Psychological Law of Consumption

Psychological Law of Consumption:
Psychological Law of Consumption: (Assumptions and and

Implication)!
The Keynesian concept of consumption function stems from the fundamental
psychological law of consumption which states that there is a common tendency
for people to spend more on consumption when income increases, but not to the
same extent as the rise in income because a part of the income is also saved. The
community, as a rule, consumes as well as saves a larger amount with a rise in
income.
Thus, Keynes’ psychological law of consumption is based on the

following propositions:
i. When the total income of a community increases, the consumption expenditure
of the community will also increase, but less proportionately.
ii. It follows from this that an increase in income is always bifurcated into
spending and saving.
iii. An increase in income will, thus, lead to an increase in both consumption and
savings. This means that with an increase in income in the community, we
cannot normally expect a reduction in total consumption or a reduction in total
savings. A rising income will often be accompanied by increased savings and a
falling income by decreased savings. The rate of increase or decrease in savings
will be greater in the initial stages of increase or decrease of income than in the
later stages.
The gist of Keynes’ law is that consumption mainly depends on income and that
income recipients always do not tend to spend all of the increased income on
consumption. This is the fundamental maxim upon which Keynes’ concept of
consumption function is based.
Keynes’ law is limited by the following assumptions:
1. Constancy of Psychological and Institutional Factors:
Propensity to consume will remain stable owing to the constancy of the existing
psychological and institutional complexities influencing consumption
expenditure.
2. Normal Economic Conditions:

General economic conditions are normal and there are no abnormal and
extraordinary circumstances such as war, revolution, inflation, etc.
3. Laissez-faire Policy:
It is assumed that there exists a free capitalist economy, in which there is no
government restriction on consumption when income increases.
Implications of the Psychological Law of Consumption:

A more detailed analysis of Keynes’ law shows that it has the following important
implications:
1. Highlighting the crucial importance of investment in an economy:

A vital point in the law is the tendency of people not to spend on consumption
the full amount of an increase in their income. There is thus a “gap” between
aggregate income and aggregate consumption.
Assuming the consumption function to be stable during a short-run period, the

“gap” will widen with an increase in income. This gives rise to the problem of
investment. Investment should be increased to fill the gap between income and
consumption. Keynes, therefore, stresses that investment is the crucial and
initiating determinant of levels of income and employment.
2. Refuting Say’s Law:

It refutes Say’s Law of market by indicating the demand deficiency and
possibility of over-production.
3. Explanation to the Business Cycle:
An explanation of the turning points of a business cycle is also provided by this
law. The upper turning point from a boom is caused by a collapse of the marginal
efficiency of capital owing to the fact that consumption expenditure does not
keep pace with increase in income during the prosperity phase.
Similarly, the law explains the revival of the marginal efficiency of capital and the
turning point of recovery from a depression, on the basis of the fact that when
income is reduced consumption expenditure does not decrease in the same
proportion.
Keynesian Psychological Law of Consumption
The concept of consumption function stems from the basic psychological law of consumption which
states that generally, people tend to spend more on consumption when there is an increase in their
income level. However, the rise in the spending behavior is not to the same extent as the rise in
income because a part of the income is saved as well.
The psychological law of consumption shows the relationship between income and consumption
pattern that exists among the household sectors in an economy. As stated by Keynes, “The
psychology of the community is such that when the aggregate real income increases, aggregate
consumption also increases, but not as much as income.”
The law is based on three interrelated propositions:
1. When aggregate income increases, consumption expenditure also increases, but less proportionately.
This is because, as a person’s income increases, most of their wants are gradually satisfied. So, less is
spent on consumption after a subsequent level of increment in their income.
2. It follows that the increment in the level of income is always divided into spending and saving.
3. An increase in income thus, leads to an increase in consumption as well as savings. Normally, people
would spend more and save more when income increases.
Assumptions
Keynes’ law is limited by the assumptions explained below:
A. Invariability of Psychological and Institutional Factors

The institutional and psychological factors of people remain constant that leads to the stability of
propensity to consume. Spending habit, income distribution, inflation, population, etc. remain the
same in the long run.
B. Laissez-faire Economic Policy
A free capitalist economy is assumed to exist where there are no government interventions even in
case of increase in the level of income. The demand and supply of goods and services are
determined by the market.
C. Normal Economic Conditions
Normal conditions are prevalent within the economy. This means that any unusual or extraordinary
circumstances such as inflation, war, revolution, etc. have no chances of occurrence.
The law is based on normal human behavior, where, the additional income earned is not just spent on
consumption, but a portion of it is saved as well. This means,
ΔY= ΔC + ΔS.
This phenomena can be explained with the help of the following table and diagram:
Income (Y) Consumption (C) Saving (S)
0 20 -20
50 60 -10
100 100 0
150 140 10
200 180 20
The diagram above shows income at OYE where no saving has yet been made. With the gradual
increase in income, aggregate saving also increases after OYE level of income. This shows that
additional income earned is divided into consumption expenditure and saving.
Implications of the Psychological Law of Consumption

The major implications of the law is it explains the phenomena that marginal propensity to consume
is less than unity i.e. MPC < 1.
MPC refers to the additional consumption per unit of additional income, represented as
MPC=ΔC/ΔY
We have, Y= C+ S
Where, Y= Income; C= Consumption; S= Saving

Let increase in income be ΔY and the corresponding increment in consumption and saving be ΔC
and ΔS.
Cite this article as: Shraddha Bajracharya, "Keynesian Psychological Law of Consumption," in Businesstopia, January
12, 2018, https://www.businesstopia.net/economics/macro/keynesian-psychological-law-consumption.
Therefore, MPC is less than 1.
The analysis of Keynes’ law shows some major implications of the psychological law of propensity to
consume, that include:
A. Highlights the importance of investment in an economy

One of the most important implications of the law is that explains the role of investment when the
community of people in an economy spends less than the increment in their salary. As a result of
this, a gap exists between aggregate income and aggregate consumption.
In order to remove the widening gap, investment should made in the economy, assuming the
consumption function is stable in the short run. Thus, Keynes stresses in the importance of
investment for determining the level of income and employment in the economy.
B. Explains the declining phenomena of MPC

When consumption level remains unchanged even with an increment in the income level, the
marginal efficiency of capital may decline. This can be avoided if the level of spending is equal to the
level of income rise.
Since investment opportunities are fluctuate with the changing rate of interest, the stable
consumption function tends to lower the marginal efficiency of capital and investment in the short
run.
C. Explanation of the business cycle

MPC being less than unity enables us to understand the fluctuations that occur in the business cycle.
When people start saving more than they spend, the economy is at boom, and this leads to fall in the
income level. When income falls, and people do not curtail their consumption to the level of
decrement in the level of income, the economy turns towards depression.
Stagflation
Meaning of Stagflation
Stagflation is an economic cycle in which there is high rate of inflation and stagnation. Inflation is
when prices of commodities are at an increasing state. Stagnation occurs when an economy faces
slow economic growth rate (decline in production).
An economy going through stagflation faces high rates of unemployment during.
Simply, stagflation is an economic situation in which prices are rising, there is a lack of job
opportunities, and business firms are not performing well. It is a period of slow economic growth or
when the economy is shrinking.
The condition of stagflation can be illustrated with the help of the following diagram:
As shown in the diagram, the initial level of output was Y1 with a general price level of Y1. The output
or total supply curve shifts from AS1 to AS2. This states that the supply of goods and services in the
economy has declined.
The figure also shows that the general price level of goods and services has increased from P1 to P2
even when the level of output has decreased. This is the rare economic condition of stagflation.
Many economists believed that stagflation was not possible. But, the event of Middle East-imposed
oil embargo in 1973 gave rise to stagflation. During this time, there was a substantial rise in price of
oil and food prices. This subsequently led to inflation. The scarcity of oil and increasing price levels
decreased the supply of commodities.
Causes of Stagflation
Economists have identified two major explanations for the occurrence of stagflation. They believe
that stagflation occurs as a result of supply side shock, and inappropriate macroeconomic policies.
For instance, increase in prices slows down economic growth by affecting production and producers.
When cost of production becomes high, production itself becomes costly and reduces profit levels of
the manufacturing firms.
When prices rise, costs of firms also rise (transport of goods become more costly), so aggregate
supply declines. This causes higher rates of inflation and lower output levels.
Inappropriate macroeconomic policies
Stagnation and inflation can occur simultaneously because of inappropriate macroeconomic
policies.
For instance, the excess of money supply in the market leads to inflation. This happens when the
central authority allows more cash in the economy. Similarly, when government imposes excessive
regulation over goods and labor markets, it results in stagnation.
Further, efforts of the government to control inflation may result in decreased productivity. This is
because producers would be unwilling to produce at lower profit margins.
Thus, when an economy enters stagflation, any effort made to overcome it, can cause further
damage to the economy.
Deflation
Meaning of Deflation
Deflation is defined as a decline in the general price level of commodities and services within a given economy.
Deflation occurs when demand for commodities decrease or supply of commodities increase. Lower demand or
higher supply forces businesses to reduce prices. This leads to a negative rate of inflation. Thus, deflation is the
opposite of inflation that occurs in an economy.
It is a phenomenon that occurs when demand for commodities decrease (may have caused because the
purchasing power of people have declined) or supply of commodities increase, leading to a decline in the
overall price level. This leads to a negative rate of inflation. Thus, deflation is the opposite of inflation that
occurs in an economy.
Understanding Deflation through a practical example
To drive the point further, let’s take an example of three friends Ron, Tina and Natasha. We give each of them
10 candies. Now we ask them if they would be willing to trade 5 of their candies for a toy.
Suppose Ron is ready to pay 4 of his candies. Tina also likes the toy so she is ready to pay 5 candies. Natasha
wants the toy more and is ready to pay 6.
Now let us take 5 candies away from each of them. Natasha obviously cannot afford to buy the toy now. Ron
likes the toy but he doesn’t want to be left with just one candy. So all of them are now unwilling to pay the
amount they were ready to pay earlier due to lower purchasing power.
We also need to consider the impact on the person who is selling the toy. He must now reduce the price of the
toy if he wishes to sell it. This leads to deflation.
Not as good as it sounds

At first sight, deflation seems like a favorable economic condition. The reality is the opposite. Deflation is a
sign of deterioration of economic conditions. It is often associated with a rise in the level of unemployment
within an economy. As demand of commodities declines, firms start producing less. Lower production reduces
the demand for factors of production – land, labor, capital and entrepreneurship. This ultimately leads to
increase in unemployment.
Decline in production affects business firms even more. Businesses have to deal with lowering profits. They are
not able to invest more capital or focus on development of new technologies.
Similarly, business firms are at loss (profits decline due to decline in production and selling of commodities)
during deflation, which further hampers the expansion of capital and development of new technologies.
Causes of Deflation
Deflation is often caused due to reduced supply of money. But, it may also result due to a decline in personal,
governmental, or investment spending. There are other economic factors that lead to the phenomena of
declining prices. Some of the factors contributing to deflation are stated below:
Increased productivity of the firms

Businesses and manufacturing firms become more productive through new and innovative processes of
production. As efficiency increases, the stock level of goods and commodities increases. To sell more and
reduce stock levels, producers reduce the price level of goods and services. This may have a profound effect on
the entire economy, leading to deflation.
For example, after the fall of Soviet Union in 1991, people from the newly formed countries were willing to
work at low wages for a living. Companies in the United States outsourced their work at lower wages to those
people. Subsequently, their supply increased and so they had to reduce price of the commodities. This led to
deflation in the 20th century.
Decrease in money supply
Deflation occurs when money supply is slower than the supply of commodities. Prices decline because there is
limited money flow in the economy. So, business firms accept lower prices for goods and services in order to
earn as much as they can.
For example, in 1913 the Federal Reserve in the United States contracted the supply of money. This reduced
the purchasing power of households and individuals. As a result, demand declined, and producers were forced
to sell at lower prices, which caused deflation.
Fall in aggregate demand
Aggregate demand falls when people demand less of the goods and services. This occurs when people hoard
money with an expectation of further rise in the value of money. Producers are thus forced to reduce the price
of commodities in order to avoid profit decline and piling up of inventories. This results in deflation in the
economy.
Deflationary Spiral
People become cautious spenders in an economy going through mild deflation. The economy reaches a
situation where it cannot revive from declining prices and aggregate demand levels. This accumulates and it
leads to further decline in prices in a vicious circle known as the deflationary spiral.
The diagram below shows how deflationary cycle affects the economy:
Change in structure of capital markets
To compete in a market, producers try to sell their products at a lower price than their competitors. The increase
in demand can help them get a return on their investment later, but this needs more investment to begin with.
Changes in capital structure can make it easy for companies to access debt and equity markets. Manufacturing
companies can invest in new technologies, reduce costs and improve efficiency.
Firms can then reduce prices of the supplied goods to make a sale in the market. This may result in deflation.
Effects of Deflation
Deflation can damage the economy severely. There have been cases where countries never recovered from this
economic condition. Some of the major impacts seen in the economy as a result of deflation are stated below:
Change in customer spending pattern

Falling prices often has an unfavorable impact on the spending pattern of consumers. It encourages people to
delay their purchases because of the expectation of further price fall in the future.
Demand for luxury goods such as TV or car reduces because people wait for the commodities to become
cheaper. Thus, deflation leads to lower consumer spending.
Cyclical unemployment
Deflation occurs due to fall in aggregate demand in the economy. This leads to business firms reducing their
output levels which results in laying off of labors. As consumers delay spending while waiting for the prices of
commodities to fall, economic activities decline, and this gives rise to unemployment.
Decline in business revenue

Business firms significantly reduce prices of the produced commodities in order to stay competitive against the
falling prices in the economy. Subsequently, revenues earned by these firms start declining.
It is natural for revenues to fall sometimes, even during normal economic conditions. The problem lies in the
fact that deflationary cycles are repetitive. Firms cannot recover from business losses during deflationary
period.
Decline in supply of credit

Financial institutions and lenders decrease the supply of credit as deflation starts rising in the economy. This is
because during deflation, value of assets used as collateral by individuals such as houses decline. So, in case
borrowers are not able to pay back the debt, lender would have to recover their investment through property
seizures. Since the value of properties are in a declining state, lenders cannot fully recover the value. Thus,
creditors become more reluctant in providing credit or loan to borrowers.
Deflationary spiral
The falling of prices of goods and services triggers the deflationary spiral.
As profits decline, businesses are less inclined to make new investments. Firms also lay off workers to cut
costs. This reduces household incomes and decreases aggregate demand. The economy falls into a deflationary
trap.
Increase in real value of debt

During the period of deflation, debtors face a difficult time in paying off their debts. Business firms as well as
individuals have to give up larger portion of their disposable income for debt face the problem of lower wages
rates. Thus, deflation increases the real value of money and the real value of debt.
Meaning
Saving is defined as the excess of income over consumption expenditure. The concept of saving is
closely related to the concept of consumption. Saving is the part of income that is not consumed.
Generally, as the level of income increase, saving also increases and vice versa.
Saving Function
Saving function or the propensity to save expresses the relationship between saving and the level of
income. It is simply the desire of the households to hoard a part of their total disposable income.
Symbolically, the functional relation between saving and income can be defined as S= f(Y).
We know,
Y= C + S;
Thus, S= Y-C;
Where, Y= Income; S= Saving; C= Consumption
The equation shows that the remaining amount after the deduction of total expenditure from total
income is saving. Thus, saving is that part of income which is not spent on consumption
Relationship between Saving and Income

 A direct relationship exists between saving and income. This means, if income increases, saving also
increases but in less proportion in comparison to income.
 When income level is low, saving is negative. In the initial stages when income is low, consumption
expenditure is more than in comparison to the level of earning, so there is no saving .i.e. dis-saving.
The table and diagram below clearly explains the relationship between income and saving:
Income (Y) Consumption (C) Saving (S) APS (S/Y) MPS (ΔS/ ΔY)
0 20 -20 – –
60 70 -10 – –
120 120 0 0 –
180 170 10 0.06 0.17
240 220 20 0.08 0.17
Table 1 Relationship between Income and Saving
Attributes of Saving Function
Saving function or propensity to save has two major attributes:

 Average Propensity to Save (APS)
 Marginal Propensity to Save (MPS)
Average Propensity to Save (APS)
The average propensity to save is a relationship between total saving and total income in a given
period of time. It is the ratio of saving to income that shows the portion of the income that people
saved.
Symbolically,
APS=S/Y
Where, S= Saving; Y= Income
For example, when the disposable income is 180, consumption is 170, and saving is 10, we can
calculate APS as
APS= 10/180 =0.06 or 6%
Cite this article as: Shraddha Bajracharya, "Saving Function," in Businesstopia, January 12,
2018, https://www.businesstopia.net/economics/macro/saving-function.
This shows that out of total income in a year, 6 % will be saved after spending on consumption. As
shown in the table above, we can see that the average propensity in save increases with the increase
in income .i.e. APS increased from 0.06 to 0.08 with the increase in income.
Diagrammatically,
APS is a point on the curve S, and it is measured as S1Y1/OY1.

Marginal Propensity to Save (MPS)
The marginal propensity to save or MPS refers to the increase in the proportion of saving as a result
of increase in the level of income. It can be defined as the ratio of change in saving to change in
income.
Symbolically,
MPS=ΔS/ΔY
Where, ΔS= Change in saving; ΔY= Change in income
For example, when income increased from 180 to 240, savings also changed from 10 to 20. We can
then calculate MPS as
MPS= 10/60 =0.17 or 17%
This shows that, when income increased, the proportion of saving also increased. The saving made
out of total income is 17%.
Diagrammatically,
In the diagram, BC is the change in income and AB is the consequent change in saving. So, MPS is
AB/BC.
Determinants of Saving Function
The determining factors that contribute to the saving function include Desire to save, Power to save,
and Facilities to save.
Desire to Save
The desire or the willingness of an individual or household to save is the major driving factor towards
saving. The factors that affect the desire of an individual to save are
i. Level of income
Level of income is an important determinant of saving in any economy or country. Higher the level of
income for any household or individual, higher the level of saving.
ii. Provisions for the future

The future requirements of money is uncertain. So, in order to have a secured future against any
uncertain events, saving up at present helps to have a pool of extra money. Savings can be taken as a
precaution for any unforeseen needs in the future.
Ability to Save
In spite of the willingness to save, one cannot save if they do not have the capacity or the ability to
save. Saving is only possible if an individual can meet all their consumption expenditures and still
save up, then it can be said that they have the ability to save. Ability to save depends on the level of
income and consumption expenditure.
The factors that determine the ability to save include
i. Labor Efficiency
The ability or power to save depends on the efficiency of labor. If an economy has an efficient group
of people, it increases production efficiency as well. This results in increasing income and thus
people can have more money that can be saved, even after meeting the consumption expenditures.
ii. Size of National Income

Higher the national income, greater is the ability to save. Low national income in developing and
under-developed countries is the main reason for no saving being made.
iii. Developmental activities

The development of various sectors like trade, industrial areas, agricultural sector, etc. is a source of
increased income level, as there will be more inflow of money into the economy.
Facilities to Save
Saving also depends on the facilities availability. This includes:
i. Development of financial institutions

The development and expansion of financial institutions like banks, co-operatives, etc. encourage
people to save more with their effective marketing strategies. They also provide attractive interest
rates on savings.
ii. Rate of interest

Attractive interest rates encourage people to save more. When the interest rates are high in the
market, people save more, and when the rates are low, they withdraw and spend on consumption.
iii. Social security system

The provision of security system such as old age pensions, medical insurance, unemployment
allowance, etc. reduces the rate of saving in a country. When there is adequate provision of social
security in the society, people feel secured about their future and they spend more of their income on
consumption.
iv. Taxation Policy

Progressive taxes reduce saving as taxes increase with the increase in income. People with higher
income save less because of the taxes they need to pay. But if the taxes on expenditure are higher
then, they are encouraged to spend less and save more.
v. Fiscal policy
The fiscal policy of the government affects the level of saving in a country. If taxes are imposed on
necessary commodities, people cannot save more. The reduction of taxes on basic goods leads to
an increase in the level of saving. Also, if taxes are high on luxury goods, people are enticed to save
more than to purchase luxury goods.
Businessmen and entrepreneurs are induced to make an investment when the return on investment
is attractive. Before investing, businessmen compare the yield from the investment and the cost
incurred in making the investment. It is only when the return is greater than cost, investment is made.
Producing in a capitalist economy, profit is the primary objective of business firms and
manufacturing companies. So in order to maximize their profit, they seek to invest in those ventures
that yield higher profit. Keynes introduced the concept of marginal efficiency of capital in order to
analyze the profitability of the prospect ventures.
Generally, marginal efficiency of capital or MEC refers to the expected rate of profit or the rate of
return from investment over its cost. Marginal efficiency of a given capital asset is the highest return
that can be yielded from the additional unit of that capital asset.
Keynes defined MEC as ‘The rate of discount which makes the present value of the prospective yield
from the capital asset equal to its supply price’.
Thus, Keynes’ marginal theory of capital is bases on two factors that include
1. Prospective yield from capital assets
The term prospective yield is the aggregate net return the investor expects to receive on the sale of
capital assets after the deduction of running costs incurred for the purchase of capital assets
considering its total expected life.
Usually, when the total expected life of the capital asset is divided into a series of periods, generally
years, the annual return is determined. This is represented as Q1, Q2, Q3… Qn and are termed as
annuities.
2. Supply price of this asset
The investor has to consider the supply price of asset that he is planning on investing. Supply price of
asset refers to the cost incurred for the acquisition of the capital asset. Here, the cost incurred is for
the purchase of or production of a new asset and not the price of any of the existing assets.
The present value of a series of expected income from the invested capital asset throughout its life
span is expressed as
Where,
SP= Supply price of new capital asset;

R1 + R2 + … + Rn = Return received annually;
r= Rate of discount applied each year;
R/ (1+r) = Current value of annuity discounted at rate r.

The concept of marginal efficiency of capital can be illustrated with a numerical.
For instance,
Expected lifespan of capital asset= 2 years
Supply price of capital asset= $ 3000

Expected Yield (first year) = $1100
Expected Yield (Second year) = $1210
Then, marginal efficiency of capital (r) is calculated as
SP= R1/ (1+r) + R2/ (1+r)2

2000/ (1+r) = 1100/ (1+e)2 + 1200
Thus, r= 10%
Taking r= 1/10
SP= 1100 + 1100/ (1+1/10) = 1000 + 1000/ (1+1/10) 2 = 2000

From the above calculation, we can it may be observed that
1. When the expected yield increases to Rn, rate of discount increases

2. Rate of discount or MEC decreases when supply price of capital asset increases with a given amount
of expected annual return on capital asset, and vice versa.
Thus, prospective yields have a direct effect on MEC whereas, supply price has an inverse effect.
This means that the rate of return over cost may vary as a result of changes in cost or change in the
amount of return. Investors would be willing to make investments only when the return from
prospective capital investment is greater than the supply price.
Investment Demand Function

According to J.M. Keynes, investment depends on the market rate of interest and the marginal
efficiency of capital. A schedule that shows the relation between interest rates and marginal
efficiency of capital is termed as investment demand schedule.
A hypothetical schedule can be prepared that shows the investment demand at varying levels of
interest rates and the effect that marginal efficiency of capital has on the demand:
Rate of Volume of Marginal

Interest ( % Investment Efficiency of
p.a) Demand ($) Capital (MEC)
10 10 10
9 20 9
8 30 8
7 4 7
6 50 6
5 60 5
From the schedule, it can be observed that investment demand rises as interest rate falls. Generally,
investment is attractive when the rate of interest is lower. When the rate of interest is 5%, the investor
would expect a return of at least 5% on the investment.
In case the marginal efficiency of capital is lower than the current rate of interest, investors would
rather save than make an investment.
The diagrammatical representation of the investment demand curve gives a curve which is known as
the investment demand function or the marginal efficiency of capital curve.
As seen in the diagram, the volume of investment has increased with the decrease in the rate of
interest. Generally, on average, the investment demand curve is inelastic. So, the change in rate of
interest has very minimum effect on the volume of investment.
However, a more important concept to consider is the shift in the investment demand curve. Keynes,
states that rate of interest is relatively constant in the short run, but MEC is highly fluctuating. So, the
investment demand function and the volume of investment moves along with the increases or
decrease in the MEC.
The diagram shows that with the change in the marginal efficiency of capital, the investment demand
curve shifts upward or downwards although the rate of interest remained unchanged.
Factors causing a shift in the Marginal Efficiency of Capital/ Investment

Demand Function
There are a number of factors that are responsible that cause a shift in the investment demand
function. Some of the most prominent factors include:
Cost of capital
If the cost of capital is cheaper, investment is more attractive and vice versa.
Change in technology
Changes in technologies can make investments more attractive with attractive future returns on
investments made in the technological sector.
Demand for goods and services

Increase in demand for goods and services increase the profitability of the companies, and in return,
increase the profitability of capital investments.
Tax rates
The tax rates imposed by the government affects the volume of investment. Higher taxes discourage
investment while the government sometimes offers tax breaks to boost investment in the economy.
Facilities for finance

If the financial institutions provide easy loan and other facilities at relatively low interest rates, it
boosts investment.
Future trade expectations

If any business venture has good future prospect towards profitability, it encourages investment in
those business sectors that yield higher rates of return in the future.
annuities.
Where,


For instance,

SP= R1/ (1+r) + R2/ (1+r)2

2000/ (1+r) = 1100/ (1+e)2 + 1200
Thus, r= 10%
Taking r= 1/10
SP= 1100 + 1100/ (1+1/10) = 1000 + 1000/ (1+1/10) 2 = 2000




10 10 10
9 20 9
8 30 8
7 4 7
6 50 6
5 60 5

Demand Function
Cost of capital

Tax rates

boosts investment.

demand-function.
annuities.
Where,


For instance,
Cite this article as: Shraddha Bajracharya, "Marginal Efficiency of Capital (MEC) and Investment Demand Function,"
in Businesstopia, January 12, 2018, https://www.businesstopia.net/economics/macro/marginal-efficiency-capital-mec-
and-investment-demand-function.

SP= R1/ (1+r) + R2/ (1+r)2

2000/ (1+r) = 1100/ (1+e)2 + 1200
Thus, r= 10%
Taking r= 1/10
SP= 1100 + 1100/ (1+1/10) = 1000 + 1000/ (1+1/10) 2 = 2000




10 10 10
9 20 9
8 30 8
7 4 7
6 50 6
5 60 5

Demand Function
Cost of capital

Tax rates

boosts investment.

demand-function.
annuities.
Where,


For instance,

SP= R1/ (1+r) + R2/ (1+r)2

2000/ (1+r) = 1100/ (1+e)2 + 1200
Thus, r= 10%
Taking r= 1/10
SP= 1100 + 1100/ (1+1/10) = 1000 + 1000/ (1+1/10) 2 = 2000




10 10 10
9 20 9
8 30 8
7 4 7
6 50 6
5 60 5

Demand Function
Cost of capital

Tax rates

boosts investment.

demand-function.
annuities.
Where,


For instance,

SP= R1/ (1+r) + R2/ (1+r)2

2000/ (1+r) = 1100/ (1+e)2 + 1200
Thus, r= 10%
Taking r= 1/10
SP= 1100 + 1100/ (1+1/10) = 1000 + 1000/ (1+1/10) 2 = 2000




10 10 10
9 20 9
8 30 8
7 4 7
6 50 6
5 60 5

Demand Function
Cost of capital

Tax rates

boosts investment.

