Board Notes

Class XII
Microeconomics & Macroeconomics

MONETARY
MACROECONOMICS RATIONAL
NORMATIVE
DISTRIBUTION ANALYSIS GOODS
ECONOMICS SCIENCE APPLIED
MARKET
INFLATION POSITIVE MACROECONOMICS SERVICES
COMPETITION
EFFICIENCY
WORLD COST FISCAL
POLICY
DEMAND

Vidyamandir Classes
Gurukul for IITJEE & Medical Preparation
 Board Notes
Class XII

Microeconomics
S.No.

(a) Introduction [4 Marks] 2

(b) Consumer Equilibrium & Demand [18 Marks] 5
(c) Producer Behavious & Supply [18 Marks] 24
(d) Forms of Market & Price Determination [10 Marks] 55
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(a) Introduction :
Economy, Central Problems and Production Possibility Curve
Economy : An economy is a system that provides people with the means to work and to earn a living in a process of
production.
How do Economic Problem Arise : Human limits are unlimited, resources to satisfy them are limited. These resources
have alternative uses. The problem of choice which arises because of scaricity called economic problem.
Economising of Resources : It means making use of available resources. Scarcity of resources have alternative uses in
relation to unlimited wants which gives rise to an economic problem. Economy has to make a choice among its available
resources.

Central Problems : The central problem is allocation of resources.

(a) What to produce ?
As the resources are limited and wants are unlimited, the economy has to choose what commodity has to produce and
in how much quantity.
The main principle is to allocate resources in such a way that generates maximum aggregate utility.

(b) How to Produce ?

It is concerned with technique of production. A good can be produced either by capital or labour intensive technique.
The principle is the production should be done in such a manner which gives maximum profit and the per unit cost of
production should be least.

(c) Whom to Produce ?

Relating to allocation of resources is of functional distribution. Goods and services are produced for the people who
can purchase them. Purchasing power depends upon distribution of income.

 The principle is to fulfill the urgent wants of each productive factor to the maximum possible extent.

Production Possibility Curve : PPC is defined as a two good economy showing various combinations that can be produced
with available technologies and with given resources which are fully and efficiently used.

Opportunity Cost : Opportunity cost of any commodity is the value of next best alternative i.e. forgone.

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Marginal Opportunity Cost : It is the rate of scarifise to produce a good.

Increasing Marginal opportunity cost: As more and more of a good is produced, factors producing it becomes marginally less
and less productive. Therefore ,more and more of other good has to be scarifised to increase the production of the former
good.

PPC Schedule and Curve :

Features :
(i) If an economy makes full use of its available resources with given technologies, it will be producing on PPC i.e. a, b,
c, d, e, f.
(ii) If the economy produces any combination of goods that lies below the PPC, it is under utilisation of resources i.e. G.
(iii)Economy cannot choose any combination above the PPC with the given resources and technology. This shows the
problem of scarcity.
(iv) Economy’s PPC may shift upward to the right if technological advancement. This will lead to growth i.e. H.
(v) The concativity of PPC is due to law of diminishing returns.

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MC/MOC Schedule and Curve (Same as PPC)

Market Economy : It is a political economic system based on private property and private benefit.

Planned Economy : It is based on government control and social welfare motive.

Positive Economics : It deals with what is or how economic problems facing an economy is actually solved.

Normative Economics : It deals with ought to be or how economic problem should be solved.

Practice Questions :
1. Why is PPC downward slopping ?
2. What is the slope of PPC ?
3. Why is PPC called opportunity cost curve ?
4. Explain the effect on PPC when there is earthquake and floods in the economy ?
5. Explain the effect on PPC if there is massive unemployment in the society ?
6. Give two examples each of underutilisation and growth of resources ?

7. Explain the shape of PPC or frontier.

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(b) Consumer’s Equilibrium : Utility Analysis

Utility : It is the amount of satisfaction which a consumer gets from consumption of a good. The unit of utility is ‘util’.
For example : ‘1 util = 1 Rupee’ assumption, means if a consumer gets 5 utils of satisfaction from consumption of a
good, the utility is taken as Rs.5 worth.

Concepts of Utility :
(a) Marginal Utility : Marginal utility means addition made to total utility by consuming an additional unit of a com-
modity
MUn = TUn – TUn – 1 where n = number of units
n – 1 = value of the previous unit
 in total utility
Also, MU =
Q (no. of units consuming)

(b) Total Utility : Total utility is the total satisfaction a consumers options from a given amount of a particular commodity.
 MU
TU =
(MU1  MU 2  . . .  MU n )

Relationship between total Utility and Marginal Utility :

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Analysis :
(a) If total utility increases at increasing rate, marginal utility rises.
(b) If total utility increases at diminishing rate, marginal utility falls.
(c) When total utility reaches maximum and is constant, marginal utility is zero.
(d) When total utility falls, marginal utility is negative.

Law of Diminishing Marginal Utility :

As more and more units are consumed, the utility derived from successive units goes on declining, it is known as
fundamental psychological law. (Refer previous schedule)

Consumer Equilibrium for a Single Commodity Approach :

It is a situation when consumer spends his given income on purchase of goods in such a way that gives him maximum
satisfaction and he feels no urge to change.
As more and more units are consume the utility derived from successive units goes on declining.

Conditions :
(a) Marginal utility in terms of money is equal to price.
(b) The gain decreases as more of a commodity is consumed after the equilibrium.

