rapidly enough and will
produce by methods that require relatively little capital. This is related
to the issue of determining the optimal output, growth, and service levels
discussed above.
Regulatory Lag and Political Problems
A related problem is that of regulatory lag, which is defined as the period
between the times it is recognized that a price increases (or decrease) is
appropriate and the effective date of the price change. Because of the often

lengthy legal proceedings involved in these price change decisions, long

periods can pass between the times when they are implemented.
The problem of regulatory lag is particularly acute during periods of
rapidly rising prices. During the late 1960s and the 1970s, for example,
inflationary pressures exerted a constant upward thrust on coasts. If normal
profits and a fair rate of return on capital are to be maintained in such a
time, expeditious price increases have to be implemented.
However, public utility commissioners are either political appointees or
elected officials, and either those who appoint them or the commissioners
themselves must periodically stand for election. Further, most voters are
consumers of utility services and naturally dislike price increases, whether
these increases are justified or not. Unlike consumers of unregulated goods
and services, however, utility customers can do exert great pressure on
public utility commissioners to deny or at least delay rate increases.
Cost of Regulation
By this time the sixth problem with price regulation should be obvious. A
great deal of careful and costly analysis must be conducted before
regulatory decisions can be made. Maintaining public utility commission
staffs is expensive, but an even more important cost element maintaining
required records and processing rate cases is borne directly by the
company. Ultimately activities are borne by consumers.
It should be pointed out that we emphatically favour utility regulation.
Indeed, we can see no other reasonable alternative to such regulation for
electric, gas telephone, and private water companies. If is clear, however,
that serious problems arise form efforts to regulate industry through price
determination. The market system, if competition is present, is a much more
efficient allocator of goods and services, and it is for this reason that
efforts are made to maintain a workable level of competition in the economy.

Regulation of Environmental Pollution

Having argued in general that there is a role for government when
externalities distort the workings of competitive markets, we now turn to
the most persuasive example-the problem of what to do in the face of
environment pollution.
Many of our streams and lakes have historically served as depositories of
chemical waste generated by industrial plants and mines. Some are cleaner
now, but many still suffer damage form earlier discharges of chemicals, like
PCBs whose "half-lives" are measured in hundreds of years. Many pesticides,
fertilizers, and detergents used by farms and homes find their way into our
lakes and waterways, where they have damaged commercial and recreational
fishing. Automobiles are primary source of many air pollutants. The residue
of their emission can foul both the air that we breathe and the land located
close to the road that we drive on. Factories generate particles of various
kinds, often through the combustion of fossil fuels; these pollute the air
and fall onto the ground-both near and far. Some of our pollution has even
been shown to cause damage on a global scale. production and emission of
chlorofluorocarbons has damaged the ozone layer and exposed much of the
planet to increased ultraviolet (UV-B) radiation from the sun; the emission
of carbon dioxide and other greenhouse gases has begun to warm the planet at
rates that many find alarming.

Why does our economy tolerate any pollution of the environment? We now know
that an externality occurs when one person (or firm's) use or abuse of a
resource damages other people who cannot obtain proper compensation. When
this occurs, a competitive economy is unlikely to function properly. For
market prices to produce an efficient allocation of resources, it is
necessary that the full cost of using each resource be borne by the person
or a firm that uses it. If this is not the case, so that the user bears only
part of the full costs, then the resource is not likely to be directed by
the price system into the socially optimal use. And why do people use
resources like the environment? This is because; pollution is a byproduct of
activities that add to their welfare. These activities bring economic gain
to producers and utility gain to consumers. We do not pollute the planet
just for fun; we do it as part of activities that improve our welfare. The
economist's view of this is that pollution creates another trade-off of cost
and benefit that must be weighed on a case by case basis.
Resources are used most efficiently in a perfectly competitive economy
because they are allocated to the people and firms that find it worthwhile
to bid the most for them. Underlying this scheme is the notion that the
resulting prices of all resources would reflect their true social costs.
Suppose, however, that the presence of external diseconomies made it
possible that people and firms did not pay the true social cost for certain
resources. Suppose that some firms or people were using water or air for
free even though other firms or people were incurring some cost from this
use. Suppose, to be quite specific, that some firms were polluting the air
or water and those others were suffering economic losses as a result. In
this case, the private costs of using air and water would vary form the
social costs. The prices paid by the user of water and air would be guided
in their decisions by the private costs of water and air-costs that would be
reflected by the prices that they had to pay. Faced with this difference
between private and social cost, these firms would "use" too much air and
water form society point of view, because the prices that they would pay for
air and water would be too low.
Note that the divergence between private and social costs occurs if and only
if the use of water or air by one firm or person imposes costs on other
firms or other people. A paper mill that uses water and then restores it to
its original quality would not be responsible for creating a divergence
between private and social costs; it would be paying the full social cost of
using the water in the (presumably minimum) cost of running the restoration
process. But if the same mill dumped untreated wastes into a stream so that
firms and towns downstream had to pay to restore the quality of the water,
then it would be responsible for creating a divergence between private and
social costs. The same is true of air pollution. If an electric power plant
used the atmosphere as a cheap and convenient place to dispose of waste but
people living and working nearby incurred some cost (including poorer health
and the more frequent need to paint their houses) as a result, then there
would be a divergence between private and social costs.
Efficient Pollution Control
Any industry should, in general, be able to vary the
that it generates at each level of output, especially
representative firm may, for example, install pollution
scrubbers or electrostatic precipitators to reduce the
that it generates at each level of output.