Saving Function
We know,
Y= C + S;
Thus, S= Y-C;
0 20 -20 – –
60 70 -10 – –
120 120 0 0 –
180 170 10 0.06 0.17
240 220 20 0.08 0.17


saved.
Symbolically,
APS=S/Y
calculate APS as
APS= 10/180 =0.06 or 6%
Diagrammatically,
income.
Symbolically,
MPS=ΔS/ΔY
MPS= 10/60 =0.17 or 17%
Diagrammatically,
AB/BC.
Desire to Save
i. Level of income

Ability to Save
i. Labor Efficiency


The Transactions Demand for Money•The transactions demand for money arises from the medium
of exchange function of money in making regular payments for goods and services. •According to
Keynes, it relates to the need of cash for the current transactions of personal and business
exchange.
___________________________________ing also depends on the facilities availability. This includes:

rates on savings.


consumption.
iv. Taxation Policy

v. Fiscal policy
Saving Function
We know,
Y= C + S;
Thus, S= Y-C;
0 20 -20 – –
60 70 -10 – –
120 120 0 0 –
180 170 10 0.06 0.17
240 220 20 0.08 0.17


saved.
Symbolically,
APS=S/Y
calculate APS as
APS= 10/180 =0.06 or 6%
Diagrammatically,
income.
Symbolically,
MPS=ΔS/ΔY
MPS= 10/60 =0.17 or 17%
Diagrammatically,
AB/BC.
Desire to Save
i. Level of income

Ability to Save
i. Labor Efficiency


Facilities to Save
Saving also depends on the facilities availability. This includes:

rates on savings.


consumption.
iv. Taxation Policy

v. Fiscal policy
hree Approaches to measuring National

Income
National income measures the income generated by a country through the production activities that
are carried out within a country during a specific period of time.
A circular flow of income and expenditure exists within an economy, where factor income is earned
from the production of goods and services, and the income is spent on the purchase of produced
goods. Thus, there are three alternative methods of computing national income. This includes:
 Product/Value Added Method

 Income/Factor Income Method
 Expenditure Method
Product/Value Added Method
The value added method/ product method is also known as the output method or inventory method.
In this method, the sum total of the gross value of the final goods and services in different sectors of
the economy like industry, service, agriculture, etc. is acquired for the current year by determining the
total production that was made during the specific time period. The value obtained is the gross
domestic product. Thus, according to this method,
GDP= Total product of (industry + service + agriculture) sector
Symbolically, GDP= ∑ (P × Q)
Where,
P= Market price of goods and services
Q= Total volume of Output

Sometimes goods produced by one sector is further processed by another sector. These goods are
termed as intermediate goods and are already included while determining the value of final goods.
So, in order to avoid the problem of double counting of value of goods, the product method if further
categorized into two approaches:
The Final Goods Approach

In this method, only the value of final goods and services are computed while estimating GDP,
regardless of any intermediate goods and their processing. This method takes into account only
those goods and services that purchased and consumed by the final consumers in the economy.
The Value Added Method

In the value added method of measuring national income, the value of materials added by producers
at each stage of production to produce the final good is considered. The difference between the
value of output and inputs at each stage of production is the value added. Thus,
Value added= Value of output – Cost of intermediate goods
If the differences are added up for all production sectors in the economy, the value of GDP is
computed. The table below clearly explains this method:
Producers Stage of Production Selling Price (Rs.) Cost Price (Rs.) Value Added (Rs.)
Farmer Wheat 60 0 60
Miller Flour 90 60 30
Baker Bread 100 90 10
Total 250 150 100
Table 1: Estimation of National Income by Value Added Method
Income/Factor Income Method
Income method is also termed as factor income method or factor share method. Under this method,
national income is measured as the total sum of the factor payments received during a certain time
period.
The factors of production include land, labor, capital, and entrepreneurship. Individuals who provide
these factor services get payment in the form of rent, wages/salaries, interest, and profit respectively.
The total sum of income received by these individuals comprise the national income for a given
period of time.
Besides these, there are professionals who employ their own labor and capital like advocates,
doctors, barbers, CAs, etc. The income of these individuals are called mixed incomes and are also
accounted for calculating the national income. However, income received in the form of transfer
payments are not included.
Thus, according to this method,

GDP= Rent (Rental incomes on agricultural and non-agricultural properties)
+ Wages/Salaries (Wages and salaries earned by employees including supplements)
+ Interest (Net interest earned by individuals other than governmental bodies)
+ Undistributed Profit (Profits earned by businesses before payment of corporate taxes and
liabilities)
+ Dividends
+ Direct taxes
+ Depreciation
Expenditure Method
The expenditure method measures the national income as the sum total of expenditures made by
individuals on personal consumption, firms on private investments, and government authorities on
government purchases.
Since incomes from production are earned as a result of expenditure made by other entities on the
produced goods and services within the economy, the result of expenditure method should be same
total as the product method. However, with an exception of avoiding intermediate expenditure in
order to evade the problem of double counting, national income under expenditure method can be
expressed as
GDP= C + I + G + (X – M)
Where, C= Consumption Expenditure (Expenditure on durable goods such as furniture, cars, and non-
durable goods such as food)
I= Investment Expenditure (Private investment in capital goods or producer goods such as buildings,
machinery, etc.)
G= Government Expenditure (Government expenses for maintaining law and order, developing pre-
requisites of development, etc.)
(X-M)= Net Export (Difference between import and export)
British economist John Maynard Keynes revolutionized the economic sector in the 1930s when he
presented his arguments against the classical economists and stated that the economy is led by
demand rather than supply.
The theory of income and output determination was first introduced by Keynes, which was later
improvised by the American economist, Paul A. Samuelson. The theory states that equilibrium level
for national income is determined when aggregate demand is equal to aggregate supply.
Aggregate demand refers to the total demand made for the goods and services produced
domestically by the households, firms, government, and foreigners. Aggregate supply is the total
quantity of goods and services supplied at a given price level.
Equilibrium and Disequilibrium
In the Keynesian model of income and output determination, market equilibrium is a state I which
aggregate expenditure and aggregate income/output are equal. A Keynesian equilibrium is
maintained until an external force disrupts the pattern of expenditure or output.
The two major composition of equilibrium are aggregate production/output and aggregate
expenditure. The total or aggregate production is measured by gross domestic product or GDP.
Aggregate expenditure is the expenditure on final goods and services that are carried out by different
macroeconomic sectors including household, firms, government, and foreigners. The four aggregate
expenditures are consumption expenditure (C), investment expenditure (I), government expenditure
(G), and net exports (X – M).
Symbolically, aggregate expenditure is expressed as
AE= C + I + G + X – M
Keynesian disequilibrium is when aggregate expenditure is not equal to aggregate production. In other
words, it is the state where either macroeconomic sectors viz. household, firms, government, and
foreign sector, do not purchase the quantities that have been produced, or the state when producers
or business firms are unable to meet the demands or sell the goods they have produced.
The two conditions that arise as a result of disequilibrium are
Case 1: Y > AE
When output is in excess of planned aggregate expenditure, output exceeds purchases, and
inventories accumulate. If more inventories accumulate than what was expected, it means that
actual investment (I) is greater than planned investment (IP).
So, firms reduce their output in order to decrease the accumulation of inventory any further. Thus, if Y
> AE or AE < Y,
 Firms reduce their level of production.

 Inventory starts accumulating since consumers are buying less than what is being produced by the
firms.
Case 2: Y < AE
In the Keynesian economic system, when aggregate output/income is less than the planned
expenditure, purchases made by households and other sectors exceed production made by firms.
Inventories decline, and if inventories are less than the expected amount, it means that actual
investment (I) is less than planned investment (IP).
In order to reach the desired level of inventories, firms invest more and expand their output. Thus,
when AE > Y,
 Firms increase their level of production

 Inventories decline since consumer purchases are greater than actual production made by the firms.
||||||
}]]]]]]]]]]]]]]]]]]]]]]]]]]
Consumer’s Equilibrium
The consumer is in equilibrium when he maximizes his utility, given his income
and the market prices.
– Anna Koutsoyiannis
Every consumer aims at getting maximum satisfaction out of his given expenditure. A consumer is
said to have attained equilibrium when he spends given income or budget in such a way as to yield
optimum satisfaction, given the prices of two goods and the consumer’s preference.
In simple words, a consumer is said to be in equilibrium when he is getting maximum satisfaction out
of his limited income.
A consumer may find out his equilibrium condition with the help of indifference curve analysis.
Assumptions
Consumer’s equilibrium through indifference curve analysis is based on the following assumptions.
1. The consumer is rational and seeks to maximize his satisfaction through the purchase of goods.
2. The consumer consumes only two goods (X and Y).
3. The goods are homogenous and perfectly divisible.
4. Prices of the goods and income of the consumer are constant.
5. The indifference map for goods X and Y are given. The indifference map is based on the consumer’s
preferences for the goods.
6. The preference or habit of the consumer does not change throughout the analysis.
7. The income of consumer is given and constant.
Conditions of Consumer’s Equilibrium

The following are the conditions of consumer’s equilibrium
1. Budget line should be tangent to the indifference curve
2. At the point of equilibrium, slope of the budget line = slope of the indifference curve
3. Indifference curve should be convex to the point of origin.
1. Budget line should be tangent to the indifference curve
Consumer’s equilibrium is based on the assumption that the income of a consumer is constant and
that he spends his entire income on purchasing two goods whose prices are given.
A budget line is a graphical representation of various combinations of two goods that a consumer
can afford at specified prices of the products at particular income level. A budget line can be drawn
on the basis of expenditure plan.
The table given below is an example of expenditure plan and the graph that follows is its presentation
on graph.
Table: Expenditure plan
Given: Budget of the consumer is Rs 10, Price of good X is Rs 1 each and Price of good Y is Rs 2 each
Combination Units of good Y Units of good X
A 5 0
C 4.5 1
E 3 4
D 1.5 7
B 0 10
Figure: Interplay of budget line and indifference curves

In the given diagram, we can see IC1, IC2 and IC3 are three different indifference curves and AB is a
budget line. A consumer can only consume such combinations of goods which lie upon the budget
line at a given income level and constant price of goods X and Y.
Since, we have,
level of income = Rs 10
price of good X = Rs 1
price of good Y = Rs 2
a consumer can only purchase goods in combination which satisfies the given equation “I = P X X QX +
PY X QY” or “10 = 1 X QX+ 2 X QY”
At point A, 0 X 1 + 5 X 2 = 10
At point C, 4.5 X 2 + 1 X 1 = 10
At point E, 3 X 2 + 4 X 1 = 10
At point D, 1.5 X 2 + 7 X 1 = 10
At point B, 0 X 2 + 10 X 1 = 10
Thus, all these points lie on the budget line AB.
By the property of indifference curves, we know,

utility in IC3 > utility in IC2 > utility in IC1
A consumer can have any combination of goods that lie on the budget line except for the
combinations A and B because in either case he would only have X or Y.
The consumer can purchase combinations C or D but these will not yield him maximum satisfaction
as they lie on lower indifference curve. On the other hand, he cannot get any combination on IC3 as it
is away from the budget line.
Thus, the consumer will be in equilibrium (achieve maximum satisfaction at any given level of
income) where the budget line is tangent to the indifference curve, i.e. at point E on IC2.
Cite this article as: Shraddha Bajracharya, "Consumer’s Equilibrium: Interplay of Budget Line and Indifference Curve,"
in Businesstopia, January 12, 2018, https://www.businesstopia.net/economics/micro/consumers-equilibrium.
2. At the point of equilibrium, the slope on indifference curve = slope of the

budget line.
At any given point on the budget line,
For example, at point E, the slope of budget line = intercept on y-axis / intercept on x-axis
or, slope of budget line at point E = 3/6 = 1/2
The slope is 1/2 throughout the budget line.
From condition 1, we have known that consumer’s equilibrium exist at the point on indifference curve
where budget line is tangent to the curve.
Thus, at equilibrium point, slope of budget line is equal to slope of the indifference curve.
3. Indifference curve should be convex to the point of origin
The other condition of equilibrium is that at the point of equilibrium, indifference curve should be
convex to the origin. It means that marginal substitution rate between X and Y (MRSXY) should be
diminishing. If indifference curve is concave and not convex to the origin, then it will not be the point
of equilibrium.
In the above figure, AB is a budget line tangent to IC curve at point E.

At point E, marginal rate of substitution is increasing instead of diminishing. It means, by moving left
or right of point E, a consumer can obtain higher amount of either good X or good Y. Thus point E is
not an equilibrium point.
A consumer will therefore be in equilibrium when at the point of tangency of indifference curve and
the budget line, the indifference curve is convex to the origin.
As shown in the above figure, a consumer is in equilibrium at point E1 where budget line AB is
tangent to the indifference curve IC1 which is convex to the origin.
Marginal Rate of Technical Substitution

Marginal rate of technical substitution (MRTS) may be defined as the rate at which the producer is
willing to substitute one factor input for the other without changing the level of production.
In other words, MRTS can be understood as the indicator of rate at which one factor input (labor) can
be substituted for the other input (capital) in the production process while keeping the level of output
unchanged or constant.
If we denote labor by ‘L’ and capital by ‘K’, then MRTS of labor for capital can be expressed as
Table 1: marginal rate of technical substitution (MRTS)
Combination Capital (C) Labor (L) MRTSL,K Output
A 12 1 100
B 8 2 4:1 100
C 5 3 3:1 100
D 3 4 2:1 100
E 2 5 1:1 100
In the above table, there are five different combinations of labor and capital, all of which yield the
same level of output.
We can see in combination A that 12 units of capital and 1 unit of labor have jointly produced 100
units of output. When the producer moves to combination B, he gave up 4 units of capital in order to
add 1 unit of labor input while keeping the production level unchanged. Hence, MRTS of labor for
capital is 4 in this case.
Likewise, if we compare the combinations B and C, the consumer gave up 3 input units of capital in
order to add 1 unit of labor. Therefore, MRTS in this case is 3.
In the same way, the MRTS is 2 and 1 between the combinations C and D, and D and E, respectively.
Principle of Marginal Rate of Technical Substitution

Marginal rate of technical substitution is based on the principle that the rate by which a producer
substitutes input of a factor for another decreases more and more with every successive
substitution.
If we assume labor (L) and capital (K) to be the two inputs of a production process, the principle of
MRTS states that the value of MRTSL,K decreases with subsequent substitution of labor for capital.
And, this diminishing rate of MRTS is also apparent from the table 1 given above.
Initially, when the producer moved from combination A to combination B, the rate of MRTS was
calculated to be 4. When the producer moved to combination C, the rate of MRTS fell and became 3.
In the same way, with each successive addition of constant unit of labor, the MRTS were calculated
to be 3, then 2 and finally, 1.
Clearly, the marginal rate of technical substitution has diminished more and more as the producer
kept on substituting input of labor for capital.
Figure 1: marginal rate of technical substitution
Causes of Diminishing Marginal Rate of Technical Substitution

Marginal rate of technical substitution is diminishing due to following reasons.
Imperfect substitutability of the factors
Two factors cannot substitute each other perfectly because they have their own uses in the
production process.
Besides, if the factors could perfectly substitute each other, increase or decrease in either of the
factors won’t bring any changes in the marginal rate of technical substitution.
Inadequacy of the factor
Substituting one factor for the other continuously causes scarcity of the factor being replaced. As a
result, the factor being tradeoff won’t be able to make as much contribution as it should have for the
efficient production.
.
Therefore, although the producer had sacrificed more units of capital input in the beginning, the rate
of substitution fell with additional substitutions.

Marginal rate of technical substitution (MRTS) may be defined as the rate at which the producer is
willing to substitute one factor input for the other without changing the level of production.
In other words, MRTS can be understood as the indicator of rate at which one factor input (labor) can
be substituted for the other input (capital) in the production process while keeping the level of output
unchanged or constant.
If we denote labor by ‘L’ and capital by ‘K’, then MRTS of labor for capital can be expressed as
Combination Capital (C) Labor (L) MRTSL,K Output
A 12 1 100
B 8 2 4:1 100
C 5 3 3:1 100
D 3 4 2:1 100
E 2 5 1:1 100
In the above table, there are five different combinations of labor and capital, all of which yield the
same level of output.
We can see in combination A that 12 units of capital and 1 unit of labor have jointly produced 100
units of output. When the producer moves to combination B, he gave up 4 units of capital in order to
add 1 unit of labor input while keeping the production level unchanged. Hence, MRTS of labor for
capital is 4 in this case.
Likewise, if we compare the combinations B and C, the consumer gave up 3 input units of capital in
order to add 1 unit of labor. Therefore, MRTS in this case is 3.
In the same way, the MRTS is 2 and 1 between the combinations C and D, and D and E, respectively.
Principle of Marginal Rate of Technical Substitution

Marginal rate of technical substitution is based on the principle that the rate by which a producer
substitutes input of a factor for another decreases more and more with every successive
substitution.
If we assume labor (L) and capital (K) to be the two inputs of a production process, the principle of
MRTS states that the value of MRTSL,K decreases with subsequent substitution of labor for capital.
And, this diminishing rate of MRTS is also apparent from the table 1 given above.
Initially, when the producer moved from combination A to combination B, the rate of MRTS was
calculated to be 4. When the producer moved to combination C, the rate of MRTS fell and became 3.
In the same way, with each successive addition of constant unit of labor, the MRTS were calculated
to be 3, then 2 and finally, 1.
Clearly, the marginal rate of technical substitution has diminished more and more as the producer
kept on substituting input of labor for capital.
Causes of Diminishing Marginal Rate of Technical Substitution
Marginal rate of technical substitution is diminishing due to following reasons.
Imperfect substitutability of the factors
Two factors cannot substitute each other perfectly because they have their own uses in the
production process.
Besides, if the factors could perfectly substitute each other, increase or decrease in either of the
factors won’t bring any changes in the marginal rate of technical substitution.
Inadequacy of the factor
Substituting one factor for the other continuously causes scarcity of the factor being replaced. As a
result, the factor being tradeoff won’t be able to make as much contribution as it should have for the
efficient production.
Therefore, although the producer had sacrificed more units of capital input in the beginning, the rate
of substitution fell with additional substitutions.
Keynes identified a basic two sector macroeconomic model to determine equilibrium, which
comprised of two major sectors, the household and business firms. The model assumes that there is
no intervention of government and no foreign trade exists.
Besides this, the two sector model has a few more assumptions that it satisfies.
Assumptions
i. Prices, wages, and interest rates are constant. Keynes argued that prices and wages are relatively
constant as opposed to the classical view which stated that they are flexible.
ii. Output is determined by demand or the total expenditure of the economy.
iii. Profits earned by the firms are distributed in the form of dividends rather than saving.
Keynes also believed that the equilibrium in national income is determined when aggregate
demand/expenditure is equal to aggregate supply.
Aggregate Demand/Expenditure
The aggregate demand/expenditure in the two sector economy is the sum total of the consumption
made by household sector (C) and investment expenditures made by business firms (I). Symbolically,
AE for two sector economy is expressed as
AE= C + I
The factors that affect household consumption include income and non-income determinants.
Generally, household consumption expenditure is affected by the current level of income. The non-
income determinants include real interest rates, consumer’s wealth, and consumers’ expectation of
future prices and incomes.
Keynes assumed that in the short run, current income is the most important factor that affects
household consumption. This can be mathematically expressed as
C= Ca + λ Y
Where, C = Total annual consumption expenditure;
Ca= Autonomous consumption (minimum level of consumption regardless of whether an individual or
a household is earning any income or not);
Λ= Marginal propensity to consume (MPC), 0< λ<1;
Y= Total income/output
MPC or the marginal propensity to consume is the amount by which consumption changes in
response to incremental change in disposable income. i.e.
MPC= ΔC/ ΔY
Graphically, the equation of consumption line C= Ca + λ Y, where, λ is the MPC resulting due to
change in income.
Cite this article as: Shraddha Bajracharya, "Income and Output Determination: Two Sector Economy," in Businesstopia,
January 26, 2018, https://www.businesstopia.net/economics/macro/income-output-determination-two-sector-economy.
Investment Expenditures
Investment expenditures are the firms’ expenses occurred during the production of goods and
services. These include expenditures on capital goods like plants, equipment, etc. Investments may
be both planned or intended or unplanned or unintended.
Keynes stated two important factors that determine investment expenditures in the short run, interest
rates and expectation of future business profits. However, the motivating factor that induces
investors is the business profitability felt by firms in the market economy.
Investment can be either autonomous or induced as shown in the figure.

Autonomous investment is not affected by interest rates and income level, whereas induced
investment is highly affected by such factors. In the diagram, EI is the autonomous investment, and
the positively sloped EI’ is the induced investment.
In determining the income equilibrium, investment is assumed to be autonomous. Investments are
made based on the firms’ future profitability, regardless of changes in interest rates. Autonomous
investment can be expressed as
I= Ia
Equilibrium Income and Output: Graphs

The determination of income/output determination in a two sector economy is illustrated in the
figures below:
Figure: Two sector equilibrium with Y= AE

The significance of the 450 line is that it consists of points which are at equal distance from the axes.
In explaining income determination with Y=AE, the vertical axis measures aggregate expenditure and
the horizontal axis measures aggregate income/output. Here, Y refers to aggregate output/income
and Ae refers to aggregate expenditure.
Equilibrium is the point where aggregate expenditure line Y=AE intersects with the 45-degree line. In
the figure, the line AE= C+I intersects the 45-degree line at point E where AE=Y and the equilibrium
level of output/income is OYe. Any points to the right of E shows excess of supply that exceeds the
desired level of expenditure i.e. Y> AE=C+I. Similarly, any point left of E shows excess of demand
where AE=C+I<Y. Thus, any points beyond E is the state of disequilibrium.
Equilibrium Income and Output: Equations

The equilibrium level of income in two sector economy can be derived mathematically where
equilibrium occurs when aggregate output is equal to aggregate expenditure.
Or, Y= AE
Or, Y= C + I
Substituting C= Ca + λY and I=Ia in Y=C + I, we get,

Y= Ca + λY + Ia
Or, Y = Ca + λY + Ia
Or, Y- λY = Ca + Ia
Or, Y (1-λ) = Ca + Ia
That is, equilibrium income/output,
Thus, the equilibrium income and output (Ye) is equal to the sum of autonomous expenditures (C a +
Ia) times the multiplier 1/ (1 – MPC).
Equilibrium Income and Output: Saving-Investment Equality Approach

Goods market is said to be in equilibrium when saving (S) is equal to planned investment spending
(I). That is, S=I
So, the level of output/income that leads to planned investment being equal to actual saving, is
termed as the equilibrium level of income/output.
Figure: Two sector equilibrium with S = I
The figure shows the equilibrium level of income/output where equality between saving and
investment exists. Saving is dependent upon income level since the ability of individuals and
households to save is determined by the size of their income. So, the line that relates saving and
income has a positive slope.
The equation for the line can be derived by substituting C= Ca + λY in the definition of saving (S= Y –
C). This gives, S= – Ca + (1 – λ) Y.
The saving equation has a negative slope indicating that saving takes place only after income level
rise above the minimum threshold level. The investment line is parallel to the horizontal axis because
investment is assumed to be autonomous which means, it is not affected by the income/output level.
In this case, equilibrium occurs when the saving line S intersects the horizontal investment line II. In
the figure, E1 is the point of equilibrium and OYe is the equilibrium level of income/output.
Any point beyond E1 will lead to disequilibrium. To the right of E1, saving exceeds investment and
output cannot increase in this situation. On the contrary, investment is more than saving to the left of
E1.
The derivation of equilibrium level of income with saving investment follows here:
In a two sector economy, aggregate demand/expenditure is determined by the consumption

expenditure made by households and investment made by the business firms. Mathematically, this is
expressed as AE= C + I.
The income of household sector is composed of consumption and saving, since a part of the income
earned is saved and becomes the supply source for the economy. Mathematically, it is expressed as
Y= C + S.
Equilibrium occurs when demand is equal to supply, that is AE= Y, substituting equations, we get,
C + I= C + S;
Therefore, I = S
From the definition of savings, we know, savings is equal to income minus consumption, and since
investment is assumed to be autonomous,
Y – C = Ia
Or, Y – (Ca + λY) = Ia [since C= Ca + λY]
Or, Y – Ca – λY = Ia
Or, Y (1-λ) = Ca + Ia
Thus, we get the equilibrium income/output as
Numerical Illustration of Equilibrium Income and Output
In order to determine how spending patterns of consumers and investors determine the income and
output in the Keynesian theory, the following table has been made
1 2 3 4 5 6
Total Output Planned Planned Planned Total Planned

and Income Consumption Saving (S= Investment Expenditure (C + Tendency of
(GDP) Expenditure GDP – C) Expenditure (I) I) Output
300 325 -25 50 375 Increase
400 400 0 50 450 Increase
500 475 25 50 525 Increase
600 550 50 50 600 Equilibrium
700 625 75 50 675 Decrease
800 700 100 50 750 Decrease
Column 1 in the table shows a hypothetical levels of income/output can be produced in a two sector
economy. Depending upon the sales target, business firms choose a certain level. Assuming firms
can plan to sell $600 billion worth of output, they manage factors of production (land, labor, capital,
and entrepreneurship) accordingly. The income level of household is assumed to be $600 billion
since, income must be equal to output.
Column 2 the amount of income households plan to spend on consumption. Column 4 shows the
planned level of investment for the firms, which is assumed to be autonomous, so it has a fixed value
of $50 billion.
Column 5 is the total of consumption spending and investment spending. The total spending
increases with the increase in GDP, as rise in income leads to rise in consumption. Here, $600 billion
is the equilibrium level which satisfies the national income accounting identity, Y= C + I or Y= C + S.
What is a demand curve?
The graphical representation of the relationship between the demand of the commodity and price of
the commodity, at any given time, is known as the demand curve.
A demand curve can also be defined as the graphical representation of a demand schedule. A
demand schedule is a tabular statement which represents the various quantity of the commodity that
the consumers are ready to buy at every different price, at any given time.
In a graph, the price of the commodity is represented in the vertical axis (Y-axis) and the quantity
demanded is represented on the horizontal axis (X-axis). A commodity’s price and its demand share
inverse relationship. This means, higher the price of the commodity, lesser will be its demand and
lower the price, higher will be the demand. Therefore, in a graph, demand curve makes a downward
slope.
In the following figures, fig. I is an example of demand schedule and fig. II is its graphical illustration
(demand curve).
Fig. I: Demand schedule
Price of soda per bottle (in Rs.) Quantity (bottles) demanded per day (*1000)
10 40
20 30
20
40 10
Fig. II: Demand curve

Movement along a demand curve
The amount of quantity demanded by the consumer changes with the rise and fall in the price of the
commodity if other determinants of demand remain constant. This alternation in demand, when
shown in the graph, is known as movement along a demand curve.
Movement along a demand curve can also be understood as the variation in quantity demanded of
the commodity with the change in its price, ceteris paribus.
There can be two types of movement in a demand curve – extension and contraction.
Extension in a demand curve is caused when the demand for a commodity rises due to fall in price.
And, contraction in demand curve is caused when the demand for a commodity falls due to rise in
price.
In the above fig. II, let us suppose Rs. 30 is the original price of the soda per bottle and 20,000 units
are the original quantity of demand. When the price falls from Rs. 30 to Rs. 20, the amount of quantity
demanded rises from 20,000 units to 30,000 units. With this change in demand, there is a movement
in the demand curve from point B to point C which is known as an extension of the demand curve.
Similarly, when the price of the soda increases from Rs. 30 to Rs. 40, the demand for the soda falls
from 20,000 units to 10,000 units. This time, there is a movement in the demand curve from point B
to point A, and this movement is known as a contraction in the demand curve.
Shift in demand curve
The amount of commodity demanded by the consumers may change due to the effect of non-price
factors as well. Non-price factors which influence demand for the commodity may be consumers’
income, the price of related goods, advertisement, climate and weather, the expectation of rise or fall
in price in future, etc.
When the amount of commodity demanded changed due to non-price factors, there is no extension
or contraction in the curve but the formation of the entirely new demand curve. As a result, demand
curve shifts from its original position.
For an example, the demand for cold drinks in the market may increase substantially even at same
price due to hot weather.
Fig. III: Shift in demand curve
The shift in demand curve is also of two types – rightward shift and leftward shift.
When the demand for a commodity increases at the same price due to favorable changes in non-
price factors, the initial demand curve shifts towards the right, and there is a rightward shift in the
demand curve. Similarly, when the demand for a commodity fails at same price due to unfavorable
changes in non-price factors, the initial demand curve shifts towards left, and there is a leftward shift
in the demand curve.
In the given fig. III, let us suppose, DD is the initial demand curve where P is the original price and Q is
the original quantity of demand of a commodity. Due to favorable changes in non-price factors, the
demand for the commodity in the market has increased from Q to Q2 amount at the same price. Thus,
the demand curve has shifted rightwards and new demand curve D 2D2 has formed.
Similarly, due to unfavorable changes in non-price factors, the demand for the commodity has fallen
from Q to Q1 amount. Thus, a new demand curve D1D1 has formed at the left side of the initial curve.
Reasons for rightward shift of curve

 Increase in consumers’ income
 Increase in price of its substitute goods
 Decrease in price of its complementary goods
 Favorable change in taste and preference
 Expectation of rise in price of the commodity in future
 Increase in population
Reasons for leftward shift of curve
 Decrease in consumers’ income
 Decrease in price of its substitute goods
 Increase in price of its complementary goods
 Unfavorable changes in taste and preference
 Expectation of fall in price of the commodity in future
 Decrease in population
Utility is the ability of a good to satisfy a want.