To Express the Marginal Utility in terms of Money following Formula is used :

MU p
 MU m (in terms of money)
MU r

where MUp = MU of a product

MUr = MU of a rupee

Numerical Example :
Assume : Price = Rs.2, MUr = Rs.2

 Consumer equilibrium (Gain falls beyond this unit) and hence the consumer equilibrium conditions are satisfied.

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Marginal Utility of a Rupee : It is worth of a rupee to a consumer is terms of other goods.

Consumer Equilibrium for a Two-Commodity Approach :

Consumer attains equilibrium when the ratio of marginal utility of a commodity to its price becomes equal to the
marginal utility of other commodity to its price.

Conditions :
(a) Marginal utulity of last rupee of expenditure on each good is the same. (Law of equi marginal utility)
(b) Marginal utility of a good falls as more of it is consumed (Law of diminishing marginal utility)

MU X MU y
MUm = Price = Cardinal approach : 
Px Py

Where MUX = MU of X Px = Price of X

MUY = MU of Y Py = Price of Y

Px  4
Numerical Example : Assume :  Income = Rs.30
Py  2 

Income = PXQx + PY Qy

Analysis :
Therefore the consumer will obtain equilibrium where he consumers four units of x and seven units of y commodity.

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Consumer Equilibrium : Indifference Curve Analysis :

Consumer’s Budget :
 Budget Line
 Budget Set
Budget Line : A budget line is a graphical representation of the combination of two goods which cost the consumer
exactly his income. It is a narrow concept as it is a concept of budget set.
Equation of Budget Line
 Px Qx + Py Qy = M

Budget Set : It refers to a set of possible combinations of the two goods which the consumers consumes which
he can afford from his income and given prices. It is a broader concept.
Equation of Budget Line
 Px Qx + Py Qy M

where P x = Price of commodity x

Qx = Quantity of commodity x
P y = Price of commodity y
Qy = Quantity of commodity y
M = Income

Note : (a) All bundles of budget set lies below the budget line or on it.

(b) All bundles of budget set lies on budget line.

Px Price of good obtain

(c) Slope of budget = 
Py Price of good sacrified

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Various causes of Shifts of Budget Line :

(a) If income changes :
It income increases the price line will shift If income decreases the price line will shift
rightwards leftwards

(b) If price of X changes

If price of X increases, price line on x-axis shift If price of X falls, price line on x-axis shift
leftrwards rightwards.

(c) If price of y changes

If price of y increases price line on y-axis shift If price of y falls price line on y-axis shift
leftwards rightwards.

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(d) If price of x and price of y increases or (g) If Px increases and Py decreases : Price line
decreases by same percentage - The budget of x -a xis shift leftwards and y-a xi s
line will shift rightwards or leftward or will rightwards respectively.
remain parallel to each other. Price line will
shift leftwards when there is price rise and
will shift rightwards when price falls.

(e) If income and price x and price y changes

by same percentage
No change in Budget and price line.

(f) If Px falls and Py increases : The price line

on x-axis shift rightwards and price line on
y-axis shift leftwards respectively.

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Monotomic References :
It means that a rational consumer always prefer more of a commodity as it offers him a higher level of satisfaction.
For example : A consumer prefer the bundle (2, 3) to (2, 2) (1, 3) (1, 2) and so on.

Indifference Schedule (IC) :

A tabular presentation of different combination of goods that gives the same level of utility to the consumer.

Marginal Rate of Substitution (MRS) :

This is defined as the rate at which the consumer is willing to scarifise a good to obtain one more unit of the other good.

Change in Y (Quantity of good scarifise)

MRS and IC =
Change in X (Quantity of good obtained)

Indifference Curve :
It is a diagramatic presentation of indifference schedule. It shows different combinations of good that gives the same
level of satisfaction to the consumer.
Assumptions :
(a) Consumer buys only two goods (b) Rational consumer
(c) Ordinal utility compressed in terms of ranking (1, 2, 3 . . . . . so on)
Analysis :

(a) A, B, C, D combinations are the locus following indifference curve.

(b) IC is a downward slopping curve is a negatively slopped. As consumption of X increases, the consumption of Y
decreases keeping utility level unchanged.
(c) IC can never touch X or Y axis, because he is consuming only one good.
(d) IC is convex to origin because marginal rate of substitution does on decreasing.

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Indifference Map :
The set of all possible indifference curve, the consumer has is called indifference map.

The features are :

(a) Consumer would like to have more and more of consumption as utility is a increasing function of consumption.
(b) In the given diagram the level of satisfaction is lowest in IC1, then a little higher in IC2 and the highest in IC3.

Indifference Curve According to Consumer Equilibrium :

Conditions :
(a) Where budget line is tangent to indifference curve.
(b) Indifference curve is convex to origin and hence marginal rate of substitution goes on falling.
Equilibrium is attained when the consumer reaches the highest possible indifference curve given his budget constraint.

Features :
1. IC1, IC2, IC3 shows the scale of preferences of consumer between two goods x and y shown by an indifference
map.
2. Points E is the consumer’s budget line tangent to IC2. Therefore, it is a position of consumer equilibrium.
3. If a consumer operates on point F, consumer MRS is less than the price ratio. Therefore, consumer will move
back to point E.
4. Points to the rights of E are desirable but not attainable.
5. Therefore ,consumer can achieve equilibrium when he consumer m units of y and n units of x, that is point E.

