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Unit I

Development economics or the economics of development is the application of economic
analysis to the understanding of the economies of developing countries in Africa, Asia,
and Latin America.
It is the sub discipline of economics that deals with the study of the processes that create or
prevent economic development or that result in the improvement of incomes, human
welfare, and structural transformation from a predominantly agricultural to a more
advanced industrial economy.
The subfield of development economics was born in the 1940s and 1950s but only became
firmly entrenched following the awarding of the Nobel Prize to W. Arthur Lewis and
Theodore W. Schultz in 1979. Lewis provided the impetus for and was a prime mover in
creating the sub discipline of development economics.
As a subfield concerned with "how standards of living in the population are determined and how
they change over time" (Stern), and how policy can or should be used to influence these
processes, development economics cannot be considered independently of the historical,
political, environmental, and socio cultural dimensions of the human experience. Hence
development economics is a study of the multidimensional process involving acceleration of
economic growth, the reduction of inequality, the eradication of poverty, as well as major
changes in economic and social structures, popular attitudes, and national institutions.
Development economics covers a variety of issues, ranging from peasant agriculture to
international finance, and touches on virtually every branch in economics: micro and macro,
labor, industrial organization, public finance, resource economics, money and banking, economic
growth, international trade, etc., as well as branches in history, sociology, and political science. It
deals with the economic, social, political, and institutional framework in which economic
development takes place.

The study of economic development has been driven by theories of economic

development, which have developed along the lines of the classical ideas, the Marxist
idea, or a combination of both.
Some approaches have focused on the internal causes of development or
underdevelopment, while others have focused on external causes.
Economic growth increase in output and income has been used as a substitute for
development and, in some cases, has been treated as synonymous with development.
Economic growth and economic development have been mostly studied by means of
cross-country econometric analysis.


Scarcity, choice and the basic economic problem

Opportunity costs, allocation of resources
Production possibility curve and productive efficiency
Positive and normative statements, Economic models.
Markets versus planning, free-market system, command economy

Scarcity, choice and the basic economic problem

Inflation, unemployment, pollution, energy shortages and government deficits are some
of the complex problems confronting an economy, which have an impact at the micro
level also. These problems arise due to the fact that resources are limited while human
wants are unlimited.

This leads to dissatisfaction, causing human being to look for ways to fulfill their needs.
Thus scarcity leads to the necessity of making choices. Problems of choice arise at all
levels - at the level of the individual, at the level of producers, and at the level of the
overall economy.

Scarcity results when natural resources, human resources and capital resources are not
available in sufficient quantity to satisfy all wants. So a producer has to decide what he
wants to produce using a particular resource.

For example, if he chooses to produce paper for textbooks from a stand of trees, then no
other product can be produced from that particular stand of trees. Yet, there are many
other products that could have been produced using the same natural resource, which are
also desired by consumers.

The opportunity cost of the decision thus becomes an important consideration; by making
a choice, the next best alternative good cannot be produced.

Consumers typically make their decisions based on two considerations- budget

constraints and personal preferences. A budget constraint is the difficulty a person faces
when he tries to satisfy his unlimited wants with a limited income.

Thus, a purchase decision is based on income, price, and personal tastes and preferences.
A consumer can have a choice of alternative products with a limited income if he can
find a person with whom he can exchange goods or services.
By means of such exchanges, he can increase his level of satisfaction. Such gains in
satisfaction can be termed as gains from trade.

Opportunity costs, allocation of resources

Opportunity cost can be defined as the cost of any decision measured in terms of the next
best alternative, which has been sacrificed. To illustrate the concept better, let us assume that a
person who has Rs. 100 at his disposal can spend it on any of the three options: having a dinner
at a restaurant, going for a music concert or for a movie. The person prefers going for a dinner
rather than to the movie, and the movie over the music concert.

Hence, his opportunity cost is sacrificing the movie, the next best alternative once he
goes for a dinner. If we carry forward the same example at the firm level, a manager planning to
hire a stenographer may have to give up the idea of having an additional clerk in the accounts
department. This is applicable even at the national level where the country allocates higher
defense expenditures in the budget at the cost of using the same money for infrastructural
projects. In order to maximize the value of the firm, a manager must view costs from this
Production possibility curve and productive efficiency
Now let us analyze how individuals, producers and other economic agents use the limited
resources to meet the unlimited needs. This to a large extent is possible with the help of the
production possibility curve (PPC). The production possibility curve can be defined as a curve
which shows the maximum combination of output that the economy can produce using all the
available resources.
The production possibility curve helps us understand the problem of scarcity better, by
showing what can be produced with given resources and technology. Technology is the
knowledge of how to produce goods and services.
The following assumptions are made in constructing a PPC:
The economic resources available for use in the year are fixed.
These economic resources can be used to produce two broad classes of goods.
Some inputs are better used in producing one of these classes of goods, rather
than the other.

Positive and normative statements

Another debate about the nature of economics is whether it is a positive or a normative
science. According to J. M. Keynes, A positive science may be defined as a body of
systematized knowledge concerning what is. A normative science or regulative science is a body
of systematized knowledge relating to the criteria of what ought to be and concerned with the
ideal as distinguished from the actual.....The objective of a positive science is the establishment
of uniformities; of a normative science, the determination of ideals.
Positive economics explains economic phenomena according to their causes and effects.
At the same time, it says nothing about the ends; it is not concerned with moral judgments. On
the other hand, normative economics explains how things ought to be. According to Milton
Freidman, positive economics deals with how an economic problem is solved.
Markets versus planning, free-market system, command economy
This economic system emphasizes the freedom of individuals as consumers and suppliers
of resources, and allows market forces to determine the allocation of scarce resources through
the price mechanism. Based on market demand and supply, consumers are free to buy goods and
services of their choice and producers allocate their resources based on the demand. Decisions
made by producers and consumers are influenced greatly by price.
23 Price plays a major role in a market economy. The role of the government is negligible:
consumers choose the goods they want and producers allocate their resources based on
the market demand for different products.
24 In such a system, efficiency is achieved through the profit motive. Producers make goods
at the lowest cost of production, and consumers get higher value goods and services at
lower prices.
Command Economy
In a command economy, all the economic decisions are taken by the government what
to produce, how to produce and for whom to produce. Thus, all decisions, from the allocation of
resources to the distribution of end products, is taken care off by the government.
In this type of systems, efficiency can be achieved only when demands are accurately
estimated and resources allocated accordingly. The USSR was an example of a command
economy. The government had complete control over the economy, and consumers were just the
price takers. The government set output targets for each district and factory and allocated the
necessary resources.
Economic models
Economic models are a set of equations or relationships used to summarize the working
of the national economy or of a business firm or some other economic unit. Models may be

simple or complex and they are used to illustrate a theoretical principle or to forecast economic
Economic models can be further classified into Micro Economics Models and
Macro Economic Models.
Micro Economic Models: Models when they incorporate individual economic
units such as households and firms, often grouped into individuals markets and industries
and the relationship between them are called as micro models.
Macro Economic Models: these models are used to explain and predict the
working or performance of the economy as a whole, e.g changes in the level of NI, the
level of employment and inflation.
Different approaches in solving the above issues/problems:
23 Inputs (Factors of production) 1) Land, 2) Labour and 3) Capital resources.
23 Land Natural resources
24 Labour human time spent in production
25 Capital resources machines, computers, hammers, trucks, automobiles etc.,
Formulation of Societies
Market Economy or Free-market or laissez-faire economy makes decisions on an
individual level with minimal government intervention.
Planned Economy or Command Economy where all economic decisions are made
by the government (Sloman, 2001).
0 Takes the initiative in combining the resources of land, labour, and capital
1 Makes strategic business decisions
2 Is an innovator
3 Commercializes new products, new production techniques, and even new forms of
business organization
4 Takes risk to get profits
Society uses its scare resources to produce goods and services
The alternatives and choices it faces can best be understood through macro economic model
We assume:
1. Full employment
2. Fixed Resources
3. Fixed Technology
4. Two goods

Important aspects
Use of Resources
Production Techniques
Wants and demand
Putting the PPF to work
Before development, the nation is poor. It must devote almost all its resources to food and
enjoy few comforts
PPF provides a rigorous definition of scarcity
How societies choose among different patterns of output, how they pay for their choices, and
how they benefit or lose
PPF answers for what, how and whom.
The Production Possibilities Frontier
Lets introduce the Production Possibilities Frontier
Better known as the PPF.
The PPF is a basic workhorse in economics.
Important for understanding some basic issues in economics.
Great application is with international trade theory.
Helps one understand and distinguish between comparative advantage and absolute
An important historical figure in all this is David Ricardo.
David Ricardo
Famous 19th century British economist.
Some consider him the grandfather of international trade theory.
Very influential in pioneering the theory of comparative advantage, inter alia.
Very interesting, very bright guy.
Had a lot of say about the corn laws in England.
The Production Possibility Frontier - What Is It?
The description of the best possible combinations of two goods to produce using all of the
available resources.
Shows the trade-off between more of one good in terms of the other.
Assumes: input endowments given, technology given, time given and efficient production.
Efficiency and Production Possibilities Frontier

PPF model
Shows possible combinations of 2 types of goods that can be produced when available
resources are used fully and efficiently
o Figure
Inefficient and unattainable production

Point I and U on the curve

Shape of the PPF


Any movement along PPF involves giving up something


Production Possibilities Frontier PPF Figure

A through F are attainable

I represents inefficient use of resources

U represents unattainable combinations

The resources in an economy are not all perfectly adaptable

Law of increasing opportunity cost each additional increment of one good requires the
economy to give up larger increments of other good
The PPF has a bowed-out shape due to the law of increasing opportunity cost

Shifts in the PPF

Economic Growth an expansion in the economys ability to produce

Changes in resource availability


Increase (more labor) PPF shifts outward

Decrease (less resources) PPF shifts inward

Increases in stock of capital goods
Technological change


Free Trade occurs when a government does not attempt to influence, through tariffs, quotas, or
other means,
what citizens can buy from other countries or

produce and sell to other countries

The Benefits of Trade allow countries to be richer by specializing in products they can produce
most efficiently
The history of trade and government involvement presents mixed evidence
There may be some ways that some governments can make things better by
But government intervening in free trade is definitely dangerous


Adam Smith argued (Wealth of Nations, 1776): Capability of one country to produce more of a
product with the same amount of input than another country.

A country should produce only goods where it is most efficient, and trade (import)
for those goods where it is not efficient

Trade between countries is, therefore, beneficial

Example: Ghana/cocoa

Export those goods and services for which a country is more productive than other countries
Import those goods and services for which other countries are more productive than it is

There may also be longterm benefits

to free trade
As people specialize and seek higher incomes, they may learn to do their specialties better

Suppose one country is more efficient than another in everything?
There are still global gains to be made if a country specializes in products it produces relatively
more efficiently than other products
David Ricardo (Principles of Political Economy, 1817):


Efficiency of resource utilization leads to more productivity

A country should import even if country is more efficient in the products

production than country from which it is buying

Trade is a positive-sum game

Produce and export those goods and services for which it is relatively more productive than other
Import those goods and services for which other countries are relatively more productive than it

Relations between Absolute Advantages Theory and Comparative Advantages Theory

Your country has comparative advantage in the product or service where the ratio is
Resources required in your country
Resources required in the other country is lowest


As products mature, location of both sales and optimal production changes
Affects the direction and flow of imports and exports

Globalization and integration of the economy has caused the changes in location to be different
Technological innovation is a key determinant of trade patterns in manufactured products.
During trade cycle, home country initially is an exporter, then loses its comparative advantage &
eventually becomes importer.

Eg. In early 1960s Xerox machine was found initially consumed in US. Exported to
Advanced countries of Europe. As demand began to grow in those countries, Xerox entered into
join ventures to produce in Japan(Fuji Xerox). Once, Xrox patents on photocopier expired, other
foreign competitors entered into market (Canon in Japan, Olivetti in Italy).

Saying Most of the new products found, produced, developed and introduced in US is
ethnocentric. Its true that it played a dominant role in global economy.
To be able to explain economic efficiency as it relates to a business.




What is Economic Efficiency?

Economic Efficiency is the wise use of available resources so that costs do not exceed benefits.

Growth economics studies factors that explain economic growth the increase in output
per capita of a country over a long period of time. The same factors are used to explain
differences in the level of output per capita between countries, in particular why some countries
grow faster than others, and whether countries converge at the same rates of growth.
Much-studied factors include the rate of investment, population growth, and
technological change. These are represented in theoretical and empirical forms (as in the
neoclassical and endogenous growth models) and in growth accounting.
Economic growth is an increase in the total output of the economy. It occurs when a society
acquires new resources, or when it learns to produce more using existing resources.
The main sources of economic growth are capital accumulation and technological advances.

Outward shifts of the curve represent economic


An outward shift means that it is possible to

increase the production of one good without
decreasing the production of the other.

From point D, the economy can choose any

combination of output between F and G.

Not every sector of the economy grows at the same

In this historic example, productivity increases were
more dramatic for corn than for wheat over this
time period.

Capital Goods and Growth in Poor and Rich Countries

Rich countries devote more resources to capital production than poor countries.
As more resources flow into capital production, the rate of economic growth in rich countries
increases, and so does the gap between rich and poor countries.
Economic Growth and the Gains from Trade
By specializing and engaging in trade, Colleen and Bill can move beyond their own
production possibilities.