– Prof. Hobson
In microeconomics, utility is a controversial topic. It is generally used to describe the degree of
satisfaction an individual receives from consuming a commodity. It can be understood as the power
of a commodity to satisfy the wants of consumers.
The satisfaction can be expected or real. And if the commodity fulfills or is expected to fulfill the
need of the consumer, the commodity is said to have utility.
For an example: A hungry person buys a burger expecting that the burger will curb his appetite. This
means that the burger has utility.
All economists would agree that the person has gained utility by consuming the burger. But when it
comes to measuring the utility, different economists have different views.
Many economists state that utility can be measured numerically while there are many others who
argue that utility is a subjective phenomenon, and thus can’t be expressed quantitatively.
This difference in opinion regarding measurement of utility has developed the concept of cardinal
and ordinal utility.
Cardinal utility
According to classical economists utility is a quantitative concept and that it can be measured in
terms of a number. Hence they developed the concept of measuring utility through cardinal
approach.
According to this concept, utility can be expressed in the same way that weight and height are
expressed. However, the economists lacked a proper unit for utility. So they derived a psychological
unit called ‘Util’. Util is not a standard unit because it varies from person to person, place to place and
time to time.
For an example, if a person assigns 20 utils to a burger and 10 utils to a sandwich, we can
understand that the burger has double the capacity to satisfy that man’s wants.
Since util is not a standard unit for measuring utility, many economists, including Alfred Marshall
suggested measurement of utility in terms of money that consumers are willing to pay for a
commodity.
If each rupee is equal to 1 util, a burger worth Rs 20 has 20 utils and a sandwich worth Rs 10 has 10
utils. Thus, whoever consumes burger will yield utility of 20 utils and those who consume sandwich
will yield utility of 10 utils.
Ordinal utility
Opposing to the concept of classical economists, modern economists claimed that absolute
measurement of utility is not possible.
According to these economists, utility is subjective phenomenon, i.e. influenced by personal feelings,
preference and opinions, and thus unquantifiable. However, they stated that utility can be clearly
expressed in terms of rank.
For an instance, if a person prefers fruit juice to soda, it means fruit juice has more utility than soda.
In this case, fruit juice can be placed in the first position and soda in the second, in terms of utility.
Income elasticity of demand is the measure of degree of change in quantity demanded for a
commodity in response to the change in income of the consumers demanding the commodity.
In simple words, it can be defined as the change in demand as a result of change in income of the
consumers. Often referred to as just ‘income elasticity’, it is denoted by Ey.
Consumer’s income is one of the major factors that determine demand of a product.
Unlike price of the product, consumer’s income share direct relationship with the demand for the
product. This implies that higher the income, more will be the demand, and lower the income, fewer
will be the demand of the commodity.
Methods of Measuring Income Elasticity of Demand
Basically, there are three methods by which we can measure income elasticity of demand. These
methods are
i. Percentage method
ii. Point method
iii. Arc method
Percentage Method
Percentage method is one of the commonly used approaches of measuring income elasticity of
demand, under which income elasticity is measured in terms of rate of percentage change in quantity
demanded of the commodity to percentage change in income of the consumers who demand that
commodity.
According to this method, income elasticity can be mathematically expressed as
Where,
ΔQ = change in quantity demanded = Q2 – Q1
Q1 = initial quantity demanded
Q2 = new quantity demanded

ΔY = change in income of the consumers = Y2 – Y1
Y1 = initial income of the consumers

Y2 = new income of the consumers
For example: The demand of quantity when the income of the consumer was Rs 3000 was 30 units.
When his income increased by Rs 2000, the quantity of commodity demanded by him became 50
units. Here, income elasticity of demand can be calculated as
Since Ey = 1, this is an example of unitary income elasticity of demand where percentage change in
income of consumer is equal to percentage change in demand of the commodity.
Point Method
Point method is one of the geometric methods of measuring income elasticity of demand at any
given point on the income demand curve.
Income demand curve is an upward sloping curve in case of normal goods and a downward sloping
curve in case of inferior goods.
However, the method of calculating income elasticity depends upon the nature of the income
demand curve. These methods are described below.
Price elasticity on a linear income demand curve

Figure: income demand curve
From percentage method, we have known that
ΔBAC and ΔAEQ1 are similar triangles in account of AAA property. Thus, ratios of the sides of both
the triangles are equal.
This implies,
Now, substituting equation (iii) in equation (ii),

Price elasticity on a non-linear income demand curve
If the income demand curve is of a non-linear nature, then income elasticity can be calculated by
drawing a tangent at the point where income elasticity is to be known. Then income elasticity can be
simply calculated by applying the equation (iv) given above.
In the figure given above, we can see DD is a non-linear demand curve and P is the point whose
income elasticity is to be calculated. Thus, a tangent MN is drawn through the point P to X-axis. Then
income elasticity is simply calculated as
Arc Method
Arc method is also a geometric method of measuring income elasticity of demand between any two
points on an income demand curve. While ‘point method’ is used to calculate income elasticity at any
given point on an income demand curve, this method is used to measure income elasticity over a
certain range or between two points on the curve.
In the figure, we can see that AB is an arc on the income demand curve DD, and C is the mid-point of
AB. Here, income elasticity of demand at point C is calculated by following ways.
At first, average of income as well as quantity demanded is measured.

Then income elasticity is calculated by applying the formula
Where,
ΔQ = change in quantity demanded = Q2 – Q1
Q1 = initial quantity demanded
Q2 = new quantity demanded
ΔY = change in income of consumer = Y2 – Y1
Y1 = initial income of consumer
Y2 = new income of consumer
What do you mean by supply?
The economy is composed of two forces – the producers (who produce goods and services) and the
consumers (who buy the products available in the market).
Supply is a fundamental concept of economics which can be defined as the total amount of a
particular good or service which is available to the consumers at the existing market. It is the quantity
of goods that the producers are able to or willing to offer for sale at given price. In simple words,
supply is the amount of specific goods available at a specific price at a specific time.
Determinants of Supply
There are a number of factors and circumstances which can influence a producer’s willingness to
supply the commodity in the market. These factors are
Price of the commodity

Any producers’ primary motive is to maximize profit or increase revenue. That is why producers tend
to supply more products in the market when the price of the product rises, with all other factors being
constant. In the same way, producers tend to supply fewer products in cases when the price falls and
other factors remain constant.
Price of the related goods

Related goods refer to the goods which are used as input for the production of the commodity.
The price of such goods is one of the major determinants of supply of the commodity. It is directly
proportional with the price of production of any commodity, i.e. when the price of related good rise
up, the production cost of the commodity also rises and when the price of related goods fall,
production cost also falls.
Producers tend to withdraw their investment from commodities which cost more to produce, directly
affecting the supply of the commodity in the market.
Price of the factors of production

The factor of production refers to the input that is required for producing a product in an economical
way. Generally, land, labor, capital and entrepreneurship are considered as the factors of production.
Producers have to pay a certain amount in terms of rent, wage and interest in the return of using
factors of production. When these prices rise up, producers may want to divert their investment
(resources, time and money) in the production of other commodities. As a result, the supply of the
product in the market decreases.
Goal of producers
The primary objective of every firm is to earn revenue and maximize profit. However, there may be
circumstances when firms focus on earning prestige rather than profit.
Companies who prioritize prestige to profit may sometimes increase the supply of the commodity in
the market even in times when they earn very little or no profit at all, just to stand out in the market.
State of technology
Technology is one of the major components of firms and industries these days. Advancement in
technology has a great impact on the production rate. It increases the production rate efficiently, and
with an increase in the amount of products produced, there will be an increase in the supply of the
commodity in the market.
Miscellaneous factors
Under this heading, we can include factors such as means of transportation and communication,
natural factors, taxation policy, expectations, agreement among the producers, etc. All these factors
have potential to influence the ability or willingness of producers to offer the product in the market.
What is supply function?
The functional relationship between the quantity of commodities supplied and various determinants
are known as supply function. It is the mathematical expression of the relationship between supply
and factors that affect the ability and willingness of the producer to offer the product. The
relationship may exist between two or more number of variables.
Mathematically, a supply function can be expressed as

Qs = f(P; Prg) where,
Qs = Quantity of commodity supplied
P = Price of the good
Prg = Price of related good

Types of Supply Function
Individual Supply Function
The algebraic expression of an individual supply schedule is called individual supply function. An
individual supply schedule is a tabular statement representing the various amounts of a commodity
that a single producer is willing to sell at a different price, during a given period of time.
Individual supply schedule
Price of milk per liter (in Rs.) Quantity supplied per day in liters (*1000)
10 10
12 13
14 20
16 25
Mathematically, a supply function can be represented as
Sx = f(Px, Po, Pf, St, T, G) where,

Sx = Supply of the commodity x
Px = Price of the commodity x
Prg = Price of related goods
Pf = Price of factors of production
St = State of technology
T = Taxation policy
G = Goals of the firm
Market Supply Function
Market supply function is the algebraic expression of the market supply schedule. Market supply
schedule can be defined as the tabular statement which represents various amounts of a commodity
that the entire producers in the whole economy are willing to supply at the optimal price, at any given
time.
Market supply schedule
Individual supply per day Market supply per day
Price of the product X per unit (in Rs.) A B C
100 750 500 450 1700
200 800 650 500 1950
300 900 750 650 2300
400 1000 900 700 2600

Market supply function can also be defined as the summation of individual supply functions within a
specific market.
Mathematically, a market supply function can be represented as
Sx = f(Px, Po, Pf, St, T, G, N, F, M) where,

Sx = Market supply of the commodity x
T = Taxation policy
G = Goals of the market
N = Number of firms
F = Future expectation regarding price of the commodity x
M = Means of transportation and communication


Goal of producers
State of technology

Cite this article as: Palistha Maharjan, "Concept of Supply Function and Its Types," in Businesstopia, January 8,
2018, https://www.businesstopia.net/economics/micro/supply-function.

10 10
12 13
14 20
16 25

T = Taxation policy
time.
100 750 500 450 1700
200 800 650 500 1950
300 900 750 650 2300
400 1000 900 700 2600
specific market.

T = Taxation policy

N = Number of firms



Goal of producers
State of technology


10 10
12 13
14 20
16 25

T = Taxation policy
time.
100 750 500 450 1700
200 800 650 500 1950
300 900 750 650 2300
400 1000 900 700 2600
specific market.

T = Taxation policy
N = Number of firms



Goal of producers
State of technology

10 10
12 13
14 20
16 25

T = Taxation policy
time.
100 750 500 450 1700
200 800 650 500 1950
300 900 750 650 2300
400 1000 900 700 2600

specific market.

T = Taxation policy
N = Number of firms
Isocost Line
The combination of factor-inputs with which a firm produces output depends upon the quantity of
output that the firm wants to produce. Besides, the combination of factor-inputs also depends upon
the amount of money that the firm wants to spend and prices of the factor-inputs.
An isocost line is a graphical representation of various combinations of two factors (labor and
capital) which the firm can afford or purchase with a given amount of money or total outlay. It is an
important tool for determining what combination of factor-inputs the firm will choose for production
process.
Suppose a producer has Rs. 200 and he wants to spend his entire outlay on two factors – labor and
capital. Further suppose that the price of Labor is Rs. 4 per unit and the price of capital is Rs 5 per
unit. If the firm spends its whole outlay of Rs 200 on labor only, he can buy 50 units of labor. And, if
the firm spends its entire outlay on capital only, then he can buy 40 units of capital.
Mathematically, an isocost line can be expressed as
C=wL+rK
Where,
C = cost of production
w = price of labor or wages
L = units of labor
r = price of capital or interest rate
K =units of capital
A firm can purchase only such combinations of factor-inputs which satisfy the given equation. For
example, a producer can purchase combinations like ’25 units labor + 20 units capital’, ‘30 units labor
+ 16 units capital’ or ’12.5 units labor + 30 units capital’ because all of them fulfill the equation at
given prices and outlay.
This concept is clearly explained by the figure given below.
Figure: isocost line
In the given diagram, x-axis represents units of labor and y-axis represents units of capital. Therefore,
OB in the figure represents 50 units of labor and OA represents 40 units of capital.
If we join points A and B, we get isocost line for Rs. 200. And, the straight line which joins points A
and B will pass through all combinations of labor and capital which the firm can buy with the outlay
of Rs 200, if it spends the entire sum on them at the given prices.
This way, an isocost line is also known as price line or outlay line. It is a counterpart of budget line of
indifference curve analysis.
The slope of the isocost line is equal to the ratio of price of factor-inputs. Mathematically, slope of an
isocost line is expressed as
And this slope remains the same throughout the isocost line.
Shift in Isocost Line

An isocost line may shift due to two reasons. They are
1. Change in total outlay to be made by the firm

2. Change in price of a factor-input
Change in total outlay to be made by the firm
When the firm decides to increase the total money to be spent on purchase of inputs while prices of
the inputs remain the same, the producer becomes able to afford such combinations of inputs which
were initially unattainable to him. This causes isocost line to shift to a new position higher to the
initial line.
Figure: shift in isocost line due to change in total outlay
In the above figure, AB is the initial isocost line. When the firm increased its total outlay, the isocost
line shifted rightwards to a higher position A’B’ where the producer could purchase combinations of
inputs with higher units of labor and capital. Likewise, if the firm reduces its total outlay, the isocost
line will shift leftwards to A”B”.
Whether the isocost line shifts toward the left or toward the right, it will always remain parallel to the
original line. It is because the slope of an isocost line is calculated as
Since we assume that no changes are made in the prices of either of the inputs, the slope remain the
same for all budget line at any given outlay. And, any lines with same slope are parallel to each other.
Change in price of a factor-input
When price of factor-input changes, the isocost line swings or rotates. The direction in which the
isocost line will swing depends upon the factor whose price has changed.
Case I: Change in price of labor
Figure: shift in isocost line due to change in price of labor
Let us suppose that a firm has total outlay of Rs. 200 and AB is initial isocost line. Let us also
suppose that the price of labor was decreased by certain amount, as a result of which the producer
became able to purchase more units of labor at the same outlay. However, the producer can’t
increase purchasing units of capital as price of capital is constant. Therefore, the position of price
line is changed in the x-axis but unchanged in y-axis.
Simply, decrease in price of labor causes anti-clockwise rotation and increase in price of labor
causes clockwise rotation.
Case II: Change in price of capital

Figure: shift in isocost line due to change in price of capital
Once again, let us assume that a firm has total outlay of Rs. 200 but this time let us suppose that the
price of capital has changed and not of labor.
In this case, the producer will be able to buy more units of capital at same outlay but won’t be able to
increase the purchasing units of labor. As a result, the isocost line shifts its position in y-axis and not
in x-axis.
In the diagram, we can see that isocost line AB shifts to new position A’B as a result of decrease in
price of capital. Likewise, the line shifts to A”B as a result of increase in price of capital.
In other words, decrease in price of capital causes clockwise shift in isocost line and increase in
price of capital causes anti-clockwise shift.
Let us suppose that an entrepreneur decided to produce 500 units of a commodity. His desired level
of output can be obtained by employing any combination of labor and capital that the isoquant (Iq)
pass through.
In the figure, we have only one isoquant which denotes that the level of output is fixed, i.e. 500 units.
On the other hand, there are three isocost lines (AB, A’B’ and A”B”) which indicates different level of
outlay (cost).
Since the isoquant (Iq) pass through points such as C, D and E, the producer can attain his desired
level of output by employing any of the combinations of labor and capital that lie at th
An isoquant represents various combinations of two factor-inputs which yield same level of output to
the producer while an isoquant map is a set of different isoquants, all of which represents unique
level of output.
On the other hand, an isocost is a line formed by combining points which represents various
combinations of two factor-inputs, given the prices of inputs and the total outlay available to the
producer. And, a family of isocost is a set of isocost lines which shows various combinations of
inputs at different level of outlay.
i.e. 500 units. On the other hand, there are three isocost lines (AB, A’B’ and A”B”) which indicates
different level of outlay (cost).
level of output by employing any of the combinations of labor and capital that lie at these points.
However, C and D being situated on the higher isocost line will be ignored by the producer as he will
require higher level of outlay to purchase these combinations.
On the other hand, the producer won’t be able to choose any combinations from the isocost line AB
because no combination of labor and capital lying on that line will be able to produce 500 units of
output.
Hence, the producer will be in equilibrium where the isocost line is tangent to the isoquant, i.e. at
point E. In this situation, the slope of isoquant is equal to the slope of isocost line.
Let us suppose that this time the producer has decided to incur an outlay of Rs. 5000 on labor and
capital. Since the total outlay is fixed, there is single isocost line AB which represents various
combinations of labor and capital that the producer can afford at Rs. 5000.
Similarly, in the figure, we have an isoquant map (three isoquants) Iq1, Iq2 and Iq3 which represents
various level of outputs, i.e. 300 units, 400 units and 500 units, respectively.
Since the isocost line AB passes through the points C, E and D, the producer can spend his total
outlay on purchasing any combinations of capital and labor lying on these points to produce outputs.
But, as we can see that the points C and D lie on the lower isoquant, the producer will choose the
combination at point E.
It is because, by the property of isoquants,
level of output in Iq3 > level of output in Iq2 > level of output in Iq1
Although the level of output is greater in Iq3 as compared to Iq2 and Iq1, the producer cannot choose
any combination at Iq3 as it is away from the isocost line.
Hence, we can once again say that the producer will be in equilibrium at the point where the slope of
isoquant is equal to the slope of isocost.
What is price elasticity of supply?
In Economics, elasticity is defined as the degree of change in demand and supply of consumers and
producers with respect to the change in income or price of the commodity.
Particularly, price elasticity of supply is a measure of the degree of change in the supplied amount of
commodity in response to the change in the commodity’s price. In simple words, it can be defined as
the rate of change in supply in response to a price change. It is denoted as PES or E s.
Mathematically, price elasticity of supply is expressed as
Degrees or Types of Price Elasticity of Supply

The degree of elasticity of supply can be of five types. They are described below in brief with figure.
Relatively elastic supply
When percentage change in quantity supplied is greater than percentage change in price, the
condition is known as relatively elastic supply. This situation when plotted in graph makes an upward
slope which intersects positive Y-axis.
Fig. i: relatively elastic supply curve
In figure i, we can see that ratio of change in quantity supplied is greater than the ratio of change in
price. As a result, when we put their values in the above mathematical expression, we get PES>1.
Elasticity tends to be greater than 1 in case of products which are not necessary to sustain our lives.
Luxury goods such as expensive smart phone, gold, etc. show this kind of price elasticity.
Relatively inelastic supply

When the percentage change in quantity supplied is lesser than percentage change in price, the
condition is known as relatively inelastic supply. This situation when plotted in graph makes highly
inclined upward slope which intersects positive X-axis.
Fig. ii: relatively inelastic supply curve

In the above figure, it is clearly shown that ratio of change in price is greater than ratio of change in
quantity, whose value when substituted in the given expression, we get PES<1.
Such kind of price elasticity can be observed in goods which are necessary in our day to day lives.
Clothes, foods, etc. are good examples of these kinds of goods.
Unitary elastic supply

When percentage change in quantity supplied is exactly equal to percentage change in price, the
situation is known as unitary elastic supply. This situation is graph is represented by an upward slope
which intersects the origin.
Fig. iii: unitary elastic supply

In the above figure, the ratio of change in quantity supplied is equal to the ratio of change in price.
Consequently, when the value of these variables are substituted in the given expression, we get
PES=1. This behavior between price and quantity supplied of commodity is also known as lock-step
movement.
Infinite/perfectly elastic supply
When a slight or minimal change in price causes infinite change in quantity supplied, it is said to be
infinite or perfectly elastic supply. In a graph, such situation is represented by a straight line which is
parallel to X-axis.
Fig. iv: perfectly elastic supply curve
In the above figure, we can see that quantity supplied has varied significantly even at the same price
level. This kind of price elasticity is expected to occur in highly luxurious goods. However,
perfectness of anything, including perfectly inelastic supply is considered to be rare or impractical in
economy.
Zero /perfectly inelastic supply

When quantity supplied remains unchanged with change in price, it is said to be zero or perfectly
inelastic supply. Such situation in graph is represented by a straight line which is parallel to Y-axis.
Fig. v: perfectly inelastic supply
In figure v, we can see that the amount of commodity supplied has remained unchanged even when
the price has greatly changed. This type of price elasticity is expected to be observed in highly
essential goods such as medicines. However, as mentioned earlier, perfectness of anything in
economy is rare or impractical.
A supply curve is a graphical representation of the relationship between the amount of a commodity
that a producer or supplier is willing to offer and the price of the commodity, at any given time. In
other words, a supply curve can also be defined as the graphical representation of a supply schedule.
In a graph, the price of the commodity is shown on the vertical axis (Y-axis) and the quantity supplied
is shown on the horizontal axis (X-axis) of the graph. It is an upward slope, which means higher the
price, higher will be the quantity supplied, and lower the price, lesser will be the quantity supplied.
Given below are two figures –I and II. Figure I is an example of supply schedule and figure II is its
graphical illustration.
Fig. I: Individual supply schedule
10 10
20 20
30 30
40 40
Fig. II: Supply curve
Movement along a supply curve
The amount of commodity supplied changes with rise and fall of the price while other determinants
of supply remain constant. This change, when shown in the graph, is known as movement along a
supply curve.
In simple words, movement along a supply curve represents the variation in quantity supplied of the
commodity with a change in its price and other factors remaining unchanged.
The movement in supply curve can be of two types – extension and contraction. Extension in a
supply curve is caused when there is an increase in the price or quantity supplied of the commodity
while contraction is caused due to a decrease in the price or quantity supplied of the commodity.
In the above fig. II, let us suppose Rs. 20 is the original price of milk per liter and 20,000 liters is the
original quantity of supply. When the price rises from Rs. 20 to Rs. 30, the amount of quantity
supplied rises from 20,000 liters to 30,000 liters, and there is a movement in the supply curve from
point B to point C. This movement is known as an extension of the supply curve.
Similarly, when the price falls from Rs. 20 to Rs. 10, the amount of quantity supplied falls from 20,000
liters to 10,000 liters, and there is another movement in the supply curve from point B to point A. This
movement is known as a contraction of the supply curve.
Shift in supply curve
The amount of commodity that the producers or suppliers are willing to offer at the marketplace can
change even in cases when factors other than the price of the commodity change. Such non-price
factors can be the cost of factors of production, tax rate, state of technology, natural factors, etc.
When the quantity of the commodity supplied changes due to change in non-price factors, the supply
curve does not extend or contract but shifts entirely. For an instance, the introduction of improved
technology in industries helps in reducing the cost of production and induces production of more
units of a commodity at the same price. As a result, the quantity of commodity supplied increases
but the price of the commodity remains as it is.
Fig. III: Shift in supply curve
The shift in supply curve can also be of two types – rightward shift and leftward shift. The rightward
shift occurs in supply curve when the quantity of supplied commodity increases at same price due to
favorable changes in non-price factors of production of the commodity. Similarly, a leftward shift
occurs when the quantity of supplied commodity decreases at the same price.
In the above fig. III, let us suppose that SS is the original supply curve where Q amount of commodity
has been supplied at price P. Due to favorable changes in non-price factors, the production of the
commodity has increased and its supply has been increased by Q2 – Q amount, at the same price.
This has caused the supply curve rightwards and new supply curve S2S2 has formed.
In the same, due to unfavorable changes in non-price factors of the commodity, the production and
supply have fallen to Q1 amount. Accordingly, the supply curve has shifted leftwards and new supply
curve S1S1 has formed.
Reasons for rightward shift of supply curve
 Improvement in technology
 Decrease in tax
 Decrease in cost of factor of production
 Favorable weather condition
 Seller’s expectation of fall in price in future
Reasons for leftward shift of supply curve

 Use of old or outdated technology
 Increase in tax
 Increase in cost of factor of production
 Unfavorable weather condition
Microeconomics refers to the study of individualistic economic behavior at the time of making
economic decisions. It studies an individual consumer, producer, manager or a firm, price of a
particular commodity or a household.
Scopes of Microeconomics
The scope or the subject matter of microeconomics is concerned with:
Commodity pricing
The price of an individual commodity is determined by the market forces of demand and supply.
Microeconomics is concerned with demand analysis i.e. individual consumer behavior, and supply
analysis i.e. individual producer behavior.
Factor pricing theory

Microeconomics helps in determining the factor prices for land, labor, capital, and entrepreneurship
in the form of rent, wage, interest, and profit respectively. Land, labor, capital, and entrepreneurship
are the factors that contribute to the production process.
Theory of economic welfare

Welfare economics in microeconomics is concerned with solving the problems in improvement and
attaining economic efficiency to maximize public welfare. It attempts to gain efficiency in production,
consumption/distribution to attain overall efficiency and provides answers for ‘What to produce?’,
‘When to produce?’, ‘How to produce?’, and ‘For whom it is to be produced?’
Significance of Microeconomics in Business Decision Making
Microeconomics plays a vital role in assisting the business firms and business decision makers.
Some of the major functions of microeconomics in business decision making are listed below:
Optimum utilization of resources
The study of microeconomics helps the decision makers to analyze and determine how the
productive resources are allocated for various goods and services. It also helps in solving the
producers’ dilemma of what to produce, how much to produce and for whom to produce.
Demand analysis
With the help of microeconomic analysis, business firms can forecast their level of demand within
the certain time interval. The demand for a commodity fluctuates depending upon various factors
affecting it. Thus, business firms and decision makers can determine the level of demand for the
commodity.
Cost analysis
Microeconomic theories explain various conditions of cost like fixed cost, variable cost, average cost,
and marginal cost. Along with this, it also provides an analysis of the short run and long run costs
that help the business decision makers determine the cost of production and other related costs, so
they can implement policies to cut down cost and increase their level of profit.
Free Market Economy

Microeconomics explains the operating of a free market economy where, an individual producer has
the freedom to take economic decisions like what to produce, how to produce, or for whom to
produce. Allocation of resources is determined by price or market mechanism i.e. interaction
between demand and supply
Production decision optimization

Microeconomics deals with different production techniques that help to find out the optimal
production decision which helps the decision makers to determine the factors needed in order to
produce a certain product or a range of products.
Pricing policy
Microeconomic analysis provides business managers with a thorough knowledge of theories of
production and pricing in order to ensure optimum profit for the firm in the long run.
Determination of Relative Prices of Products & Factors of production
Microeconomics helps in analyzing market mechanisms i.e. determinants of demand and supply
which are responsible for the determining prices of commodities in the market. Along with this, it
provides an insight on theories relating to prices of a factor of rent, wage, interest, and profit.
Basis of Managerial Economics

Microeconomics used for the study of a business unit, but not the economy as a whole is known as
managerial economics. The various tools used in microeconomics like cost and price determination,
at an individual level becomes the foundation of managerial economics.
Basis of Welfare Economics

Microeconomics is not only concerned with analyzing economic condition but also with the
maximization of social welfare. It studies how given resources are utilized to gain maximum benefit
under various market conditions like monopoly, oligopoly, etc. Analysis of production efficiency,
consumption efficiency, and overall economic efficiency are conducted on the basis of
microeconomics.
Formulation of Public Economic Policies
Microeconomics tools are useful for introducing policies relating to tax, tariff, debt, subsidy, etc. it
helps the governmental bodies to fixate on the tax rate, types of tax, and the amount of tax to be
charged to buyers and sellers.
Helpful in Foreign Trade

Microeconomics is useful in explaining and determining the rate of foreign exchange between
currencies, fixing international trade and tariff rules, defining the cause of disequilibrium in the
balance of payment (BOP), and formulating policies to minimize it.
In economics, an externality is a term used to describe the cost or benefit incurred by the third party
who did not choose to receive that cost or benefit. It is the consequence of economic activities
endured by an unrelated third party due to lack of control over the factors that create the cost or
benefit.
An externality can be positive or negative.
Positive externality
Positive externality or benefit is an involuntary gain in the welfare of one party due to activities of
another party. The party causing benefit does not receive any financial compensation.
Given below are few examples of positive externalities which will clarify the concept of positive
externality.
Example 1: A farmer who farms fruit does not only produce fruits for selling but also helps bee
farmers around the area. The bees can collect ample amount of nectar to prepare honey and
increases the benefit of bee farmers for which bee farmers won’t be charged any money.
At the same time, bees help in pollination at a fruit farm. Fruit farmers do not need to pay any kind of
compensation to the bee farmers for this benefit.
Example 2: You go to college and university, and pay for education for personal benefit. However,
your knowledge is helpful not only to you but also to other members of the society.
Also, when you join any company, the employers of that place would not need to spend time and
money to train you, causing the company notable benefit.
Negative externality
Contrary to positive externality, negative externality or cost is an involuntary loss in the welfare of one
party due to activities of another party. The party which causes loss does not need to pay
compensation to the one suffering from it.
Few examples of negative externality are given below that will help you further understand about
negative externality.
Example 1: Chemical manufacturing industries degrade the natural state of water resources by
mixing sewage into them. The consequence of water pollution is faced not only by the industry
causing it but by all the people living in and around that environment.
People may even suffer from airborne diseases. But the expenses that incur to people for treating
their health won’t be paid by the industries.
Example 2: People who use the automobile for transportation contribute to air pollution as well as
congestion. Other people who do not own an automobile are also affected by these problems.
All producers must tag a reasonable price on their commodity in order to convince consumers to
choose and use their products.
On the other hand, producers look forward to receiving a certain minimal amount in return for their
goods and services, without which they won’t be able to generate profit.
Producers set a certain amount of price for their goods and services, depending upon different inputs
that are used during the production procedure. However, sometimes, consumers may be willing to
pay price greater than that set by the producers due to the various market condition.
This difference between the minimum price that the producers are willing to supply or sell their
commodity at and the actual price they receive from consumers in exchange of the commodity is
known as producer surplus or producer welfare. The difference amount or surplus is an additional
benefit that the producers gain through selling their products.
For instance, let us suppose, ABC is a firm which produces rain boots. After careful evaluation of the
cost of production and desired profit, the firm decided to sell its product at dollar 40 per pair. The firm
produced 1000 pairs and distributed in the market. However, due to the availability of limited amount
of boots, consumers became ready to pay dollar 50 for a pair.
If the firm had sold all 1000 pairs of rain boots for dollar 40 per pair, it would have earned revenue of
dollar 40,000. But, since the firm was able to sell each pair for dollar 50, it gained total revenue of
dollar 50,000, generating producer surplus of dollar 10,000.
Figure: graphical representation of producer surplus
Graphically, producer surplus is the area above the supply curve and below the equilibrium market
price.
In the given figure, DD is a linear demand curve, SS is a linear supply curve and O is the point of
equilibrium where Q amount of commodity is supplied at price P. Thus, in the above figure, the area
of ΔNOP gives producer surplus.
All producers must tag a reasonable price on their commodity in order to convince consumers to
choose and use their products.
On the other hand, producers look forward to receiving a certain minimal amount in return for their
goods and services, without which they won’t be able to generate profit.
Producers set a certain amount of price for their goods and services, depending upon different inputs
that are used during the production procedure. However, sometimes, consumers may be willing to
pay price greater than that set by the producers due to the various market condition.
This difference between the minimum price that the producers are willing to supply or sell their
commodity at and the actual price they receive from consumers in exchange of the commodity is
known as producer surplus or producer welfare. The difference amount or surplus is an additional
benefit that the producers gain through selling their products.
For instance, let us suppose, ABC is a firm which produces rain boots. After careful evaluation of the
cost of production and desired profit, the firm decided to sell its product at dollar 40 per pair. The firm
produced 1000 pairs and distributed in the market. However, due to the availability of limited amount
of boots, consumers became ready to pay dollar 50 for a pair.
If the firm had sold all 1000 pairs of rain boots for dollar 40 per pair, it would have earned revenue of
dollar 40,000. But, since the firm was able to sell each pair for dollar 50, it gained total revenue of
dollar 50,000, generating producer surplus of dollar 10,000.
Figure: graphical representation of producer surplus
Graphically, producer surplus is the area above the supply curve and below the equilibrium market
price.
In the given figure, DD is a linear demand curve, SS is a linear supply curve and O is the point of
equilibrium where Q amount of commodity is supplied at price P. Thus, in the above figure, the area
of ΔNOP gives producer surplus.
In economics, deadweight loss (excess burden) is a term used to describe the loss caused to the
society due to market inefficiencies.
It occurs when equilibrium for goods and services is not attained. In other words, it occurs when
supply curve of a commodity does not intersect the demand curve at the free market equilibrium
point.
In a graph, the deadweight loss is represented by the area between supply curve and demand curve,
bound by initial quantity demanded and new quantity demanded.
Figure: graphical representation of price ceiling and deadweight loss
In the above graph, SS is a supply curve and DD is a demand curve. They intersect at free market
equilibrium point E where the Q1 amount of commodity is supplied at price P1.
Let us suppose P2 is the price ceiling of the commodity. As price ceiling is lesser than the equilibrium
price, consumers’ demand for the commodity increases. However, producers are not willing to offer
goods at such low price and therefore cut off their supply, making Q2 the new supplied in the market.
Thus, the area in the graph bounded by supply curve, demand curve, initial quantity supplied (Q1) and
final quantity supplied (Q2) gives the measure of deadweight loss.
Causes of deadweight loss
Government’s intervening activities such as price ceiling, price flooring and taxation are the major
reasons for the deadweight loss. These activities cause inefficient allocation of resources in the
market creating an imbalance between supply and demand of the commodity.
Price ceiling
A price ceiling is a measure of price control imposed by the government on particular commodities in
order to prevent consumers from being charged high prices.
As mentioned above, price ceiling creates a deadweight loss if it is set below the equilibrium price. It
is because fall in price increases demand of consumers and decreases supply from producers
simultaneously, creating an imbalance in the free market equilibrium.
Price floor
Likewise, the price floor is another measure of price control on how low a price can be charged for a
commodity.
When a price floor is set above the free market equilibrium price, there is an excessive supply of the
commodity but significantly low demand. The goods and services will no longer be sold in quantities
they would have otherwise and the imbalance in demand and supply results in a deadweight loss.
Taxes
Imposing taxes on goods and services increases the price of the commodity which is followed by a
decrease in demand for that commodity.
Once again, commodity fails to make as many sales as it would have made without taxes and cause
imbalances in the free market equilibrium.
Cross elasticity of demand is a measure of degree of change in demand of a commodity due to

change in price of another commodity.
Cross elasticity of demand can also be understood as the proportionate change in quantity
demanded of commodity ‘X’ due to proportionate change in price of commodity ‘Y’. Cross elasticity
of demand is denoted by Exy and is mathematically represented as
Cross elasticity of demand is one of the major tools that businessmen (producers) take help from in
order to make correct business decisions. Described below are its few applications in business
sector.
Determining nature of relationship between any two goods
We have already understood that cross elasticity of demand is the rate of change of demand for one
commodity in response to change in price of another commodity. Cross elasticity of demand can
only be measured between any two goods at a time, and the outcome is the representation of the
relationship shared by those two goods.
Cross elasticity is greater than zero when rise in price of commodity X causes rise in demand of
commodity Y. Such type of response can be observed in substitute goods such as Coke and Pepsi.
In the same way, cross elasticity is equal to zero when rise in price of commodity X does not cause
any effect on the demand of commodity Y. This type of response can be seen in goods that are not
related to each other such as sugar and shoe.
And, cross elasticity is lesser than zero when rise in price of commodity Y causes fall in demand of
commodity X. Such type of response can be seen in complementary goods such as tea and sugar.
Forecasting change of demand