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Analysis :
1. Slope of IC is equal to slope of budget line
Px
MRSxy 
Py
What the consumer is willing to buy (IC) is equal what the consumer can buy (budget line)
2. Marginal rate of substitution of two commodities X and Y goes on falling.

Utility Approach :
(i) It is an cardinal concept
i.e. measured in money terms.
(ii) Diminishing marginal utility is applicable i.e. as more and more units a consumer consumes, the marginal
utility goes on falling.
(iii) Diminishing marginal utility is shown by MU curve which is falling throughout.
(iv) Consumer equilibrium condition

MU X MU y
(a) MUm = Price (b) 
PX Py

(v) The approach assumes constant MUm or constant income.

Indifference Approach :
(i) It is an ordinal concept i.e. that can be ranked and not measured.

(ii) Diminishing MRS is observed i.e. as the consumer has more unit of good x, its subjective worth declines. So,
the consumer is willing to give up less units of good y for an additional of good X.
(iii) MRS is the slope of IC which is convex to the origin due to it.

(iv) Consumer equilibrium condition.

P
(a) MRS  X (b) Convexticity of IC
PY

(v) The approach slits price effect into substitution effect and income effect.

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Demand
Meaning : Demand is a willingness of a consumer to purchase a commodity at a particular price and time.
Factors Affecting Demand :
Dx = f (Px , Py , T , y)
where Dx = Demand for a particular good
f = Function of (effected by)
Px = Price of particular good
P y = Price of related good
y = Income of the consumer
T = Taste and preferences

(a) Price of Particular Good : The price of particular good and demand for that particular good are inversely related to
each other i.e. if the price of commodity increases then the demand for that particular good will decrease and
vise-versa.

(b) Price of Related Good : There are two types of related good :
(i) Substitute good (ii) Complementary good

(i) Substitute Goods : These are those goods which are used in place of each other.
For eg. : Tea, Coffee, Pepsi and Coke etc.
If the price of substitute good increases then the demand for particular good increases and vice versa.
(ii) Complementary Good : These are these goods which are used together.
For eg. Tea, Sugar ; Car, Petrol and Ink, Pen.
If the price of complementary good increases then the demand for particular good decreases and vice-versa.

(c) Taste and Preferences : If the taste is favourable then the demand for particular good will increases, if unfavourable
the demand will decreases.

(d) Income of the Consumers : (Money Income)

There are two types of goods : Normal Good (Superior Quality) – If income increases demand for normal good
increases and vice-versa.
Inferior Good (Low Quality) – If income increases the demand for imperior good decreases and vice-versa.

Law of Demand :
“Other things being constant” : Price of a commodity and quantity demanded for that particular good are inversely related
to each other.

Demand Schedule : It is a tabular presentation of various quantity demanded at different prices and at a particular period
of time.

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Demand Curve : It is a graphical representation of demand

schedule showing various quantity demanded at different
prices at a particular period of time :

Assmptions of Demand :
“Other things being constant” means :
(i) Price of related good remain constant (ii) Income of the consumers remain constant
(iii) There is no change in taste and preferences.

Note : The law of demand is based on (utility = price) law of diminishing marginal utility.

Reasons for Demand Curve as Downward Slopping Curve :

(i) Law of Diminishing Marginal Utility : As more and more units, a consumer consumes the marginal utility from
successive units goes on declining. The consumer pays according to the utility. Therefore as the quantity demanded
increases the price falls. For eg. A hungry man is maximum satisfied with the first chapatti as compared to second and
third.

(ii) Price Effect : It is summation of income effect and substitution effect.

Income Effect : It is the change in demand caused due to change in price due to the change in real income.
For eg. If the price increases from Rs.25 to Rs.50 per unit, the demand for that particular good falls from 4 units to
2 units. The purchasing power or the real income has fallen down.

Substitution Effect : It is the substitution of one commodity to another when it becomes relatively cheaper.
For eg : If the price of tea increases the demand for tea decreases because now the coffee is more cheaper and price
of coffee remains constant.

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Factors which affect the demand are called determinants of demand. Determinants of demand are categorised
into two categories :
(i) Price of the commodity itself [Dx = f (Px)]
(ii) Other factors [Dx = f (Py, T, y)]
Change in price of commodity itself affecting the demand is known as movement along the same demand curve
leading to expansion and contraction.
Change in other factors affecting the demand is known as shift in demand curve leading to increase and decrease in
downward.

Important Differences :

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Increase and Decrease in Demand :

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Market Demand : It is defined as the summation of all individual households willingness to purchase commodities at
different prices and at a particular period of time.

Market Demand Schedule : It is a tabular presentation of the quantities purchased by all individual households at
different price and particular period of time.

Market Demand Curve : It is graphical presentation of market demand schedule showing various quantities demanded by
various individuals at different prices and at a particular period of time.

Schedule :
(units)

Factors affecting market demand :

(i) Price of commodity itself
(ii) Price of related goods
Discussed before
(iii) Income of consumer
(iv) Taste and preference
(v) Number of consumers are more, the demand will increase and vice versa.
(vi) Distribution of Income : If it is equal or uneven then the demand for commodity will increase, if inequal then the
demand will decrease
(vii) Age sex compsotion of Population : If the population constitutes more students then the demand for the stationary
items will increase, if more children then the demand for toys will increase.