Objective: transformation and economic development in undeveloped areas
History: once succeed in past as parts of classical economics.

New opportunity:
New cases: China, India, Russia
New development in other areas, such as game theory, public choice and economic history
New economists from developing countries who observe and experience the process of
No institutional factors or variables in the model of mainstream, so no concerning on institutions
in development economics,
Not to say, concerning on the system of government

In 1950s, overlook the market system, stress on capital, and on governments, but in distribute
capital and technology rather than in supplying public goods. So no institutional change
of governments, no advantage of governments in efficiency, no labor division and
specialization in private and public goods between market and governments
Maybe politician and elites dont like it

In 1970s, governments failed, back to market,

But, still no efficiency of governments, no market economys efficiency
No institutional change of public finance, no efficiency of governments
The system of public finance is important, but be ignored.

In 1990s, public finance or relationship between market and governments has been discussed
(Stiglitz, 1999) in development economics.
Popular of new institutional school

Uncorporate equilibrium of group game theory(Auman and Shelling)

Public budget system be still overlooked
How to establish or initiate a new institution


Perfectly competitive markets are defined by two primary characteristics:

The goods being offered for sale are all the same, and

The buyers and sellers are so numerous that no single buyer or seller can influence the

market price.

Problem of mainstream model:

The price is an exogenous variable in the function of economic growth, and a base on which
economic entities make their decisions.
Information economics no use about information of prices, here, because consumers always
change their ideas.
The efficiency of market economy missed:
The role of entrepreneur: Guess the price of goods, even in a perfect competitive market

The efficiency of public finance: Bargaining between taxpayers and governments for the price of
public goods

The model in mainstream just concerns production, which rely on labor, capital, technology, then
innovation, but no any business
Misunderstanding: capitalists or entrepreneurs market economy

This misleading no influence on USA, but impact on developing countries which lack of
entrepreneurs and institutions.

What is market economy?

Distribute resources by market system?
Maximum of profit by mathematics?
If so, the planner will do it best (Barro & Sala-i-Martin, 2004).
But who knows the information in calculation?

The advantage of market over plan: Run business and efficiency from the mechanism of prices
Need a institution to permit entrepreneurs to guess and bargain the price with consumers, and
governments do it with taxpayers.

Ways of economic development:

Trade: entrepreneurs guess preferences of consumers, and raise the prices;
Technology of trade to reduce transaction cost: invention of money;
Institutional changes to reduce transaction cost: property right system;
Technology of production to reduce costs: machines and organizations;
Institutional changes in governments to reduce transaction cost: budget system;
Capital and resources to replace labor: no save of cost, but bring us more leisure time----

the objective of economic development

All factors have been analyzed in past, but budget system.What is it? How to get it?


Is a state or government a trouble maker (like it in SA)? Or is it a solution (like it in EA)
( Evans,1992)
No answer just like private company, but we cannot ignored it

The key points here are what kind of government it is, what it does as a government and how it
does those works. ----Efficiency
Efficiency of governments
Come from the political structure or budget system
The change of structure is slow and difficult
East Asia rely on both of market and government----strange way
However, not to plan or distribute resources, but to supply public goods efficiently

Three systems:

the system to enforce laws and contracts with sovereignty,

the system of making decisions and supervising the actions of governments by taxpayers,

the system of showing and coordinating the preference of taxpayers on public goods and
negotiating between taxpayers and governments
The hardness of economic development
We cannot copy a system; they are a consequence of political struggle or cooperate game.
The system change will be influenced heavily by culture, history and old system.

Mass democracy is not a good way; the important point is taxpayer participating in the system.
keep small group for cost and equilibrium(Olson,1980)

Adam Smiths invisible hand of the marketplace leads self-interested buyers and
sellers in a market to maximize the total benefit that society can derive from a market.
An externality refers to the uncompensated impact of one persons actions on the wellbeing
of a bystander.
Externalities cause markets to be inefficient, and thus fail to maximize total surplus. When a
person engages in an activity that influences the well-being of a bystander and yet neither
pays nor receives any compensation for that effect.
When the impact on the bystander is adverse, the externality is called a negative
When the impact on the bystander is beneficial, the externality is called a positive

Externality: a by-product of a transaction that affects someone not immediately involved

in the transaction.
Imply that the competitive equilibrium will not result in the social optimum
Imply that the competitive equilibrium will result in a dead weight loss
Create a role for government intervention
Negative Externalities
Automobile exhaust
Cigarette smoking
Barking dogs (loud pets)
Loud stereos in an apartment building
Positive Externalities
Restored historic buildings
Research into new technologies
Negative externalities lead markets to produce a larger quantity than is socially desirable.
Positive externalities lead markets to produce a smaller quantity than is
socially desirable.
Externalities, which occur in cases where the "market does not take into account the
impact of an economic activity on outsiders." There are positive externalities and negative
externalities. Positive externalities occur in cases such as when a television program on family
health improves the public's health. Negative externalities occur in cases such as when a
companys process pollutes air or waterways. Negative externalities can be reduced by using
government regulations, taxes, or subsidies, or by using property rights to force companies and
individuals to take the impacts of their economic activity into account.
EXTERNALITIES: impacts on third parties besides the buyer and seller.
Consumption Externalities: impacts on third parties as a result of the consumption of a good.
Eg. Each infected person who takes Drugs eliminates disease helps all of society, not Just the
drug company which provides the medicine.
Production Externalities: impacts on third parties as a result of the production of a good. Eg.
New discoveries & innovations impact all of Society, not just the scientist who disovers them
and the firm who employs the Scientist (streptomyacin patent problem)
Market Power: The power of a single Company to change the price of a good or service in the
MONOPOLY. Examples: Drug Companies while they have Patents.

Inequities: any economic, social or political mechanism that systematically causes one part of
the population to be worse off than another part of a population through time without the
possibility of correction. Examples: Poor Populations have greater vulnerability to TB due to
their economic and social conditions.
Dynamic Market Failure: the failure through time to achieve technological change and the
failure of the market to achieve stable, equilibrium outcomes. Examples: As a disease disappears
in a given locale:
lack of incentives for new drug development
Lack of treatment for those who are diseased
Both in the area and in other areas where pandemics may occur
Indivisibilities: a problem cannot be sub- divided into smaller pieces for the purpose of Solving
the problem or marketing the solution Example: even one remaining infected person means no
cure has been achieved. Any plan to wipe out a disease means that a comprehensive worldwide
plan must be undertaken.
Information Asymmetry: decision makers do not have access to the same information which
leads to different definitions, boundaries, and solutions to problems to be solved and social
outcomes. Examples: indifference to disease, lack of education about how to treat diseases, and
failure to understand the tradeoff between private rights and public goods.


Unit II

A market is any one of a variety of different systems, institutions, procedures, social
relations and infrastructures whereby persons trade, and goods and services are exchanged,
forming part of the economy. It is an arrangement that allows buyers and sellers to exchange
things. Markets vary in size, range, geographic scale, location, types and variety of human
communities, as well as the types of goods and services traded.
Some examples include local farmers markets held in
town squares or parking
lots, shopping centers and shopping malls, international currency and commodity markets,
legally created markets such as for pollution permits, and illegal markets such as the market for
illicit drugs.
In mainstream economics, the concept of a market is any structure that allows buyers
and sellers to exchange any type of goods, services and information. The exchange of goods or
services for money is a transaction. Market participants consist of all the buyers and sellers of a
good who influence its price.

This influence is a major study of economics and has given rise to several theories and
models concerning the basic market forces of supply and demand. There are two roles in
markets, buyers and sellers. The market facilitates trade and enables the distribution and
allocation of resources in a society.
Markets allow any tradable item to be evaluated and priced. A market emerges more or
less spontaneously or is constructed deliberately by human interaction in order to enable the
exchange of rights (cf. ownership) of services and goods.
Historically, markets originated in physical marketplaces which would often develop into
or from small communities, towns and cities.

Although many markets exist in the traditional sense such as a marketplace there are
various other types of markets and various organizational structures to assist their functions. The
nature of business transactions could define markets.
Financial markets
Financial markets facilitate the exchange of liquid assets. Most investors prefer investing
in two markets, the stock markets and the bond markets. NYSE, AMEX, and the NASDAQ are
the most common stock markets in the US. Futures markets, where contracts are exchanged
regarding the future delivery of goods are often an outgrowth of general commodity markets.
Currency markets are used to trade one currency for another, and are often used for
speculation on currency exchange rates. The money market is the name for the global market for
lending and borrowing.
Prediction markets
Prediction markets are a type of speculative market in which the goods exchanged are
futures on the occurrence of certain events. They apply the market dynamics to facilitate
information aggregation.
Organization of markets
A market can be organized as an auction, as a private electronic market, as a commodity
wholesale market, as a shopping center, as a complex institution such as a stock market, and as
an informal discussion between two individuals.
Markets of varying types can spontaneously arise whenever a party has interest in a good
or service that some other party can provide. Hence there can be a market for cigarettes in

correctional facilities, another for chewing gum in a playground, and yet another for contracts for
the future delivery of a commodity. There can be black markets, where a good is exchanged
illegally and virtual markets, such as eBay, in which buyers and sellers do not physically interact
during negotiation. There can also be markets for goods under a command economy despite
pressure to repress them.
Mechanisms of markets
In economics, a market that runs under laissez-faire policies is a free market. It is "free"
in the sense that the government makes no attempt to intervene through taxes, subsidies,
minimum, price ceilings, etc. Market prices may be distorted by a seller or sellers with monopoly
power, or a buyer with monopsony power.
Such price distortions can have an adverse effect on market participant's welfare and
reduce the efficiency of market outcomes. Also, the level of organization or negotiation power of
buyers, markedly affects the functioning of the market. Markets where price negotiations meet
equilibrium though still do not arrive at desired outcomes for both sides are said to experience
market failure.
Study of markets
The study of actual existing markets made up of persons interacting in space and place in
diverse ways is widely seen as an antidote to abstract and all-encompassing concepts of
the market and has historical precedent in the works of Fernand Braudel and Karl
The latter term is now generally used in two ways. First, to denote the abstract mechanisms
whereby supply and demand confronts each other and deals are made.
In its place, reference to markets reflects ordinary experience and the places, processes and
institutions in which exchanges occur.
Second, the market is often used to signify an integrated, all-encompassing and cohesive
capitalist world economy.
A widespread trend in economic history and sociologyis skeptical of the idea that it is
possible to develop a theory to capture an essence or unifying thread to markets.
For economic geographers, reference to regional, local, or commodity specific markets can
serve to undermine assumptions of global integration, and highlight geographic variations
in the structures, institutions, histories, path dependencies, forms of interaction
and modes of self-understanding of agents in different spheres of
exchange Reference to actual markets can show capitalism not as a totalizing
force or

completely encompassing mode of economic activity, but rather as a set of economic

practices scattered over a landscape, rather than a systemic concentration of power


The Basic Decision-Making Units
A firm is an organization that transforms resources (inputs) into products (outputs). Firms are
the primary producing units in a market economy.
An entrepreneur is a person who organizes, manages, and assumes the risks of a firm, taking
a new idea or a new product and turning it into a successful business.
Households are the consuming units in an economy.
The Circular Flow of Economic Activity

The circular flow of economic activity shows the connections between firms and households
in input and output markets.
Input Markets and Output Markets
Output, or product, markets are the markets in which goods and services are exchanged.
Input markets are the markets in which resourceslabor, capital, and landused to produce
products, are exchanged.
Input Markets
Input markets include:
The labor market, in which households supply work for wages to firms that demand labor.

The capital market, in which households supply their savings, for interest or for claims to
future profits, to firms that demand funds to buy capital goods.
The land market, in which households supply land or other real property in exchange for
The price of the product in question.
The income available to the household.
The households amount of accumulated wealth.
The prices of related products available to the household.
The households tastes and preferences.
The households expectations about future income, wealth, and prices.
Quantity Demanded
Quantity demanded is the amount (number of units) of a product that a household would buy
in a given time period if it could buy all it wanted at the current market price.

Demand in Output Markets

A demand schedule is a table showing how much of a given product a household would be
willing to buy at different prices.
Demand curves are usually derived from demand schedules.


The demand curve is a graph illustrating how much of a given product a

household would be willing to buy at different prices.

The Law of Demand

The law of demand states that there is a negative, or inverse, relationship between price and
the quantity of a good demanded and its price.
This means that demand curves slope downward.

Other Properties of Demand Curves

Demand curves intersect the quantity (X)-axis, as a result of time
limitations and diminishing marginal utility.
Demand curves intersect the (Y)-axis, as a result of limited incomes and wealth.
Income and Wealth
Income is the sum of all households wages, salaries, profits, interest payments, rents, and
other forms of earnings in a given period of time. It is a flow measure.
Wealth, or net worth, is the total value of what a household owns minus what it owes. It is a
stock measure.
Normal Goods are goods for which demand goes up when income is higher and for which
demand goes down when income is lower.
Inferior Goods are goods for which demand falls when income rises.
Substitutes are goods that can serve as replacements for one another; when the price of one
increases, demand for the other goes up. Perfect substitutes are identical products.