Cross elasticity can be used by a businessman (producer) to predict the future demand of his
product in case when he has the idea of probable future price of substitute or complementary goods.
Let us suppose that there’s a company which manufactures Limes (cold drink) and there is another
cold drink in the market called Oranges. The cross elasticity of demand between Limes and Oranges
is +1.5.
Let us also suppose that the manufacturer of Limes received the information that the price of
Oranges is about to fall by 10% in the upcoming month.
From the above information, the manufacturer of Limes can predict by how much the demand of its
product will fall as a result of fall in price of Oranges, and thus will be able to make necessary
decisions to keep up its revenue.
Classification of market
Cross elasticity of demand is also helpful in classifying the type of market.
Higher the value of cross elasticity of demand between the products, greater will be the competition
in the market, and lower the value of cross elasticity, the market will be less competitive. In the same
way, if cross elasticity is zero or almost zero, there is monopoly or zero competition in the market.
Pricing policy
Price of one product can directly affect the price of another if they are related to each other. That is
why large firms which produce more than one product must evaluate cross price elasticity between
each of their products in order to efficiently price them.
For an example: Le t us suppose Oral-D is company which produces toothpaste as well as toothbrush
(complementary goods). The rise in price of any one of these products causes fall in demand of that
product as well as the other. Therefore, the company must be careful while deciding whether or not
to increase the price of any product.
Determination of boundaries between industries

Concept of cross elasticity helps producers determining boundaries of their industries.
Complementary goods belong to different industries. Thus, the negative value of cross elasticity of
demand indicates that the products are from different industries.
.
In the same way, substitute goods belong to same industry. Thus, positive value of cross elasticity of
demand indicates that the products are from same industry.
What are other people reading?
The law of supply states that, other things remaining the same, the quantity supplied of a commodity
is directly or positively related to its price. In other words, when there is a rise in the price of a
commodity the quantity supplied of it in the market increases and when there is a fall in the price of a
commodity, its quantity supplied decreases, other things remaining the same. Thus, the supply
curve of a commodity slopes upward from left to right.
Law of Supply Assumptions
The term “other things remaining the same” refers to the following assumptions in the law of supply:
1. No change in the state of technology.

2. No change in the price of factors of production.
3. No change in the number of firms in the market.
4. No change in the goals of the firm.
5. No change in the seller’s expectations regarding future prices.
6. No change in the tax and subsidy policy of the products.
7. No change in the price of other goods.
The law of supply can be explained with the help of supply schedule and supply curve as explained
below.
Supply Schedule
Supply Schedule is a tabular presentation of various combinations of price and quantity supplied by
the seller or producer during a period of time. We can show the supply schedule through the
following imaginary table.
The given schedule shows positive relationship between price and quantity supplied of a commodity.
In the beginning, when the price is Rs.10 per kg, quantity supplied by the seller is 1kg. As the price
increases from Rs.10 per kg to Rs.20 per kg and then to Rs.30 per kg, the quantity supplied by the
seller also increases from 1 kg to 2 kg and then to 3 kg respectively.
Further rise in price to Rs.40 and then to Rs.50 per kg results in increase in quantity supplied by the
seller to 4kg and then to 5kg. Thus, the above schedule shows that there is positive relationship in
between price and quantity supplied of a commodity.
Supply curve
The supply curve is a graphical representation of a supply schedule. By plotting various combinations
of price and quantity supplied of the table, we can derive an upward sloping demand curve as shown
in the figure below:
In the given figure, price and quantity supplied are measured along the Y-axis and the X-axis
respectively. By plotting various combinations of price and quantity supplied we derived
points A, B, C, D, E curve and joining these points we find an upward sloping i.e. SS1. The positive
slope of the supply curve SS1 establishes the law of supply and shows the positive relationship in
between price and quantity supplied.
Exceptions and Limitations of the Law of Supply

Auction Sale
The law of supply states that quantity supplied increases with increase in price and vice-versa. But
this law doesn’t hold true in case of auction sale. An auction sale takes place at that time when the
seller is in financial crisis and needs money at any cost.
Price expectation of seller

If the seller expects that the price of commodity is going to fall in near future, he will try to sell more
even if the price level is very low. On the other hand, if the seller expects further rise in price of the
commodity he will not sell more even if the price level is high. It is against the law of supply.
Stock clearance sale
When a seller wants to clear its old stock in order to store new goods, he may sell large quantity of
goods at heavily discounted price. It is also against the law of supply.
Fear of being out of fashion

As we know that quantity supplied of a commodity is affected by fashion, taste and preferences of
the consumer, technology and time. If the seller thinks that the goods are going to be outdated in the
near future, he sells more at a lower price which is also against the law of supply.
Perishable goods
Those goods which have very short life-time and they become useless after that are all perishable
goods. Those goods must be made available in the market at its right time whatever be its price. So
the seller becomes ready to sell his goods at any offered price. It is also against the law of supply.

The law of supply states that, other things remaining the same, the quantity supplied of a commodity
is directly or positively related to its price. In other words, when there is a rise in the price of a
commodity the quantity supplied of it in the market increases and when there is a fall in the price of a
commodity, its quantity supplied decreases, other things remaining the same. Thus, the supply
curve of a commodity slopes upward from left to right.
Law of Supply Assumptions
The term “other things remaining the same” refers to the following assumptions in the law of supply:
1. No change in the state of technology.

2. No change in the price of factors of production.
3. No change in the number of firms in the market.
4. No change in the goals of the firm.
5. No change in the seller’s expectations regarding future prices.
6. No change in the tax and subsidy policy of the products.
7. No change in the price of other goods.
The law of supply can be explained with the help of supply schedule and supply curve as explained
below.
Supply Schedule
Supply Schedule is a tabular presentation of various combinations of price and quantity supplied by
the seller or producer during a period of time. We can show the supply schedule through the
following imaginary table.
The given schedule shows positive relationship between price and quantity supplied of a commodity.
In the beginning, when the price is Rs.10 per kg, quantity supplied by the seller is 1kg. As the price
increases from Rs.10 per kg to Rs.20 per kg and then to Rs.30 per kg, the quantity supplied by the
seller also increases from 1 kg to 2 kg and then to 3 kg respectively.
Further rise in price to Rs.40 and then to Rs.50 per kg results in increase in quantity supplied by the
seller to 4kg and then to 5kg. Thus, the above schedule shows that there is positive relationship in
between price and quantity supplied of a commodity.
Supply curve
The supply curve is a graphical representation of a supply schedule. By plotting various combinations
of price and quantity supplied of the table, we can derive an upward sloping demand curve as shown
in the figure below:
In the given figure, price and quantity supplied are measured along the Y-axis and the X-axis
respectively. By plotting various combinations of price and quantity supplied we derived
points A, B, C, D, E curve and joining these points we find an upward sloping i.e. SS1. The positive
slope of the supply curve SS1 establishes the law of supply and shows the positive relationship in
between price and quantity supplied.
Exceptions and Limitations of the Law of Supply

Auction Sale
The law of supply states that quantity supplied increases with increase in price and vice-versa. But
this law doesn’t hold true in case of auction sale. An auction sale takes place at that time when the
seller is in financial crisis and needs money at any cost.
Price expectation of seller
If the seller expects that the price of commodity is going to fall in near future, he will try to sell more
even if the price level is very low. On the other hand, if the seller expects further rise in price of the
commodity he will not sell more even if the price level is high. It is against the law of supply.
Stock clearance sale
When a seller wants to clear its old stock in order to store new goods, he may sell large quantity of
goods at heavily discounted price. It is also against the law of supply.
Fear of being out of fashion

As we know that quantity supplied of a commodity is affected by fashion, taste and preferences of
the consumer, technology and time. If the seller thinks that the goods are going to be outdated in the
near future, he sells more at a lower price which is also against the law of supply.
Perishable goods
Those goods which have very short life-time and they become useless after that are all perishable
goods. Those goods must be made available in the market at its right time whatever be its price. So
the seller becomes ready to sell his goods at any offered price. It is also against the law of supply.
[Related Reading: Law of Demand]
Law of supply from businesstopia
Meaning
The term ‘isoquant’ is composed of two terms ‘iso’ and ‘quant’. Iso is a Greek word which means
equal and quant is a Latin word which means quantity. Therefore, these words together refer to equal
quantity or equal product.
An isoquant curve is the representation of a set of locus of different combinations of two inputs
(labor and capital) which yield the same level of output. It is also known as or equal product curve or
producer’s indifference curve.
It is a firm’s counterpart of the consumer’s indifference curve. Thus, an isoquant may also be defined
as the graphical representation of different combinations of two inputs which give same level of
output to the producer. Since all the combinations lying in an isoquant curve yield the same level of
production, a producer is indifferent between the combinations.
Few Definitions of Isoquant Curve

The isoproduct curves show the different combinations of two resources with
which a firm can produce equal amount of product.
– Bilas
Isoproduct curve shows the different input combinations that will produce a
given output.
– Samuelson
An isoquant curve may be defined as a curve showing the possible combinations
of two variable factors that can be used to produce the same total product.
– Peterson
An isoquant is a curve showing all possible combinations of inputs physically
capable of producing a given level of output.
– Ferguson
Example of Isoquant Schedule and Isoquant Curve

Table 1: isoquant schedule
Combinations Labor (L) Capital (K) Output (units)
A 1 12 100
B 2 8 100
C 3 5 100
D 4 3 100
E 5 2 100
The given isoquant schedule represents various combinations of inputs (labor and capital).
From the table, we can see combination A consists of 1 unit of labor and 12 units of capital which
together produce 100 units of output. In combination B, when 1 unit of labor was added in place of 4
units of capital, the production process still produced 100 units of output. In the same way, other
combinations C (3L + 5K), D (4L + 3K) and E (5L + 2K) made the same level of output, i.e. 100 units.
Figure 1: graphical representation of isoquant schedule (isoquant curve)
Assumptions of Isoquant Curve
The concept of isoquant is based on the following assumptions.
1. Only two inputs (labor and capital) are employed to produce a good.
2. There is technical possibility of substituting one input for another. It implies that the production
function is of variable proportion type.
3. Labor and capital are divisible.
4. The producer must be rational, i.e. trying to maximize his profit.
5. State of technology is given and unchanged.
6. Marginal rate of technical substitution diminishes in production process.

Marginal rate of technical substitution (MRTS) indicates the rate at which one factor (labor) can be
substituted for the other input (capital) in the production process of a commodity without changing
the level of output or production. The marginal rate of technical substitution of labor for capital
(MRTSL,K) can be defined as the units of capital which can be replaced by one unit of labor, keeping
constant the level of output. Mathematically, it is represented as
Combination Capital (K) Labor (L) MRTSL,K Output
A 12 1 100
B 8 2 4:1 100
C 5 3 3:1 100
D 3 4 2:1 100
E 2 5 1:1 100
Given table 2 represents various combinations of inputs, all of which yield the same level of output,
i.e. 100 units, to the producer.
Comparing combination A with B, we see that 4 units of capital is replaced by 1 unit of labor, without
altering the output. Therefore, 4:1 is the marginal rate of technical substitution in this case.
Similarly, if we compare combination B with C, we can find that the MRTS for this case is 3:1.
Likewise, MRTS between C and D, and D and E is 2:1 and 1:1, respectively.

Figure 2 is a graphical representation of MRTS. In the figure, MRTS between any two points is given
by the slope between those points.
For example, MRTS between the points A and B can be found as
In the same way, MRTS at any particular point on the isoquant curve can be calculated by finding the
slope of the line that is tangent to that point on the curve.
Properties of Isoquant Curve

The isoquant curve has almost the same properties as are possessed by the indifference curve of the
theory of consumer behavior. They are explained below.
Isoquant is convex to the origin

The isoquant is convex to the origin because the marginal rate of technical substitution (MRTS)
between the inputs is diminishing. As shown in the tabular example of MRTS, the ratio by which the
input units of capital is substituted by labor units diminishes with more and more substitution of
labor for capital. Thus, the isoquant curve is convex to the origin.
If the isoquant curve had been concave to the origin, it would imply that the MRTS increases as more
and more of labor is substituted for capital. And this would be against the assumption that the
isoquant curve is based on.
Isoquant is negatively sloped

The isoquant curve is neither upward sloping nor horizontal but always slopes downward from left to
right. It is because the producer will have to give up some of the input units of capital to increase the
input of labor when keeping the production amount unchanged.
Increasing input units of either of the factors without deducing the input of the other factor will result
in increased production and it is beyond the principle of isoquant curve.
In the figure, when OK1 units of capital were employed, OL1 units of labor were employed too. When
the input units of labor was increased to OL2, the input units of capital was reduced to OK2.
Therefore, the curve is downward sloping from to right. And slope of any downward sloping curve is
always negative.
Higher isoquant represents higher production

The isoquant which is in higher stage has higher units of labor and capital combinations. Greater
combination of labor and capital makes large scale of production. So, higher the isoquant curve,
greater will be the production level.
In the figure, we can see that there are two isoquant curves (Iq1 and Iq2). We can also see that the
combination A lies on Iq1 and combination B lies on Iq2.
Combination A consists of OL1 units of labor and OK1 units of capital which is visibly lesser than the
OL2 units of labor and OK2 units of capital at point B. So we can say that production level at Iq2 is
higher than the production level at Iq1.
Two isoquants never intersect each other
Each isoquant curve is a representation of particular level of production. The level of production or
output of a production process is same throughout the curve.
In the above figure, Iq1 and Iq2 are two isoquant curves and R is the point where both the curves
intersect.
According to the principle of isoquant curve, production level at point S = production level at point R =
production level at point T
Also, production level at point P = production level at point R = production level at point Q
But, production level at point S and point T ≠ production level at point P and point Q
Therefore, two isoquant curves cannot intersect. Yet, two isoquant curves need not be parallel to
each other.
The parallelism of isoquant curves depend upon the MRTS. The isoquant curves can be parallel only
when the MRTS of both the curves are equal.
Meaning
The term ‘isoquant’ is composed of two terms ‘iso’ and ‘quant’. Iso is a Greek word which means
equal and quant is a Latin word which means quantity. Therefore, these words together refer to equal
quantity or equal product.
An isoquant curve is the representation of a set of locus of different combinations of two inputs
(labor and capital) which yield the same level of output. It is also known as or equal product curve or
producer’s indifference curve.
It is a firm’s counterpart of the consumer’s indifference curve. Thus, an isoquant may also be defined
as the graphical representation of different combinations of two inputs which give same level of
output to the producer. Since all the combinations lying in an isoquant curve yield the same level of
production, a producer is indifferent between the combinations.
Few Definitions of Isoquant Curve

The isoproduct curves show the different combinations of two resources with
which a firm can produce equal amount of product.
– Bilas
Isoproduct curve shows the different input combinations that will produce a
given output.
– Samuelson
An isoquant curve may be defined as a curve showing the possible combinations
of two variable factors that can be used to produce the same total product.
– Peterson
An isoquant is a curve showing all possible combinations of inputs physically
capable of producing a given level of output.
– Ferguson
Example of Isoquant Schedule and Isoquant Curve

Table 1: isoquant schedule
Combinations Labor (L) Capital (K) Output (units)
A 1 12 100
B 2 8 100
C 3 5 100
D 4 3 100
E 5 2 100
The given isoquant schedule represents various combinations of inputs (labor and capital).
From the table, we can see combination A consists of 1 unit of labor and 12 units of capital which
together produce 100 units of output. In combination B, when 1 unit of labor was added in place of 4
units of capital, the production process still produced 100 units of output. In the same way, other
combinations C (3L + 5K), D (4L + 3K) and E (5L + 2K) made the same level of output, i.e. 100 units.
Figure 1: graphical representation of isoquant schedule (isoquant curve)
Assumptions of Isoquant Curve
The concept of isoquant is based on the following assumptions.
1. Only two inputs (labor and capital) are employed to produce a good.
2. There is technical possibility of substituting one input for another. It implies that the production
function is of variable proportion type.
3. Labor and capital are divisible.
4. The producer must be rational, i.e. trying to maximize his profit.
5. State of technology is given and unchanged.
6. Marginal rate of technical substitution diminishes in production process.

Marginal rate of technical substitution (MRTS) indicates the rate at which one factor (labor) can be
substituted for the other input (capital) in the production process of a commodity without changing
the level of output or production. The marginal rate of technical substitution of labor for capital
(MRTSL,K) can be defined as the units of capital which can be replaced by one unit of labor, keeping
constant the level of output. Mathematically, it is represented as
Combination Capital (K) Labor (L) MRTSL,K Output
A 12 1 100
B 8 2 4:1 100
C 5 3 3:1 100
D 3 4 2:1 100
E 2 5 1:1 100
Given table 2 represents various combinations of inputs, all of which yield the same level of output,
i.e. 100 units, to the producer.
Comparing combination A with B, we see that 4 units of capital is replaced by 1 unit of labor, without
altering the output. Therefore, 4:1 is the marginal rate of technical substitution in this case.
Similarly, if we compare combination B with C, we can find that the MRTS for this case is 3:1.
Likewise, MRTS between C and D, and D and E is 2:1 and 1:1, respectively.

Figure 2 is a graphical representation of MRTS. In the figure, MRTS between any two points is given
by the slope between those points.
For example, MRTS between the points A and B can be found as
In the same way, MRTS at any particular point on the isoquant curve can be calculated by finding the
slope of the line that is tangent to that point on the curve.
Properties of Isoquant Curve

The isoquant curve has almost the same properties as are possessed by the indifference curve of the
theory of consumer behavior. They are explained below.
Isoquant is convex to the origin

The isoquant is convex to the origin because the marginal rate of technical substitution (MRTS)
between the inputs is diminishing. As shown in the tabular example of MRTS, the ratio by which the
input units of capital is substituted by labor units diminishes with more and more substitution of
labor for capital. Thus, the isoquant curve is convex to the origin.
If the isoquant curve had been concave to the origin, it would imply that the MRTS increases as more
and more of labor is substituted for capital. And this would be against the assumption that the
isoquant curve is based on.
Isoquant is negatively sloped

The isoquant curve is neither upward sloping nor horizontal but always slopes downward from left to
right. It is because the producer will have to give up some of the input units of capital to increase the
input of labor when keeping the production amount unchanged.
Increasing input units of either of the factors without deducing the input of the other factor will result
in increased production and it is beyond the principle of isoquant curve.
In the figure, when OK1 units of capital were employed, OL1 units of labor were employed too. When
the input units of labor was increased to OL2, the input units of capital was reduced to OK2.
Therefore, the curve is downward sloping from to right. And slope of any downward sloping curve is
always negative.
Higher isoquant represents higher production

The isoquant which is in higher stage has higher units of labor and capital combinations. Greater
combination of labor and capital makes large scale of production. So, higher the isoquant curve,
greater will be the production level.
In the figure, we can see that there are two isoquant curves (Iq1 and Iq2). We can also see that the
combination A lies on Iq1 and combination B lies on Iq2.
Combination A consists of OL1 units of labor and OK1 units of capital which is visibly lesser than the
OL2 units of labor and OK2 units of capital at point B. So we can say that production level at Iq2 is
higher than the production level at Iq1.
Two isoquants never intersect each other
Each isoquant curve is a representation of particular level of production. The level of production or
output of a production process is same throughout the curve.
In the above figure, Iq1 and Iq2 are two isoquant curves and R is the point where both the curves
intersect.
According to the principle of isoquant curve, production level at point S = production level at point R =
production level at point T
Also, production level at point P = production level at point R = production level at point Q
But, production level at point S and point T ≠ production level at point P and point Q
Therefore, two isoquant curves cannot intersect. Yet, two isoquant curves need not be parallel to
each other.
The parallelism of isoquant curves depend upon the MRTS. The isoquant curves can be parallel only
when the MRTS of both the curves are equal.
Monetary policy adopted by the government affects the LM curve, whereas, the fiscal policy affects
the IS curve. Expansionary monetary policy shifts the LM curve to the right, lowers interest rates and
stimulates aggregate output. Contractionary monetary policy has an inverse effect on the curve.
On the other hand, Fiscal policy causes a shift in the IS curve, where an expansionary policy shifts the
curve to the right, stimulates aggregate demand by increasing government expenditures and
reducing tax rates.
The effect of the changes in the policies on interest rates and aggregate income/output has been
discussed further.
Response to a Change in Monetary Policy

The figure presented below illustrates the changes that occur in interest rates and output as a result
of increased money supply in the economy.
Initially, the economy was in equilibrium at point E for both money market and goods market, where
the IS curve IS1 intersects the LM curve LM1. Assuming that, at Y1 level of aggregate output, the
economy is suffering from an unemployment rate of 10%, so, as a part of its expansionary monetary
policy, the government decides to reduce unemployment and increase output by raising the supply of
money.
The rise in money supply results in the rightward supply of LM curve, from LM 1 to LM2 which moves
the equilibrium point of the goods market and money market to E1 (intersection of IS1 and LM2). As a
result of increased money supply, interest rates decline from i1 to i2, and aggregate level of output
increased from Y1 to Y2.
When the equilibrium is at point E1, the rise in money supply (shifts the LM curve to the right) creates
excess of money supply, and decreases the interest rate. Subsequently, investment expenditures and
net export rise, which leads to an increase in the aggregate demand and consequently, aggregate
output rises. When the economy reaches at E2, the excess supply of money is eliminated because the
fall in interest rates and increase in aggregate output have raised the demand for quantity demanded
for money. This keeps increasing until it equals the increased supply of money.
Contrarily, a decline in the supply of money has a reverse effect. It shifts the LM curve to the left,
resulting in reduced output and increased interest rates. Thus, a positive relationship can be
determined between aggregate output and money supply. Aggregate output expands with the
increase in money supply and contracts as money supply decreases.
Response to a Change in Fiscal Policy
The ISLM model can demonstrate how changes in fiscal policy affects interest rates and aggregate
output. When the government is not willing to raise the supply of money when the economy is
suffering from unemployment at E1 point of equilibrium, the federal government adopts an
expansionary fiscal policy.
The figure shows how interest rates and aggregate output respond to the fiscal policy where the
government has increased its expenses and reduced taxes on disposable income.
An increase in spending made by the government or the reduction in taxes cause the IS curve to shift
from IS1 to IS2. The equilibrium point in both the goods market and money market shift from E 1 to E2,
where the IS curve, IS2 and LM curve, 1 intersect. The change in fiscal policy results in rise in
aggregate output from Y1 to Y2, and a rise in rate of interest from i1 to i2.
The change in fiscal policy leads to an increased level of output and interest rates is because an
increase in government expenses directly affects aggregate demand. A decline in taxes result in
more disposable income, consequently leading to a rise in consumption expenditure. The rise in
aggregate demand raises the aggregate output, which subsequently leads to increase in demand for
money. This further creates an excess demand of money, which in turn increases the rate of interest.
At equilibrium point E2, the excess of money demand in the economy due to rise in aggregate output
is eliminated by the increment in interest rates, which lowers the demand for money.
A contractionary fiscal policy on the other hand, has a reverse effect, and so it reduces aggregate
demand, shifts the IS curve to the left and causes in the decline of interest rates and final output.
Thus, it can be concluded that aggregate output and interest rates have a positive relationship with
government expenses, whereas they have a negative relationship with taxes.
Various economic theories have been proposed by different economic school of thoughts and they
have explained the causes of inflation in different ways. According to the neo-classical economists,
inflation is caused due to the increase in the supply of money. They believe that the economy
functions at full employment. So, any rise in money supply leads to a proportional rise in price level.
On the other hand, Keynes explains that the inflation occurs when total expenditure exceeds total
output/production. He stated that the increase in expenditure such as investment or government
expenditure leads to increase in demand and hence causes inflation. Inflation is usually a non-
monetary phenomena for Keynes.
According to the monetarist school of thoughts, inflation is a monetary phenomenon. Milton

Freidman, one of the leading economists of monetarist school of thought states that even though
rise in money supply leads to rise in price levels, the two do not have a proportional relationship.
Thus, incorporating the different school of thoughts, the modern theory of inflation considers
monetary and real factors to explain he causes of inflation through demand pull and cost-push
arguments.
Demand Pull Inflation

Inflation caused due to excessive demand is termed as demand pull inflation. It exists in the
economy when overall price of goods and services increase due to increase in aggregate demand,
but the aggregate supply remains the same.
When the economy is at full employment, it is not possible to produce goods and services any further
because the available resources have been optimally utilized. In this case, the supply of commodities
is limited, but the demand is increasing. Consequently, the price of the commodity rise and leads to
inflation.
For instance, take an example of a kid who loves candies. Suppose he has two friends Ran and Tina.
All the three kids want a particular toy available in the market with limited stock, maybe a single
piece. All the three kids have 10 candies each. The kid loves candies, so in return for the toy, he is
willing to give 5 of his candies. Ran, on the other hand, is willing to give 6 candies. However, Tina
loves the toy more than she loves candies. So she is willing to give 8 candies.
In this case, the toy seller would set the price depending on the willingness of the customers to pay
for the toy. If there are more number of people like Tina in the market, the shopkeeper will set the
price high. The price of the commodities depend on the demand and types of consumers. As the
demand is high, and stock of the commodity is limited, inflation occurs.
The example above defines how demand pulls price and leads to inflation in the economy. This can
further be explained using the demand curve where the rise in price is caused due to the upward shift
in demand curve.
In the diagram, the horizontal line shows quantity (AD & AS), whereas the vertical line shows price. As
shown in the figure, aggregate demand (AD1) intersects aggregate supply (AS) at point A where, the
equilibrium price level is P1 and the quantity is Q1. When the aggregate demand increases, the initial
AD1 curve shifts rightwards to AD2 and AD3 which intersects the initial AS curve at point B and C in
which the new equilibrium price level are P2 and P3 respectively.
The increase in price from P1 to P2 and P3 is known as semi inflation. The price rise from P1 to P2 and
P3 is because of the rise in aggregate demand for goods and services at a given supply situation.
Corresponding to the P3 level of price level, the economy has reached full employment level. So, the
aggregate supply curve (AS) becomes vertical.
Further rise in AD to AD4 increases the price to P4 but there is no increase in output since, the
economy is at full employment. Such increase in price is known as inflation. As shown in the
diagram, the price continues to rise if the aggregate demand keeps increasing.
Inflationary Gap
The gap that occurs when aggregate demand is more than aggregate supply at full employment level
is known as inflationary gap. The concept of inflationary gap was first introduced by J.M. Keynes in
his article ‘How to pay for the war’ in 1940.
According to Keynes, at full employment level, even when the demand for a commodity rises, the
output remains the same. This causes a rise in price level and creates a gap between demand and
supply of the commodity. The gap is termed as inflationary gap.
For example, the daily demand for milk in an economy is 1500 liters. But the economy can only
produce (supply) 1000 liters of milk by utilizing its full capacity. This creates an excess demand of
500 liters, which is the inflationary gap.
Mathematically,
Inflationary gap= Aggregate Demand – Aggregate Supply (at full employment level)
Cite this article as: Shraddha Bajracharya, "Causes of Inflation," in Businesstopia, January 11,
2018, https://www.businesstopia.net/economics/macro/causes-inflation.
Diagrammatically, this concept can be better explained through the following graph:
In the figure, output (supply) is shown by X axis and aggregate demand is shown by Y axis. The line
passing through origin is 45 degree line which shows aggregate demand is equal to total output. The
AD curve (C + I + G) intersects the 450 line at point E. So, the point of equilibrium is E, and the
equilibrium level of output is Y. Yf is the level of output at full employment level. At this level,
aggregate demand YfA is greater than aggregate output (supply) YfB. So, the gap between aggregate
demand and aggregate supply is AB which is known as the inflationary gap.
Causes of Demand Pull Inflation
Some of the factors contributing to demand pull inflation are explained below:
Increase in money supply