amount
in the
control
amount

of pollution
long run. A
devices like
of pollution

The figure below shows why, untreated waste of the industry dumps into the
environment increase the level of total social costs. The figure also shows
the costs of pollution control at each level of discharge of the industry's
wastes. Just as clearly, the more the industry cuts down on the amount of
wastes it discharges, the higher are its costs of pollution control. In
addition, the figure shows the sum of these two costs-the cost of pollution
and the cost of pollution control-at each level of discharge of the
industry's wastes.

Form the point of view of society as a whole, the industry should reduce its
discharge of pollution to the point where the sum of these costs is
minimized. Specifically, the efficient level of pollution in the industry is
R in the Figure A Why? Because increasing pollution from a level lower than
R would improve social welfare. Discharging one more unit of pollution would
increase the cost of pollution, but it would reduce the cost of pollution
control by more. Reducing pollution from a level higher than R would also
improve welfare. In this case, discharge one fewer unit of pollution would
increase the cost of pollution control, but it would reduce the cost of
pollution by more.
To make this more evident, curve AA' in Figure B shows the marginal cost of
an extra unit of discharge of waste at each level. Curve BB' in Figure B
also shows the marginal cost of reducing the industry's discharge of waste
by 1 unit. The economically efficient level of pollution for the industry
occurs at the point where the two curves intersect. At this point, the cost
of an extra unit of pollution would just equal the extra cost of reducing
pollution by an extra unit. Regardless of whether we look at Figure A or
Figure B, the answer is the same: R is the economically efficient level of
pollution.

Earlier we observed that the efficient level of pollution is generally not

zero. It should now be clear why this is true. The costs of reducing
pollution can exceed the associated benefits if control is pushed beyond a
certain point. In Figures A and B, this point is reached when pollution is
limited to R. But, could the efficient level of pollution be zero? Sure.
Zero would be the right answer if the pollutant were so damaging that the
marginal cost of even the first unit released into the environment exceeded
the marginal cost of not allowing its release. Graphically, zero could be
efficient in Figure B if marginal-cost curve AA' started form a point on the
vertical axis that was higher than S (indicating that the cost of pollution
would increase faster form zero that the cost of pollution control would
fall).

Direct Regulation, Effluent Fees, and Transferable Emission Permits

Left to its own devices, the industry in Figure B would not necessarily
reduce its pollution level to R. Why? This is because; it would not
necessarily pay all of the social costs of its pollution. Indeed, if the
industry paid no private cost for its pollution, then it would emit T unitsthe quantity for which the marginal cost of control would equal zero. This,
of course, is the heart of the problem. How can the government establish
incentives that would lead industries to choose the efficient amount of
pollution control in their own best interest, even if they do not face all
the social costs of residual emissions?
Direct regulation of polluting activity (i.e., setting a legal limit for
pollution) frequently comes to mind. The government could, for example,
simply limit the industry's pollution to R units by decree. Direct
regulation of this sort was popular in the United States shortly after the
passage of the first Clean Air Act in the 1970s. The decree were generally
associated with definitions of the "best available technologies" for
pollution control, but they were criticized frequently for being too rigid
to accommodate efficiently the changing landscape of modern industry and the
diversity of the suppliers of modern markets.