Complements are goods that go together; a decrease in the price of one results in an
increase in demand for the other, and vice versa.
Shift of Demand versus Movement along a Demand Curve

A change in demand is not the same as a change in quantity demanded.

In this example, a higher price causes lower quantity demanded.
Changes in determinants of demand, other than price, cause a change in demand, or a shift of
the entire demand curve, from DA to DB.
A Change in Demand versus a Change in Quantity Demanded

When demand shifts to the right, demand increases. This causes quantity demanded to be
greater than it was prior to the shift, for each and every price level.

Demand for a good or service can be defined for an individual household, or for a group of
households that make up a market.
Market demand is the sum of all the quantities of a good or service demanded per period by
all the households buying in the market for that good or service.

Assuming there are only two households in the market, market demand is derived as

Supply in Output Markets




A supply schedule is a table showing how much of a product firms

will supply at different prices.
Quantity supplied represents the number of units of a product that a
firm would be willing and able to offer for sale at a particular price
during a given time period.


Price of soybeans per bushel ($)

A supply curve is a graph illustrating how much of a product a firm will supply at
different prices.






Thousands of bushels of soybeans

produced per year

The Law of Supply

The law of supply states that there is a positive relationship between price and quantity of a
good supplied.
This means that supply curves typically have a positive slope.
Determinants of Supply
The price of the good or service.
The cost of producing the good, which in turn depends on:

The price of required inputs (labor, capital, and land),

The technologies that can be used to produce the product,

The prices of related products.

A Change in Supply versus a Change in Quantity Supplied

A change in supply is not the same as a change in quantity supplied.

In this example, a higher price causes higher quantity supplied, and a move along the demand
In this example, changes in determinants of supply, other than price, cause an increase in
supply, or a shift of the entire supply curve, from SA to SB.

A Change in Supply versus a Change in Quantity Supplied

When supply shifts to the right, supply increases. This causes quantity supplied to be greater
than it was prior to the shift, for each and every price level.

A Change in Supply versus a Change in Quantity Supplied

The supply of a good or service can be defined for an individual firm, or for a group of
firms that make up a market or an industry.
Market supply is the sum of all the quantities of a good or service supplied per period by all
the firms selling in the market for that good or service.

Market Supply
As with market demand, market supply is the horizontal summation of individual
firms supply curves.

Market Equilibrium
The operation of the market depends on the interaction between buyers and sellers.
Equilibrium is the condition that exists when quantity supplied and quantity demanded are
At equilibrium, there is no tendency for the market price to change.

Market Equilibrium

Only in equilibrium is quantity supplied equal to quantity demanded.

At any price level other than P0, the wishes of buyers and sellers do not coincide.
Market Disequilibria

Excess demand, or shortage, is the condition that exists when quantity demanded exceeds
quantity supplied at the current price.
When quantity demanded exceeds quantity supplied, price tends to rise until equilibrium is

Excess supply, or surplus, is the condition that exists when quantity supplied exceeds
quantity demanded at the current price.
When quantity supplied exceeds quantity demanded, price tends to fall until equilibrium is


Elasticity the concept
The responsiveness of one variable to changes in another
When price rises, what happens to demand?
Demand falls

How much does demand fall?
If price rises by 10% - what happens to demand?
We know demand will fall
By more than 10%?
By less than 10%?
Elasticity measures the extent to which demand will change
4 basic types used:
Price elasticity of demand
Price elasticity of supply
Income elasticity of demand
Cross elasticity

Price Elasticity of Demand

The responsiveness of demand to changes in price
Where % change in demand
is greater than % change in price elastic
Where % change in demand is less than % change in price - inelastic

If the answer is between -1 and infinity: the relationship is elastic

Note: PED has sign in front of it; because as price rises demand falls and vice-versa
(inverse relationship between price and demand)

If demand is price elastic:
Increasing price would reduce TR (% Qd > % P)
Reducing price would increase TR (% Qd > % P)
If demand is price inelastic:
Increasing price would increase TR (% Qd < % P)
Reducing price would reduce TR (% Qd < % P)
Income Elasticity of Demand:
The responsiveness of demand to changes in incomes
Normal Good demand rises as income rises and vice versa
Inferior Good demand falls as income rises and vice versa
Income Elasticity of Demand:
A positive sign denotes a normal good
A negative sign denotes an inferior good

Cross Elasticity:
The responsiveness of demand of one good to changes in the price of a related good
either a substitute or a complement
Goods which are complements:
Cross Elasticity will have negative sign (inverse relationship between the two)
Goods which are substitutes:
Cross Elasticity will have a positive sign (positive relationship between the
Price Elasticity of Supply:
The responsiveness of supply to changes
in price
If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes
in price

If Pes is elastic supply can react quickly to changes in price

Determinants of Elasticity
Time period the longer the time under consideration the more elastic a good is likely to be
Number and closeness of substitutes the greater the number of substitutes, the more
The proportion of income taken up by the product the smaller the proportion the
more inelastic
Luxury or Necessity - for example, addictive drugs
Importance of Elasticity
Relationship between changes in price and total revenue
Importance in determining what goods to tax (tax revenue)
Importance in analysing time lags in production
Influences the behaviour of a firm
Consumer Buying Behavior
Consumer Buying Behavior refers to the buying behavior of final consumers (individuals &
households) who buy goods and services for personal consumption.
Study consumer behavior to answer: How do consumers respond to marketing efforts
the company might use?

Buyers Black

Factors Affecting Consumer Behavior: Culture

Most basic cause of a person's wants and behavior.
Groups of people with shared value systems based on common life experiences.
Hispanic Consumers
African American Consumers
Asian American Consumers
Mature Consumers

Social Class
People within a social class tend to exhibit similar buying behavior.


Types of Buying Decisions

The Buyer Decision Process

The Buyer Decision Process Step 1. Need Recognition

Need Recognition
Difference between an actual state and a desired state

The Buyer Decision Process Step 2. Information Search

The Buyer Decision Process Step 3. Evaluation of Alternatives

The Buyer Decision Process Step 4. Purchase Decision

The Buyer Decision Process Step 5. Post purchase Behavior

Cognitive Dissonance

Stages in the Adoption Process


Adoption of Innovations

Influences on the Rate of Adoption of New Products


Production and Cost in the Long Run
The key difference between the short run and the long run is that there are no diminishing
returns in the long run.
Diminishing returns occur because workers share a fixed facility. In the long run the firm
can expand its production facility as its workforce grows.
By scale of an enterprise or size of a plant we mean the amount of investment in fixed
factors of production
Costs of production are lower in larger plants than in smaller ones
This is due to economies of large-scale production
The term economies refers to cost advantages
When these economies are over-exploited the result may be cost disadvantages, i.e.
Economies of scale: a situation in which an increase in the quantity produced decreases the
long-run average cost of production.
Economies of scale refer to cost savings associated with spreading the cost of indivisible
inputs and input specialization.
When economies of scale are present, the LAC curve will be negatively sloped.

Long-run Average Cost

Long-run average cost (LAC) is total cost divided by the quantity of output when the firm
can choose a production facility of any size.
The LAC curve describes the behavior of average cost as the plant size expands. Initially, the
curve is negatively sloped, and then beyond some point, it becomes horizontal.
Long-run Average Cost
When long-run total cost is proportionate to the quantity produced, long-run average
cost does not change as output increases.

The long-run average cost curve is horizontal for 7 or more rakes per hour.
Labor Specialization
In a large operation, each worker specializes in fewer tasks thus is more productive than his or
her counterpart in a small operation.
Higher productivity (more output per worker) means lower labor costs per unit of output, thus
lower production costs (ever-decreasing average cost).
Minimum Efficient Scale
The minimum efficient scale describes the output at which economies of scale are exhausted
and the long-run average cost curve becomes horizontal.
Once the minimum efficient scale has been reached, an increase in output no longer decreases
the long-run average cost.
A firm experiences diseconomies of scale when an increase in output leads to an increase in
long-run average costthe LAC curve becomes positively sloped.
Diseconomies of scale may arise for two reasons:
Coordination problems
Increasing input costs

After firm has reached its efficient scale, further increases in number of workers will
lead to inefficiency.
Co-ordination of different processes becomes difficult and decision-making process
becomes slow
Supervision of workers becomes difficult, management problems get out of hand with
adverse effects on managerial efficiency.
External Economies
Economies available to all firms in the industry.
For eg. Construction of roads, railways in an area reduces costs for all firms in that area
Discovery of a new technique, rise of industries using by-products, availability of skilled
labour through the establishment of special technical schools
External economies usually occur when an industry is heavily concentrated in a particular
Internal Economies of Scale
Internal economies are available to a particular firm and give it an advantage over other
firms engaged in the industry
Arise from the expansion of the size of a particular firm
From a managerial point of view internal economies are most important as they can be
effected by managerial decisions of an individual firm to change its size/scale
Internal economies arise due to a firms own expansion while external economies arise
due to expansion of some other industry or due to some external factor.
Labour Economies
Reduction in labour costs per unit due to increasing division/specialization of labour
Arise due to increase in the skill of workers and saving of time involved in changing from
one operation to another
Many operations may be performed mechanically rather than manually
Economies are maximum where products are complex and the manufacturing processes
can be sub-divided.
Technical Economies
Derived from the use of scientific processes and machines that a large production firm
can afford.
Managerial Economies
-With the increase in the size of a firm, the efficiency of management increases because of
greater specialization in managerial staff

-Experts in a large firm can be hired to look after various divisions like purchasing, sales,
production, financing, personnel.
Marketing Economies
A large firm can obtain economies in purchasing and sales as it has bulk requirements
and can hence get better terms
It gets the advantage of prompt deliveries, careful attention and special facilities from its
A large firm can also spread its advertising cost over bigger output.
Economies of Vertical Integration
Larger firm can integrate a number of stages of production
Production is better planned and this leads to cost control
Eg. Oil refining companies controlling distribution, i.e. owning petrol pumps-forward
integration, or controlling oil reserves through oil exploration backward integration
Financial Economies
Larger firms get credit more easily and also on better terms
Better image, easier access to capital/stock markets.
Economies of Risk-spreading
Larger size of business, greater scope for spreading of risks through diversification
Diversification can be either of products or of markets.
The Object of Cost Analysis
Managers seek to produce the highest quality products at the lowest possible cost.
Firms that are satisfied with the status quo find that competitors arise that can produce at
lower costs.
The advantages once assigned to being large firms (economies of scale and scope) have
not provided the advantages of flexibility and agility found in some smaller
Cost analysis is helpful in the task of finding lower cost methods to produce goods and

Meaning of Cost
There are Many Economic Cost Concepts
Opportunity Cost -- value of next best alternative use.
Explicit vs. Implicit Cost -- actual prices paid vs. opportunity cost of owner supplied
Depreciation Cost Measurement.
Accounting depreciation (e.g., straight-line depreciation) tends
to have little relationship to the actual loss of value
To an economist, the actual loss of value is the true cost of using machinery.
Inventory Valuation
Accounting valuation depends on its acquisition cost.
Economists view the cost of inventory as the cost of replacement.
Unutilized Facilities. Empty space may appear to have "no cost
Economists view its alternative use (e.g., rental value) as its opportunity cost.
Measures of Profitability.
Accountants and economists view profit differently.
Accounting profit, at its simplest, is revenues minus explicit costs.
Economists include other implicit costs (such as a normal profit on invested
Economic Profit = Total Revenues Explicit Costs Implicit Costs
Sunk Costs -- already paid for, or there is already a contractual obligation to pay
Incremental Cost - - extra cost of implementing a decision = D TC of a decision
Marginal Cost -- cost of last unit produced = TC/ Q
TC = FC + VC fixed & variable costs


Unit III
In economics, market structure (also known as market form) describes the state of a
market with respect to competition.
Basic market structures
Perfect competition, in which the market consists of a very large number of firms producing
a homogeneous product.
Monopolistic competition, also called competitive market, where there are a large number of
independent firms which have a very small proportion of the market share.
Oligopoly, in which a market is dominated by a small number of firms which own more than
40% of the market share.
Oligopsony, a market dominated by many sellers and a few buyers.
Monopoly, where there is only one provider of a product or service.
Natural monopoly, a monopoly in which economies of scale cause efficiency to increase
continuously with the size of the firm. A firm is a natural monopoly if it is able to serve
the entire market demand at a lower cost than any combination of two or more smaller,
more specialized firms.
Monopsony, when there is only one buyer in a market.
The imperfectly competitive structure is quite identical to the realistic market conditions
where some monopolistic competitors, monopolists, oligopolists, and duopolists exist and
dominate the market conditions. The elements of Market Structure include the number and size
distribution of firms, entry conditions, and the extent of differentiation.
These somewhat abstract concerns tend to determine some but not all details of a specific
concrete market system where buyers and sellers actually meet and commit to trade. Competition
is useful because it reveals actual customer demand and induces the seller (operator) to provide
service quality levels and price levels that buyers (customers) want, typically subject to the
sellers financial need to cover its costs.

In other words, competition can align the sellers interests with the buyers interests and
can cause the seller to reveal his true costs and other private information. In the absence of
perfect competition, three basic approaches can be adopted to deal with problems related to the
control of market power and an asymmetry between the government and the operator with
respect to objectives and information: (a) subjecting the operator to competitive pressures, (b)
gathering information on the operator and the market, and (c) applying incentive regulation.