One of the most important reasons for demand pull inflation is the excess of money supply in
comparison to output produced in the economy. When the central monetary authority of the country
supplies more money, interest rates decline. This leads to more investment which further leads to
increase in income through multiplier effect. Subsequently, demand increases, resulting in price rise.
Increase in government expenditure

Increase in government expenditure raises the income level of the people. Increase in income
increases the expenditure (demand) of the households and shifts the demand curve upwards. But, at
the given level of output, the growing needs of people cannot be met, which leads to an increase in
general prices of commodities.
Increase in private expenditure
Total private expenditure has two components, consumption and investment. An increase in
consumption directly leads to an upward shift in demand curve. Similarly, increased investment leads
to more job opportunities and hence higher income level which also increases the aggregate
demand. Consequently, the price level rises.
Reduction in taxes
Reduction in direct taxes lead to higher level of disposable income which increases the aggregate
demand of households and individuals. At a fixed level of supply, a higher demand leads to inflation.
Increase in net exports

Increase in net export means more inflow of foreign currency which increases the income level of
people. This leads to an increase in aggregate demand. But, at a given level of output, price levels
rise as the demand is high but supply is limited. Similarly, more export and less import may result in
shortage of commodities in the domestic market. As a result, demand increases but supply remains
same, so prices rise.
Deficit financing
When governmental expenses are in excess to its revenue, deficit of balance occurs. In order to level
of deficit balance, government prints more money as a solution, which leads to inflation. Such
situation occurs during war or internal conflicts.
Cost Push Inflation

Inflation caused due to an increase in the cost of production is known as cost push inflation. When
manufacturing firms face higher production costs, they usually raise the price of their products to
maintain their profit margins. This differential raise in price is cost push inflation.
Cost push inflation occurs when at a given demand level, aggregate supply declines due to increase
in production costs such as labor wages or cost of raw materials. This causes the supply to
decrease, consequently, increasing the price of commodities. Therefore, it is also known as supply
side inflation.
For example, in 1970s, oil crisis caused a huge cost push inflation in the economy. The scarcity of oil
due to Middle East-imposed embargo led to decrease in its supply. Since the demand remained
same, the price increased rapidly causing the prices to inflate. Further, this inflated the price of other
commodities which required oil as a raw material.
The concept of cost push inflation can be explained with the diagram below:
In the diagram, vertical axis represents price level and horizontal axis represents quantity level. At the
beginning, aggregate demand curve (AD) intersects aggregate supply curve (AS) at point A, where the
equilibrium price level and quantity are P1 and Q1 respectively. As the supply falls short and the
supply curve shifts leftward from AS1 to AS2, the equilibrium level is restored at point B where the
price is higher rises to P2.
If aggregate supply declines further, AS curve shifts to AS3 thereby causing a rise in price to P3. The
rise in price levels from P1 to P2 and P3 is cost push inflation.
Thus, the figure shows that a decrease in aggregate supply of commodities in relation to demand
leads to inflation, but at the same time reduces the output level in the economy.
Causes of Cost Push Inflation

The major factors leading to cost push inflation are described below:
Increase in wage rate
When the increase in wage rate is greater than the level of labor productivity, it leads to inflation.
Although general rise in wage does not lead to inflation, the presence of labor unions, wages
generally exceed productivity, thereby, causing inflation.
Increase in input prices or interest rates

The rise in prices of factors of input such as raw materials, electricity, water supply, oil, etc. leads to
rise in price of goods and services. Similarly, increase in interest rates raise the cost of capital,
ultimately leading to inflation.
Increase in profit margin

When manufacturing firms increase their profit margin per unit of output, with no increase in cost of
production or demand of the commodity in the market, prices rise rapidly causing inflation.
Indirect taxation or removal of subsidies

Increase in indirect taxes like VAT, excise duty, custom duty, etc. directly increases prices of
commodities. Likewise, removal of government subsidies also leads to higher payment of subsidized
goods.
Depreciation of currency
If the domestic currency is devalued against foreign currency, the prices of imported goods increase.
If the economy is predominated by imports, it will have greater impact on the domestic price
movement, leading to higher inflation.
Supply shock
Factors such as natural calamities, power shortage, crop failures, strikes, etc. also cause shortage in
the supply of goods and services, which leads to inflation in the economy.
income-is-lm-curves.
IS and LM curve helps to determine the rate of interest and equilibrium level of income through the
equilibrium of money market and goods market. In an open economy, the increase in income level
leads to imports of foreign goods rather than spending on domestic products. So, the IS curve in an
open economy is steeper.
IS curve in the open economy, represents the goods market, and includes net exports as it is included
in aggregate demand in an economy. The determined exchange rate for import and export of goods
have an effect in the IS curve.
LM curve represents equilibrium in the money market at different interest rates and income levels.
The intersection of IS and LM curves the rate of interest and income level in the open economy. This
relation is illustrated in the figure below:
The figure shows that the negatively sloped IS curve intersects with the positively sloped LM curve at
point E. At point E, the equilibrium rate of interest is r, and Y is the equilibrium level of income. The
condition leads to the equilibrium of money market and real market or the goods market. Thus, at
point E, demand for money and its supply in the market is equal. Along with this, the level of spending
is also equal to the level of investment at this point.
Concept of Demand
Demand refers to the quantity of a commodity or a service that people are willing to buy at a certain
price during a certain time interval. It can be termed as a desire with the ‘willingness’ and ‘ability’ to
pay for a commodity.
An increase in the price of the commodity decrease the demand for that commodity, while the
decrease in price increases its demand. The phenomena is termed as law of demand.
Concept of Demand Function

Demand function is an algebraic expression that shows the functional relationship between the
demand for a commodity and its various determinants affecting it. This includes income and price
along with other determining factors.
Here, the demand for the commodity is the dependent variable, while its determinants are the
independent variables.
Determinants of Demand
Price of the given commodity
Other things remaining constant, the rise in price of the commodity, the demand for the commodity
contracts, and with the fall in price, its demand increases.
Price of related goods
Demand for the given commodity is affected by price of the related goods, which is called cross price
demand.
Income of the individual consumer
Change in consumer’s level of income also influences their demand for different commodities.
Normally, the demand for certain goods increase with the increasing level of income and vice versa.
Tastes and preferences

The taste and preferences of individuals also determine the demand made for certain goods and
services. Factors such as climate, fashion, advertisement, innovation, etc. affect the taste and
preference of the consumers.
Expectation of change in price in the future
If the price of the commodity is expected to rise in the future, the consumer will be willing to
purchase more of the commodity at the existing price. However, if the future price is expected to fall,
the demand for that commodity decreases at present.
Size and composition of population

The market demand for a commodity increases with the increase in the size and composition of the
total population. For instance, with the increase in total population size, there is an increase in the
number of buyers. Likewise, with an increase in the male composition of the population, the demand
for goods meant for male increases.
Season and weather

The market demand for a certain commodity is also affected by the current weather conditions. For
instance, the demand for cold beverages increase during summer season.
Distribution of income
In case of equal distribution of income in the economy, the market demand for a commodity remains
less. With an increase in the unequal distribution of income, the demand for certain goods increase
as most people will have the ability to buy certain goods and commodities, especially luxury goods.
Types of Demand Function

Based on whether the demand function is in relation to an individual consumer or to all consumers in
the market, the demand function cab be categorized as
 Individual Demand Function

 Market Demand Function
Individual Demand Function
Individual demand function refers to the functional relationship between demand made by an
individual consumer and the factors affecting the individual demand. It shows how demand made by
an individual in the market is related to its determinants.
Mathematically, individual demand function can be expressed as,

Dx= f (Px, Pr, Y, T, F)
Where,
Dx= Demand for commodity x;
Cite this article as: Shraddha Bajracharya, "Concept of Demand Function and its Types," in Businesstopia, January 9,
2018, https://www.businesstopia.net/economics/macro/concept-demand-function-types.
Px= Price of the given commodity x;

Pr= Price of related goods;
Y= Income of the individual consumer;
T= Tastes and preferences;
F= Expectation of change in price in the future.
Market Demand Function

Market demand function refers to the functional relationship between market demand and the
factors affecting market demand. Market demand is affected by all the factors that affect an
individual demand. In addition to this, it is also affected by size and composition of population,
season and weather conditions, and distribution of income.
Mathematically, market demand function can be expressed as,
Dx= f (Px, Pr, Y, T, F, Po, S, D)
Where,

F= Expectation of change in price in the future;
Po= Size and composition of population;

S= Season and weather;
D= Distribution of income.
Concept of Demand
Demand refers to the quantity of a commodity or a service that people are willing to buy at a certain
price during a certain time interval. It can be termed as a desire with the ‘willingness’ and ‘ability’ to
pay for a commodity.
An increase in the price of the commodity decrease the demand for that commodity, while the
decrease in price increases its demand. The phenomena is termed as law of demand.
Concept of Demand Function

Demand function is an algebraic expression that shows the functional relationship between the
demand for a commodity and its various determinants affecting it. This includes income and price
along with other determining factors.
Here, the demand for the commodity is the dependent variable, while its determinants are the
independent variables.
Determinants of Demand
Price of the given commodity
Other things remaining constant, the rise in price of the commodity, the demand for the commodity
contracts, and with the fall in price, its demand increases.
Price of related goods
Demand for the given commodity is affected by price of the related goods, which is called cross price
demand.
Income of the individual consumer
Change in consumer’s level of income also influences their demand for different commodities.
Normally, the demand for certain goods increase with the increasing level of income and vice versa.
Tastes and preferences

The taste and preferences of individuals also determine the demand made for certain goods and
services. Factors such as climate, fashion, advertisement, innovation, etc. affect the taste and
preference of the consumers.
Expectation of change in price in the future
If the price of the commodity is expected to rise in the future, the consumer will be willing to
purchase more of the commodity at the existing price. However, if the future price is expected to fall,
the demand for that commodity decreases at present.
Size and composition of population

The market demand for a commodity increases with the increase in the size and composition of the
total population. For instance, with the increase in total population size, there is an increase in the
number of buyers. Likewise, with an increase in the male composition of the population, the demand
for goods meant for male increases.
Season and weather

The market demand for a certain commodity is also affected by the current weather conditions. For
instance, the demand for cold beverages increase during summer season.
Distribution of income
In case of equal distribution of income in the economy, the market demand for a commodity remains
less. With an increase in the unequal distribution of income, the demand for certain goods increase
as most people will have the ability to buy certain goods and commodities, especially luxury goods.
Types of Demand Function

Based on whether the demand function is in relation to an individual consumer or to all consumers in
the market, the demand function cab be categorized as
 Individual Demand Function

 Market Demand Function
Individual Demand Function
Individual demand function refers to the functional relationship between demand made by an
individual consumer and the factors affecting the individual demand. It shows how demand made by
an individual in the market is related to its determinants.
Mathematically, individual demand function can be expressed as,

Dx= f (Px, Pr, Y, T, F)
Where,
Cite this article as: Shraddha Bajracharya, "Concept of Demand Function and its Types," in Businesstopia, January 9,
2018, https://www.businesstopia.net/economics/macro/concept-demand-function-types.

F= Expectation of change in price in the future.
Market Demand Function

Market demand function refers to the functional relationship between market demand and the
factors affecting market demand. Market demand is affected by all the factors that affect an
individual demand. In addition to this, it is also affected by size and composition of population,
season and weather conditions, and distribution of income.
Mathematically, market demand function can be expressed as,
Dx= f (Px, Pr, Y, T, F, Po, S, D)
Where,

F= Expectation of change in price in the future;
Po= Size and composition of population;

S= Season and weather;
D= Distribution of income.
Concept
The circular flow of income or the circular flow model is a simple economic model that shows the
circulation of money between producers and consumers within an economy. It refers to the flow of
goods and services among the various sectors of the economy, balanced by the flow of monetary
payments made in exchange for those goods and services.
The circular flow income is called so because the movement of income and expenditure continues
throughout the economy and repeats itself, forming the circular flow of income.
The two basic aspects of circular flow model are consumers and producers. Consumers are the
households that provide factors of production such as land, capital, labor, etc. to the producers or the
firms that use these factors of production and make the goods and services available to the
households in return.
Households
The basic economic purpose of households or consumers is to supply the producers with the
required factors of production- land, labor, capital, and entrepreneurship. The factor owners provide
these factors of production in return for the reward they receive as income. Households then spend
the income to fulfill their wants and needs in the form of consumption expenditure.
Firms
Business firms are the producers that utilize the factors of production to produce goods and services
that meet the unlimited needs and wants of the consumers or households. In return for the factors of
production received, business firms make payment to the households in the form of rent, interest,
wages, and profit. These firms also get income in return for the goods and services they supply to the
households.
In the circular flow model, the expense made by one sector becomes the income for the other sector,
and the goods and services produced by firms is the demand made by the households. The model
assumes that during the exchange process, the firms receive the same amount as spent by the
households, and the only source of goods and services for the households are the business firms.
The model can be viewed from two different perspectives:
 The flow of goods and service, called Real Flow

 The flow of money, Monetary Flow
Real Flow
Real Flow of income implies the flow of factor services from the household sector to the business
sector and the corresponding flow of goods and services from the business sector to the household
sector.
Monetary Flow
Monetary flow refers to the transfer of factor income viz. rent, wages, interest, and profit from the
business sector to the household sector or the factory owners as a monetary reward for their factor
services. Corresponding to this, money flows as consumption expenditure when household sector
purchases goods and services from the business firms.
In macroeconomics, a circular flow model can be classified into three categories depending upon
their field of scope as given below.
1. Two-Sector Model
The circular flow model in the two-sector economy is a hypothetical concept which consists of only
two aspects, household and business sector. The state of equilibrium in the two-sector economy is
defined as a situation in which no change occurs in the levels of income (Y), expenditure (E), and
output (O).
i.e. Y=E=O
This means that the expenses made by the households become the source of income for the
business entities. The entities transfer the income to the factor owners to attain the factors of
production. Further, the factor owners spend this income on goods and services produced by the
business entities. This leads to a circular movement of income and expenditure in the economy.
2. Three-Sector Model
The three sector model describes the economy with the inclusion of the government sector along
with household and business sectors. Here, the source of income for the government is in the form
of taxes, subsidies and transfer payments made by the households and business firms.
3. Four Sector Model

The four sector model is a modern monetary economy that comprises of household, business
sectors, government, and foreign sectors. Each of the sectors in the economy receives payment in
one form or another. Money acts as an exchange tool for the smooth transfer of goods and services
among the international markets. The residual amount from the transaction flows into the capital
market as savings which are further used as investments for business firms and government sector.
4. Five Sector Model

The five sector model comprises of leakages and injections that occur in the economy and is a more
realistic representation of the economy. The leakages comprise of savings (S), taxes (T), and imports
(M), whereas, the injections comprise of investment (I), government spending (G), and exports (X).
The model states that equilibrium occurs when the total leakages are equal to the total injections
that occur in the economy.
i.e. S+T+M= I+G+X

Cite this article as
Income elasticity of demand is the degree of responsiveness of quantity demanded of a commodity

due to change in consumer’s income, other things remaining constant. In other words, it measures by
how much the quantity demanded changes with respect ot the change in income.
The income elasticity of demand is defined as the percentage change in quantity demanded due to
certain percent change in consumer’s income.
Expression of Income Elasticity of Demand

Where, EY = Elasticity of demand

q = Original quantity demanded
∆q = Change in quantity demanded
y = Original consumer’s income

∆y= Change in consumer’s income
Example to Explain Income Elasticity of Demand

Suppose that the initial income of a person is Rs.2000 and quantity demanded for the commodity by him is 20
units. When his income increases to Rs.3000, quantity demanded by him also increases to 40 units. Find out the
income elasticity of demand.
Solution:
Here, q = 100 units

∆q = (40-20) units = 20 units
y = Rs.2000
∆y =Rs. (3000-2000) =Rs.1000

Now,
Hence, an increase of Rs.1000 in income i.e. 1% in income leads to a rise of 2% in quantity
demanded.
Types of Income Elasticity of demand

1. Positive income elasticity of demand (EY>0)
If there is direct relationship between income of the consumer and demand for the commodity, then
income elasticity will be positive. That is, if the quantity demanded for a commodity increases with
the rise in income of the consumer and vice versa, it is said to be positive income elasticity of
demand. For example: as the income of consumer increases, they consume more of superior
(luxurious) goods. On the contrary, as the income of consumer decreases, they consume less of
luxurious goods.
Cite this article as: Shraddha Bajracharya, "Income Elasticity of Demand: Definition and Types with Examples,"
in Businesstopia, January 11, 2018, https://www.businesstopia.net/economics/micro/income-elasticity-demand.
Positive income elasticity can be further classified into three types:
 Income elasticity greater than unity (EY > 1)

If the percentage change in quantity demanded for a commodity is greater than percentage change
in income of the consumer, it is said to be income greater than unity. For example: When the
consumer’s income rises by 3% and the demand rises by 7%, it is the case of income elasticity
greater than unity.
In the given figure, quantity demanded and consumer’s income is measured along X-axis and Y-axis
respectively. The small rise in income from OY to OY1 has caused greater rise in the quantity
demanded from OQ to OQ1 and vice versa. Thus, the demand curve DD shows income elasticity
greater than unity.
 Income elasticity equal to unity (EY = 1)
If the percentage change in quantity demanded for a commodity is equal to percentage change in
income of the consumer, it is said to be income elasticity equal to unity. For example: When the
consumer’s income rises by 5% and the demand rises by 5%, it is the case of income elasticity equal
to unity.
respectively. The small rise in income from OY to OY1 has caused equal rise in the quantity
demanded from OQ to OQ1 and vice versa. Thus, the demand curve DD shows income elasticity
equal to unity.
 Income elasticity less than unity (EY < 1)
If the percentage change in quantity demanded for a commodity is less than percentage change in
income of the consumer, it is said to be income greater than unity. For example: When the
consumer’s income rises by 5% and the demand rises by 3%, it is the case of income elasticity less
than unity.
respectively. The greater rise in income from OY to OY1 has caused small rise in the quantity
demanded from OQ to OQ1 and vice versa. Thus, the demand curve DD shows income elasticity less
than unity.
2. Negative income elasticity of demand ( EY<0)
If there is inverse relationship between income of the consumer and demand for the commodity, then
income elasticity will be negative. That is, if the quantity demanded for a commodity decreases with
the rise in income of the consumer and vice versa, it is said to be negative income elasticity of
demand. For example:
As the income of consumer increases, they either stop or consume less of inferior goods.
respectively. When the consumer’s income rises from OY to OY1 the quantity demanded of inferior
goods falls from OQ to OQ1 and vice versa. Thus, the demand curve DD shows negative income
elasticity of demand.
3. Zero income elasticity of demand ( EY=0)
If the quantity demanded for a commodity remains constant with any rise or fall in income of the
consumer and, it is said to be zero income elasticity of demand. For example: In case of basic
necessary goods such as salt, kerosene, electricity, etc. there is zero income elasticity of demand.
respectively. The consumer’s income may fall to OY1 or rise to OY2 from OY, the quantity demanded
remains the same at OQ. Thus, the demand curve DD, which is vertical straight line parallel to Y-axis
shows zero income elasticity of demand.
The law of diminishing marginal utility was first propounded by 19th century German economist H.H.
Gossen which explains the behavior of the consumers and the basic tendency of human nature.
Hence, this law is also known as Gossen’s First Law. This was further modified by Marshall.
According to Marshall,
The additional benefit a person derives from a given increase of his stock of
anything diminishes with the growth of the stock that he already has.
According to Paul A. Samuelson,
As the amount consumed of a good increases, the marginal utility of the good
leads to decrease.
As per the definitions, we can conclude that, if the consumer consumes goods continuously, the
utility obtained from every successive unit goes on diminishing. If the consumer is consuming the
goods continuously, firstly he reaches the point of maximum satisfaction which is known as level of
satiety. If he continues to consume the goods again, the utility obtained from that particular goods
goes in negative aspect or he gets inutility.
[Related Reading: Concept of Utility: Cardinal and Ordinal Utility]
Law Of Diminishing Marginal Utility Assumptions

1. The consumer who is consuming the goods should be logical and knowledgeable to consume every
unit of goods.
2. The goods which are to be consumed should be equal in size and shape.
3. Consumer should consume the goods without time gap.
4. The consumer’s income, preference, taste and fashion should not be changed while consuming the
goods.
5. To hold the law good, utility should be measured in countable units or cardinal numbers. The utility
obtained from those goods is measured in ‘utils’ unit.
6. As we know that money is the measuring rod of utility, being so, marginal utility of money should
remain constant during consumption of the goods.
Example to Demonstrate Law of Diminishing Marginal Utility

This law can be illustrated with the help of a table shown below:
The table shows that when a consumer consumes 1st unit of orange he derives the marginal utility
equal to 6utils. As the consumer consumes 2nd and 3rd units of orange, the marginal utility is declined
from 4utils to 2utils respectively.
When he consumes 4th unit of orange the marginal utility becomes zero, which is called the point of
satiety. Similarly, from the consumption of 5th and 6th units of orange, the marginal utility becomes
negative, i.e., he gets disutility instead of utility from these units of consumption.
Thus, the table shows that a consumer consumes more and more units of a commodity at a certain
period of time, the marginal utility declines, becomes zero and even negative.
This law can be further explained with the help of a diagram:

In the figure, X-axis represents units of orange and Y-axis represents utility. MU is the marginal utility
curve which slopes downward from left to right. It means that as a consumer consumes more and
more units of a commodity, the marginal utility he derives from the additional unit of consumption
goes on declining, becomes zero(at point D) and even negative(at point E and F.)
[Related Reading: Principle of Marginal Rate of Substitution]
Exceptions Where Law of Diminishing Marginal Utility Doesn’t Apply

Dissimilar units
This law is applicable for homogenous unit only, i.e. only if all units of a commodity consumed are
similar in length, breadth, shape and size. If there is a change in such factors, the utility obtained from
it can be increased. For example: If the 2nd orange is much larger than the 1st one, it will yield more
satisfaction than the 1st.
Unreasonable quantity
The quantity of the commodity a consumer consumes should be reasonable. If the units of
consumption are too small, then every successive unit of consumption may give higher utility to the
consumer. For example: If a person is given water by a spoon when he is very thirsty, each additional
spoonful will give him more satisfaction.
Not a suitable time period
There should not be very long gap between the consumption of different units of the commodity. If
there is time lag between the consumption of different units, then this law may not hold good. For
example: If a man has lunch at 10 a.m. and dinner at 8 p.m. and eats nothing in between, the dinner
will possibly yield even more satisfaction than the lunch, i.e. his marginal utility will not diminish.
Rare collection
This law does not apply for rare collections such as old coins, stamps and so on because the longer
and larger the number he collects, the greater will be the utility.
Cite this article as: Shraddha Bajracharya, "Law of Diminishing Marginal Utility: Assumptions and Exceptions,"
in Businesstopia, January 11, 2018, https://www.businesstopia.net/economics/micro/law-diminishing-marginal-utility.
Change in taste and fashion of the consumer

The law of diminishing marginal utility will be applicable only if the consumer is not supposed to
change taste and fashion of the commodity whatever he/she was using previously.
Abnormal person
The law of diminishing marginal utility is applicable for normal person only. Abnormal persons such
as drunkards and druggist are not associated with the law.
Change in income of the consumer

To hold the law good, there should not be any change in the income of the consumer. If the income
of the consumer increases, he will consume more and more units of a commodity which he prefers.
As a result, utility can be increased rather than decreased.
Habitual goods
The law will not be applicable for habitual goods such as consumption of cigarettes, consumption of
drugs, alcohol, etc.
Durable and valuable goods

The law is not applicable in case of durable goods as well as valuable goods such as buildings,
vehicles, gems, gold, etc.
Law of diminishi
Changes in monetary policy variables lead to shift in LM curve. The LM curve is affected by the
changes in exogenous variables or by the behavioral shift in the demand for money. The two main
factors that affect the LM curve include change in demand for money and change in supply of
money. The effect of these factors have been explained below:
Changes in Money Supply

The increase in money supply due to the government’s monetary expansion policy, shifts the LM
curve rightwards. When the central monetary authority of the government or the country adopts an
easy expansionary monetary policy, the supply of money increases in the economy and the LM curve
shifts right. Expansionary or easy monetary policies include lower bank discount rates, purchase of
securities in open market, and reduction in required reserve ratio (RRR).
On the other hand, a decline in money supply will lead to the leftward shift of the LM curve. When the
government follows a contractionary monetary policy, supply of money in the economy declines.
Under a tight monetary policy, the central bank raises the bank rates, makes sale of securities in the
open market, and increases the RRR requirements as well.
As a result of this, shortage of money occurs at points on the initial LM curve. The condition for
excess demand of money in the market can only be eliminated by increasing the interest rate, which
reduces the quantity of money demanded, until it reaches a point where supply of money is equal to
demand of money.
Autonomous Changes in Money Demand

The theory of asset motive states that there can be an autonomous rise in the demand for money.
This means that no change occurs in the money demand even due inflation, deflation, interest rates,
or the level of aggregate output/income.
For instance, when the return on bonds become unstable, dealing with bonds become more riskier
than money, and the demand for money would increase at any given level of output, interest rate, or
price levels. When holding bonds become a riskier asset, people would want to shift from holding
bonds to holding money.
The increase in autonomous demand for money thus shifts the LM curve to the left, although the
rising demand for money results in the rate of interest at any given level of output.
Changes in monetary policy variables lead to shift in LM curve. The LM curve is affected by the
changes in exogenous variables or by the behavioral shift in the demand for money. The two main
factors that affect the LM curve include change in demand for money and change in supply of
money. The effect of these factors have been explained below:
National income is defined as the total annual value of all the goods and services produced by a
country, measured in terms of money. National income data provides a summary statement of a
country’s aggregate economic activities. It not only helps to measure the size and health of an
economy but also to understand how it functions.
According to Marshall, ” The labor and capital of a country acting on its natural resources produce
annually a certain net aggregate of commodities, material and immaterial including services of all
kinds. This is the true net annual income or revenue of the country or national dividend.”
Various Concepts of National Income
The measurement of national income accounts for different concepts that have a significant role
while determining its value. The important concepts of national income have been explained below:
Gross Domestic Product (GDP)

Gross Domestic Product (GDP) is a primary indicator of how an economy is functioning. It is the total
annual value of all final goods and services produced within the domestic territory of the country. It
takes into account the income earned domestically by foreigners but excludes income earned by
nationals living and earning in the foreign country.
GDP considers only the value of those final goods and services that are produced at a current market
price. So, it is also termed as GDP at market price.
GDP comprises of wages and salaries, rents, interest, dividend, undistributed corporate profits, profits
from self-employed people, partnership, direct taxes, etc.
From the definition,
GDP = Total product of agricultural sector + Total product of industrial sector + Total product of
tertiary sector (service sector).
Alternatively, GDP= ∑ (P*Q)
Where, P= Market price of goods and services; Q = Total volume of output.
Nominal and Real GDP

The GDP measured on the basis of current price is termed as nominal GDP. The value of goods and
services produced in a year is measured in terms of money and current market prices. However, with
nominal GDP, the problem arises when comparing GDP of one year with another, as money is not a
stable measure of purchasing power.
On the other hand, GDP measured on the basis of constant prices or base year price. The fluctuations
in prices of goods and services may show an increase in GDP for a year, but it may be lower than the
GDP in the previous year. In order to rectify this problem, a base year is determined considering the
price during that year was normal.
Now, the base year is taken in order to determine the real GDP. Thus,
Real GDP= GDP of current year * Base year/ Current year index
GDP Deflator
GDP Deflator is defined as the measure of relative change in current level price in comparison to the
level of price in the base year. In other words, it is the ratio of nominal GDP and real GDP multiplied by
100.
Thus,
GDP Deflator= Nominal GDP/ Real GDP X 100

Gross National Product (GNP)
Gross National Product (GNP) is the total annual value of final goods and services produced by
domestically owned factors of production. It comprises of income earned by nationals in the foreign
countries but doesn’t consider domestically earned income by foreigners.
Cite this article as: Palistha Maharjan, "Concepts of National Income," in Businesstopia, January 6,
2018, https://www.businesstopia.net/economics/macro/national-income-concepts.
GNP includes all parts of the production that are either produced for commercial sale or for personal
consumption. In order to avoid the problem of double counting, only the value of final goods and
services produced or value added by producers at each level is included in GNP.
Thus, GNP= GDP + NFIA
Where, GDP= Gross domestic product; NFIA= Net factor income from abroad.
Net National Product (NNP) at market price