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Price Elasticity of Demand :

Meaning : It is the degree of responsiveness of change in quantity demanded due to change in price.
(Law of demand : ‘Other things being constant is applicable)

Degree of Elasticity of Demand :

Demand for different commodities respond differently to change in price. It is broadly classified into five categories :
(i) When percentage change in quantity demanded is equal to percentage change in price. The demand for the
commodity is known as unit elastic demand. For eg. comfort goods.

(ii) More than Unit Elastic Demand : (Ed > 1)

When percentage change in quantity demanded is greater than percentage change in price, the demand for the
commodity is known as more than unit elastic demand. For eg. Luxury goods.

(iii) Less than Unit elastic Demand (Ed < 1)

When percentage change in quantity demanded is less than percentage change in price, the demand for the
commodity is known as less than unit elastic demand. Eg: necessary goods

(iv) Perfectly Inelastic Demand (Ed = 0)

When with the change in price, demand does not reponds at all, it is known as perfectly inelastic demand.
Eg., life saving drungs

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(v) Perfectly Elastic Demand (Ed =  (Infinity))

When demand goes on expanding or contracting without any change in price, it is known as perfectly elastic
demand. It is seen in perfect competition situation

Methods of Measuring Elasticity of Demand

(i) Percentage Method : According to this method price elasticity of demand is measured by taking the ratio of
percentage change in quantity demanded to the percentage change in price. As price and quantity demanded are
inversely related, the price elasticity of demand. Therefore Ed is always negative in number. To understand we take
an absolute value only otherwise our Ed will be less than 1
Change in Q.D.
 100
%  in Q.D. Original Q.D.
Ep  
%  in Price Change in P
 100
Original P
Q
 100
Q Q P
  
P P Q
 100
P
(ii) Expenditure Method : It measures the relationship between the expenditure and its effect on elasticity of
demand. It indicates the direction in which the total expenditure on a product changes as a result of change in
price of the commodity there are three cases:

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Factors Affecting Elasticity of Demand :

(i) Availability of Substitutes : If there are many substitutes of a commodity then the demand for that particular good is
elastic in demand. If a commodity has no substitute, then the demand for particular good is inelastic.
(ii) Nature of Commodity : If the commodity is a luxury good, then the demand for a commodity is elastic while as if the
commodity is a necessity, then the demand is inelastic.
(iii) Share in total expenditure : If the share is large of the expenditure undertaken, then the demand for commodity is
elastic. If the share is small of the expenditure, then the demand for commodity is inelastic.
(iv) Habitual Commodity : If the commodity is a habit of the consumer, the demand for the commodity is elastic and
vice-versa.
(v) Time Period : If the time period is short, the demand for commodity is inelastic while if the time period is long, then
the demand for commodity is elastic.
(vi) Price Level : If the commodity is very high leveled or low leveled price then the demand for the commodity is
inelastic.

Concept of Rectangular Hyperbola :

A rectangular hyperbola (Ed = 1 throughout) has a special property that the areas of all rectangles formed on the demand
curve is the same. For eg., At point A, rectangle POQA is equal to point B, the rectangle P0 O Q, B is formed.

(iii) Geometric Method :

It is used when elasticity is to be measured at different points on a straight line demand curve.

Here, AE is a straight line demand curve which is extended both sides touching X and Y axis. Elasticity of demand
at any point is measured by dividing the line segment below the point with the line segment above the point.
line segment below the point
Ep 
line segment above the point
CE
At point C = ,  Ep  1
CA

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DE
At point D = ,  Ep  1
DA
BE
At point B = ,  Ep  1
BA
EE
At point E = ,  Ep  1
EA
AE
At point A = ,  Ep  
AA

PRACTICE QUESTIONS
Consumes Equilibrium and Demand :
1. Explain why does MRS goes on declining as consumer moves along the curve to the right ?
2. Where is consumer equilibrium achieved according to indifference curve analysis ?
3. Why does a consumer buy more at less price or vice versa? / Why is demand curve has a negatively slopped curve ?

4.(a) What is the relation between good x and good y in each case if with the fall in price of X, demand for good y increases
and fall ? Give reason :
(b) In a particular city, the people are employed due to a industry was established. How will it effect the demand for black
and white and coloured television.try Making shifts in demand curve ?
(c) The govt. of India has encouraged the tourism by reducing the airfare to four metro cities. How will it effect the demand
for air travel ?
5. A consumer consumes only two goods. What are the conditions of consumer’s equilibrium in the utility approach ?
Explain the changes that will take place if the consumer is not in equilibrium ?
6. Explain why MRS must equal MRE when a consumer is in equilibrium ?
7. What is the relation between good X and Y in each case, if with the fall in price of X demand for good Y (i) rises (ii)
falls?

8.(a) What is the measure of Ep

– when demand and price change by same %
– when demand falls to zero if price is ?
9. How does the nature of a commodity influence its price elasticity of demand ?

10. The diagram shows PQ is the demand curve of a commodity.

On the basis of this diagram, state whether the following
statements are true or false along with the reasons :
(a) demand at points S is price inelastic
(b) demand at point R is price inelastic
(c) demand at point S is more price elastic than at point R
(d) price elasticity of demand at point S is greater than the
price elasticity of demand at point T

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Numericals :
1. The quantity demanded of a commodity at a price of Rs.8 per unit is 600 units. Its price falls by 25% and quantity
demanded rises by 120 units. Calculate its price elasticity of demand ?
2. A consumer buys 100 units of good at price of Rs.5 per unit. When price changes then he buys 140 units. What is the
new price if Ed is –2 ?
3. As a result of fall in price from Rs.7 to Rs.5, the total expenditure increases from 3500 to 6250. Calculate price
elasticity.
4. Kanav buys Rs.10 unit of good of X at a price of Rs.5 per unit. The price elasticity of demand for this good is 2.
Price falls to Rs.4 unit. How many unit of good X will Kanav now buy at this price ?
5. Price elasticity of demand of a good is –1. 60 units of this good are bought at a price of Rs.8 per unit. At what price will
45 units be bought ?
6. Find out price elasticity of demand ?