The correct sequence of the market structure from most to least competitive is perfect
competition, imperfect competition, oligopoly, and pure monopoly.

The main criteria by which one can distinguish between different market structures are:
the number and size of producers and consumers in the market, the type of goods and services
being traded, and the degree to which information can flow freely.
Most markets fall between the two extremes of monopoly and perfect competition
An imperfectly competitive firm
would like to sell more at the going price
faces a downward-sloping demand curve
recognises its output price depends on the quantity of goods produced and sold
An oligopoly
an industry with a few producers
Each recognising that its own price depends both on its own actions and those of its
In an industry with monopolistic competition
there are many sellers producing products that are close substitutes for one another
Each firm has only limited ability to influence its output price.


Number Ability to
of firms affect





Fruit stall

Monopolistic competition




Corner shop










Post Office

Perfect competition
Imperfect competition:

The minimum efficient scale and market demand

The minimum efficient scale (mes) is the output at which a firms long-run average cost
curve stops falling.
The size of the mes relative to market demand has a strong influence on market structure.

Monopolistic competition

many firms
no barriers to entry
product differentiation

so the firm faces a downward-sloping demand curve

The absence of entry barriers means that profits are competed away...
Monopolistic competition (2)

Firms end up in TANGENCY EQUILIBRIUM, making normal profits.

Firms do not operate at minimum LAC.
Price exceeds marginal cost.
Unlike perfect competition, the firm here is eager to sell more at the going market price.
A market with a few sellers.
The essence of an oligopolistic industry is the need for each firm to consider how its own
actions affect the decisions of its relatively few competitors.
Oligopoly may be characterized by collusion or by non-co-operation.
Collusion and cartels
An explicit or implicit agreement between existing firms to avoid or limit competition with
one another.
Is a situation in which formal agreements between firms are legally permitted? e.g.
Collusion is difficult if
There are many firms in the industry
The product is not standardized
Demand and cost conditions are changing rapidly
There are no barriers to entry
Firms have surplus capacity

The kinked demand curve

Consider how a firm may perceive its demand curve under oligopoly.
It can observe the current price and output, but must try to anticipate rival reactions to any
price change.
The kinked demand curve (2)

The firm may expect rivals to respond if it reduces its price, as this will be seen as an
aggressive move.
So demand in response to a price reduction is likely to be relatively inelastic.
The demand curve will be steep below P0.
The kinked demand curve (3)

But for a price increase rivals are less likely to react, so demand may be relatively elastic
above P0 so the firm perceives that it faces a kinked demand curve.

The kinked demand curve (4)

Given this perception, the firm sees that revenue will fall whether price is increased or
So the best strategy is to keep price at P0.
Price will tend to be stable, even in the face of an increase in marginal cost.
Game theory: some key terms

A situation in which intelligent decisions are necessarily interdependent.


A game plan describing how the player will act or move in every conceivable

Dominant strategy

Where a players best strategy is independent of those chosen by others.

Nash-Cournot equilibrium

R and R are the reaction functions for firms A and B respectively. Each shows the best
each firm can do given its expectations about the other
E is the Nash-Cournot equilibrium
At E, each firms guess about its rival is correct and neither will wish to change its behaviour
Contestable markets
A contestable market is characterised by free entry and free exit
no sunk costs
allows hit-and-run entry
Contestability may constrain incumbent firms from exploiting their market power.
Strategic entry deterrence
Some entry barriers are deliberately erected by incumbent firms:
threat of predatory pricing
spare capacity
advertising and R&D
product proliferation
Actions that enforce sunk costs on potential entrants
Imperfect Competition and Market Power
An imperfectly competitive industry is an industry in which single firms have some control
over the price of their output.
Some examples are Monopoly, Oligopoly and Monopolistic competition.

Market power is the imperfectly competitive firms ability to raise price without losing all
demand for its product.
Price: The Fourth Decision Variable
Firms with market power must decide:

how much to produce,

how to produce it,

how much to demand in each input market, and

what price to charge for their output.

A market structure in which only one producer or seller exists for a product that has no close
Characteristics of Monopoly
The degree of control over price that is held by the monopolist
The individual supply of the monopolist coincides with the market supply
Market demand equals the demand for the monopolists product or service
The monopolist is a price maker

Sources of Monopoly
Economies of scale
In capital intensive industries, the economies of large-scale production may lead to a
small number of firms producing the product
Natural monopolies: Public utilities
In cases where one or two firms can adequately supply all the service needed, it may
be desirable to limit the number of firms within a given territory
Government regulation of these monopoly franchises.

Control of raw materials

An effective barrier to entry is ownership or control of essential raw materials
Effective for years in the production of aluminum
ALCOA and its control of bauxite


The exclusive right to use, keep, or sell an invention for a period of 20 years

Threat of infringement suits.

Competitive tactics

Aggressive production and merchandising techniques

Illegal predatory pricing policies
Aggressive innovation techniques

Determining Monopoly Price

The monopolists demand curve slopes downward to the right because it is the market
demand curve of all consumers
The first question the monopolist asks is, How many units of my good can I expect to sell
at various prices?
Price and Output Decisions in Pure Monopoly Markets
With one firm in a monopoly market, there is no distinction between the firm and the
industry. In a monopoly, the firm is the industry.
The market demand curve is the demand curve facing the firm, and total quantity supplied in
the market is what the firm decides to produce.
Price and Output Decisions in Pure Monopoly Markets
The demand curve facing a perfectly competitive firm is perfectly elastic; in a monopoly, the
market demand curve is the demand curve facing the firm.
The Monopolists Demand Curve

The Monopolists Cost Curves

The monopolists cost curves reflect the law of diminishing marginal productivity

Thus, the cost curves have the same general shape and characteristics as the cost curves in a
competitive industry
Marginal Revenue Curve Facing a Monopolist

For a monopolist, an increase in output involves not just producing more and selling it, but
also reducing the price of its output to sell it.
At every level of output except one unit, a monopolists marginal revenue is below price.

Cost and Revenue Curves for a Monopoly

Facts about Monopoly

A monopoly firm has no supply curve that is independent of the demand curve for its
A monopolist sets both price and quantity, and the amount of output supplied depends on
both its marginal cost curve and the demand curve that it faces.
Since entry is blocked, the monopolist can earn economic profits in the long run.

Monopolists can earn losses in the short run if demand is not sufficient or if costs are too
Price and Output Choices for Monopolist Suffering Losses in the Short-Run

It is possible for a profit-maximizing monopolist to suffer short-run losses.

If the firm cannot generate enough revenue to cover total costs, it will go out of business in
the long-run.
Perfect Competition and Monopoly Compared

Relative to a competitively organized industry, a monopolist restricts output, charges higher

prices, and earns positive profits.
Monopolistic Competition
Monopolistic competition is a common form of industry (market) structure, characterized by
a large number of firms, none of which can influence market price by virtue of size alone.
Some degree of market power is achieved by firms producing differentiated products.
New firms can enter and established firms can exit such an industry with ease.

Product Differentiation
Establishment of real or imagined characteristics that identify a firms product as unique.
Product Differentiation

Based on the

Reduces the Elasticity of Demand Facing a Firm

availability of substitutes, the demand curve faced by a
competitor is likely to be

less elastic than the demand curve faced by a perfectly competitive firm, and likely to be
more elastic than the demand curve faced by a monopoly.

Substitution Effect
A change in quantity demanded of a good due to a change in the price relative to substitute
Increased sales at the expense of other firms

Monopolistic Competition in the Short Run

In the short-run, a monopolistically competitive firm will produce up to the point where

MR = MC.
A market structure in which relatively few firms produce identical or similar products
Two basic characteristics:


Each firm has some ability to influence price

The interdependence among firms in setting their pricing policies
Entry barriers exist.

Competition in Oligopoly
Firms in oligopolies tend to concentrate on nonprice competitive policies like advertising
Frequently use administered prices

A predetermined price set by the seller rather than a price determined solely by
demand and supply in the marketplace

Use of nonprice competition eg rebates, promotional deals, etc..

Measurements of Concentration
Concentration ratio

A measure of market power calculated by determining the percentage of industry

output accounted for by the largest firms

Herfindahl Index

A measure of market power calculated by summing the squares of the market shares
of each firm in the industry
Gives much great weight to firms with large market shares. A HI value of <1000
indicates a highly competitive industry.
Competition Among Consumers

A market structure in which there is a single buyer (e.g., rural area granary)


A market structure in which there are only a few buyers (e.g., tobacco market)

Monopsonistic competition

A market structure in which there are many buyers offering differentiated

conditions to sellers (e.g., toy manufacturers)


The Theory of Factor Pricing is concerned with the evaluation of the services of the factors
of production.
It deals with the determination of the share prices of four factors of production, e.g. land,
labor, capital and organization.
Pricing of factors of Production is Functional not Personal.

The rewards of Factors of Production are Income from the factors of production point of
view but Cost from firms point of view.
The Theory of Marginal Productivity
This theory was discussed by many economists like J. B. Clark, Ricardo and Marshall.

It states that in a competitive market, the price or reward of each factor of production tends to
be equal to its Marginal Productivity.
The payment made to the factor concerned is just equal to the value of the addition made to
the total production on account of the employment of the additional unit of a factor.
Terms used in the theory;

Units of Resource
Marginal Product
Marginal Revenue Product (MRP) = Product Price X MP
Marginal Resource Cost (MRC)

When both MRP and its Marginal Cost are equal, the entrepreneur stops employing further
factors of production.

Least Cost Combination of Resources must be applied to maximize the profit which is
arrived by equalizing the ratios between the marginal products and the prices of different
factors of production.

Assumptions of the Marginal Productivity Theory

Identical Products
Factors can be substituted
Perfect Mobility of Factors
Perfect Competition
Law of Diminishing Returns Applies

MRP Curve as Resource Demand Schedule

The MRP curve is also the Demand curve because in a competitive market the product price
and the resource price e.g. wage is fixed.
At different wage rates firm hire corresponding number of labor.

If we take the given table data and say that wage rate is Rs.14 so only 1 labor will be hired
and if wage rate is Rs.6 so 5 labors will be hired because MRP is 14 and 6 respectively at
different number of labors hired.
The Theory of Marginal Productivity

Criticism on Marginal Productivity Theory

Units are not Homogeneous

Factors are not Perfect Substitutes

Law of Diminishing Returns
Difficulty in measurement of MP
Neglected the Effects of Supply

Modern Theory of Factor Pricing

This theory was presented to solve the problem of determination of resource prices which
was ignored by the Marginal Productivity theory as it only states the units of factors of
production to be employed.
This theory takes the demand and supply of each factor and determine their prices by the
equilibrium of market demand for factors and supply of those factors.
Demand for Factors of Production;

Demand for factors is a Derived Demand

Demand For Factors Depends Upon Two Parameters

Magnitude of Demand

High demand if the factor is important in production process

High demand if final product demand is high in the market
Low demand if factor has close substitute
Elasticity of Demand for Factors

If factor price form small portion of total cost so its demand will be inelastic and
vice versa
Depends upon the elasticity of demand for commodity.
If factor is easily substitutable then demand will be elastic

Supply of Factors of Production

The supply of factors of production is a complicated topic but still it can be said that the
higher the price of a factor of production, other things remaining the same, the greater
will be its supply and vice versa.
The prices of factors of production are determined by the interaction of the forces of demand
and supply.

Examples of Perfectly Co
It is rare to find a pure example of perfect competition
But there are some close approximations:
Foreign exchange dealing
Homogeneous product - US dollar or the Euro
Many buyers & sellers
Usually each trader is small relative to total market and has to take
price as given
Sometimes, traders can move currency markets
Agricultural markets
Pig farming, cattle

Farmers markets for apples, tomatoes

Wholesale markets for fresh vegetables, fish, flowers
Street food markets in developing countries.


Prices and Incomes in Competitive Factor Markets Factors of production are

the resources used to produce goods and services.
The factors of production are


Factor prices determine incomes:

Labor earns wages.

Capital earns interest.

Land earns rent.

Entrepreneurship earns normal profit.
Economic profit (loss) is paid to (borne by) the owner of the firm.

Factors of production are traded in markets where their prices and quantities are
determined by the market forces of demand and supply.
This chapter focuses on competitive factor markets.
The laws of demand and supply apply to a competitive factor market: the demand curve
slopes downward and the supply curve slopes upward.
The income earned by the owner of a factor of production equals the equilibrium price
multiplied by the equilibrium quantity. Figure 14.1 shows a factor market at its equilibrium price
and quantity.

Prices and Incomes in Competitive Factor Markets

An increase in the demand for a factor of production raises its equilibrium price,
increases its equilibrium quantity, and increases its income.
An increase in the supply of a factor of production lowers its equilibrium price, increases
its equilibrium quantity, and has an ambiguous effect on its income.
The effect of an increase in the supply of a factor of production on its income depends on
the elasticity of demand.
Labor Markets
Labor markets allocate labor and the price of labor is the wage rate. In the United States,
the real wage rate (the wage rate adjusted for inflation) has risen by 100 percent and the total
quantity of labor hours has increased by over 100 percent.