Net National Product (NNP) is the net output of the economy that is calculated after deducting the
value of depreciation from the gross national product.
In the process of producing goods and service, some parts of capital goods are utilized causing it to
depreciate in value. For instance, the use of assets like machinery, buildings, etc. result in the
depreciation of their value. NNP is thus calculated by deducting the depreciated value from GNP.
This is also termed as National Income or NI at market price.
Thus, NNP= GNP- Depreciation
Net National Product (NNP) at factor cost

National Income is also termed as Net National Product at factor cost. NNP is calculated after
deducting indirect taxes like sales tax, excise duty, etc. that are included in the market price of
produced goods and services. Subsidies, on the other hand, are added to the NNP to reduce the
market price of the produced goods.
So, NI or NNP at factor cost= NNP- Indirect taxes + Subsidies

Personal Income
Personal Income refers to the aggregate income received by the individuals of a country in a year
from all sources before the payment of direct taxes. It is calculated by deducting undistributed
business profits, taxes, and employee contributions to security plans.
However, payments like government and business transfer payments, gifts and remittance from
abroad, gains from interest on public debts are a source of individual income that is added to
national income. So,
Personal Income= National Income – Undistributed business profits – Taxes – Social security
contribution + transfer payments + interest on public debt
Disposable Income (DI)

Disposable income or personal disposable income is the actual amount received by an individual
after the deduction of direct taxes that the individuals are liable to pay to the government. It is
referred to the actual income that individuals can spend for consumption and expenditure. So,
DI= Personal Income- Direct taxes
Since the total disposable income is not spent on consumption alone, some part of it is saved as
well. Thus,
DI= C + S
Where, C= Consumption; S= Saving

The concept of disposable income is useful in understanding the consumption pattern of individuals
and households. It also gives a concise picture of how much income is actually available to the
households for expenditure at a personal level.
Per Capita Income
Per Capita Income of a country usually refers to the average earning of an individual in a particular
year. In order to determine the per capita income of a country, the national income of the country is
divided by the population of the country in that particular year. Thus,
Per Capita Income= National Income of a country/ Total population of the country
The per capita income of a country helps in determining the standard of living of the countries and
also serves as an index to determine economic development of different countries.
Various Concepts of National Income
The measurement of national income accounts for different concepts that have a significant role
while determining its value. The important concepts of national income have been explained below:
Gross Domestic Product (GDP)

Gross Domestic Product (GDP) is a primary indicator of how an economy is functioning. It is the total
annual value of all final goods and services produced within the domestic territory of the country. It
takes into account the income earned domestically by foreigners but excludes income earned by
nationals living and earning in the foreign country.
GDP considers only the value of those final goods and services that are produced at a current market
price. So, it is also termed as GDP at market price.
GDP comprises of wages and salaries, rents, interest, dividend, undistributed corporate profits, profits
from self-employed people, partnership, direct taxes, etc.
From the definition,
GDP = Total product of agricultural sector + Total product of industrial sector + Total product of
tertiary sector (service sector).
Alternatively, GDP= ∑ (P*Q)
Where, P= Market price of goods and services; Q = Total volume of output.
Nominal and Real GDP

The GDP measured on the basis of current price is termed as nominal GDP. The value of goods and
services produced in a year is measured in terms of money and current market prices. However, with
nominal GDP, the problem arises when comparing GDP of one year with another, as money is not a
stable measure of purchasing power.
On the other hand, GDP measured on the basis of constant prices or base year price. The fluctuations
in prices of goods and services may show an increase in GDP for a year, but it may be lower than the
GDP in the previous year. In order to rectify this problem, a base year is determined considering the
price during that year was normal.
Now, the base year is taken in order to determine the real GDP. Thus,
Real GDP= GDP of current year * Base year/ Current year index
GDP Deflator
GDP Deflator is defined as the measure of relative change in current level price in comparison to the
level of price in the base year. In other words, it is the ratio of nominal GDP and real GDP multiplied by
100.
Thus,
GDP Deflator= Nominal GDP/ Real GDP X 100
Gross National Product (GNP)

Gross National Product (GNP) is the total annual value of final goods and services produced by
domestically owned factors of production. It comprises of income earned by nationals in the foreign
countries but doesn’t consider domestically earned income by foreigners.
Cite this article as: Palistha Maharjan, "Concepts of National Income," in Businesstopia, January 6,
2018, https://www.businesstopia.net/economics/macro/national-income-concepts.
GNP includes all parts of the production that are either produced for commercial sale or for personal
consumption. In order to avoid the problem of double counting, only the value of final goods and
services produced or value added by producers at each level is included in GNP.
Thus, GNP= GDP + NFIA
Where, GDP= Gross domestic product; NFIA= Net factor income from abroad.
Net National Product (NNP) at market price

Net National Product (NNP) is the net output of the economy that is calculated after deducting the
value of depreciation from the gross national product.


Personal Income

Since the total disposable income is not spent on consumption alone, some part of it is saved as
well. Thus,
DI= C + S

Per Capita Income

Business decision making is essentially a process of selecting the best out of alternative opportunities open to the
firm. The steps below put managers analytical ability to test and determine the appropriateness and validity of
decisions in the modern business world. Following are the various steps in decision making process:
1. Establish objectives
2. Specify the decision problem
3. Identify the alternatives
4. Evaluate alternatives
5. Select the best alternatives
6. Implement the decision
7. Monitor the performance
Modern business conditions are changing so fast and becoming so competitive and complex that personal
business sense, intuition and experience alone are not sufficient to make appropriate business decisions. It is in
this area of decision making that economic theories and tools of economic analysis contribute a great deal.
Basic Economic Tools in Managerial Economics for Decision Making

Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to the
managers in his decision making practice. These tools are helpful for managers in solving their business related
problems. These tools are taken as guide in making decision.
Following are the basic economic tools for decision making:
1. Opportunity cost
2. Incremental principle
3. Principle of the time perspective
4. Discounting principle
5. Equi-marginal principle
1. Opportunity Cost Principle

By the opportunity cost of a decision is meant the sacrifice of alternatives required by that decision. For e.g.
1. The opportunity cost of the funds employed in one’s own business is the interest that could be earned on
those funds if they have been employed in other ventures.
2. The opportunity cost of using a machine to produce one product is the earnings forgone which would have
been possible from other products.
3. The opportunity cost of holding Rs. 1000as cash in hand for one year is the 10% rate of interest, which
would have been earned had the money been kept as fixed deposit in bank.
Its clear now that opportunity cost requires ascertainment of sacrifices. If a decision involves no sacrifices, its
opportunity cost is nil. For decision making opportunity costs are the only relevant costs.
2. Incremental Principle
It is related to the marginal cost and marginal revenues, for economic theory. Incremental concept involves
estimating the impact of decision alternatives on costs and revenue, emphasizing the changes in total cost and
total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in
the decisions.
The two basic components of incremental reasoning are
1. Incremental cost
2. Incremental Revenue
The incremental principle may be stated as under:
“A decision is obviously a profitable one if —
 it increases revenue more than costs

 it decreases some costs to a greater extent than it increases others
 it increases some revenues more than it decreases others and
 it reduces cost more than revenues”
3. Principle of Time Perspective

Managerial economists are also concerned with the short run and the long run effects of decisions on revenues as
well as costs. The very important problem in decision making is to maintain the right balance between the long run
and short run considerations.
For example; Suppose there is a firm with a temporary idle capacity. An order for 5000 units comes to
management’s attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the whole lot but not more. The
short run incremental cost(ignoring the fixed cost) is only Rs.3/-. There fore the contribution to overhead and profit
is Rs.1/- per unit (Rs.5000/- for the lot)
Analysis:
From the above example the following long run repercussion of the order is to be taken into account:
1. If the management commits itself with too much of business at lower price or with a small contribution it
will not have sufficient capacity to take up business with higher contribution.
2. If the other customers come to know about this low price, they may demand a similar low price. Such
customers may complain of being treated unfairly and feel discriminated against.
In the above example it is therefore important to give due consideration to the time perspectives. “a decision should
take into account both the short run and long run effects on revenues and costs and maintain the right balance
between long run and short run perspective”.
4. Discounting Principle
One of the fundamental ideas in Economics is that a rupee tomorrow is worth less than a rupee today. Suppose a
person is offered a choice to make between a gift of Rs.100/- today or Rs.100/- next year. Naturally he will chose
Rs.100/- today. This is true for two reasons-
1. The future is uncertain and there may be uncertainty in getting Rs. 100/- if the present opportunity is not
availed of
2. Even if he is sure to receive the gift in future, today’s Rs.100/- can be invested so as to earn interest say as
8% so that one year after Rs.100/- will become 108
5. Equi – Marginal Principle

This principle deals with the allocation of an available resource among the alternative activities. According to this
principle, an input should be so allocated that the value added by the last unit is the same in all cases. This
generalization is called the equi-marginal principle.
Suppose, a firm has 100 units of labor at its disposal. The firm is engaged in four activities which need labors
services, viz, A,B,C and D. it can enhance any one of these activities by adding more labor but only at the cost of
other activities.

Personal Income

DI= C + S

Per Capita Income
\\What is price ceiling?
Price ceiling is a measure of price control imposed by the government on particular commodities in
order to prevent consumers from being charged high prices.
Price ceiling can also be understood as a legal maximum price set by the government on particular
goods and services to make those commodities attainable to all consumers.
Effect of price ceiling
Price ceiling is practiced in an attempt to help consumers in purchasing necessary commodities

which government believes to have become unattainable for consumers due to high price. However,
price ceiling in a long run can cause adverse effect on market and create huge market inefficiencies.
Some effects of price ceiling are
Shortage
If price ceiling is set above the existing market price, there is no direct effect. But, if price ceiling is
set below the existing market price, the market undergoes problem of shortage.
When price ceiling is set below the market price, producers will begin to slow or stop their production
process causing less supply of commodity in the market. On the other hand, demand of the
consumers for such commodity increases with the fall in price. And with this imbalance between
supply and demand of the commodity, shortage is created in the market.
Government rationing and queuing

When there is extreme shortage in the market, government begins rationing distribution to restrict the
demand of the consumers. As a result, consumers won’t be able to utilize as much goods as they
need.
Government rationing also results in consumers needing to stay in queue for great deal of times, and
this can be troublesome to elderly, disabled and other people who cannot afford to stay in line for a
long time.
Black market
Shortage of commodities encourages black market. Sellers begin trading commodities to relatives
and friends, and they start charging other people prices multiple times higher than that of price
ceiling.
Degradation of quality
Producers won’t be able to generate desirable profit when government set price ceiling. During such
condition, many producers may use raw materials of comparatively lesser quality in order to maintain
same or almost same revenue as before.
What is price floor?
Like price ceiling, price floor is also a measure of price control imposed by the government. But this
is a control or limit on how low a price can be charged for any commodity.
It is legal minimum price set by the government on particular goods and services in order to prevent
producers from being paid very less price.
Price ceiling as well as price floor are both intended to protect certain groups, and these protection is
only possible at the price of others. Price floor is typically proposed to ensure good income of people
involved in farming, agriculture and low-skilled jobs.
Effect of price floor
Government enforce price floor to oblige consumer to pay certain minimum amount to the producers.
Government set price floor when it believes that the producers are receiving unfair amount. Price
floor is enforced with an only intention of assisting producers. However, price floor has some adverse
effects on the market. These effects are
Supply surplus
If price floor is less than market equilibrium price then it has no impact on the economy. But if price
floor is set above market equilibrium price, immediate supply surplus can be observed.
At higher market price, producers increase their supply. In contrast, consumers’ demand for the
commodity will decrease, and supply surplus is generated.
Cite this article as: Palistha Maharjan, "Effects of Price Ceiling and Price Floor," in Businesstopia, January 6,
2018, https://www.businesstopia.net/economics/micro/effects-price-ceiling-and-price-floor.
Government intervention
When price floor is continued for a long time, supply surplus is generated in a huge amount.
In case of producer surplus, producers would have reduced the price to increase consumers’
demands and clear off the stock. But since it is illegal to do so, producers cannot do anything. So,
government has to intervene and buy the surplus inventories. Government may sell these inventories
in situation when there is scarcity of those commodities, or it can also distribute to the poor people
and public entities.
Minimum wage and unemployment

If minimum wage is set below the market price, no effect is seen. But if minimum wage is set above
market price, employers may distribute more work among few workers and terminate rest of the
workers in order to not to pay more wage to more workers. Setting price floor will obviously help few
workers in getting higher wage. But at the same time, other workers will also have to lose their jobs,
creating unemployment.
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Indifference Curve Analysis:

Assumptions, Indifference Schedule
and the Meaning of Marginal Rate
of Substitution
Updated on March 24, 2020
Sundaram Ponnusamy
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Introduction
Indifference curve analysis is basically an attempt to improve cardinal utility analysis (principle of marginal
utility). The cardinal utility approach, though very useful in studying elementary consumer behavior, is
criticized for its unrealistic assumptions vehemently. In particular, economists such as Edgeworth, Hicks, Allen
and Slutsky opposed utility as a measurable entity. According to them, utility is a subjective phenomenon and
can never be measured on an absolute scale. The disbelief on the measurement of utility forced them to explore
an alternative approach to study consumer behavior. The exploration led them to come up with the ordinal
utility approach or indifference curve analysis. Because of this reason, aforementioned economists are known
as ordinalists. As per indifference curve analysis, utility is not a measurable entity. However, consumers can
rank their preferences.
Indifference Curve Analysis Vs. Marginal Utility Approach
Let us look at a simple example. Suppose there are two commodities, namely apple and orange. The consumer
has $10. If he spends entire money on buying apple, it means that apple gives him more satisfaction than
orange. Thus, in indifference curve analysis, we conclude that the consumer prefers apple to orange. In other
words, he ranks apple first and orange second. However, in cardinal or marginal utility approach, the utility
derived from apple is measured (for example, 10 utils). Similarly, the utility derived from orange is measured
(for example, 5 utils). Now the consumer compares both and prefers the commodity that gives higher amount
of utility. Indifference curve analysis strictly says that utility is not a measurable entity. What we do here is that
we observe what the consumer prefers and conclude that the preferred commodity (apple in our example) gives
him more satisfaction. We never try to answer ‘how much satisfaction (utility)’ in indifference curve analysis.
Assumptions
Theories of economics cannot survive without assumptions and indifference curve analysis is no different. The
following are the assumptions of indifference curve analysis:
Rationality
The theory of indifference curve studies consumer behavior. In order to derive a plausible conclusion, the
consumer under consideration must be a rational human being. For example, there are two commodities called
‘A’ and ‘B’. Now the consumer must be able to say which commodity he prefers. The answer must be a
definite. For instance – ‘I prefer A to B’ or ‘I prefer B to A’ or ‘I prefer both equally’. Technically, this
assumption is known as completeness or trichotomy assumption.
Consistency
Another important assumption is consistency. It means that the consumer must be consistent in his preferences.
For example, let us consider three different commodities called ‘A’, ‘B’ and ‘C’. If the consumer prefers A to B
and B to C, obviously, he must prefer A to C. In this case, he must not be in a position to prefer C to A since
this decision becomes self-contradictory.
Symbolically,
If A > B, and B > c, then A > C.
More Goods to Less
The indifference curve analysis assumes that consumer always prefers more goods to less. Suppose there are
two bundles of commodities – ‘A’ and ‘B’. If bundle A has more goods than bundle B, then the consumer
prefers bundle A to B.
Substitutes and Complements
In indifference curve analysis, there exist substitutes and complements for the goods preferred by the consumer.
However, in marginal utility approach, we assume that goods under consideration do not have substitutes and
complements.
Income and Market Prices
Finally, the consumer’s income and prices of commodities are fixed. In other words, with given income and
market prices, the consumer tries to maximize utility.
Indifference Schedule
An indifference schedule is a list of various combinations of commodities that give equal satisfaction or utility
to consumers. For simplicity, we have considered only two commodities, ‘X’ and ‘Y’, in our Table 1. Table 1
shows various combinations of X and Y; however, all these combinations give equal satisfaction (k) to the
consumer.
Table 1: Indifference Schedule

Combinations X (Oranges) Y (Apples) Satisfaction
A 2 15 k
B 5 9 k
C 7 6 k
D 17 2 k
You can construct an indifference curve from an indifference schedule in the same way you construct a demand
curve from a demand schedule.
On the graph, the locus of all combinations of commodities (X and Y in our example) forms an indifference
curve (figure 1). Movement along the indifference curve gives various combinations of commodities (X and
Y); however, yields same level of satisfaction. An indifference curve is also known as iso utility curve (“iso”
means same). A set of indifference curves is known as an indifference map.
Marginal Rate of Substitution

Marginal rate of substitution is an eminent concept in the indifference curve analysis. Marginal rate of
substitution tells you the amount of one commodity the consumer is willing to give up for an additional unit of
another commodity. In our example (table 1), we have considered commodity X and Y. Hence, the marginal
rate of substitution of X for Y (MRSxy) is the maximum amount of Y the consumer is willing to give up for an
additional unit of X. However, the consumer remains on the same indifference curve.
In other words, the marginal rate of substitution explains the tradeoff between two goods.
Diminishing marginal rate of substitution
From table 1 and figure 1, we can easily explain the concept of diminishing marginal rate of substitution. In our
example, we substitute commodity X for commodity Y. Hence, the change in Y is negative (i.e., -ΔY) since Y
decreases.
Thus, the equation is
MRSxy = -ΔY/ΔX and
MRSyx = -ΔX/ΔY
However, convention is to ignore the minus sign; hence,
MRSxy = ΔY/ΔX
In figure 1, X denotes oranges and Y denotes apples. Points A, B, C and D indicate various combinations of
oranges and apples.
In this example, we have the following marginal rate of substitution:
MRSx for y between A and B: AA1/A1B = 6/3 = 2.0
MRSx for y between B and C: BB1/B1C = 3/2 = 1.5
MRSx for y between C and D: CC1/C1D = 4/10 = 0.4
Thus, MRSx for y diminishes for every additional units of X. This is the principle of diminishing marginal rate of
substitution.
14
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The Law of Equi-Marginal Utility or

Gossen's Second Law
Updated on December 23, 2016
Sundaram Ponnusamy
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Introduction
The fundamental problem in an economy is that there are unlimited human wants. However, there are no
adequate resources to satisfy all human wants. Hence, a rational individual tries to optimize the available scarce
resources in order to attain maximum satisfaction. An individual’s attempt to optimize the available scare
resources is known as consumer’s behavior. The law of equi-marginal utility explains such consumer’s
behavior when the consumer has limited resources and unlimited wants. Because of this reason, the law of
equi-marginal utility is further referred to as the law of maximum satisfaction, the principle of income
allocation, the law of economy in expenditure or the law of substitution.
What does the law say?

Suppose that a person possesses $200 (limited resources). However, his wants are unlimited. The law explains
how the person allocates the $200 among his or her various wants in order to maximize the satisfaction. The
point at which the consumer’s satisfaction is maximum with the given resources is known as consumer’s
equilibrium. Hence, we can say that the law explains how the consumer’s equilibrium is attained. The law is
basically a cardinal utility approach.
Concept of Equi-marginal Utility
Now let us see how an individual maximizes his or her satisfaction with the help of equi-marginal utility. The
law says that in order to attain maximum satisfaction, an individual allocates the resources in such a way that he
or she derives equal marginal utility from all things on which the resources are spent. For instance, you have
$100 and you spend the money to buy 10 different things. What the law says is that you spend money on each
thing in such a way that all the 10 things provide you with the same amount of marginal utility. According to
the law of equi-marginal this is the way to attain maximum satisfaction.
Assumptions of the Law of Equi-Marginal Utility

The following explicit assumptions are necessary for the law of equi-marginal utility to hold good:
1. Consumer’s income is given (limited resources).
2. The law operates based on the law of diminishing marginal utility.
3. The consumer is a rational economic individual. This means that the consumer wants to gain maximum
satisfaction with limited resources.
4. The marginal utility of money is constant.
5. Another important assumption is that the utility of each commodity is measurable in cardinal numbers (1, 2, 3
and so on).
6. The prices of the commodities are constant.
7. There prevails perfect competition in the market.
Explanation of the Law of Equi-Marginal Utility

Let us look at a simple illustration to understand the law of equi-marginal utility. Suppose there are two
commodities X and Y. The consumer’s income is $8. The price of a unit of commodity X is $1. The price of a
unit of commodity Y is $1.
Assume that the consumer spends all his $8 to purchase commodity X. Since the price of a unit of commodity
X is $1, he can buy 8 units. Table1 shows the marginal utility derived from each unit of commodity X. since the
law is based on the concept of diminishing marginal utility, the marginal utility derived from the subsequent
unit diminishes.
Table 1
Units of Commodity X Marginal Utility of X
1st unit (1st dollar) 20
2nd unit (2nd dollar) 18
3rd unit (3rd dollar) 16
4th unit (4th dollar) 14
Consider that the consumer spends all his $8 to purchase commodity Y. Since the price of a unit of commodity
Y is $1, he can buy 8 units. Table2 shows the marginal utility derived from each unit of commodity Y. since the
law is based on the concept of diminishing marginal utility, the marginal utility derived from the subsequent
unit diminishes.
Table 2
Units of Commodity Y Marginal Utility of Y
1st unit (1st dollar) 16
2nd unit (2nd dollar) 14
3rd unit (3rd dollar) 12

Units of Commodity Y Marginal Utility of Y
Now the consumer plans to allocate his $8 between commodity X and Y. Let us see how much money he
spends on each commodity. Table 3 shows how the consumer spends his income on both the commodities.
Table 3
Units of Commodities
Marginal Utility of X Marginal Utility of Y
(X and Y)
1 20 (1st dollar) 16 (3rd dollar)
2 18 (2nd dollar) 14 (5th dollar)
3 16 (4th dollar) 12 (7th dollar)
4 14 (6th dollar) 10
5 12 (8th dollar) 8
6 10 6
7 8 4
8 6 2
Since the first unit of commodity X gives the highest utility (20 utils), he spends the first dollar on X. Second
dollar also goes to commodity X as it gives 18 utils (the second highest). Both the first unit of commodity Y
and the third unit of commodity X give the same amount of utility. However, the consumer prefers to buy
commodity Y because has already spent two dollars on commodity X. Similarly, the fourth dollar is spent on X,
fifth dollar on Y, sixth dollar on X, seventh dollar on Y and eighth dollar on X.
In this manner, the consumer consumes 5 units of commodity X and 3 units of commodity Y. In other words, 5
units of commodity X and 3 units of commodity Y leave him with the same amount of marginal utility.
Therefore, according to the law of equi-marginal utility, the consumer is at equilibrium at this point.
Furthermore, this is point at which the consumer experiences maximum satisfaction. Let us calculate the total
utility of commodities consumed to understand this.
Total utility = TUX + Y = TUX + TUY = (20 + 18 + 16 + 14 + 12) + (16 + 14 + 12) = 122
Any other combinations of commodities would have left the customer with less total utility. This is a simple
hypothetical illustration to explain how consumer’s equilibrium is attained with the concept of equi-marginal
utility.
Graphical Illustration
Figure 1 details the above explanation graphically. In figure 1, X-axis measures units of money spent on
commodity X and Y, or units of commodities (X and Y) consumed. Y-axis measures marginal utility derived
from each unit of commodity X and Y.
Condition for Equilibrium
The law states that the consumer is said to be at equilibrium, when the following condition is met:
(MUX/PX) = (MUY/PY) or
(MUx/MUY) = (Px/PY)
In our example, the consumer reaches equilibrium when he consumes the fifth unit of commodity X and third
unit of commodity Y ((12/1) = (12/1)).
Limitations of the Law of Equi-Marginal Utility

Though the law of equi-marginal utility appears to be very convincing, the following arguments are advanced
against it:
Firstly, the utility derived from commodities is not measurable in cardinal numbers.
Secondly, the marginal utility of money cannot be constant. As the money you possess depletes, the marginal
utility of money increases.
Thirdly, even a rational economic individual does not allocate his or her income according to the law. Usually,
people tend to spend in a certain rough fashion. Therefore, the applicability of the law is doubtful.
Finally, the law assumes that commodities and their marginal utilities are independent. However, in real life,
we see many substitutes and complements. In this case, the law loses its credibility.
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How Do Income and Substitution

Effects Work on Consumer’s
Equilibrium for Giffen, Normal and
Inferior Goods?
Updated on March 24, 2020
Sundaram Ponnusamy
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Giffen Goods Explanation

While all normal goods and many of the inferior goods obey law of demand, which states that more quantities
of commodities are demanded at less prices, there are certain inferior goods that do not follow the law of
demand. Such type of commodities are termed as Giffen Goods. In case of Giffen goods, there is a positive
relationship between price and quantity demanded. Not all inferior goods are Giffen goods. However, Giffen
goods are inferior goods. This type of commodities are named after a renowned British statistician and
economist called Sir Robert Giffen. In case of Giffen goods, when price increases, its quantity demanded also
increases.
Giffen’s observation attributes that very poor workers increase their consumption of cheap food like bread,
when its price increased. He claims that according to his study, the workers spent large portions of their income
on bread when its price increased. The reason behind this is that they were unable to afford expensive foods
such as meat because their prices also increased. Since large portion of income was spent on bread (the
cheapest food available), the workers were unable to buy expensive foods. Therefore, consumption of bread
increased even when its price increased. This scenario causes a paradoxical situation and this paradox is
popularly known as Giffen paradox.
Income and Substitution Effects on Giffen Goods

In figure 1, the consumer’s initial equilibrium point is E1, where original budget line M1N1 is tangent to the
indifference curve IC1 . X-axis represent Giffen goods (commodity X) and Y-axis denotes superior goods
(commodity Y). Assume that price of Giffen goods decreases. This causes the budget line to shift outward and
forms a new budget line M1N3. The consumer moves to the new equilibrium point E3. At this new equilibrium
point the quantity demanded of commodity X decreases by X2X1. This movement represents the total price
effect. Total price effect consists of income effect and substitution effect. By drawing a parallel budget line
M2N2, we are eliminating the income effect. Hence, the consumer again moves to another equilibrium point E2.
At E2, the quantity demanded of commodity X increases by X1X3. This is because of the substitution effect
alone.
Thus, income effect = X2X1 - X1X3, which must be negative. Furthermore, the substitution effect is positive. In
this way, the income effect and substitution effect work in the opposite direction in case of Giffen goods.
However, in the modern economy, it is difficult to find an example for Giffen paradox. Furthermore, many
economists are not ready to believe that Giffen paradox was actually observed. Hence, with little empirical
evidence it is plausible to conclude that the Giffen paradox in real life is very unlikely.
Income and Substitution Effects on Normal Goods

Normal goods, as the name indicate, are goods that we use in our day-to-day life. People tend to use more of
normal goods when as income increases.
Let us see what figure 2 depicts. The consumer’s original equilibrium is E1. At this point, the budget line
M1N1 is tangent to the indifference curve IC1. Suppose the price of commodity X (normal goods) decreases and
other things remain the same. The price decline shifts the budget line to M1N3. Consequently, the consumer
moves to new equilibrium point E3. Consumer’s movement from E1 to E3 is the total price effect. Let us
eliminate the income effect from the price effect by following Hicks’ version. To do so, we draw an imaginary
budget line M2N2, which is tangent to IC1 at E2. E2 equilibrium point after the elimination of the income effect.
Hence, total price effect = X1X3
Substitution effect = X1X2
Income effect =X2X3
Income and Substitution Effects on Inferior Goods

Inferior goods are cheap alternatives for normal goods. People use inferior goods when they are unable to
afford normal goods or expensive goods. Therefore, consumption of inferior goods by a person decreases if
income increases above a certain level. This implies that inferior goods have strong positive substitution effect.
However, when the price of an inferior good falls, the consequence will be an increase in the quantity
demanded because of significant negative income effect.
In figure 3, X-axis represents inferior goods (commodity X) and Y-axis denotes superior goods (commodity Y).
The consumer’s original equilibrium point is E1. At this equilibrium point, the budget line M1N1 is tangent to
indifference curve IC1. If price of commodity X is reduced, new budget line M1N2 is formed and the consumer
moves to the new equilibrium point E2. At E2, the budget line M1N2 is tangent to indifference curve IC2. Here,
consumer’s movement from equilibrium point E1 to equilibrium point E2 is the total price effect. We follow
Hicks’ version to eliminate the income effect from the price effect. To accomplish this, an imaginary budget
line M2N3 is drawn in such a way that it is parallel to budget line M1N2 and tangent to the original indifference
curve IC1 at E3. Hence, E3 is the equilibrium point after the elimination of income effect.
Here, total price effect = X1X2
Substitution effect = X1X3
Thus, income effect = total price effect – substitution effect
i.e., income effect = X1X2 - X1X3= - X2X3
Thus, in case of inferior goods, the positive substitution effect (X1X3) is stronger than the negative income
effect (X2X3). This implies that many of the inferior goods obey the law of demand.
The following table shows substitution and income effects of a price decline on quantity demanded of different
types of commodities:
Table 1
Substitution
Type of Good Income Effect Total Effect
Effect
Normal Increase Increase Increase
Inferior (but not Increase Decrease Increase

Substitution
Type of Good Income Effect Total Effect
Effect
Giffen)
Giffen Increase Decrease Decrease
33
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The Hicksian Method and The

Slutskian Method
Updated on February 18, 2017
Sundaram Ponnusamy
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Income and Substitution Effects of a Price Change