Effluent fees offer governments a second approach to pollution control. An

effluent fee is a unit price that a polluter must pay to the government for
discharging waste. The idea behind the imposition is that they can bring the
marginal private cost of polluting faced by firms closer to the true
marginal social cost of their emissions. In Figure B, for example, an
effluent fee of E per unit of pollution discharge might be charged. If it
were, then the (private) marginal cost of an additional unit of pollution
discharge to the industry would be E, and so the industry would cut back its
pollution so long as the marginal cost of reducing pollution by a unit were
less than E. As you can see form Figure B, marginal cost falls short of E as
long as the pollution discharge exceeds R. To maximize their profits,
therefore, the firms in the industry would reduce pollution to R units.
Effluent fees often have one major advantage over direct regulation. It is,
of course, socially desirable to use the cheapest way to achieve any given
reduction in pollution, and a system of effluent fees is more likely to
accomplish this result than direct regulation. To see why, first consider a
particular polluter facing an effluent charge. It would find it profitable
to reduce its discharge of waste to the point where the (marginal) cost of
reducing its emissions by 1 unit equalled the fee. The effluent fee would be
the same for all polluters. And it is a simple matter to show that the total
cost of achieving the corresponding reduction in total emissions across all
of the polluters would thereby be minimized. To that end, suppose that the
cost of reduction waste discharges by an additional unit were not the same
for all polluters (as might be the case if they were given individual
quantity limits). The cost of achieving the same amount of total pollution
control could then be reduced by allowing polluters whose marginal control
costs were high to increase their emissions (and lower their marginal
control costs) while encouraging polluters whose marginal control costs were
low to reduce theirs (by and equal amount).
Effluent fees do not however, guarantee the same constant level of total
emissions that could be expected if a set of individual quantity limits were
issued. Why not? Because firms will pay for the right to more or less
pollution as they increase or decrease their outputs. So, although direct
regulation would restrict total emissions regardless of business conditions,
and equivalent effluent fee could, at best, guarantee that the expected
value of equivalent effluent fee could, at best, guarantee that the expected
value of total emission s over along period of time would correspond to the
same total. Variation in the level of total pollution can be harmful in some
cases, and not in others. The point here is that preference for effluent
fees is not quite so clear-cut when the reality of uncertainty is brought to
bear on the discussions.
Governments have recently learned that they can work the trade-off between
the certainty of direct regulation and the efficiency of effluent charges by
issuing a fixed number of transferable emission permits-permits that allow
the holder to generate a certain amount of pollution. The total number of
permits can be limited, so that total pollution can be held below any
targeted level. The economically efficient amount might be the pollution
target, but there could be others (especially if it was difficult to collect
the information necessary to identify the efficient level or if there were
an emissions threshold beyond which damage would be severe). In any case,
allowing permits to be bought and sold would mean that firms whose marginal
control costs were high would probably try to buy some (so that they could
increase their emissions) and firms whose marginal control costs were low
would try to sell some (and make money even though they would have to reduce

their emissions). In fact, the market would work to bring the marginal cost
of pollution control at each firm equal to the market price of permits, and
so to would bring the marginal cost of pollution control at every firm in
line with the marginal cost at every other firm. Notice that this is exactly
the condition for minimizing the cost of holding total emissions to a
particular level.
Transferable Emission Permits
Government have recently learned that they can work the trade-off between
the certainty of direct regulation and the efficiency of effluent charges by
issuing a fixed number of transferable emissions permits permits that
allow the holder to generate a certain amount of pollution. The total number
of permits can be limited, so that total pollution can be held below any
targeted level. The economically efficient amount might be the pollution
target, but there could be others (especially if it were difficult to
collect the information necessary to identify the efficient level or it
there were an emissions threshold beyond which damage would be severe). In
any case, allowing permits to be bought and sold would mean that firms whose
marginal control costs were high would probably try to but some (so that
they could their emissions) and firms whose marginal control costs were low
would try to sell some (and make money even thought they would have to
reduce their emissions). In fact, the market would work to bring the
marginal cost of pollution control at each firm equal to the market price of
permits, and so it would bring the marginal cost of pollution control at
every form in line with the marginal cost at every other firm. Notice that
this is exactly the condition for minimizing the cost of holding total
emissions to a particular level.

Unit 3. Macro Economic Concept and Policies

(a) Keynesianism Vs Menetarism

Keynesianism emphasises the role that fiscal policy can play in stabilising
the economy. In particular Keynesian theory suggests that higher government
spending in a recession can help the economy recover quicker. Keynesians say
it is a mistake to wait for markets to clear like classical economic theory
suggests.
Monetarism emphasises the importance of controlling the money supply to
control inflation. Monetarists are generally critical of expansionary fiscal
policy arguing that it will cause just inflation or crowding out and
therefore not help.
Principles of Keynesianism
In a recession / liquidity trap, government intervention can stimulate
aggregate demand and real output through government borrowing and
higher government spending. Therefore Keynesians advocate expansionary
fiscal policy in a recession.
Keynesians reject the theory of crowding out presented by Monetarists.
Keynesians say that if there is a sharp rise in private sector
borrowing, government spending can offset this decline in spending.
Paradox of thrift. A key element in Keynesian theory is the idea of a
glut in savings. Keynes argued in a recession, people responded to
the threat of unemployment by increasing saving and reducing their
spending. This was a rational choice, but it contributes to an even
bigger decline in AD and GDP.