Figure 14.2(a) shows these trends in wages and quantity of labor supplied over the last four

Figure 14.2(b) shows the shifts in the demand

and supply curves for labor.
Both labor supply and labor demand have
increased since 1961.
The increase in labor demand exceeded the
increase in labor supply, so the wage rate

The Demand for Labor

A firms demand for labor is a derived demanda demand for a factor of production
that is derived from the demand for the goods or services produced by the factor.
The firm compares the marginal revenue from hiring one more worker with the marginal
cost of hiring that worker.
Marginal Revenue Product
The marginal revenue product of labor (MRP) is the change in total revenue that results
from employing one more unit of labor.
The marginal revenue product of labor equals the marginal product of labor multiplied by
marginal revenue.
For a perfectly competitive firm, marginal revenue equals price.
So the marginal revenue product of labor equals the marginal product of labor multiplied
by the price of the product

Marginal revenue product diminishes as the quantity of labor employed increases

because the marginal product of labor diminishes.
For a firm in monopoly (or monopolistic competition or oligopoly) marginal revenue is less than
price and marginal revenue decreases as the quantity sold increases.
So for a firm in a non-competitive market, MRP diminishes as the quantity of labor employed
increases for two reasons:
the diminishing marginal product of labor
decreasing marginal revenue

The Labor Demand Curve

The marginal revenue product curve for labor is the demand curve for labor. If marginal
revenue product exceeds the wage rate, the firm increases profits by hiring more labor.
If marginal revenue product is less than the wage rate, the firm increases profits by hiring
less labor.
If marginal revenue product equals the wage rate, the firm is employing the profitmaximizing quantity of labor.
Because the marginal revenue product of labor decreases as the quantity of labor
employed increases, if the wage rate falls, the quantity of labor demanded increases.

Figure 14.3 shows the relationship between a firms marginal revenue product curve and
demand for labor curve. The bars show marginal revenue product, which diminishes as the
quantity of labor employed increases.
The marginal revenue product curve passes through
the mid points of the bars.
The MRP of the 3rd worker is $12 an hour, so
at a wage rate of $12 an hour, the firm hires 3
workers on its demand for labor curve.

Equivalence of Two Conditions for Profit Maximization

The firm has two equivalent conditions for maximizing profit. They are:
Hire the quantity of labor at which the marginal revenue product of labor (MRP) equals
the wage rate (W).
Produce the quantity of output at which marginal revenue (MR) equals marginal cost
Begin with the first condition: MRP = W.
This condition can be rewritten as: MR MP =
W. Divide both sides by MP to obtain MR =
W/MP. But W/MP = MC.
Replace W/MP with MC to obtain the second condition for maximum profit, MR = MC.
Changes in the Demand for Labor
The demand for labor changes and the demand for labor curve shifts if:
The price of the firms output changes
The prices of other factors of production
change Technology changes
Market Demand
The market demand for labor is obtained by summing the quantities of labor demanded by all firms at
each wage rate.
Because each firms demand for labor curve slopes downward, so does the market demand curve.

Elasticity of Demand for Labor

The elasticity of demand for labor measures the responsiveness of the quantity of labor
demanded in the market to a change in the wage rate.
The elasticity of demand for labor depends on:
The labor intensity of the production process
The elasticity of demand for the product
The substitutability of capital for labor

The Supply of Labor

People allocate their time between leisure and labor and this choice, which determines the quantity of
labor supplied, depends on the wage rate.
A persons reservation wage is the lowest wage rate for which he or she is willing to supply labor.
As the wage rate rises above the reservation wage, the household changes the quantity of labor

Substitution effect

The opportunity cost of leisure increases with the wage.

The substitution effect describes how a person responds by increasing the quantity of labor supplied as the
wage rate rises.

Income effect

An increase in income enables the consumer to buy more of all goods.

Leisure is a normal good, and the income effect describes how a person responds by increasing the
quantity of leisure and decreasing the quantity of labor supplied.

Backward-bending supply of labor curve

At low wage rates the substitution effect dominates the income effect, so a rise in the wage rate
increases the quantity of labor supplied.
At high wage rates the income effect dominates the substitution effect, so a rise in the wage rate
decreases the quantity of labor supplied.
The labor supply curve slopes upward at low wage rates but eventually bends backward at high wage

Labor Market Equilibrium

Wages and employment are determined by equilibrium in the labor market.
The demand for labor has increased because of technological change.
Technological change destroys some jobs but creates others.
On the average, technological change creates more jobs than it destroys and the jobs that
it creates pay higher wage rates than did the jobs that it destroys. The supply of labor has
increased because of an increase in population and technological change and capital
accumulation in the home.
The demand for labor has increased by more than the supply of labor, so the equilibrium
wage rate has increased and the quantity of labor employed has also increased. But the highskilled computer-literate workers have benefited from the information revolution while some
low-skill workers have lost out.
Capital markets are the channels through which firms obtain financial resources to buy physical
factors of production that economists call capital.
The available financial resources come from savings.

The real interest rate is the return on capital and is the price determined in the capital market.

Figure 14.5(b) shows the changes in the

demand for and supply of capital that have
changed the equilibrium quantity and real
interest rate over the last four decades.

The Demand for Capital

A firms demand for financial capital stems from its demand for physical capital.
The firm employs the quantity of physical capital that makes the marginal revenue
product of capital equal to the price of the capital.
The returns to capital come in the future, but capital must be paid for in the present.
So the firm must convert the future marginal revenue product of capital to a present
Discounting and Present Value
Discounting is converting a future amount of money into a present value.
The present value of a future amount of money is the amount that, if invested today, will
grow to be as large as that future amount when the interest that it will earn is taken into
The easiest way to understand discounting is to begin with the relationship between an
amount invested today, the interest that it earns, and the amount it grows to in the future.
If the interest rate for one period is r, then the amount of money a person has one year in
the future is:
Future amount = Present value + (r Present value) Future amount = Present value (1
+ r)
So the present value of the future amount
is: Present value = Future amount/(1 + r)
Similarly, the amount of money that a person has n years in the future is:
Amount n years in future = Present value (1 +
r) So the present value is:
Present value = Amount n years in future/(1 + r)
Because the return a firm earns from investing in capital accrues over a number of future
years, the firm must calculate the present value of each years returns and then sum them
The net present value of an investment subtracts the cost of the capital good from the present value of
its marginal revenue product.

If the net present value is positive, buying the capital is profitable for the firm, and the firm buys the
A rise in the interest rate lowers the net present value of the marginal revenue product of capital,
which in turn lowers the net present value of the capital.
As the interest rate rises, fewer projects have positive net present value, other things remaining the
same, and the quantity of capital demanded decreases.

The Demand Curve for Capital

The quantity of capital demanded by a firm depends on the marginal revenue
product of capital and the interest rate.
The demand curve for capital shows the relationship between the quantity of
capital demanded by the firm and the interest rate, other things remaining the
Two main factors that change the MRP of capital and the demand for capital are:
Population growth

Technological change

The Supply of Capital

The quantity of capital supplied results from peoples savings decisions.
The main factors that determine savings are:
Expected future income
The interest rate
Supply Curve of Capital
The supply curve of capital shows the relationship between the interest rate and the
quantity of capital supplied, other things remaining the same.
A rise in the interest rate brings an increase in the quantity of capital supplied and a
movement along the saving supply curve.
The main influences on the supply of capital are:
The size and age distribution of the population
The level of income
The Interest Rate
The savings plans of households and the investment plans of firms are coordinated through the capital
Adjustments in the real rate of interest make these plans compatible.

Figure 14.6 shows capital market equilibrium and changes in equilibrium

Population growth and technological advances have

increased the demand for capital.
Population growth and income growth have increased
the supply of capital.

A natural resource, or what economists call land, falls into two categories:
Renewable natural resources are resources that can be used repeatedly, such as land (in its everyday
sense), rivers, lakes, rain, and sunshine.
Nonrenewable natural resources are natural resources that can be used only once and that cannot be
replaced once they have been used, such as coal, oil, and natural gas.

The Supply of Renewable Resources

The demand for natural resources as inputs into production is based on the same principle of marginal
revenue product as the demand for capital.
But the supply of natural resources is special.

The quantity of land (and other renewable natural resources) at any given time is fixed,

which means the supply of land is perfectly inelastic.

Figure 14.7 illustrates this case.

The quantity of land (and other renewable natural resources)

at any given time is fixed, which means the supply of land is
perfectly inelastic.
Figure 14.7 illustrates this case.

Natural Resource Markets

The price (rent) for land and other renewable natural resources is determined solely by market
The market supply curve for land is perfectly inelastic, but the supply curve facing any one firm in a
competitive land market is perfectly elastic.
Each firm can rent as much land as it wants at the going market price.

The Supply of a Nonrenewable Natural Resource

For a nonrenewable natural resource, there are three supply concepts:

The stock of a nonrenewable natural resource is the quantity in existence at any given time.
This quantity (like the quantity of land) is fixed and is independent of the price of the resource.
The known stock of a nonrenewable natural resource is the quantity that has been discovered.
This quantity increases over time because advances in technology enable ever less accessible sources
to be discovered.
The flow supply of a nonrenewable natural resource is the rate at which the resource is supplied for
use in production during a given time period.

This supply is perfectly elastic at the price that equals the present value of the expected price of the
resource next period

The opportunity cost of selling a resource this year is the present value of the resource next year.
If this years price exceeds the present value of next years price, owners sell this year.

If this years price is less than the present value of next years price, owners hold on to their stock this
year and plan to sell next year.
These actions make the flow supply perfectly elastic at the present value of next years expected

Figure 14.9 shows how the average prices for the nine most used minerals in production
have fallen over the last 30 years, rather than increased at a rate equal to the interest rate.

Income, Economic Rent, and Opportunity Cost

Large and Small Incomes
Demand and supply in factor markets determine the equilibrium price and quantity of each
factor of production and determine who receives a large income and who receives a small

Large incomes are earned by factors of production that have a high marginal revenue product and a
small supply. National news anchors are an example.
Small incomes are earned by factors of production that have a low marginal revenue product and a
large supply. Fast-food workers are an example.

Economic Rent and Opportunity Cost

The total income received by an owner of a factor of production is made up of its economic rent and
its opportunity cost.
Economic rent is the income received by the owner of a factor of production over and above the
amount required to induce that owner to offer the factor for use.
The opportunity cost of using a factor is the income required to induce its owner to offer the resource
for use, which is the value of the factor in its next best use.

Market Power in the Labor Market

Just as a monopoly firm can restrict output and raise price, so can a monopoly owner of a resource
restrict supply and raise price.
The main source of market power in labor markets is a labor union, which is an

organized group of workers that aims to increase wages and influence other job
There are two types of unions:
A craft union is a group of workers who have a similar range of skills but work for many different
industries and regions.
Examples include the carpenters union or electrical workers union.

An industrial union is a group of workers who have a variety of skills and job types but work for the same
firm or industry.
Examples include the United Auto Workers and the Steelworkers Union.

Union organization in the United States peaked in market strength in the 1950s when 35
percent of the non-agricultural workforce belonged to unions. Today that number has
declined to 12 percent.
There are three forms of union organization.
In an open shop, workers have the right to be employed by the firm without joining the
union. There is no union restriction over who can work in the shop, or firm.
In a closed shop, workers must be union members in order to be employed by the
company. The TaftHartley Act of 1947 made closed shop union arrangements illegal.
In a union shop the firm may hire nonunion workers but the workers must join the union
within a brief period of time after being hired. Twenty states have made union shops
illegal by passing right-to-work laws, which give individuals the right to work for a firm
without joining a union.
Unions and employers negotiate wages, benefits, and working conditions through a
process called collective bargaining
The union and the employer use different methods to strengthen their respective positions
in the bargaining process:
The union can call a strike where all union members are to refuse to work.
The employer can call a lockout where the firm refuses to operate its plant and allow its
employees to work, depriving them of a paycheck.

The employer and the union engage in binding arbitration to resolve a lengthy dispute--an
independent third party enters the collective bargaining process to determine the wage
rates to be paid and resolve any other issues being negotiated.
Unions Objectives and Constraints
A union has three objectives:
Raise compensation

Improve working conditions

Expand job opportunities for its members

Unions are constrained in their pursuit of these goals by:

The ability to restrict non-union labor from replacing union labor, which depends upon
having a large fraction of the relevant labor force.
The ability to retain union jobs in the face of higher wages and benefits, which depends
upon the elasticity of demand for the union labor.
Increasing the marginal revenue product (MRP) of labor: Unions try to increase the
marginal product of union labor, to make the firms demand for labor less elastic.
Encouraging import restrictions: Unions seek government assistance to reduce
availability of substitute goods and services that are produced by non-union labor.
Supporting minimum wage laws: Unions seek to increase the cost of employing unskilled
labor to replace higher- skilled union labor.
The Scale of Union-Nonunion Wage Differentials
The average effect of union activity on wage rates in the United States has been a 30
percent increase in wages compared to non-union labor markets.
But not all unionized industries have achieved higher wages.
In mining and financial services, union wages are no different than non-union wages.
Union wages are 65 percent higher in the construction industry.
A monopsony is a market with just one buyer.
Decades ago, large manufacturing plants, steel mills and coal mines were often the sole
buyer of labor in their local labor markets.
Because a monopsonist firm controls the labor market, it has the market power to set the
market wage rate.
In monopsony the firms marginal cost of labor (MCL) exceeds the average cost of labor
(the wage rate) for all levels of labor employed.
The wage rate increases with the quantity of labor supplied, which means the firms
average cost curve is the supply curve for labor.
The MCL curve for the firm is upward sloping and higher than the supply curve for labor
for all quantities of labor.
To maximize its profit, a monopsonist firm hires the quantity of labor where its MCL is
equal to MRP.
At the profit-maximizing quantity of labor, marginal revenue product (MRP) exceeds
minimum wage rate at which that quantity of labor is willingly supplied.