A change in the price of a commodity alters the quantity demanded by consumer. This is known as price effect.
However, this price effect comprises of two effects, namely substitution effect and income effect.
Substitution Effect
Let us consider a two-commodity model for simplicity. When the price of one commodity falls, the consumer
substitutes the cheaper commodity for the costlier commodity. This is known as substitution effect.
Income Effect
Suppose the consumer’s money income is constant. Again, let us consider a two-commodity model for
simplicity. Assume that the price of one commodity falls. This results in an increase in the consumer’s real
income, which raises his purchasing power. Due to an increase in the real income, the consumer is now able to
purchase more quantity of commodities. This is known as income effect.
Hence, according to our example, the decline in the price level leads to an increasing consumption. This occurs
because of the price effect, which comprises income effect and substitution effect. Now, can you tell how much
increase in consumption is due to income effect and how much increase in consumption is due to substitution
effect? To answer this question, we need to separate the income effect and substitution effect.
How to separate the income effect and substitution effect?
Let us look at figure 1. Figure 1 shows that price effect (change in Px), which comprises substitution effect and
income effect, leads to a change in quantity demanded (change in Qx).
Figure 1
The splitting of the price effect into the substitution and income effects can be done by holding the real income
constant. When you hold the real income constant, you will be able to measure the change in quantity caused
due to substitution effect. Hence, the remaining change in quantity represents the change due to income effect.
To keep the real income constant, there are mainly two methods suggested in economic literature:
1. The Hicksian Method
2. The Slutskian method
The Hicksian Method

Let us look at J.R. Hicks’ method of bifurcating income effect and substitution effect.
In figure 2, the initial equilibrium of the consumer is E1, where indifference curve IC1 is tangent to the budget
line AB1. At this equilibrium point, the consumer consumes E1X1 quantity of commodity Y and OX1 quantity of
commodity X. Assume that the price of commodity X decreases (income and the price of other commodity
remain constant). This result in the new budget line is AB2. Hence, the consumer moves to the new equilibrium
point E3, where new budget line AB2 is tangent to IC2. Thus, there is an increase in the quantity demanded of
commodity X from X1 to X2.
An increase in the quantity demanded of commodity X is caused by both income effect and substitution effect.
Now we need to separate these two effects. In order to do so, we need to keep the real income constant i.e.,
eliminating the income effect to calculate substitution effect.
According to Hicksian method of eliminating income effect, we just reduce consumer’s money income (by way
of taxation), so that the consumer remains on his original indifference curve IC1, keeping in view the fall in the
price of commodity X. In figure 2, reduction in consumer’s money income is done by drawing a price line
(A3B3)parallel to AB2. At the same time, the new parallel price line (A3B3) is tangent to indifference curve
IC1 at point E2. Hence, the consumer’s equilibrium changes from E1 to E2. This means that an increase in
quantity demanded of commodity X from X1 to X3 is purely because of the substitution effect.
We get the income effect by subtracting substitution effect (X1X3) from the total price effect (X1X2).
Income effect = X1X2 - X1X3 = X3X2
The slutskian Method

Now let us look at Eugene Slutsky’s method of separating income effect and substitution effect. Figure 3
illustrates the Slutskian version of calculating income effect and substitution effect.
In figure 3, AB1 is the initial budget line. The consumer’s original equilibrium point (before price effect takes
place) is E1, where indifference curve IC1 is tangent to the budget line AB1. Suppose the price of commodity X
falls (price effect takes place) and other things remain the same. Now the consumer shifts to another
equilibrium point E2, where indifference curve IC3 is tangent to the new budget line AB2. Consumer’s
movement from equilibrium point E1 to E2 implies that consumer’s purchase of commodity X increases by
X1X2. This is the total price effect caused by the decline in price of commodity X.
Now the task before us is to isolate the substitution effect. In order to do so, Slutsky attributes that the
consumer’s money income should be reduced in such a way that he returns to his original equilibrium point
E1 even after the price change. What we are doing here is that we make the consumer to purchase his original
consumption bundle (i.e., OX1 quantity of commodity X and E1X1 quantity of commodity Y) at the new price
level.
In figure 3, this is illustrated by drawing a new budget line A4B4, which passes through original equilibrium
point E1 but is parallel to AB2. This means that we have reduced the consumer’s money income by AA4 or
B4B2 to eliminate the income effect. Now the only possibility of price effect is the substitution effect. Because
of this substitution effect, the consumer moves from equilibrium point E1 to E3, where indifference curve IC2 is
tangent to the budget line A4B4. In Slutsky version, the substitution effect leads the consumer to a higher
indifference curve.
Thus, income effect = X1X2 - X1X3 = X3X2
QUESTIONS & ANSWERS

10
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Meaning of Opportunity Cost and

Its Economic Significance
Sundaram Ponnusamy
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Source
 Short-Run Average and Marginal Cost Curves

 Isoquant - Meaning and Properties
Introduction to Cost Function

The relationship between cost and output is known as the cost function. Cost functions are derived from
production functions. The production function expresses the functional relationship between input and output.
In simple terms, the production function states that output depends upon various quantities of inputs. If prices
of inputs are known, we can calculate the costs of production. The cost of production of a commodity is the
aggregate of prices paid for the factors of production used in producing that commodity.
Opportunity Cost
Modern economists have rejected the labor and sacrifices nexus to represent real cost. Rather, in its place they
have substituted opportunity or alternative cost.
The concept of opportunity cost occupies an important place in economic theory. The concept was first
developed by an Austrian economist, Wieser. The other notable contributors are Daven Port, Knight, Wicksteed
and Robbins. The concept is based on the fundamental fact that factors of production are scarce and versatile.
Our wants are unlimited. The means to satisfy these wants are limited, but they are capable of alternative uses.
Therefore, the problem of choice arises. This is the essence of Robbins’ definition of economics.
The opportunity cost of anything is the alternative that has been foregone. This implies that one commodity can
be produced only at the cost of foregoing the production of another commodity. As Adam Smith observed, if a
hunter can bag a deer or a beaver in the course of a single day, the cost of a deer is a beaver and the cost of a
beaver is a deer. A man who marries a girl is foregoing the opportunity of marrying another girl. A film actor
can either act in films or do modeling work. She cannot do both the jobs at the same time. Her acting in film
results in the loss of an opportunity of doing modeling work.
In the words of Prof. Byrns and Stone “opportunity cost is the value of the best alternative surrendered when a
choice is made.”
In the words of John A. Perrow “opportunity cost is the amount of the next best produce that must be given up
(using the same resources) in order to produce a commodity.”
Importance of the Concept of Opportunity Cost
1. Determination of Relative Prices of goods
The concept is useful in the determination of the relative prices of different goods. For example, if a given
amount of factors can produce one table or three chairs, then the price of one table will tend to be three times
equal to that one chair.
2. Fixation of Remuneration to a Factor
The concept is also useful in fixing the price of a factor. For example, let us assume that the alternative
employment of a college professor is work as an officer in an insurance company at a salary of $4,000 per
month. In such a case, he has to be paid at least $4,000 to continue to retain him in the college.
3. Efficient Allocation of Resources
The concept is also useful in allocating the resources efficiently. Suppose, opportunity cost of 1 table is 3 chairs
and the price of a chair is $100, while the price of a table is $400. Under such circumstances, it is beneficial to
produce one table rather than 3 chairs. Because, if he produces 3 chairs, he will get only $300, whereas a table
fetches him $400, that is, $100 more.
Limitations
The concept has the following drawbacks:
1. Specific
If a factor’s service is specific, it cannot be put to alternative uses. The transfer cost or alternative cost in such a
case is zero. This is pure rent, according to Mrs. Joan Robinson.
2. Inertia
Sometimes, factors may be reluctant to move to alternative occupations. In such a case, a payment exceeding
the pure transfer cost will have to be made to induce it to take to an alternative occupation.
3. Perfect Competition
The concept rests on the assumption of perfect competition. However, perfect competition is a myth, which
seldom prevails.
4. Private and Social Costs
A discrepancy is likely to arise between private and social costs. For example, let us assume that a chemical
factory discharges industrial refuse into a river. This causes serious health hazards, which cannot be measured
in money terms.
5. Alternatives are not clearly known
The foregone opportunities are often not ascertainable. This also poses a serious limitation of the concept.
Other Types of Cost

Money Cost and Real Cost
Money cost or nominal cost is the total money expenses incurred by a firm in producing a commodity. It
includes the following elements:
1. Cost of raw materials
2. Wages and salaries of labor
3. Expenditure on machinery and equipment
4. Depreciation on machines, buildings and such other capital goods
5. Interest on capital
6. Other expenses like advertisement, insurance premium and taxes.
7. Normal profits of the entrepreneur
Real cost is a subjective concept. It expresses the pains and sacrifices involved in producing a commodity.
Marshall defined real cost as follows, “The exertions of all the different kinds of labor that are directly or
indirectly involved in making it; together with the abstinences or rather the waiting required for saving the
capital used in making it.”
However, real costs are not amenable to precise measurement. Modern economists therefore prefer the concept
of opportunity cost.
Private, External and Social Costs
Sometimes, there is a discrepancy between the cost incurred by a firm and the cost incurred by the society. For
example, an oil refinery discharges its wastes in the river causing water pollution. Likewise, various types of air
pollution and noise pollution are caused by various agencies engaged in production activities. Such pollutions
result in tremendous health hazards, which involve cost to the society as a whole. A cost that is not borne by the
firm, but is incurred by others in the society is called an external cost.
The true cost to the society must include all costs, regardless of the persons on whom its impact falls and its
incidence as to who bear them.
Thus, social cost = private cost + external cost
Or external cost = social cost – private cost
Implicit Cost and Explicit Cost
Explicit costs are those costs, which are actually paid by the firm. To put it in other words, explicit costs are
paid out costs. Explicit costs include wages and salaries, prices of raw materials, amounts paid on fuel, power,
advertisement, transportation, taxes and depreciation charges. Explicit costs are recorded in the firm’s books of
account.
Implicit costs are the imputed value of the entrepreneur’s own resources and services. In other words, implicit
costs are costs, which self-owned and self-employed resources could have earned in their best alternative uses.
It refers to the highest income, which might have been received by him if he has let his labor, building and
money to someone else. These costs are frequently ignored in calculating the expenses of production.
Historical and Replacement Cost
Historical cost refers to the cost of an asset, acquired in the past whereas replacement cost refers to the cost,
which has to be incurred for replacing the same asset.
Increment and Sunk costs
The increment costs are the additions to costs resulting from a change in product lines, introduction of a new
product, replacement of obsolete plant and machinery, etc.
Sunk costs are those which cannot be altered, increased or decreased by changing the rate of output and the
level of business activity. All the past costs are considered as sunk costs because they are known and given and
cannot be revised as a result of changes in market conditions.
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How to Derive Consumer's

Equilibrium Through the Technique
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Sundaram Ponnusamy
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 How Do Income Effect, Substitution Effect and Price Effect Influence Consumer's Equilibrium?
 The Hicksian Method and The Slutskian Method
Introduction
The goal of a consumer is to get maximum satisfaction from the commodities he purchases. At the same time,
the consumer possesses limited resources. Hence, he is trying to maximize his satisfaction by allocating the
available resources (money income) among various goods and services rationally. This is the main theme of the
theory of consumer behavior. Further, you could ascertain that a consumer is in equilibrium when he obtains
maximum satisfaction from his expenditure on the commodities given the limited resources. You can analyze
consumer’s equilibrium through the technique of indifference curve and budget line.
Assumptions
1. The consumer under consideration is a rational human being. This means that the consumer always tries to
maximize his satisfaction with limited resources.
2. There prevails perfect competition in the market.
3. Goods are homogeneous and divisible.
4. The consumer has perfect knowledge about the products available in the market. For instance, prices of
commodities.
5. Prices of commodities and consumer’s money income are given.
6. Consumer’s indifference map remains unchanged throughout the analysis.
7. Consumer’s tastes, preferences and spending habits remain unchanged throughout the analysis.
Price Line or Budget Line

Price line or budget line is an important concept in analyzing consumer’s equilibrium. According to Prof.
Maurice, “The budget line is the locus of combinations or bundles of goods that can be purchased if the entire
money income is spent.”
Table 1
Total Amount Spent on
X (units) Y (units)
X + Y (in $)
4 0 8+0=8
3 2 6+2=8
2 4 4+4=8
1 6 2+6=8
0 8 0+8=8
Suppose there are two commodities, namely X and Y. Given the market prices and the consumer’s income, the
price line shows all the possible combinations of X and Y that a consumer could purchase at a particular time.
Let us consider a hypothetical consumer who has a fixed income of $8. Now, he wants to spend the entire
money on two commodities (X and Y). Suppose the price of commodity X is $2, and the price of commodity Y
$1. The consumer could spend all money on X and get 4 units of commodity X and no commodity Y.
Alternatively, he could spend entire money on commodity Y and get 8 units of commodity Y and no
commodity X. The table given below exhibits the numerous combinations of X and Y that the consumer can
purchase with $8.
In figure 1, horizontal axis measures commodity X and vertical axis measure commodity Y. The budget line or
price line (LM) indicates various combinations of commodity X and commodity Y that the consumer can buy
with $8. The slope of the budget line is OL/OM. At point Q, the consumer is is able to buy 6 units of
commodity Y and 1 unit of commodity X. Similarly, at point P, he is able to buy 4 units of commodity Y and 2
units of commodity X.
The slope of the price line (LM) is the ratio of price of commodity X to price of commodity Y, i.e., Px/Py. In our
example, price of commodity X is $2 and price of commodity Y is $1; hence, the slope of the price line is Px.
Note that the slope of the budget line depends upon two factors: (a) money income of the consumer and (b)
prices of the commodities under consideration.
Reasons for Many Budget Lines

(a) Consumer’s Income Change
An outward parallel shift in the budget line occurs because of an increase in consumer’s money income
provided that the prices of commodities X and Y remain unchanged (it means constant slope - Px/Py). Likewise,
a reduction in consumer’s money income creates a parallel inward shift in the budget line.
In figure 2, LM denotes the initial price line. Assume that the prices of the two goods and consumer’s money
income are constant. Now, the consumer is able to purchase OM quantity of commodity X or OL quantity of
commodity Y. If his income increases, the price line shifts outward and becomes L1M1. He can now buy
OM1 quantity of commodity X and OL1 quantity of commodity Y. A further increase in income causes a further
outward shift in the price line to L2M2. Price line L2M2 indicates that the consumer can buy OM2 quantity of
commodity X and OL2 quantity of commodity Y. Similarly, if there is a decrease in consumer’s income, the
price line will shift inward (for example, L3M3).
(b) Price Change
The slope of a price line is associated with the prices of commodities under consideration. Hence, if there is a
change in the price of any one of the commodities, there will be a change in the slope of the price line. Assume
that the price of commodity X decreases and the price of commodity Y remain unchanged. In this case, the
price ratio Px/Py (slope of price line) tends to decrease. In figure 3, this scenario is denoted by the shifts in the
price line from LM to LM1 then to LM2 and so on. Conversely, if the price of commodity X rises, the price ratio
Px/Py will rise. This leads to the price line shifts from LM2 to LM1 and to LM.
Indifference Map
A set of indifference curves that shows a consumer’s preferences is known as an indifference map. The
indifference map of a consumer, since is composed of indifference curves, exhibits all properties of a normal
indifference curve. Some of the most important properties of an indifference curve are: indifference curves are
convex to the origin; they always slope downwards from left to right; higher indifference curves indicate higher
levels of satisfaction; they do not touch any of the axes (example: figure 4).
Necessary conditions for consumer’s equilibrium

The following are the two important conditions to attain consumer’s equilibrium:
Firstly, marginal rate of substitution must be equal to the ratio of commodity prices. Symbolically,
MRSxy = MUx/MUY = Px/Py.
Secondly, indifference curve must be convex to the origin.
Consumer's Equilibrium
Now we have both budget lines and indifference map of the consumer. A budget line represents consumer’s
limited resources (what is feasible) and indifference map represent consumer’s preferences (what is desirable).
The question now is that how the consumer is going to optimize his limited resources. An answer for this
question would be consumer’s equilibrium. In other words, the consumer’s equilibrium means the combination
of commodities that maximizes utility, given the budget constraint. To obtain consumer’s equilibrium
graphically, you just need to superimpose the budget line on the consumer’s indifference map. This is shown in
figure 5.
At point E, consumer’s equilibrium is attained. Because the indifference curve IC2 is the best possible
indifference curve that the consumer can reach with the given resources (budget line). The tangency of
indifference curve IC2 and the price line represent the above statement. At the point of tangency, the slope of
the budget line (Px/Py) and the marginal rate of substitution (MRSxy = MUx/MUy) are equal: MUx/MUy =
Px/Py (first condition for consumer’s equilibrium). From figure 5, we can understand that the second condition
for consumer’s equilibrium (indifference curve must be convex to the origin) is also fulfilled.
A small algebraic manipulation in the above equation gives us MUx/Px = MUy/Py, which is the marginal utility
per dollar rule for consumer’s equilibrium. Thus, all the conditions for consumer’s equilibrium are fulfilled.
The combination (X0Y0) is an optimal choice (point E) for the consumer.
76
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Law of Diminishing Marginal Utility

- Detailed Explanation
Updated on January 3, 2017
Syed Hunbbel Meer

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Note: There are two laws of utility that are often discussed together: law of diminishing marginal utility and
the law of equi-marginal utility. This article explains the law of diminishing marginal utility.
The law of diminishing marginal utility is an important concept to understand. It basically falls in the category
of Microeconomics, but it is of equal and significant importance in our day-to-day decisions. In this article, you
will find the definition of the law of diminishing marginal utility, its detailed explanation with the help of a
schedule and diagram, assumptions we make in the law of diminishing marginal utility and the exceptions
where the law of diminishing marginal utility does not apply.
We will first start with the basic definition of ‘Utility’.
Utility:
Utility is the capacity of a commodity through which human wants are satisfied.
Law of Diminishing Marginal Utility:

The law of diminishing marginal utility is comprehensively explained by Alfred Marshall. According to his
definition of the law of diminishing marginal utility, the following happens:
“During the course of consumption, as more and more units of a commodity are used, every successive unit
gives utility with a diminishing rate, provided other things remaining the same; although, the total utility
increases.”
Utils:
'Utils' is considered as the measurable 'unit' of utility.
Explanation for the Law of Diminishing Marginal Utility:

We can briefly explain Marshall’s theory with the help of an example. Assume that a consumer consumes 6
apples one after another. The first apple gives him 20 utils (units for measuring utility). When he consumes the
second and third apple, the marginal utility of each additional apple will be lesser. This is because with an
increase in the consumption of apples, his desire to consume more apples falls.
Therefore, this example proves the point that every successive unit of a commodity used gives the utility with
the diminishing rate.
We can explain this more clearly with the help of a schedule and diagram.
Schedule for Law of Diminishing Marginal Utility:

Unit of Consumption Marginal Utility Total Utility
1 20 20
2 15 35
3 10 45
4 05 50
5 00 50
6 -05 45
The schedule explains that with each additional unit consumed the marginal utility increases with a diminishing rate. After the
saturation point though, the utility starts to fall.
In the above table, the total utility obtained from the first apple is 20 utils, which keep on increasing until we
reach our saturation point at 5th apple. On the other hand, marginal utility keeps on diminishing with every
additional apple consumed. When we consumed the 6th apple, we have gone over the limit. Hence, the marginal
utility is negative and the total utility falls.
With the help of the schedule, we have made the following diagram:
Saturation Point: The point where the desire to consume the same product anymore becomes zero.
Disutility: If you still consume the product after the saturation point, the total utility starts to fall. This is
known as disutility.
When the first apple is consumed, the marginal utility is 20. When the second apple is consumed, the marginal
utility increases by 15 utils, which is less than the marginal utility of the 1st apple – because of the diminishing
rate. Therefore, we have shown that the utility of apples consumed diminishes with every increase of apple
consumed.
Similarly, when we consumed the 5th apple, we are at our saturation point. If we consume another apple, i.e.
6th apple, we can see that the marginal utility curve has fallen to below X-axis, which is also known
as ‘disutility’.
The unit and its quality must remain same.
Assumptions in the Law of Diminishing Marginal Utility:

For the law of diminishing marginal utility to be true, we need to make certain assumptions. Each assumption is
quite logical and understandable. If any of the assumptions are not true in the case, the law of diminishing
marginal utility will not be true.
Following are the assumptions in the law of diminishing marginal utility:
 The quality of successive units of goods should remain the same. If the quality of the goods increase or
decrease, the law of diminishing marginal utility may not be proven true.
 Consumption of goods should be continuous. If there comes a substantial break in the consumption of goods,
the actual concept of diminishing marginal utility will be altered.
 Consumer’s mental outlook should not change.
 Unit of good should not be very few or small. In such a case, the utility may not be measured accurately.
Exceptions for the Law of Diminishing Marginal Utility:

The law of diminishing marginal utility states that with the consumption of every successive unit of commodity
yields marginal utility with a diminishing rate. However, there are certain things on which the law of
diminishing marginal utility does not apply.
Following are the exceptions for this law:
 Desire for money.
 Desire for knowledge.
 Use of liquor or wine.
 Collection of rare objects.
Conclusion:
This concludes the explanation for the law of diminishing marginal utility. Feel free to ask any question in the
comment section below.
© 2013 Syed Hunbbe
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Advantages of the Law of Diminishing

Marginal Utility
Sundaram Ponnusamy
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 Advantages and Disadvantages of the Marginal Utility Analysis

 The Law of Equi-Marginal Utility or Gossen's Second Law
Introduction
In social sciences, you often find that there is a wide gap between theories and their practical application. Have you
ever thought why it happens? The answer is very simple. Almost all theories of social sciences are based on
general human behavior and certain assumptions. Assumptions are necessary to hold the theory good. However,
some of these assumptions are very unrealistic and do not work in all situations. In addition, it is hard to predict
human behavior. Hence, theories that rely on such unrealistic assumptions and unpredictable human behavior fail
to work in a real life scenario. Because of this reason, there is a wide gap between theories and their practical
application. However, the law of diminishing marginal utility is completely different in this regard. Though the theory
is derived from general human behavior, it possesses great practical importance. Let us see how the law of
diminishing marginal utility is helpful in various fields of economics.
Basis for Progressive Taxation
The law of diminishing marginal utility is one of the fundamental principles in public finance. The law serves as the
basis for progressive taxation. Adam Smith explained canons of taxation in his book ‘Wealth of Nations’. One of the
canons of taxation is ‘Ability to Pay’. This means that taxes should be imposed according to the ability of people to
pay. The law of diminishing marginal utility is crucial in determining people’s ability to pay. According to Prof. Pigou,
the marginal utility of money for a poor person is higher than that for a rich person. This is so, because a poor
person possesses little money; therefore, the utility derived from each unit of money is huge. This implies that rich
people are able to pay more as taxes than poor people are. This concept leads to progressive taxation system,
which imposes heavier tax burden on the rich. This is one of the very important practical applications of the law of
diminishing marginal utility.
Redistribution of Income
Income distribution is the core concept in public finance. What the government does through taxation is taking away
some of the resources from rich and spending them to improve the welfare of poor. Note that when a person
possesses less money, the utility derived from it is huge. At the same time, when a person possesses more money,
the utility derived from it is less because of the abundance. When taxes are imposed on rich, some of their money is
taken away. Hence, the utility derived from the remaining money improves. At the same time, the money taken from
the rich is spent to improve the welfare of poor. This implies that the poor becomes better off now. This activity
helps to attain an egalitarian society. This process can be explained with the help of the following figure:
Let us suppose that there are two individuals (A and B) in a society. The poor man’s income is OA. OB’ is the rich
man’s income. Suppose the government imposes tax on the rich; therefore, income of the rich is reduced by B’B.
Now, the same amount of money income is transferred to the poor. This raises the poor man’s income by AA’. From
the picture, you can understand that the marginal utility of the rich improves from D’ to D because of taxation. And
the poor man’s utility declines from C to C’. This implies that money in the hands of the poor has increased. This
activity leads to an egalitarian society.
Derivation of Demand Curve
The law of diminishing marginal utility is the basis to derive demand curve. The law further helps to understand why
the demand curve slopes downward. Click here to know how to derive demand curve from the law of diminishing
marginal utility. In addition, Go here to understand the relationship between the law of diminishing marginal utility
and downward slope of a demand curve.
Value Determination
The law of diminishing marginal utility is helpful to determine the value or price of a commodity. For example, the
law explains that the marginal utility of a commodity decreases as the quantity of it increases. When the marginal
utility falls, consumers do not prefer to pay high price. Therefore, the seller has to reduce the price of the
commodity, if he or she wants to sell more. In this way, the law plays a crucial role in determining price of a
commodity.
Water – Diamond Paradox
The principle of diminishing marginal utility is beneficial to understand the difference between value-in-use and
value-in-exchange. For instance, let us consider two commodities – water and diamond. Water is essential for our
survival (value-in-use) but it is not costly (no or little value-in-exchange). On the contrary, diamonds are useful just
for showy purpose (no value-in-use) but they are very costly (high value-in-exchange).
Water is abundant and hence has no marginal utility. Because of this reason, want has no or little value-in-
exchange. On the contrary, diamonds are scarce and hence possess a very high marginal utility. Therefore,
diamonds have high value-in-exchange. In this way, the law of diminishing marginal utility tells us why diamonds
are highly priced when compared to water. This scenario is often referred to as water - diamond paradox.
The following diagram provides you with more information on this paradox:
In figure 2,
UU1 - marginal utility curve for diamond
VV1 - marginal utility curve for water
OA represents the supply of diamond

OF represents the supply of water
Since the quantity of diamonds is less (OA), the marginal utility derived from diamonds is high (AB). Therefore,
diamonds are priced high (OC) as the price of a commodity is associated with its marginal utility. Let us look at the
case of water. The quantity of water is high. Therefore, the marginal utility derived from water is less (FE). Because
of small amount of marginal utility, water is priced less (OD).
Optimum Utilization of Expenditure
The law of diminishing marginal utility is useful for individuals to determine how much money should be spent on a
particular commodity. The equilibrium point is where marginal utility is equal to price (point E in figure 3). At this
point, we can say that the individual utilizes his or her expenditure optimally. Though we do not calculate all these
things in our day-to-day purchasing activities, it happens naturally. We do not pay a high price for a commodity that
does not give us utility. In this sense, the law of diminishing marginal utility does play an eminent role in all
economic activities.
Basis for Economic Laws
Furthermore, the law of diminishing marginal utility serves as a basis for some important economic concepts such
as law of demand, consumer’s surplus, law of substitution and elasticity of demand.
l Meer
7
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Economies of Scale - Meaning and