7. If value of price elasticity of demand of a commodity is –3, what will be percentage change in demand as a result of 10%
change in price ?
8. 2% fall in price leads to same percentage change in quantity demanded ? If elasticity of demand is 2.5, find the percentage
change in demand ?
9. Complete the table :

10. A consumer wants to consume two good X and Y. The price of X and Y goods are Rs.4 and Rs.5 respectively. The
consumer’s income is Rs.20.
(i) Write down the equation of budget line.
(ii) What is the slope of budget line ?
(iii) How much of good y can she consume if she spends her entire income on that good ?

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(c) Production
Production Functions : It refers to technological relationship between physical inputs and physical output.
Output = f (Input)
Example : Wheat = f (land, labour capital seeds, fertilisers)

Types of Production Function :

Short Run : It is the time period in which the output can be increased only by increasing variable factors, fixed factors
remain constant. The economist have made a law named is ‘Return to a factor’ or law of variable proportion.

Long Run : It is the time period in which all factors of production can change in the same proportion. The economists
have named the law as ‘Returns to scale’.

Total Physical Product (TPP) : It refers to the total volume of goods and services produced by a firm with the given
inputs in a given period of time.

TPP = EMPP, TPP = APP Q

Marginal Physical Product (MPP) : It is an addition to the total production when an additional unit of a variable factor is
employed.

TPP
MPPn = TPPn – TPPn – 1, MPP 
Q
Average Physical Product (APP) : It is the per unit production of a variable factor in a given period of time.

TPP
APP 
Q

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Relationship between TPP, MPP, APP

Schedule :

Production Curve :

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Law of Variable Proportion :

As more and more variable inputs are employed with fixed factors, TPP increases at increasing rate, TPP increases at
diminishing rate, reaches to the maximum and finally falls.
If more and more variable factors are employed with fixed factors, MPP rises, falls, becomes zero and finally negative.

Production Schedule :

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Assumptions :
(i) Technique of production does not change.
(ii) All units of a variable factor are equally efficient.
(iii) Factors of production are not perfect substitutes.
(iv) This process is undertaken in short run.

Ist Phase : Increasing Returns to a Factor : TPP increases at increasing rate, MPP rises. Therefore, when more and more
units of a variable factors is employed with fixed factors i.e. variable factors are less in proportion to fixed factors.
There is underutilisation of resources.

IInd Phase : Diminishing returns to a factor

TPP increases at diminishing rate and reaches to maximum, MPP falls and becomes zero but remains positive. With the
increase in variable factor along with fixed factor i.e. variable factor and fixed factor are in equal proportion. This is
optimum utilisation of resources. A rational firm tries to operate in this phase.

IIIrd Phase : Negative returns to a factor

TPP falls, MPP becomes negative. Therefore with the increase in variable factors along with fixed factors i.e. variable
factors are more in proportion to fixed factors. There is over utilisation of resources. It is an economy absurdity.

Analysis : Law of variable proportion is extention to law of diminishing returns.

Reasons for Increases in Returns to a factor :

(i) Optimum utilisation of factors : The under utilised fixed factors like machines, buildings are better and fully used.
Therefore factor proportions become more suitable for production.

(ii) Specilisation : It results to division of labour which help in getting increasing returns.

(iii) Volume Discounts : It is the discount on price when large quantity is purchased which gives increasing returns to a
factor (producer)

Diminishing Returns to a Factor :

(i) Use beyond Optimum Capacity : After achieving optimum combination of variable and fixed factors efficiency
starts declining when more units of variable factors are employed.

(ii) Scarcity of Resources : It is due to limited resources and unlimited wants which brings diminishing returns.

(iii) Lack of perfect substitutes between factors : Upto a certain limit of factors production can be substituted for one
another but beyond a certain stage, this is not possible. The factors of production becomes imperfect substitutes
leading to diminishing returns.

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PRACTICE QUESTIONS

1. Show with the help of a table that changes in the TPP, MPP and APP as we apply more and more units of a variable
factors on some fixed factors ?

2. What will you say about MPP when TPP is falling ?

3. TPP will increase only when MPP increases. It is true or false ?

4. Explain meaning of increasing return to a factor with the help of TPP schedule and curve ?

5. Explain effects on TPP when all inputs are increased in the same proportion.

6. Explain reasons behind law of variable proportion.

7. (a) How does TPP change with change in MPP of an input ?

(b) What happens to TP when MP becomes negative ?
(c) Describe the stage of a firm’s operation is returns to a variable factor ?

8. Give reason whether the following are true or false :

(i) When there are diminishing returns to a factor, total product always decreases.
(ii) Total product will increase only when marginal product increases.

Numericals :
1. Complete the table assuming that there are increasing returns to a factor :

2. Complete the table :

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3. Identify the different phases of law of variable proportion from the schedule :

4. Calculate TP and MP :

5. Complete the table :

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Producer’s Equilibrium
Meaning : It is position where producer attains maximum profit and has no incentive/urge to increase or decrease the
output.