Monopsony Tendencies
Today monopsony is rare.
A large managed health-care organization might be the only employer of health-care
workers in a local area.
But often, where a monopsony tendency is present, a union is also active.
Monopsony and a Union
Sometimes both the firm and the employees have market power when a monopsony
encounters a labor union, a situation called a bilateral monopoly.
Both the employer and the union must judge each others market power and come to an
agreement on labor supplied and wages paid.
Depending on the relative costs that each party can inflict on the other, the outcome of
this situation may favor either the union or the
The MCL curve is equal to the labor supply
curve over this range of labor.
If this part of the supply curve of labor
intersects the monopsony MRP curve, as a
result of the minimum wage the monopsony
increases the quantity of labor employed and
pays a higher wage rate than if the minimum
wage were not imposed.


Unit IV & V

the social
Economics is
and consumption of goods and

science that

The term
Greek (oikonomia, "management of
+ (nomos,

the production,

economics comes



fromthe Ancient
"rules of the

house(hold)". Current economic models developed out of the broader field of political
economy in the late 19th century, owing to a desire to use an empirical approach more akin to
the physical sciences.
A definition that captures much of modern economics is that of Lionel Robbins in a 1932
"The science which studies human behavior as a relationship between ends and scarce
means which have alternative uses." Scarcity means that available resources are insufficient to
satisfy all wants and needs. Absent scarcity and alternative uses of available resources, there is
no economic. The subject thus defined involves the study of choices as they are affected by
incentives and resources.
Economics aims to explain how economies work and how economic agents interact.
Economic analysis is applied throughout society, in business, finance and government, but
also in crime, education, the family, health, law, politics, religion, social institutions, war,
and science. The expanding domain of economics in the social sciences has been described as
economic imperialism.
distinctions are drawn between various dimensions of economics:
economics (describing "what is") and normative economics (advocating
and applied economics or between
ought to be") or between economic theory


"orthodox" dealing with the "rationality-individualism-equilibrium nexus")

and heterodox economics (more "radical" dealing with the "institutions-history-social

structure nexus").
However the primary textbook distinction is between microeconomics ("small"
economics), which examines the economic behavior of agents (including individuals and firms)
and macroeconomics ("big" economics), addressing issues of unemployment, inflation,
monetary and fiscal policy for an entire economy.


The city states of Sumer developed a trade

and market economy based originally on

the commodity money of the Shekel which was a

certain weight measure of barley, while

the Babylonians and their city state neighbors later developed the earliest system of economics
using a metric of various commodities that was fixed in a legal code. The early law codes from
Sumer could be considered the first (written) economic formula, and had many attributes still in
use in the current price system today... such as codified amounts of money for business deals
(interest rates), fines in money for 'wrong doing', inheritance rules, laws concerning how private
property is to be taxed or divided, etc. For a summary of the laws, see Babylonian law and
Ancient economic thought.
Chinese, Persian and Arab civilizations.

earlier Mesopotamian, Greek, Roman, Indian,
Notable writers include Aristotle, Chanakya (also

known as Kautilya), Qin Shi Huang, Thomas Aquinas and Ibn Khaldun through to the 14th
century. Joseph Schumpeter initially considered the late scholastics of the 14th to 17th centuries
as "coming nearer than any other group to being the 'founders' of scientific economics" as to
monetary, interest, and value theory within a natural-law perspective. After discovering Ibn
Khaldun's Muqaddimah, however, Schumpeter later viewed Ibn Khaldun as being the closest
forerunner of modern economics, as many of his economic theories were not known in Europe
until relatively modern times.
Publication of Adam Smith's The Wealth of Nations in 1776, has been described as "the
effective birth of economics as a separate discipline."[29] The book identified land, labor, and
capital as the three factors of production and the major contributors to a nation's wealth.
Adam Smith wrote The Wealth of Nations
In Smith's view, the ideal economy is a self-regulating market system that automatically
satisfies the economic needs of the populace. He described the market mechanism as an
"invisible hand" that leads all individuals, in pursuit of their own self-interests, to produce the
greatest benefit for society as a whole. Smith incorporated some of the Physiocrats' ideas,
including laissez-faire, into his own economic theories, but rejected the idea that only agriculture
was productive.
In his famous invisible-hand analogy, Smith argued for the seemingly paradoxical notion
that competitive markets tended to advance broader social interests, although driven by narrower
self-interest. The general approach that Smith helped initiate was called political economy and
later classical economics. It included such notables as Thomas Malthus, David Ricardo, and John
Stuart Mill writing from about 1770 to 1870.

While Adam Smith emphasized the production of income, David Ricardo focused on the
distribution of income among landowners, workers, and capitalists. Ricardo saw an inherent
conflict between landowners on the one hand and labor and capital on the other. He posited that
the growth of population and capital, pressing against a fixed supply of land, pushes up rents and
holds down wages and profits.
Malthus cautioned law makers on the effects of poverty reduction policies
Thomas Robert Malthus used the idea of diminishing returns to explain low living standards.
Population, he argued, tended to increase geometrically, outstripping the production of food,
which increased arithmetically. The force of a rapidly growing population against a limited
amount of land meant diminishing returns to labor. The result, he claimed, was chronically low
wages, which prevented the standard of living for most of the population from rising above the
subsistence level.
Malthus also questioned the automatic tendency of a market economy to produce full
employment. He blamed unemployment upon the economy's tendency to limit its spending by
saving too much, a theme that lay forgotten until John Maynard Keynes revived it in the 1930s.
Coming at the end of the Classical tradition, John Stuart Mill parted company with the earlier
classical economists on the inevitability of the distribution of income produced by the market
system. Mill pointed to a distinct difference between the market's two roles: allocation of
resources and distribution of income. The market might be efficient in allocating resources but
not in distributing income, he wrote, making it necessary for society to intervene.
Value theory was important in classical theory. Smith wrote that the "real price of every
thing ... is the toil and trouble of acquiring it" as influenced by its scarcity. Smith maintained that,
with rent and profit, other costs besides wages also enter the price of a commodity. Other
classical economists presented variations on Smith, termed the 'labour theory of value'. Classical
economics focused on the tendency of markets to move to long-run equilibrium.


Microeconomics looks at interactions through individual markets,
and government regulation. A given market might be for a product, say
the services
a factor
considers aggregates of quantity demanded by buyers and quantity supplied by

given scarcity
fresh corn, or
sellers at each

possible price per unit. It weaves these together to describe how the market may reach
equilibrium as to price and quantity or respond to market changes over time.
This is broadly termed supply and demand analysis. Market structures, such as perfect
competition and monopoly, are examined as to implications for behavior and economic
efficiency. Analysis of change in a single market often precedes from the simplifying assumption
that behavioral relations in other markets remain unchanged, that is, partial-equilibrium analysis.
General-equilibrium theory allows for changes in different markets and aggregates across all
markets, including their movements and interactions toward equilibrium.
Supply and demand
Market failure
Public sector
In microeconomics, production is the conversion of inputs into outputs. It is an economic
process that uses resources to create a commodity that is suitable for exchange. This can include
manufacturing, warehousing, shipping, and packaging. Some economists define production
broadly as all economic activity other than consumption. They see every commercial activity
other than the final purchase as some form of production. Production is a process, and as such it
occurs through time and space. Because it is a flow concept, production is measured as a "rate of
output per period of time".
There are three aspects to production processes, including the quantity of the commodity
produced, the form of the good created and the temporal and spatial distribution of the
commodity produced. Opportunity cost expresses the idea that for every choice, the true
economic cost is the next best opportunity. Choices must be made between desirable

yet mutually exclusive actions. It has been described as expressing "the basic relationship
between scarcity and choice.". The notion of opportunity cost plays a crucial part in ensuring that
scarce resources are used efficiently. Thus, opportunity costs are not restricted to monetary or
financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that
provides utility should also be considered.
The inputs or resources used in the production process are called factors of production.
Possible inputs are typically grouped into six categories. These factors are raw materials,
machinery, labour services, capital goods, land, and enterprise. In the short-run, as opposed to the
long-run, at least one of these factors of production is fixed. Examples include major pieces of
equipment, suitable factory space, and key personnel.
A variable factor of production is one whose usage rate can be changed easily. Examples
include electrical power consumption, transportation services, and most raw material inputs. In
the "long-run", all of these factors of production can be adjusted by management. In the short
run, a firm's "scale of operations" determines the maximum number of outputs that can be
produced, but in the long run, there are no scale limitations. Long-run and short-run changes play
an important part in economic models.
Economic efficiency describes how well a system generates the maximum desired output
a with a given set of inputs and available technology. Efficiency is improved if more output is
generated without changing inputs, or in other words, the amount of "friction" or "waste" is
reduced. Economists look for Pareto efficiency, which is reached when a change cannot make
someone better off without making someone else worse off.
Economic efficiency is used to refer to a number of related concepts. A system can be
called economically efficient if: No one can be made better off without making someone else
worse off, more output cannot be obtained without increasing the amount of inputs, and
production ensures the lowest possible per unit cost. These definitions of efficiency are not
exactly equivalent. However, they are all encompassed by the idea that nothing more can be
achieved given the resources available.

Specialization is considered key to economic efficiency because different individuals or
countries have different comparative advantages. While one country may have an absolute
advantage in every area over other countries, it could nonetheless specialize in the area which it
has a relative comparative advantage, and thereby gain from trading with countries which have

no absolute advantages. For example, a country may specialize in the production of high-tech
knowledge products, as developed countries do, and trade with developing nations for goods
produced in factories, where labor is cheap and plentiful.
According to theory, in this way more total products and utility can be achieved than if
countries produced their own high-tech and low-tech products. The theory of comparative
advantage is largely the basis for the typical economist's belief in the benefits of free trade. This
concept applies to individuals, farms, manufacturers, service providers, and economies. Among
each of these production systems, there may be a corresponding division of labour with each
worker having a distinct occupation or doing a specialized task as part of the production effort, or
correspondingly different types of capital equipment and differentiated land uses.
Adam Smith's Wealth of Nations (1776) discusses the benefits of the division of labour.
Smith noted that an individual should invest a resource, for example, land or labour, so as to earn
the highest possible return on it. Consequently, all uses of the resource should yield an equal rate
of return (adjusted for the relative riskiness of each enterprise). Otherwise reallocation would
result. This idea, wrote George Stigler, is the central proposition of economic theory, and is today
called the marginal productivity theory of income distribution. French economist Turgot had
made the same point in 1766.
In more general terms, it is theorized that market incentives, including prices of outputs
and productive inputs, select the allocation of factors of production by comparative advantage,
that is, so that (relatively) low-cost inputs are employed to keep down the opportunity cost of a
given type of output. In the process, aggregate output increases as a by product or by design.
Such specialization of production creates opportunities for gains from trade whereby resource
owners benefit from trade in the sale of one type of output for other, more highly-valued goods.
A measure of gains from trade is the increased output (formally, the sum of increased consumer
surplus and producer profits) from specialization in production and resulting trade.


The supply and demand model describes how prices vary as a result of a balance between
product availability and demand. The graph depicts an increase (that is, right-shift) in demand
from D1to D2 along with the consequent increase in price and quantity required to reach a new
equilibrium point on the supply curve (S).
The theory of demand and supply is an organizing principle to explain prices and
quantities of goods sold and changes thereof in a market economy. In microeconomic theory, it
refers to price and output determination in a perfectly competitive market. This has served as a
building block for modeling other market structures and for other theoretical approaches.
For a given market of a commodity, demand shows the quantity that all prospective
buyers would be prepared to purchase at each unit price of the good. Demand is often
represented using a table or a graph relating price and quantity demanded (see boxed figure).
Demand theory describes individual consumers as rationally choosing the most preferred
quantity of each good, given income, prices, tastes, etc. A term for this is 'constrained utility
maximization' (with income as the constraint on demand). Here, utility refers to the
(hypothesized) preference relation for individual consumers. Utility and income are then used to
model hypothesized properties about the effect of a price change on the quantity demanded.
The law of demand states that, in general, price and quantity demanded in a given market
are inversely related. In other words, the higher the price of a product, the less of it people would
be able and willing to buy of it (other things unchanged). As the price of a commodity rises,
overall purchasing power decreases (the income effect) and consumers move toward relatively
less expensive goods (the substitution effect). Other factors can also affect demand; for example
an increase in income will shift the demand curve outward relative to the origin, as in the figure.
Supply is the relation between the price of a good and the quantity available for sale from
suppliers (such as producers) at that price. Supply is often represented using a table or graph
relating price and quantity supplied. Producers are hypothesized to be profit-maximizes, meaning
that they attempt to produce the amount of goods that will bring them the highest profit. Supply

is typically represented as a directly proportional relation between price and quantity supplied
(other things unchanged).
In other words, the higher the price at which the good can be sold, the more of it
producers will supply. The higher price makes it profitable to increase production. At a price
below equilibrium, there is a shortage of quantity supplied compared to quantity demanded. This
pulls the price up. At a price above equilibrium, there is a surplus of quantity supplied compared
to quantity demanded. This pushes the price down. The model of supply and demand predicts
that for given supply and demand curves, price and quantity will stabilize at the price that makes
quantity supplied equal to quantity demanded. This is at the intersection of the two curves in the
graph above, market equilibrium.
For a given quantity of a good, the price point on the demand curve indicates the value,
or marginal utility to consumers for that unit of output. It measures what the consumer would be
prepared to pay for the corresponding unit of the good. The price point on the supply curve
measures marginal cost, the increase in total cost to the supplier for the corresponding unit of the
good. The price in equilibrium is determined by supply and demand. In a perfectly competitive
market, supply and demand equate cost and value at equilibrium.
Demand and supply can also be used to model the distribution of income to the factors of
production, including labour and capital, through factor markets. In a labour market for example,
the quantity of labour employed and the price of labour (the wage rate) are modeled as set by the
demand for labour (from business firms etc. for production) and supply of labour (from workers).