Types
Sundaram Ponnusamy
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Introduction
The scale of production has an important bearing on the cost of production. It is a common experience of every
producer that costs can be reduced by increased production. That is why the producers are keener on expanding
the size or scale of production. In the process of expansion, the producer may benefit from the emergence of
economies of scale. These economies are broadly classified into two types:
1. Internal Economies
2. External Economies
Internal Economies
When a firm expands its scale of production, the economies, which accrue to this firm, are known as internal
economies.
According to Cairncross, “Internal economies are those which are open to a single factory or a single firm
independently of the action of other firms. They result from an increase in the scale of output of the firm, and
cannot be achieved unless output increases. They are not the result of inventions of any kind, but are due to the
use of known methods of production which a small firm does not find worthwhile.”
Internal economies may be of the following types:
1. Technical Economies
Technical economies are those, which accrue to a firm from the use of better machines and techniques of
production. As a result, production increases and cost per unit of production decreases.
Following Prof. Cairncross, we may classify the various kinds of technical economies as follows:
(a) Economies of Increased Dimensions
Certain technical economies may arise because of increased dimensions. For example, a double decker bus is
more economical than a single decker. One driver and one conductor may be needed, whether it is a double
decker or a single decker bus.
(b) Economies of Linked Processes
As a firm increases its scale of operations, it can properly be linked to various production processes more
efficiently. For example, in order to obtain the advantage in a linkage process, both editing and printing of
newspapers are generally carried out in the same premises.
In the words of Prof. Cairncross, “There is generally a saving in time and a saving in transport costs, when the
two departments of the same factory are brought closer together than two separate factories.”
(c) Economies of the Use of By-products
A large firm is in a better position to utilize the by-products efficiently and attempt to produce another new
product. For example, in a large sugar factory, the molasses left over after the manufacture of sugar from out of
the sugarcane can be used for producing power alcohol by installing a small plant.
(d) Economies in Power
Large sized machines without continuous running are often more economical than small sized machines
running continuously in respect of power consumption. For example, a big boiler consumes more or less the
same power as that of a small boiler but gives more heat.
(e) Economies of Increased Specialization
A large firm can divide the work into various sub-processes. Therefore, division of labor and specialization
become possible. At one stroke, all the advantages of division of labor can be achieved. For example, only well
established big school can have specialized teachers.
2. Economies of Continuation
Technical economy is also realized due to al long-run continuation of the production process. For example,
composing and printing of 1000 copies may cost $200; but if we increase the number of copies to 2000 it may
cost only $250, because the same sheet plate which has been composed previously can be utilized for the
increased number of copies also.
3. Labor Economies
A large firm employs a large number of laborers. Therefore, each person can be employed in the job to which
he is most suited. Moreover, a large firm is in a better position to attract specialized experts into the industry.
Likewise, specialization saves time and encourages new inventions. All these advantages result in lower costs
of production.
4. Marketing Economies
Economies are achieved by a large firm both in buying raw materials as also in selling its finished products.
Since the large firm purchases its requirements in bulk, it can bargain on its purchases on favorable terms. It
can ensure continuous supply of raw materials. It is eligible for preferential treatment. The special treatment
may be in the form of freight concessions from transport companies, adequate credit from banks and other
financial treatments etc. In terms of advertisements also, it is better placed than the smaller firms. Better-trained
and efficient sales persons can be appointed for promoting sales.
5. Financial Economies
The credit requirements of the big firms can be met from banks and other financial institutions easily. A large
firm is able to mobilize much credit at cheaper rates. Firstly, investors have more confidence in investing
money in the well-established large firms. Secondly, the shares and debentures of a large firm can be disbursed
or sold easily and quickly in the share market.
6. Managerial Economies
On the managerial side also, economies can be achieved; when output increases, specialists can be more fully
employed. A large firm can divide its big departments into various sub-departments and each department may
be placed under the control of an expert. A brilliant organizer can devote himself wholly to the work of
organizing while the routine jobs can be left to relatively low paid workers.
7. Risk Bearing Economies
The larger the size of a firm, the more likely are its losses to be spread among its various activities according to
the law of averages.
A big firm produces a large number of items and of different varieties so that the loss in one can be counter
balanced by the gain in another. For example, a branch bank can spread its risk by diversification of its
investment portfolio rather than a unit bank. Suppose a bank in a particular locality is facing a run on the bank,
it can recall its resources from other branches, and can easily overcome the critical situation. Thus,
diversification avoids “putting all its eggs in one basket.”
8. Economies of Research
A large sized firm can spend more money on its research activities. It can spend huge sums of money in order
to innovate varieties of products or improve the quality of the existing products. In cases of innovation, it will
become an asset of the firm. Innovations or new methods of producing a product may help to reduce its average
cost.
9. Economies of Welfare
A large firm can provide welfare facilities to its employees such as subsidized housing, subsidized canteens,
crèches for the infants of women worker, recreation facilities etc.; all these measures have an indirect effect on
increasing production and at reducing the costs.
External Economies
External economies refer to gains accruing to all the firms in an industry due to the growth of that industry. All
the firms in the industry irrespective of their size can enjoy external economies. The emergence of external
economies is due to localization.
The main types of external economies are as follows:
1. Economies of Concentration
When a number of firms are located in one place, all the member firms reap some common economies. Firstly,
skilled and trained labor becomes available to all the firms.
Secondly, banks and other financial institutions may set up their branches, so that all the firms in the area can
obtain liberal credit facilities easily. Thirdly, the transport and communication facilities may get improved
considerably. Further, the power requirements can be easily met by the electricity boards. Lastly,
supplementary industries may emerge to assist the main industry.
2. Economies of Information
The economies of information may arise because of the collective efforts of the various firms. Firstly, an
individual firm may not be in a position to spend enormous amounts on research. However, by pooling all their
resources new inventions may become possible. The fruits of the invention can be shared by all the member
firms. Secondly, publication of statistical, technical and marketing information will be of vital importance to
increase output at lower costs.
3. Economies of Disintegration
When the industry grows, it becomes possible to split up production into several processes and leave some of
the processes to be carried out more efficiently by specialized firms. This makes specialization possible and
profitable. For example, in the cotton textile industry, some firms may specialize in manufacturing thread, some
others in producing vests, some in knitting briefs, some in weaving t-shirts etc. The disintegration may be
horizontal or vertical. Both will help the industry in avoiding duplication, and in saving time materials.
Relationship between Internal and External Economies
No watertight compartmental division can be made between internal and external economies. When a number
of firms are combined into one, external economies will become internal economies. Internal economies are
due to the expansion of individual firm while external economies arise due to the growth of the entire industry.
External economies are a pre-requisite for the growth of backward regions.
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Canons of Taxation in Economics

Updated on October 21, 2013
Syed Hunbbel Meer

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Source
Adam Smiths' The Wealth of Nations
The Wealth of Nations
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Canons of Taxation:
The canons of taxation were first presented by Adam Smith in his famous book ‘The Wealth of Nations’. These
canons of taxation define numerous rules and principles upon which a good taxation system should be built.
Although these canons of taxation were presented a very long time ago, they are still used as the foundation of
discussion on the principles of taxation.
Adam Smith originally presented only 4 canons of taxation, which are also commonly referred to as the ‘Main
Canons of Taxation’ or ‘Adam Smith’s Canons of Taxation’. Along with the passage of time, more canons were
developed to better suit the modern economies. In the following article, you will read the 9 canons of taxation that
are most commonly discussed and used.
Adam Smith's Canons of Taxation:

Adam Smith originally presented the following four canons of taxation. The rest were developed later:
1. Canon of Equality
2. Canon of Certainty
3. Canon of Convenience
4. Canon of Economy
These 9 canons of taxation are:
1. Canon of Equality
2. Canon of Certainty
3. Canon of Convenience
4. Canon of Economy
5. Canon of Productivity
6. Canon of Simplicity
7. Canon of Diversity
8. Canon of Elasticity
9. Canon of Flexibility
Let’s start discussing each of these 9 canons of taxation:

Source
1. Canon of Equality:
The word equality here does not mean that everyone should pay the exact, equal amount of tax. What equality
really means here is that the rich people should pay more taxes and the poor pay less. This is because the amount
of tax should be in proportion to the abilities of the taxpayer. It is one of the fundamental concepts to bring social
equality in the country.
The canon of equality states that there should be justice, in the form of equality, when it comes to paying taxes. Not
only does it bring social justice, it is also one of the primary means for reaching the equal distribution of wealth in an
economy.
2. Canon of Certainty:
The tax payers should be well-aware of the purpose, amount and manner of the tax payment. Everything should be
made clear, simple and absolutely certain for the benefit of the taxpayer. The canon of certainty is considered a
very important guidance rule when it comes to formulating the tax laws and procedures in a country. The canon of
certainty ensures that the taxpayer should have full knowledge about his tax payment, which includes the amount to
be paid, the mode it should be paid in and the due-date. It is believed that if the canon of certainty is not present, it
leads to tax evasion.
3. Canon of Convenience:
Canon of convenience can be understood as an extension of canon of certainty. Where canon of certainty states
that the taxpayer should be well-aware of the amount, manner and mode of paying taxes, the canon of convenience
states that all this should easy, convenient and taxpayer-friendly. The time and manner of payment must be
convenient for the tax payer so that he is able to pay his taxes in due time. If the time and manner of the payment is
not convenient, then it may lead to tax evasion and corruption.
4. Canon of Economy:
The whole purpose of collecting taxes is to generate revenue for the company. This revenue, in turn, is spent on
public welfare projects. The canon of economy – keeping in view the above-mentioned purpose – states that the
cost of collecting taxes should be as minimum as possible. There should not be any leakage in the way. In this way,
a large amount of the collections will go directly to the treasury, and therefore, will be spent in the government
projects for the welfare of the economy, country and the people. On the other hand, if the canon of economy isn’t
applied and the overall cost of collecting taxes is unreasonably high, the collected amount will not be sufficient in
the end.
5. Canon of Productivity:
By virtue of the canon of productivity, it is better to have fewer taxes with large revenues, rather than more taxes
with lesser amounts of revenue. It is always considered better to impose the only taxes that are able to produce
larger returns. More taxes tend to create panic, chaos and confusion among the taxpayers and it is also against the
canon of certainty and convenience to some extent.
6. Canon of Elasticity:
An ideal system of taxation should consist of those types of taxes that can easily be adjusted. Taxes, which can be
increased or decreased, according to the demand of the revenue, are considered ideal for the system. An example
of such a tax can be the income tax, which is considered very much ideal in accordance with the canon of elasticity.
This example can also be taken in accordance with the canon of equality. Flexible taxes are more suited for
bringing social equality and achieving equal distribution of wealth. Since they are elastic and easily adjustable,
many government objectives can be achieved through them.
7. Canon of Simplicity:
The system of taxation should be made as simple as possible. The entire process should be simple, non-technical
and straightforward. Along with the canon of certainty, where the amount, time duration and manner of payment is
made certain, the canon of simplicity avoids cases of corruption and tax evasion if the entire method is made simple
and easy.
Poll Time!
Which one do you think is the most important Canon of Taxation?
 Canon of Equality
 Canon of Certainty
 Canon of Convenience
 Canon of Economy
 Canon of Productivity
 Canon of Simplicity
 Canon of Diversity
 Canon of Elasticity
 Canon of Flexibility
See results
8. Canon of Diversity:
Canon of diversity refers to diversifying the tax sources in order to be more prudent and flexible. Being heavily
dependent on a single tax source can be detrimental for the economy. Canon of diversity states that it is better to
collect taxes from multiple sources rather than concentrating on a single tax source. Otherwise, the economy is
more likely to be confined, and hence, its growth will be limited as well.
9. Canon of Flexibility:
Canon of flexibility means that the entire tax system should be flexible enough that the taxes can easily be
increased or lowered, in accordance with the government needs. This flexibility ensures that whenever the
government requires additional revenue, it can be generated without much hassle. Similarly, when the economy
isn’t booming, lowering taxes shouldn’t be a problem either.
Economics in One Lesson: The Shortest and Surest Way to Understand Basic Economics
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Conclusion:
So these are the 9 canons of taxation that are used as the fundamentals for any taxation system and study about
taxation principles. As mentioned earlier, Adam Smith originally presented the first four canons. Later, in order to
better suit to modern economies and for the sake of evolution as well, more canons were introduced.
I hope the explanation was easy to comprehend. However, if you still have any questions about the canons of
taxation, feel free to ask in the comment section below. Moreover, you will also find the following articles interesting:
Related Articles:
Advantages and Disadvantages of Direct Taxes:
This article explains all the various advantages and disadvantages of direct taxes. Along with the merits and
demerits, it is also discussed that which benefits of the direct taxes are in accordance of certain canons of taxation.
18
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How Do Income Effect, Substitution

Effect and Price Effect Influence
Consumer's Equilibrium?
Sundaram Ponnusamy
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Income Effect on Consumer's Equilibrium

Income effect attributes how a change in the consumer’s income influences his total satisfaction. Assume that
the prices of commodities that the consumer purchases remain constant. Now, he is able to experience more or
less satisfaction depending upon the change in his income. Thus, we can define income effect as the effect
caused by changes in consumer’s income on his purchases while prices of commodities remaining the same.
Figure 1 explains the effect of change in the consumer’s income on his equilibrium level.
In figure 1, Point E is the initial equilibrium position of the consumer. At point E, the indifference curve IC1 is
tangent to the price line MN. Suppose the consumer’s income increases. This causes the budget line shifts from
MN to M1N1 and then to M2N2. Consequently, the equilibrium point shifts from E to E1 and then to E2.
Income Consumption Curve
You can obtain income consumption curve (ICC) by joining all equilibrium points E, E1 and E2 as shown in
figure 1. Normal goods generally have positively sloped income consumption curves, which implies that
consumer’s purchases of the two commodities increases as his income increases. At the same time, this may not
be applicable in all cases.
Substitution Effect on Consumer's Equilibrium

Suppose there are two commodities, namely apple and orange. Your money income is $100, which does not
change. You need to purchase apple and orange using the entire money income, i.e. $100. Assume that the
price of apple increases and the price of orange decreases. What do you do in this case? You tend to buy more
oranges and less apples since oranges are cheaper than apples. What exactly you are doing is that you are
substituting oranges for apples. This is known as substitution effect.
The substitution effect occurs because of the following two reasons:
(a) The relative prices of commodities change. This makes one commodity cheaper and the other commodity
costlier.
(b) Money income of the consumer does not change.
Figure 2 is helpful to understand the concept of substitution effect in a simple manner.
In figure 2, AB represents the original budget line. The point Q represents the original equilibrium point, where
the budget line is tangent to the indifference curve. At point Q, the consumer buys OM quantity of commodity
X and ON quantity of commodity Y. Assume that the price of commodity Y increases and the price of
commodity X decreases. As a result, the new budget line would be B1A1. The new budget line is tangent to the
indifference curve at point Q1. This is the new equilibrium position of the consumer after the relative prices
change.
At the new equilibrium point, the consumer has decreased the purchase of commodity Y from ON to ON1 and
increased the purchase of commodity X from OM to OM1. However, the consumer stays on the same
indifference curve. This movement along the indifference curve from Q to Q1 is known as the substitution
effect. In simple terms, the consumer substitutes one commodity (its price is less) for the other (its price is
more); it is known as the ‘substitution effect.’
Price Effect on Consumer's Equilibrium

For simplicity, let us consider two-commodity model. In substitution effect, prices of both the commodities
change (price of commodity Y increases and price of commodity X decreases). However, in price effect, price
of any one of the commodities changes. Thus, price effect is the change in the quantity of commodities or
services purchased due to a change in the price of any one of the commodities.
Let us consider two commodities, namely commodity X and commodity Y. Price of commodity X changes.
Price of commodity Y and consumer’s income are constant.
Suppose price of commodity X decreases. In figure 3, the decline in the price of commodity X is represented by
the corresponding shifts of budget line from AB1 to AB2, AB2 to AB3 and AB3 to AB4. The points C1, C2, C3 and
C4 denote respective equilibrium combinations. According to figure 3, consumer’s real income increases as the
price of commodity X reduces. Due to an increase in the consumer’s real income, he is able to purchase more
of both commodities X and Y.
Price Consumption Curve
You can derive the Price Consumption Curve (PCC) by joining all equilibrium points (in the above example,
C1, C2, C3 and C4). In the above figure, the PCC has a positive slope. This means that as price of commodity X
falls, the consumer’s real income increases.
Derivation of Demand Curve from Price Consumption

Curve
The price consumption curve (PCC) tells us what happens to the quantity demanded when there is a change in
price. A consumer’s demand curve also explains the relationship between the price and quantity demanded of a
commodity. Therefore, price consumption curve is useful to derive an individual consumer’s demand curve.
Though a consumer’s demand curve and his price consumption curve give us same information, the demand
curve is more straightforward in what it tries to convey.
Figure 4 illustrates the process of deriving the individual consumer‘s demand curve from his price consumption
curve.
In figure 4, horizontal axis measures commodity A, and vertical axis represents consumer’s money income. IC1,
IC2, and IC3 denote indifference curves. Suppose the price of commodity A continuously decreases. As a result,
LN, LQ and LR are the subsequent budget lines of the consumer. Initially, P1 is consumer’s equilibrium. At this
equilibrium point, the consumer buys OM1 quantity of commodity A.
Price of a unit of commodity A = total money income/number of the units that can be bought with that money.
Hence, at P1 (equilibrium point – budget line is tangent to the indifference curve IC1), the price per unit of
commodity A is OL/ON. At OL/ON price, the consumer demands OM1 quantity of commodity A.
Likewise, at OL/OQ price, the consumer is able to buy OM2 quantity of commodity A and at OL/OR price, he
buys OM3 quantity of commodity A.
If you connect all equilibrium points (P1, P2 and P3), you will be able to get the price consumption curve.
The demand curve, as mentioned above, depicts the prices and corresponding quantities of commodity
purchased by the consumer.
For illustration purpose, suppose the consumer’s income is $40, ON = 8 units, OQ = 10 units and OR = 20
units. With the help of this information, you can construct a demand schedule as follows:
Table 1: Price-Demand Schedule for Commodity A

Price of A (in $) = Total
Quantity of A
Budget Line Money Income/No. of
Demanded
Units of A
LN OL/ON (40/8 = 5) OM1 = 8 units
LQ OL/OQ (40/10 = 4) OM2 = 10 units

Price of A (in $) = Total
Quantity of A
Budget Line Money Income/No. of
Demanded
Units of A
LR OL/OR (40/20 = 2) OM3 = 20 units
Once you have the demand schedule, you can derive an individual consumer’s demand curve as shown in
figure 5.
Figure 5 illustrates a consumer’s demand curve. If you need to construct a market demand curve, it will be
possible by a horizontal summation of individual demand curves.
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Types and Functions of Economic
Systems
Chrisagbe
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Contact Author
What Are Economic Systems?

Due to the problem of scarcity, every economic system (be it capitalist, socialist, or any other economic
system) needs to function to satisfy societal needs. Given such scarce resources, it believed that choices must
be made regarding:
 What to produce.
 How much of each commodity to produce.
 How to produce it.
 For whom to produce it for.
Every society sets up some means for answering its fundamental economic questions. This entity is called the
economic system.
Basically, an economic system refers to the means by which decisions involving economic variables are made
in a society. In this light, a society’s economic system determines how the society answers its fundamental
economic questions of, again, what to produce, how the output is to be produced, who is to get this output, and
how future growth will be facilitated, if at all.
The essential differences of economic systems lie in the extent to which economic decisions are made by
individual as opposed to governmental bodies and in whether the means of production are privately or publicly
owned.
Types of Economic Systems

There are different types of economic system. These include: the traditional, the command/socialist economy,
pure capitalism, and mixed economic systems.
 The traditional economy. This is the type of economy in which the organization of production and distribution is
frequently governed by tribal rules or customs. This type existed mostly in the early stages of development where
the economy is strongly linked to the social structure of the community and people perform economic tasks for
non-economic reasons. In the traditional economy, economic matters are largely determined by social or religious
customs and traditions. For example, women may plough fields because that is their customary role and not
because they are good at doing so. Traditional economic systems are often found in less developed countries,
where they may be a hindrance to economic progress.
 The command economy. In the command economy, an authoritarian central government calls the tune. It
operates on instruction from those in power. In this type of economy, decisions in connection with the functions of
an economic system are taken on a collective or group basis. There is collective ownership of factors of production.
The group that owns the factors of production and takes decisions may be some government body. A command
economy is a centrally planned economy. There is typically very little freedom of choice. The occupation of
workers, the quantities of which type of commodity to be produced, and the distribution of income are
determined by the central planners plus making arrangements for future economic growth. Cuba, North Korea,
Russia, and Iran are examples of economies that are closest to perfect command economies.
 Pure capitalism. Pure capitalism is an economic system based on private ownership and the freedom of
individuals to conduct their economic affairs without interference from government bodies or other groups.
Capitalist economic systems are characterized by a great deal of freedom of choice exercised by consumers and
business firms in the market for commodities and resources. The capitalist economy is also known as the free
exchange economy or market economy. The essence of pure capitalism is freedom. There is freedom to own
property, freedom to buy and sell, and freedom from government interference in the economic aspect of each
individual’s life. Capitalism is best characterized by the economy of the United States, even though it is not a
purely capitalist economy.
 Mixed economy. Many economies are best described as mixtures of capitalistic and command systems. The
United States and other countries where markets are heavily relied on to allocate resources and distribute output
are known as mixed capitalistic systems. The characteristics of free enterprise system are manifested in most of its
economic activities. However, some of its economic decisions of the mixed economy are taken on collective basis
and some of the productive resources or goods are owned by a governmental body. In the mixed capitalistic
economic system, both government and private decisions are important.
Functions of an Economic System

Economic systems everywhere may perform similar functions. These functions may be traditional or non-
traditional. As mentioned, the traditional functions include the following:
 What to produce.
 How to produce, i.e. what method of factor combination to adopt in order to maximize the use of the
resources.
 For whom to produce.
 How to distribute the goods and services produced.
Economists have realized the importance of economic growth and the attainment of full employment, if the
system must achieve the best use of its scarce resources. Attainments of full employment and high economic
growth have become the non-traditional functions.
Traditional Functions of Every Economic System
The traditional functions of every economic system include the following:
 What not to produce. In deciding on what goods to produce, an economic system also decides in what not to
produce. For example, if the system wants to provide roads and recreational facilities, it may have problems since
it may lack enough resources to do so at the same time. It will be necessary that it chooses between the two. It
may for instance have to choose roads. An economic system can consider a wide variety of goods than the other
which is poorly endowed.
 What method to use. Economic systems also function to decide on the particular technique to be used in
production. Here, the economic system decides what method of factor combination to be employed in order to
maximize the use of the scarce resources, by minimizing cost and increasing productivity. The decision may involve
whether to employ labor-intensive or capital-intensive methods of production. In a free exchange economy, its
choice will depend on relative factor endowment and factor prices. In developing countries for instance, labor is
more abundant and cheap. A labor-intensive method may be preferred.
 For whom to produce. Another problem the economic system is faced with is for whom to produce. To get
maximum use from the scarce resources, the commodity must be produced in an area where it would be
demanded and where costs will be minimized. The production unit may be sited near the source of raw material or
the market center depending on the nature of the product.
Non-Traditional Functions of Every Economic System
 Enduring economic growth. Economic systems must ensure economic growth. Owing to scarcity of resources,
the society must know whether its capacity to produce goods and services is expanding or decreasing. Some major
ways to promote economic growth include ensuring adequate rate of growth of per capita income, improvement
in technology through the adoption of superior techniques of production, and better and more extensive
education and training of the labor force and others.
 Ensuring full employment. Society must also ensure full employment. It is the task of economic systems to
ensure that resources are not idle or unemployed, since resources are scarce. In the market economy, full
employment is achieved by stimulating demand.
Producer’s Equilibrium
The primary objective of any business firm is to maximize profit. And, a producer is said to be in
equilibrium when he attains maximum profit from limited outlay or limited output.
A producer may find out his equilibrium condition by the help of isoquant map and a family of isocost
line.
An isoquant represents various combinations of two factor-inputs which yield same level of output to
the producer while an isoquant map is a set of different isoquants, all of which represents unique
level of output.
On the other hand, an isocost is a line formed by combining points which represents various
combinations of two factor-inputs, given the prices of inputs and the total outlay available to the
producer. And, a family of isocost is a set of isocost lines which shows various combinations of
inputs at different level of outlay.
Optional Choice of Inputs
A producer may maximize his profit through two ways. They are
 A producer can either minimize the cost of production for any given level of output.
 Or, maximize the output at any given level of outlay.
Let us examine these two options separately.
Least Cost Combination: Minimization of Cost for Given Level of Output
Sometimes, the producer may have a particular level of output in mind, for example, constructing a
building, making a dress, or producing X amount of certain commodity, etc.
To produce this given level of output the producer will have to choose the combination of factor-
inputs in such a way that his cost of product is as less as possible so that his profit is maximized.
Thus, a producer will try to produce given level of output with least cost combination.
The concept is explained by the help of an isoquant and a family of isocost in the following diagram.
Figure: minimizing cost for a constant level of output

Let us suppose that an entrepreneur decided to produce 500 units of a commodity. His desired level
of output can be obtained by employing any combination of labor and capital that the isoquant (Iq)
pass through.
In the figure, we have only one isoquant which denotes that the level of output is fixed, i.e. 500 units.
On the other hand, there are three isocost lines (AB, A’B’ and A”B”) which indicates different level of
outlay (cost).
level of output by employing any of the combinations of labor and capital that lie at these points.
However, C and D being situated on the higher isocost line will be ignored by the producer as he will
require higher level of outlay to purchase these combinations.
On the other hand, the producer won’t be able to choose any combinations from the isocost line AB
because no combination of labor and capital lying on that line will be able to produce 500 units of
output.
Hence, the producer will be in equilibrium where the isocost line is tangent to the isoquant, i.e. at
point E. In this situation, the slope of isoquant is equal to the slope of isocost line.
Maximization of Output for a Given Level of Outlay (Cost)

Sometimes, there may be situation where the producer has fixed outlay from which he has to
produce as much output as possible in order to maximize his profit.
Cite this article as: Shraddha Bajracharya, "Producer’s Equilibrium: Optional Choice Of Inputs," in Businesstopia,
January 8, 2018, https://www.businesstopia.net/economics/micro/producers-equilibrium-optional-choice-of-inputs.
How a producer attains equilibrium is such condition is explained by the help of an isocost line and
an isoquant map.
Figure: maximizing output for a given level of outlay
Let us suppose that this time the producer has decided to incur an outlay of Rs. 5000 on labor and
capital. Since the total outlay is fixed, there is single isocost line AB which represents various
combinations of labor and capital that the producer can afford at Rs. 5000.
Similarly, in the figure, we have an isoquant map (three isoquants) Iq1, Iq2 and Iq3 which represents
various level of outputs, i.e. 300 units, 400 units and 500 units, respectively.
Since the isocost line AB passes through the points C, E and D, the producer can spend his total
outlay on purchasing any combinations of capital and labor lying on these points to produce outputs.
But, as we can see that the points C and D lie on the lower isoquant, the producer will choose the
combination at point E.
It is because, by the property of isoquants,
level of output in Iq3 > level of output in Iq2 > level of output in Iq1
Although the level of output is greater in Iq3 as compared to Iq2 and Iq1, the producer cannot choose
any combination at Iq3 as it is away from the isocost line.
Hence, we can once again say that the producer will be in equilibrium at the point where the slope of
isoquant is equal to the slope of isocost.
c) Demand-pull Inflation: Demand-pull inflation occurs when the overall
demand for goods or services increases faster than the production capacity
of the economy. This type of inflation leads to a demand-supply gap (i.e., a
shortage), which results in an increase in price (see also the law of supply
and demand). To illustrate this, we can look at a simple supply and
demand diagram. As you can see in the illustration below, an increase in
demand causes the aggregate supply curve (AD) to shift to the left (i.e.,
up). However, the aggregate supply curve (AS) doesn’t change. Therefore,
the new equilibrium price (P2) at the new intersection of AS and AD is
higher than the old price (P1). Hence, as the name suggests, demand-pull
inflation is caused by a shift in demand.
A popular example of demand-pull inflation is the oil industry. Over the last
decades, the demand for oil has increased significantly. However, oil is a scarce
resource, so there is only a limited amount available on our planet. Thus, demand has
increased more rapidly than supply, and as a result, a barrel of oil costs almost three
times as much today as it did 20 years ago. Because oil is such a precious resource, this
price increase had an important impact on overall price levels within the economy, as
it caused demand shifts and changes in the prices of related goods.
Factors causing excess demand:
2) Increase in Money supply.

3) Increase in Govt. expenditure
4) Increase in private expenditure
5) Rise in disposable income
6) Increase in population
7) Repayment of public debts.
8) Generation of Black Money.
d) Cost-push Inflation: Cost-push inflation occurs as a result of an increase in
the cost of production. That is, when the prices of inputs (e.g., raw materials, labor)
increase, the production of goods or services becomes more expensive, and producers
need a higher price to be profitable. Going back to our supply and demand diagram,
we can see that the higher input prices cause the aggregate supply curve (AS) to shift
to the left, whereas the aggregate demand curve (AD) doesn’t change (see also shifts in
aggregate demand). As a result, the price level increases from P1 to P2. So unlike
demand-pull inflation, cost-push inflation is caused by a shift in supply.
Again, one of the most famous examples of cost-push inflation can be found in the oil
industry. Particularly, in the 1973 oil crisis, which is also known as the first oil shock.
This crisis was triggered when the members of the Organization of the Petroleum
Exporting Countries (OPEC) proclaimed an oil embargo, which resulted in a sudden
supply shock (i.e., a sudden decrease in the oil supply). As a result, the price of oil globally
surged from USD 3.00 to USD 12.00 per barrel, without a change in demand.
Factors causing reduction in supply of goods and services.
1) Scarcity of factors of production.

2) Hoarding
3) Natural Calamities
4) Increase in Exports.
5) Operation of the law of diminishing return.
6) War Period

Psychological Law of Consumption

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Psychological Law of Consumption

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Psychological Law of Consumption:

Psychological Law of Consumption: (Assumptions and and

Thus, Keynes’ psychological law of consumption is based on the

2. Normal Economic Conditions:

Implications of the Psychological Law of Consumption:

1. Highlighting the crucial importance of investment in an economy:

Assuming the consumption function to be stable during a short-run period, the

2. Refuting Say’s Law:

Keynesian Psychological Law of Consumption

The law is based on three interrelated propositions:

A. Invariability of Psychological and Institutional Factors

Income (Y) Consumption (C) Saving (S)

Implications of the Psychological Law of Consumption

Where, Y= Income; C= Consumption; S= Saving

A. Highlights the importance of investment in an economy

B. Explains the declining phenomena of MPC

C. Explanation of the business cycle

Not as good as it sounds

Increased productivity of the firms

Change in customer spending pattern

Decline in business revenue

Decline in supply of credit

Increase in real value of debt

Relationship between Saving and Income

180 170 10 0.06 0.17

240 220 20 0.08 0.17

Table 1 Relationship between Income and Saving

Attributes of Saving Function

Saving function or propensity to save has two major attributes:

APS is a point on the curve S, and it is measured as S1Y1/OY1.

Where, ΔS= Change in saving; ΔY= Change in income

MPS= 10/60 =0.17 or 17%

ii. Provisions for the future

The factors that determine the ability to save include

ii. Size of National Income

iii. Developmental activities

i. Development of financial institutions

ii. Rate of interest

iii. Social security system

iv. Taxation Policy

SP= Supply price of new capital asset;

R/ (1+r) = Current value of annuity discounted at rate r.

Supply price of capital asset= $ 3000

Expected Yield (Second year) = $1210

Then, marginal efficiency of capital (r) is calculated as

SP= R1/ (1+r) + R2/ (1+r)2

SP= 1100 + 1100/ (1+1/10) = 1000 + 1000/ (1+1/10) 2 = 2000

1. When the expected yield increases to Rn, rate of discount increases

Investment Demand Function

Rate of Volume of Marginal

Factors causing a shift in the Marginal Efficiency of Capital/ Investment

Demand for goods and services

Facilities for finance

Future trade expectations

SP= Supply price of new capital asset;

R/ (1+r) = Current value of annuity discounted at rate r.

Supply price of capital asset= $ 3000

Expected Yield (Second year) = $1210

Then, marginal efficiency of capital (r) is calculated as

SP= R1/ (1+r) + R2/ (1+r)2

SP= 1100 + 1100/ (1+1/10) = 1000 + 1000/ (1+1/10) 2 = 2000

1. When the expected yield increases to Rn, rate of discount increases

Investment Demand Function

Rate of Volume of Marginal