Two Approaches of Producer Equilibrium :

(i) Total Revenue and Total cost approach (TR and TC)
(ii) Marginal Revenue and Marginal cost approach (MR and MC)

Total Revenue and Total Cost Approach : A producer is in equilibrium at the level of output where the difference
between TR and TC is maximum. The profit falls as more output is produced.

Schedule :

In Perfect Competition :
 Firm is only a price taken and cannot influence the price.
 Price (AR) remains the same at all levels of output.
 TR of the firm is an upward sloping straight line curve increasing at
increasing rate.
 TC curve rises as output increasing initially at a diminishing and
finally at a increasing rate.

Explanation:
Upto ON level of putput the firm is suffering losses as TC curve lies above the TR curve. Point B is the break even point
i.e. no profit no loss (normal profit). Here TR = TC. Beyond ON level of output the firm starts earning profit as TR > TC.
The total profits are maximum at OQ level of output. The vertical difference between TR and TC is maximum i.e. PM.
Beyond this point the difference between TR and TC reduces i.e. profit falls.

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Marginal Revenue and Marginal Cost Approach :

Generally, a firm’s profit maximising condition is MR = MC and MC is rising. But in perfect competion, this condition
is P = MC. As P = AR = MR
Therefore the conditions of profit maximising are :
(i) P = MC (ii) MC should be rising

PP is a price line. MC curve is a smooth curve (all units are

percectly divisible). The firms will maximise the profit at OQ level

of output where P = MC i.e. price line intersects MC curve.

We know that area under price line is TR, Area under MC curve is

TVC and profit = total revenue – total cost

At output OQ At output OQ1 At output OQ2

TR = OPAQ TR = OPAQ1 TR = OPAQ2
TVC = OMAQ TVC = OMOQ1 TVC = OMLQ2
Profit = TR – TVC Profit = TR – TVC Profit = TR – TVC
= PAM = PADM < PAM = PAM – ALA(Loss)
= P < MC (Loss)
Here the firm’s scarifise (Q1 A AQ) is > than savings of the firm (Q1DAQ)

Question : Why does produces does not opt for producing when the MC is falling ?

At point A, MC is decreasing. Therefore it cannot be profit

maximising level of output because of the firm increases its output

beyond OQ0, MC falls and remains below MR or price. Firm can

add to its total profit by expanding output upto Q level of output.

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Rising MC curve is a supply curve :

We know that industry is a particular and firm is a price taker. If the

industry fixes the price higher, than the equilirbium point will

move upwards from E to E. The firm will increase the output i.e.

from OQ to OQ1. Therefore, higher the price more is the quantity

sold (P to P). Hence proved that rising MC curve is a supply curve.

Numerical Based on Approach :

(i) TR and TC Approach :

Analysis : At 3 unit he earns maximum profit because beyond the 3 unit he will incurr losses i.e. profit falls.

(ii) MR and MC Approach :

Analysis : At 4unit the producer will attain maximum profit because price MR = MC, MC is rising.

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Revenue
Meaning : The revenue of a firm is the money receipt that a firm gets from selling its output.
Concept of Revenue :
Total Revenue : It is the total amount of money receipt by the firm from the sale of total output. It is same thing as total
expenditure by the buyers on purchase of the product of the firm. Example : If a firm sells 100 units at the rate Rs.150
per unit then the total revenue is equal to Rs.15000
Total Revenue = Price Quantity Sold

Marginal Revenue : It is the addition to the total revenue from the sale of an additional unit of a commodity.
Example : A firm gets TR of Rs.15000 by selling 100 units and Rs.15500 by selling 101 units then MR is Rs.500.
MRn = TRn – TRn – 1
Average Revenue : It is the per unit revenue of the product sold. AR is something as price because price paid by the
consumer is the per unit revenue of the firm. Example : TR of a firm from sale of 100 units is Rs.15000. Then AR is
TR
Rs.150. Therefore AR = Q

 TR P  Q 
Important  AR    P
 Q Q 
AR is demand curve because it indicates quantity demanded by the buyers at different prices. AR is also known as price
line or price curve.

Relationship Between TR and MR in Imperfect Market Condition :

(When a firm sells more quantity by lowering the prices)

Schedule :

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Relationship Between TR and MR :

(i) TR increases at diminishing rate, MR falls but remains positive.
(ii) TR reaches maximum, MR is zero.
(iii) TR falls, MR becomes negative.

Relationship Between AR and MR [Refer schedule and graph as above]

(i) At first unit AR = MR.
(ii) AR and MR downward sloping curve i.e. a firm can sell more only by lowering the price.
(iii) MR falls twice the rate than AR i.e. MR falls at a faster rate than AR.

Relationship Between TR, MR and AR in Perfect Market Competition :

When a firm sells more quantity at the same price.

Schedule:

(i) TR increases but at a constant rate because price is constant. Graphically, TR curves is upward sloping straight
line curve throughout starting from the origin.
(ii) AR is unchanged as output changes because price remains constant. Graphically, AR curve is parallel to x-axis.
AR (demand curve or price line) is perfectly elastic demand curve (Ed = )
(iii) AR or price is constant. Therefore AR = MR. Graphically, MR is parallel to x-axis.