Demand and supply are used to explain the behavior of perfectly competitive markets,
but their usefulness as a standard of performance extends to any type of market. Demand and
supply can also be generalized to explain variables applying to the whole economy, for example,
quantity of total output and the general price level, studied in macroeconomics.
In supply-and-demand analysis, the price of a good coordinates production and
consumption quantities. Price and quantity have been described as the most directly observable
characteristics of a good produced for the market. Supply, demand, and market equilibrium are
theoretical constructs linking price and quantity. But tracing the effects of factors predicted to
change supply and demandand through them, price and quantityis a standard exercise in
applied microeconomics and macroeconomics. Economic theory can specify under what
circumstances price serves as an efficient communication device to regulate quantity. A real-

world application might attempt to measure how much variables that increase supply or demand
change price and quantity.
Marginalism is the use of marginal concepts within economics. Marginal concepts are
associated with a specific change in the quantity used of a good or of a service, as opposed to
some notion of the over-all significance of that class of good or service, or of some total quantity
thereof. The central concept of marginalism proper is that of marginal utility, but marginalists
following the lead of Alfred Marshall were further heavily dependent upon the concept of
marginal physical productivity in their explanation of cost; and the neoclassical tradition that
emerged from British marginalism generally abandoned the concept of utility and gave marginal
rates of substitution a more fundamental role in analysis.

Pollution can be a simple example of market failure. If costs of production are not borne
by producers but are by the environment, accident victims or others, then prices are
The term "market failure" encompasses several problems which may undermine standard
economic assumptions. Although economists categories market failures differently, the
following categories emerge in the main texts.
Natural monopoly, or the overlapping concepts of "practical" and "technical" monopoly,
involves a failure of competition as a restraint on producers. The problem is described as
one where the more of a product is made, the greater the returns are. This means it only
makes economic sense to have one producer.

Information asymmetries arise where one party has more or better information than the
other. The existence of information asymmetry gives rise to problems such as moral hazard, and
adverse selection, studied in contract theory. The economics of information has relevance in
many fields, including finance, insurance, contract law, and decision-making under risk and
Incomplete markets is a term used for a situation where buyers and sellers do not know
enough about each other's positions to price goods and services properly. Based on George

Akerlof's Market for Lemons article, the paradigm example is of a dodgy second hand car
market. Customers without the possibility to know for certain whether they are buying a "lemon"
will push the average price down below what a good quality second hand car would be. In this
way, prices may not reflect true values.
Public goods are goods which are undersupplied in a typical market. The defining
features are that people can consume public goods without having to pay for them and that more
than one person can consume the good at the same time.
Externalities occur where there are significant social costs or benefits from production or
consumption that are not reflected in market prices. For example, air pollution may generate a
negative externality, and education may generate a positive externality (less crime, etc.).
Governments often tax and otherwise restrict the sale of goods that have negative externalities
and subsidize or otherwise promote the purchase of goods that have positive externalities in an
effort to correct the price distortions caused by these externalities. Elementary demand-andsupply theory predicts equilibrium but not the speed of adjustment for changes of equilibrium
due to a shift in demand or supply.
In many areas, some form of price stickiness is postulated to account for quantities, rather
than prices, adjusting in the short run to changes on the demand side or the supply side. This
includes standard analysis of the business cycle in macroeconomics. Analysis often revolves
around causes of such price stickiness and their implications for reaching a hypothesized longrun equilibrium. Examples of such price stickiness in particular markets include wage rates in
labour markets and posted prices in markets deviating from perfect competition.

Macroeconomic instability, addressed below, is a prime source of market failure, whereby

a general loss of business confidence or external shock can grind production and distribution to a
halt, undermining ordinary markets that are otherwise sound.
Environmental scientist sampling water
Some specialised fields of economics deal in market failure more than others. The
economics of the public sector is one example, since where markets fail, some kind of regulatory
or government programme is the remedy. Much environmental economics concerns externalities
or "public bads".

Policy options include regulations that reflect cost-benefit analysis or market solutions
that change incentives, such as emission fees or redefinition of property rights. Environmental
economics is related to ecological economics but there are differences.
In Virtual Markets, buyer and seller are not present and trade via intermediates and
electronic information.
One of the assumptions of perfectly competitive markets is that there are many producers,
none of whom can influence prices or act independently of market forces. In reality, however,
people do not simply trade on markets, they work and produce through firms. The most obvious
kinds of firms are corporations, partnerships and trusts. According to Ronald Coase people begin
to organize their production in firms when the cost of doing business becomes lower than doing
it on the market. Firms combine labour and capital, and can achieve far greater economies of
scale (when producing two or more things is cheaper than one thing) than individual market
Labour economics seeks to understand the functioning of the market and dynamics for
labour. Labour markets function through the interaction of workers and employers. Labour
economics looks at the suppliers of labour services (workers), the demanders of labour services
(employers), and attempts to understand the resulting patterns of wages and other labour income
and of employment and unemployment, Practical uses include assisting the formulation of full
employment of policies.
Industrial organization studies the strategic behavior of firms, the structure of markets
and their interactions. The common market structures studied include perfect competition,
monopolistic competition, various forms of oligopoly, and monopoly.
Financial economics, often simply referred to as finance, is concerned with the allocation
of financial resources in an uncertain (or risky) environment. Thus, its focus is on the operation
of financial markets, the pricing of financial instruments, and the financial structure of
Managerial economics applies microeconomic analysis to specific decisions in business
firms or other management units. It draws heavily from quantitative methods such as operations
research and programming and from statistical methods such as regression analysis in the
absence of certainty and perfect knowledge. A unifying theme is the attempt to optimize business

decisions, including unit-cost minimization and profit maximization, given the firm's objectives
and constraints imposed by technology and market conditions.
Public finance is the field of economics that deals with budgeting the revenues and
expenditures of a public sector entity, usually government. The subject addresses such matters as
tax incidence (who really pays a particular tax), cost-benefit analysis of government programs,
effects on economic efficiency and income distribution of different kinds of spending and taxes,
and fiscal politics. The latter, an aspect of public choice theory, models public-sector behavior
analogously to microeconomics, involving interactions of self-interested voters, politicians, and
Much of economics is positive, seeking to describe and predict economic phenomena.
Normative economics seeks to identify what is economically good and bad.
uses microeconomic techniques
the allocative
efficiency within an economy and the income distribution associated with it. It attempts
to measure social welfare by examining the economic activities of the individuals that
comprise society.

Macroeconomics examines the economy as a whole to explain broad aggregates and their
interactions "top down," that is, using a simplified form of general-equilibrium theory. Such
aggregates include national income and output, the unemployment rate, and price inflation and
sub aggregates like total consumption and investment spending and their components. It also
studies effects of monetary policy and fiscal policy.

Since at least the 1960s, macroeconomics has been characterized by further integration as
to micro-based modeling of sectors, including rationality of players, efficient use of market
information, and imperfect competition. This has addressed a long-standing concern about
inconsistent developments of the same subject.
Macroeconomic analysis also
and growth of national income. Such
change and labor force growth.

considers factors affecting the long-term level

factors include capital accumulation, technological

Growth economics studies factors that explain economic growth the increase in output
per capita of a country over a long period of time. The same factors are used to explain
differences in the level of output per capita between countries, in particular why some countries
grow faster than others, and whether countries converge at the same rates of growth.
Much-studied factors include the rate
of investment, population
and technological change. These are represented in theoretical and empirical forms (as in
the neoclassical and endogenous growth models) and in growth accounting.

It is a generally said that 90% of the products we use today did not exist in their current
form five years ago. Similarly, 90% of the products we will be using five years from now do not
exist currently. Generally we can all identify products that have changed from their original form
and/or content. And, with today's rapid changes in technology, almost every product will undergo
some sort of modification during its lifetime.
A Product in its life cycle under goes a lot of stages, sales and profit of a product shows a
lot of variation in each stage so it becomes important for a marketer to know the marketing
situation and where his product is placed in Product Life Cycle (PLC),thus impacting the
marketing strategy and the marketing mix.
Knowledge of the products life cycle can provide valuable insights into ways the product
can be managed to enhance sales and profitability. Marketing activities are heavily dependent on
the stage in the product life cycle.
Product Life Cycle has four stages:
In reality very few products follow such a prescriptive cycle. The length of each stage
varies enormously. For example Fashion products tend to have a short life cycle i.e. the time
between the launch of a product and the point at which the product is mature is very quick.
The decisions of marketers can change the stage, for example from maturity to decline by
A marketer needs to study following parameters to know the product life cycle stage :

This is the stage when a product is launched so a marketer knows that his product is in in
introduction stage.
During this stage parameters show following features:

Sales- Product is new and the strategy of the marketer is to make more and more people
try the product. The firm will create product awareness & develop a market for the
product. Sales are very low as people are little apprehensive in using a new product.
Profits- Profits are low and for some product they can be even in negative. As sales are
low and company is spending a huge amount on promotion to inform potential
Customers- Customers using these products are innovators.
Competitors- Competitors are very few as this is a new market. To be the first one to
launch the product helps in long run as customer tend to trust the initiator.
Cost- Cost per customer is high as promotion expenditure is high.
To tackle the challenges mentioned above marketer has to develop a new marketing mix. For this
stage marketing mix can be as follow:
Product- In this stage a product should be in a basic form as this is the first stage. Branding
and quality level is established
Price- Price skimming may be used if the product is a new development & there are no
competitors or pricing may be low penetration pricing to build market share rapidly. Low
prices encourage more people to discover the new product.
Promotion- Promotion is mainly aimed at innovators and early adopters. Informative
advertising is used until the product becomes known. Limiting the marketing to the target
consumers of the product will save money that would cost to send the announcements to
Place- Initially selective placement is done that is limited product availability in few outlets.
An example is Iris-based personal identity cards which are in the introduction stage of the
product life cycle. Iris recognition is a method of biometric authentication that uses pattern
recognition techniques based on high-resolution images of the irides of an individual's eyes.

Iris recognition technology is primarily deployed in high-security physical access

implementations substituting for passports and controlling access to restricted areas at airports;
database access and computer login;. The most prominent deployments of iris recognition
technology have been pilot programs at ATMs in England, Japan, and the U.S One of the largest
current deployments of these algorithms is in the United Arab Emirates, where every day about
10 Billion iris comparisons are performed in real-time database searches. Travelers arriving at 35
air, land, and sea ports have their Iris Codes quickly computed and compared against all the Iris
Codes in a central database. Altogether, some 60 million persons worldwide have so far had their
iris patterns mathematically computed and enrolled by these algorithms.
Iris recognition is forecast to play a role in a wide range of other applications in which a person's
identity must be established or confirmed. These include electronic commerce, information
security, entitlements authorization, building entry, automobile ignition, forensic and police
applications, network access and computer applications, or any other transaction in which
personal identification currently relies just on special possessions or secrets (keys, cards,
documents, passwords, PINs).
This is the second stage of the PLC it is marked by high sales. In this stage marketer realizes that
the product is valuable to the customer and targets a huge uncaptured market. Parameters of this
stage are as follow:
Sales- High sales as by now the product gains confidence of early adapters and they start
buying the product.
Profits- In this stage profit rise as sales increase tremendously.
Customers- They are early adopters.
Competitors- As market starts expanding, number of competitors grow. Some competitors
just copy the most successful product or try to improve over the original product
resulting in much product variety.
Cost- It reduces a bit as the demand for the product increases so cost becomes less per

For this stage marketer should develop marketing mix as follow:

Product- Company improves the product quality and additional features and support services
may be added to the product. Company can also provide warranty and service. Changes
should be made in accordance with the customer needs.
Price- Price should be such that it can penetrate market. Price is reduced a little due to the
entry of the competitors.
Promotion- Advertising is now more focused on brand building. A shift from product
awareness advertising to persuasive advertising is undertaken to encourage brand loyalty.