Keynesians usually believe there is a degree of wage rigidity. In a

recession, Keynes said wages may be sticky downward as unions resist
nominal wage cuts, this can lead to real wage unemployment. Also, in a
recession, when an economy has spare capacity, increasing Aggregate
demand will have an impact on real output and only minimal effect on
the price level.
Keynesians believe there is often a multiplier effect. This means an
initial injection into the circular flow can lead to a bigger final
increase in real GDP.
Generally, Keynesians are more likely to stress the importance of
reducing unemployment rather than inflation.
Keynesians reject real business cycle theories (an idea that the
government can have no influence over the economic cycle)

Monetarism
Monetarists more critical of ability of fiscal policy to stimulate
growth in real GDP.
Monetarists / classical economists believe wages are more flexible
and likely to adjust downwards to prevent real wage unemployment
Monetarists stress the importance of controlling the money supply to
keep inflation low.
Monetarists more likely to place emphasis on reducing inflation than
keeping unemployment low.
Monetarists stress the role of the natural rate of unemployment
(supply side unemployment)
Convergence of Keynesianism and Monetarism.
The distinction between Keynesian and monetarists positions is a bit more
blurred. For example, many Keynesian economists have taken on board ideas
of a natural rate of unemployment, in addition to demand deficient
unemployment. New Classical economists are more likely to accept ideas of
rigidities in prices and wages.

(b) Saving-Investment Theory

Saving is the part of personal income that is neither consumed nor paid out
in taxes.
The income saved is canalise to business firms in two different ways.
(I)
Households buy bonds and stocks issued by business firms, and the
firms then use the money to buy investment goods.
(II) Households deposit saving into the banks. The banks then lend the
money to the firms, which use it to buy investment goods.
Investment is the portion of final products that adds to the nation's stock
of income yielding physical assets or that replaces old, worn-out physical
assets.
Final goods that business firms keep for themselves are called private
investment or private capital formation. Private investment consists of
inventory investment and fixed investment.
(I)
Inventory investment means goods purchased by the business firms
but not resold to consumers in the current period, stays in the
stock raise the level of inventories. Inventories of raw materials,

(II)

parts and finished goods are essential forms of income yielding

assets for business.
Fixed investment includes all final goods purchased by business
firms other than addition to inventory. It includes all final goods
purchased by business firms that are not intended to resale. The
main types of fixed investment (investment on capital goods) are
structures (factories, office building, plants and machinery).

Saving Investment Theory

First of all coined by Thomas Tooke in 1844.

Further explained by classical economist who believe on monetarism.
This theory is also called as Income Theory
Elaborate and explained by J. M. Keynes in the name of SavingInvestment Theory
The major objective of this theory is to explain the changes in price
level or the value of money

Classical View/Thought
The classical view states that the economy is always at full-employment
equilibrium.
This theory is termed as Income Theory.
The saving and investment are always equal. The classical economists believe
that equality between saving and investment brought by interest rate.
When, saving exceeds investment, the rate of interest falls to discourage
saving and encourage investment and vice versa.

Effect on price:
Price = AY/AO

Where, AY= Aggregate Income And AO=Aggregate Output

If AY>AO, Price increase

If AY<AO, Price decrease
Therefore, the major cause of change in price is money income or money
supply or the interest rate in the economy.

Keynes disagree with equilibrium of saving and investment is brought

by the rates of interest rather, it is the changes in the level of
income which play a role in equalization of saving and investment.
Equilibrium (S=I) below full employment in the economy.
Keynes established this equality by using the economy's equilibrium
situation, the economy is said to be in equilibrium when aggregate
expenditure ( AE) is equal to income of the economy. That is, Y = AE
or AD = f(Y)
Effect on price:
If factor of production/resources constraint, increase in price
If no constraint, price level remains same
Therefore, the major cause of change in AD is income rather than
interest rate.
Assuming two sector model, aggregate expenditure equals to consumption
plus investment (I), AE = C + I and national income (Y) equals to
consumption plus saving (S). This gives saving (S) equals to
Investment (I), i.e., S = I.
Equilibrium situation is the situation where S=I.
From income perspective, Y = C + S .(1)
From expenditure perspective, Y = C + I (2)
So that S = I i.e. state of equilibrium

The changes in Y makes S = I

If I>S, Y increases unless S=I, leads to increase in price. (when I+,

Y also +)
If I<S, Y decreases unless S=I, leads to decrease in price. (when I-,
Y also -)
Note: The state of disequilibrium in the economy does not last long

Price Effect:

When investment is greater than saving, the level of income will also
be increased by multiplier process. This causes to rise saving and
equality between then takes place.

Similarly, when saving is greater than investment opposite will occur,

i.e. level of income will decrease which causes saving to decrease.

The equality between saving and investment can exist at below full
employment level.

Saving-Investment theory explains the disequilibrium between saving

and investment causes fluctuation in price or the value of money by
affecting the level of income. If saving and investment are equal, the
price level is stable.

If the saving exceeds investment price level falls and if investment

exceeds saving, price level increases.

Thus, the price level is the consequence of the change in income

rather than the quantity of money