Relationship Between Price Line And TR

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To prove area under price line is TR :

(i) In perfect competition firm is a price taker and industry is a price maker.
(ii) TR = P Q. If a firm sells 4 units at rate Rs.10 per unit then TR = 40.
(iii) Graphically if the price is OP and PA is the price lines, firm sells OQ units of output. Therefore TR = OP  OQ.
(iv) ARea of a rectangle OQAP i.e. under PL is equal.

Relationship Between AR, MR and TR (General Relationship)

It is the marginals which purchase average up and pulls average down.

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PRACTICE QUESTIONS

1. The MR schedule of a monopoly firm is given below. Derive TR and AR.

2. Complete the table :

3. Complete the table :

4. Complete the table :

5. Explain why MR = MC is the profit maximisation principle of a firm ?

6. What will be the effect on MR when TR increases at decreasing/increasing constant rate ?
7. “A producer will increase his profit by reducing production when his MC is greater than his MR”. Explain.
8. Complete the table :

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9. Explain showing TR, AR and MR of a firm who can sell any quantity at a given price. Take at least five output levels.

10. What change should take place in total revenue so that :

(a) MR is positive
(b) MR is falling

11. Calculate AR, MR and TR from the following :

6 10
7 9
8 8
9 7
10 6

12. Complete the following table :

13. What will be the effect of the following changes in total revenue on marginal revenue ?
(i) TR decreasing rate but increases
(ii) TR increases at a constant rate

14. What change in total revenue will result in :

(i) Decrease in marginal revenue
(ii) An increase in marginal revenue

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Supply
Meaning : It is the quantity offered for sale at a particular price and time by a firm.

Determinants of Supply :
Sx = f (Px, Py, Tech., Ip, Ed)
Whereas Sx = Supply of a particular good
f = function of
Px = Price of a particular good
Py = Price of other good
Tech. = Technology
Ip = Input Price
Ed = Excise Duty

Price of Commodity Itself :

Price of the commodity itself and supply for that particular good are directly related to each other i.e. higher the price
of the good more is the supply of that particular good and vice versa.

Price of other Good :

Price of other good and the supply of the particular good are inversely related to each other. For e.g., If the price of
wheat increases the supply of pulses will fall and vice versa.

Technology :
If the technology is advanced then the cost of production will decline which will increase the supply.
If the technology is backward or outdated then the cost of production will increase which will reduce the supply.

Input Price : Input price means payment made to the factors of production i.e. rent, wages, interest, profit. If the input
price increases, then cost of production increases which will lead to fall in supply.
If the input price falls, cost of production also falls which will increase the supply.

Excise Duty : It is the tarrif tax imposed by the government on a firm on producing a commodity.
If excise duty increases, cost of production increases which will reduce the supply.
If excise duty falls, cost of production also fall which will increase the supply.

Law of Supply : Other things being constant

Price of the commodity itself and supply of that particular good are directly related to each other.

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Schedule : It is a tabular presentation of different quantity supplied at a given price and time.
Price Q.S.
1 10
2 20
3 30

Curve : It is a graphical presentation showing the various quantity supplied at a given and time :

Assumptions : ‘Other things being constant’ means other than price of that commodity itself :
(a) Technology remains constant (b) Price of other good does not change
(c) Input price remains constant (d) Excise duty remains constant

Changes in Supply : Changes in supply means change in supply due to :

(i) Price of commodity itself (ii) Other factors
Change in supply due to price of the commodity itself is known as movement along the same supply curve leading to
expansion and contraction.
Change in supply due to other factors is known as shift in supply curve leading to increase and decrease in supply curve.

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Market Supply :
Meaning : It is defined as the quantity supplied by all the individual firms at a given price and time :

Meaning of Supply Schedule :

It is a tabular presentation of the quantity supplied by all the firms at a given price and time.

Market Supply Curve :

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Determinants of Market Supply :

Sx = f (Px, Py, Tech., Tp, Ed, O, NF, NC, IS )
Where O = Objective
NF = Number of firms
NC = Natural condition
From I to V (Same as supply)

(vi) Objective Firm : The firm takes into consideration the social prestige issue ignoring the profit maximisation
motive.

(vii) Number of Firms : If number of firms are more in number then the supply is more and vice versa.

(viii) Natural Condition : If the natural condition is favourable for the producer then supply is more and vice versa.

(ix) Infrastructure : If the transportation, communication, banking, post and telegraph, availability is the for a
producer then the supply will be more and vice versa.

Price Elasticity of Supply :

It is degree of responsiveness of change in quantity supplied due to change in price. (Application of law of supply)

Degree’s of Elasticity :
(i) Perfectly Inelastic Supply (Es = 0)
When the supply for a commodity does not responds with changes in price. The supply is known as prefectly
inelastic.

(ii) Less than unit elastic supply (Es < 1)

When percentage change in quantity supplied is less than percentage change in price then the supply is less than
unit elastic.

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(iii) Unit Elastic Supply : (Es = 1)

When percentage change in quantity supply is equal to percentage change in price the supply is unit elastic.

(iv) More than unit Elastic Supply : (Es > 1)

When percentage change in quantity supplied is more than percentage change in price.

(v) Perfectly Elastic : (Es = )

When supply goes on expanding and contracting without change in price.

Methods of Measuring Price Elasticity :

(i) Percentage Method (ii) Geometric Method

Percentage Method : Price elasticity of supply is measured by the following formula :

%  in Q.S.