Place- Strategy should be to build an intensive distribution channel so that product can cater
to increasing demand easily. Its coverage should increase.
An example is ipod which is in its Growth stage.
In the recent years sales of iPods have been slowing. Over the years iPod sales have mirrored the
S-curve, depicts the product life cycle.

iPod sales from 2004 to 2007

As is apparent from the sales graph, iPod is in the Growth stage of the PLC.
iPod Growth strategies:
Sales can come from 3 sources
Non users: Apple cant depend on new users to increase the sales as in previous years as
with 140 million iPods sold and likely more than 200 million total sold, its increasingly
difficult to keep expanding the market to new users. Yet the market will continue to
expand, albeit at a much slower rate.
Competitors customers: The competing devices are cheaper and target more price sensitive
consumers. Apple recently cut iPod Shuffle prices from $79 to $49 making iPods more
competitive among lower-priced devices. This may slightly increase its market share, but
not to an extent large enough to boost sales growth significantly.
Current users:They are the largest source of potential sales. Apple is providing some
additional features to boost the sales. It has extended its iPod line to include iPod Minis smaller, cheaper versions of the iPod with less memory - and the iPod Shuffle, a strippeddown player that Apple promotes for its ability to play songs randomly. Apple has also
encouraged the development of accessories, including a flashlight that snaps on to iPods.
And despite resisting at first, Apple has introduced the iPhoto, which lets users download
digital photos from their computers.

The marketing mix used by the marketer in the previous stage pushes the product in the next
stage of PLC i.e. Maturity. This stage influences the parameters in the following way:
Sales- In this stage the sales are initially at peak but the rate of growth of sales starts
decreasing. So at a later stage of maturity the sales become constant. Decline in sales
show that maturity stage is coming to an end
Profits- Profits are high initially but on a later stage they start decreasing. This is due to
promotion costs and price cuts by competitors to attract more business. Thus less efficient
firms drop out of the market due to increasing pressure on prices.
Customers- Majority of target customer is using the product.
Competitors- Numbers of the competitors become constant. Competition is tougher due to
the presence of aggressive competitors.
Costs- Costs reduces per customers as in this stage a marketer should sale in high volumes
and lower margins to maximize the profit thus reducing the cost.
This stage is most challenging stage for the marketer. It becomes very necessary to come up with
a strategy to overcome this problem and avoid the entry of its product in decline stage. At this
stage marketer tries to sell more to the existing customer this can be done by following
marketing mix:
Product- Marketer needs to diversify brand and product item so that customer buys more.
This can be done by providing various varieties of product item.
Price- It has to be competitive to match the price offered by the other companies.
Promotion- Marketer needs to stress on brand differences and product differentiation. In
this stage companies involve in fierce persuasive advertising battle. Sales promotion
tools like premiums, discounts,free goods etc.
Place- Till this stage product already makes sufficient penetration so a marketer should look
at those places that have remained undiscovered. Distribution becomes more intensive &
incentives may be offered to encourage preference over competing products
Products, when they reach the maturity stage begin to look old and tired. A brand Manager
needs to refresh the products image using Repositioning strategy. The various
repositioning strategies are:
Image Repositioning: The product and target market stay the same but the product
image changes. Eg: Cadbury Snack
Product Repositioning: Changing the product to make it more attractive to the
current market. Eg: Most new models of cars
Intangible Repositioning: Using the same product to target a different target segment.
Eg: Lucozade change from targeting the sick to targeting the athletes.
Tangible Repositioning: The most radical strategy as both product and target market
are changed. Eg: Volkswagens revitalizing of the Skoda Brand.

The decline stage is the last stage of the PLC. This stage can be identified by the following
changes in the parameters:
Sales- They are declining in this stage. It becomes really difficult for the marketer to revive
the sales or continue with the product.
Profit- Profits are declining in this stage as sales are diminishing. All though profits can be
optimized by reducing the promotional expenditure.
Customers- They are those people who are innovators and use out of date products.
Competitors- Numbers are declining as intelligent companies leave these products and start
concentrating on those products that are in demand. Some companies completely
withdraw from the market.
Costs- Low cost per customer.
To survive this stage marketer should change the marketing mix. Following marketing mix can
be followed:
Product- At this stage the best strategy is to phase out the weaker product and concentrate
on strong product. Maintain the product- possibly rejuvenating it by adding new
features & finding new uses.
Price- Price of the product should be reduced to increase the sales.
Promotion- It should be just sufficient to retain the remaining users as one cannot capture
new customers at this stage.
Place- Concentrate only on those distribution channels which are still showing sales. All
other channels should be phased out.
For example: Typewriters, cloth diapers, black and white televisions, VCR and cassette
Product Life cycle model though considered as straightforward and powerful model needs
to be used carefully as it is hard to tell in which stage the product is as there are constant
short term fluctuations due to external factors resulting in incorrect marketing actions. In
conclusion the model is useful to identify the symptoms of each stage.


As per RBI definitions A market for short terms financial assets that are close substitute for
money, facilitates the exchange of money in primary and secondary market .
The money market is a mechanism that deals with the lending and borrowing of short term
funds (less than one year).
A segment of the financial market in which financial instruments with high liquidity and very
short maturities are traded.

It doesnt actually deal in cash or money but deals with substitute of cash like trade bills,
promissory notes & government papers which can converted into cash without any loss at
low transaction cost.
It includes all individual, institution and intermediaries.


Transaction have to be conducted without the help of brokers.

It is not a single homogeneous market, it comprises of several submarket like call money
market, acceptance & bill market.
The component of Money Market are the commercial banks, acceptance houses & NBFC
(Non-banking financial companies).
In Money Market transaction can not take place formal like stock exchange, only through
oral communication, relevant document and written communication transaction can be
Objective of Money Market
To provide a reasonable access to users of short-term funds to meet their requirement quickly,
adequately at reasonable cost.

To provide a parking place to employ short term surplus funds.


Development of trade & industry.
Development of capital market.
Smooth functioning of commercial banks.
Effective central bank control.
Formulation of suitable monetary policy.
Non inflationary source of finance to government.


Money Market consists of a number of sub-markets which collectively constitute the money
market. They are,
Call Money Market
Commercial bills market or discount market
Acceptance market
Treasury bill market


A variety of instrument are available in a developed money market. In India till 1986, only a few
instrument were available.
They were
Treasury bills
Money at call and short notice in the call loan market.
Commercial bills, promissory notes in the bill market.

Now, in addition to the above the following new instrument are available:
Commercial papers.
Certificate of deposit.
Inter-bank participation certificates.
Repo instrument
Banker's Acceptance
Repurchase agreement
Money Market mutual fund


CP is a short term unsecured loan issued by a corporation typically financing day to day
CP is very safe investment because the financial situation of a company can easily be
predicted over a few months.
Only company with high credit rating issues CPs.


(T-bills) are the most marketable money market security.
They are issued with three-month, six-month and one-year maturities.

T-bills are purchased for a price that is less than their par(face) value; when they mature, the
government pays the holder the full par value.
T-Bills are so popular among money market instruments because of affordability to the
individual investors.
A CD is a time deposit with a bank.

Like most time deposit, funds can not withdrawn before maturity without paying a penalty.
CDs have specific maturity date, interest rate and it can be issued in any denomination.
The main advantage of CD is their safety.
Anyone can earn more than a saving account interest.


Repo is a form of overnight borrowing and is used by those who deal in government
They are usually very short term repurchases agreement, from overnight to 30 days of more.
The short term maturity and government backing usually mean that Repos provide lenders
with extreamly low risk.
Repos are safe collateral for loans.

A bankers acceptance (BA) is a short-term credit investment created by a non-financial firm.
BAs are guaranteed by a bank to make payment.

Acceptances are traded at discounts from face value in the secondary market.

BA acts as a negotiable time draft for financing imports, exports or other transactions in
This is especially useful when the credit worthiness of a foreign trade partner is unknown.
Reserve bank of India.
DFHI (discount and finance house of India).
Commercial banks

Public sector banks

SBI with 7 subsidiaries
Cooperative banks
20 nationalized
banks ii. Private banks
Indian Banks
Foreign banks
4. Development bank

Indigenous banks
Money lenders


State cooperative

Central Cooperative Banks

Primary Agri credit societies
Primary urban banks

State Land development banks

Central land development banks

Primary land development banks


Purchasing power of your money goes down, in case of up in inflation.
Dichotomized and loosely integrated
Irrational structure of interest rates
Highly volatile market

Seasonal stringency of loan able funds

Lack of funds in the money market
Inadequate banking facilities


Highly organized banking system
Presence of central bank
Availability of proper credit instrument
Existence of sub-market
Ample resources
Existence of secondary market
Demand and supply of fund


Integration of unorganized sector with the organized sector
Widening of call Money market
Introduction of innovative instrument
Offering of Market rates of interest
Promotion of bill culture
Entry of Money market mutual funds
Setting up of credit rating agencies
Adoption of suitable monetary policy
Establishment of DFHI
Setting up of security trading corporation of India ltd. (STCI)


Socialistic Pattern Of Society
Public Utility Services
Planned Economy
Balanced Economic Growth
Creation Of Infrastructure
Less Profitable And Highly Risky Industries
Establishment Of Defense Industry
Foreign Competition And Protection

Government Intervene in
Fiscal and Monetary Policy
Union Budget
Development Banking
Industrial Policy Resolutions
Exim Policy
Public Sector

Fiscal Policy
Part of Government policy which is concerned with raising revenue through taxation and other
Deciding on the level and pattern of expenditure
Different policy adopted in different economies

Objectives of Fiscal Policy

Maximize the level of aggregate saving
Divert capital resources
Maximize the rate of capital formation
Protect the economy from inflation
Eliminate inequalities and bring equitable distribution of income
Eliminate sectoral imbalance

In common terms, National Income means the total value of goods and services produced
annually in a country.
In other words, National Income is the total amount of income accruing to a country from
economic activities in a years time.
National Income helps us to know the economic progress achieved and to make comparative
Traditional Definition
Proposed by Marshall, Pigou, Fisher discusses about the reasons influencing economic welfare and
compares it in different years.

Modern Definition
Simon Kuznets defines it as The net output of commodities and services flowing during the year
from the countrys productive system in the hands of the ultimate consumers.
JM.Keynes, a famous economist defined National Income as

National Income is the money value of all goods and services produced in the country during a

Methods of Measuring NI

Selection of method depends on the availability of data in the country and the purpose
Measuring National Income PM

The total value of the final goods and services produced in a country during a year is calculated at
market price.
All productive activities such as agricultural products, commodities produced at industries, etc are
collected and assessed at market price.
Only final goods and services are included and the intermediary goods and services are left
Money sent by Indian citizens working aboard are also added.

GROSS NATIONAL INCOME = Money Value of total goods and services + Income from abroad

Measuring National Income - IM


The net income payments received by all citizens of a country in a particular year are
added up.


Income details are obtained from Income Tax Dept. (High Income) and Wages Bills.
Income by way of net wages, net rents, net interest, net profits are added together but
incomes received in form of transfer payments are exempted.

GROSS NATIONAL INCOME = Rent + Wages + Interest + Profit + Income from abroad

Measuring National Income EM

The total expenditure incurred by the society in a particular year is added together. This
includes personal consumption expenditure, net domestic investment, government expenditure
on goods and services, net foreign investment.

GROSS NATIONAL INCOME = Individual Expenditure + Government Expenditure

Measuring National Income VAM


The difference between the value of material outputs and inputs at each stage of production is the
value added.
All such difference are added up for all industries in the economy, to arrive at the GDP

Some Facts
The first attempt to calculate National Income of India was made by Dada Bai Naoroji in 1867-68.
This was followed by several attempts.
The first scientific attempt was made by Prof.V.K.R.V.Rao in 1931-32. But was not satisfactory.
The first official attempt was made by Prof.P.C.Mahalanobis in 1949-49.

The final report was submitted in 1954.

Today the National Income is calculated by the Central Statistical Organization.

Non availability of reliable statistics
Service of Housewives
Owner-occupied Houses
Self Employed persons
Goods meant for self-consumption
Illegal Activites
Wages and Salaries paid in Kind
Intermediate and Final Goods

Second-hand Goods and Assets

Price Changes

Transfer Payments etc..

Personal Income
Per Capita Income

Inflation Definitions


Substantial rise in price Johnson

Continuing increase in general price level Brooman
Persistent and appreciable rise in general level of price Shapiro
Substantial inflation is always and everywhere phenomenon Prof. Friedman



CREEPING Slow rise






% increase in
< 3%

Effect on economy

3-6% but less

than 10%

Warning signal


Safe and essential

Affects poor and

middle class. Need
to be controlled by
M & F policy
Immeasurable and

Further classification of Inflation


1. Excess demand over supply cause rise in price

2. Price rise in proportion to increase in money supply
3. Increase in money supply creates more demand for goods but supply cannot be increased

Caused by wage increase enforced by labour unions and profit by employers

Also known as New Inflation
Due to wage-push, profit-push
Increase in money supply
Increase in disposable income
Increase in public expenditure
Expansion of private sector
Monetary policy credit policy
Black money
Increase in exports
Natural calamities
Artificial scarcities
International factors


Credit control
Demonetization of currency of higher denominations
Issue of new currency
Reduction in unnecessary expenditure by Government
Increase in taxes
Increase in savings on part of citizens
Increase production
Rational wage policy
Price control by Government Law