%  in Price

Change in Q.S.
 100
Original Q.S. Q.S. P Q.S. P
    
Change in P Q P  P Q
 100
Original P

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Q.S. P 10 2
Example : Es      1 i.e. unit elastic
P Q 1 20

 Elasticity of supply is positive in number because price and quantity supplied are directly related to each other.

Geometry Method : According to this elasticity of supply is measured at a particular point by the following formula :
Supply curve int ercept on X-axis
Es 
Quantity supplied at point P

There are three cases under this method :

(i) Es > 1 : To calculate elasticity at point P on a supply curve SS. The following formula has to be used.
Es = supply curve intercept on x-axis
Q.s. at point P

Draw a perpendicular intersecting x-axis at point Q. This gives us output OQ supplied at price P.
Extend the supply curve leftward intersecting x-axis at point T which gives us intercept TQ on axis.
TQ
 TQ > OQ
OQ
Es > 1
Analysis : Any straight line supply curve starting from y-axis has price elasticity greater than one on all points.

(ii) Es < 1 :
To measure elasticity of supply at point P, following formula is used.
Supply curve intersect on x -axis
Es 
Q.S. at point P

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Draw a perpendicular intersecting x-axis at point Q. This gives output OQ supplied at price P.
Extend the supply curve leftward intersecting x-axis at point T which gives us intercept TQ on x-axis.
TQ
 TQ < OQ
OQ
Es < 1
Analysis : Any straight line supply curve starting from x-axis has price elasticity less than on all points.

(iii) Es = 1 : To measure elasticity at P following formula is used :

Supply curve intersect on x -axis
Es 
Q.S. at point P

Draw a perpendicular intersecting x-axis at point Q. This gives output OQ supplied at price P.
Extend the supply curve leftward touching the origin at point T gives intercept TQ on x-axis.
TQ
Es   TQ = OQ
OQ
Es = 1
Analysis : Any straight line supply curve starting from the origin has price elasticity equal on all points.

Factors Affecting Price Elasticity of Supply :

(i) Cost of Production : If cost of production increases at decreasing rate, then the supply for the commodity
will be elastic.
If the cost of production increases at increasing rate, then the supply for the commodity will be inelastic.

(ii) Nature of commodity : If the commodity is durable then the supply of commodity will be elastic and if it is
perishable then the supply of commodity will be inelastic.

(iii) If the time period is short then the supply of commodity will be inelastic and if the time period is long then the
supply of the commodity will be elastic.

Market Period : If refers to very short period which means the

producer cannot increase the supply even by increasing the
number of variable factors and therefore it is perfectly
inelastic.

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PRACTICE QUESTIONS

1. Draw supply curve with Es = 0, Es = 1, Es > 1, Es < 1 throughout.

2. Draw supply curves out of which one is elastic and the other is inelastic.
3. Explain the concept of shift and meaning of movement along the same supply cureve.
4. What effect does an increase in input price have on supply curve ?
5. A firm’s supply curve consists of raising portion of its MC. Explain.
6. Show that the rising portion of MC curve is the supply curve of a competitive firm.
7. How is supply of a product-affected by decrease in tax?
8. Why do technological progress and increase in number of firms shift the supply curve to the right ?
9. What will be the effect on the supply curve of stainless steel utensils if a new technique of production has reduced the
marginal cost of producing stainless steel ?
10. If a farmer grows rice and wheat, how will an increase in price of wheat effect the supply curve of rice.
11. How will an increase in number of firms shift the market supply curve ?
12. How is supply of a particular good affected by the decrease in excise duty ?

Numericals :
1. The Eds of a commodity g is half the price elasticity of supply of commodity x. 16% rise in price of x results in a 10%
rise in supply. If price of x falls by 8%, calculate % fall in its supply. (ans: 10%)

2. The price of a commodity is Rs.5 per unit and its quantity supplied is 600 units. If its price rises to Rs.6 per unit,
its quantity supplied rises by 25%. Calculate Eds. (ans: 1.25)

3. At a price of 8 per unit, the quantity supplied of a commodity is 200 units. Its Eds is 1.5. If its price rises to Rs.10 per
unit, calculate its quantity supplied at new price.(ans: 275)

4. There are three firms A, B and C in the market. The supply schedule for the market and that for firms A and B is given
below. Prepare supply schedule for firm C.

5. When price of a good rises by 10%, the supply remains the same what is Es ?(ans: 0)

6. The price of a good falls from Rs.6 to Rs.5. As a result, supply by a firm falls by 600 units. If Es = 2, find the quantity
supplied at Rs.6. (ans: 1800units)

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7. Es of a good is 2. A producer sells 60 units of a good at a price of Rs.6 per unit. At what price will he sell 40 units?
(ans: Rs.5)
8. A seller of onions sells 80 quintals a day when price of onions is Rs.4 per kg. The Es of onions is 2. How much quantity
will this seller supply when the price rises to Rs.5 kg ? (ans: 40)
9. Commodities X and Y have equal 5. The supply of x rises from 400 units to 500 units due to a 20% rise in price.
Calculate the % fall in supply of y if its price falls by 8%. (ans: 10%)
10. At a price of Rs.8 per unit, the quantity supplied of a commodity is 200. Its price Es Rs.1.5. If its price rises to Rs.10
per unit, calculate its quantity supplied at new price. (ans: 275units)

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Cost :
Meaning : It is the money expenditure increased by a firm on account of factor inputs and non-factor inputs.
Economic Cost : The summation of explicit and implicit cost is economic cost.
Emplicit cost = These are money payments which is actually made by firms for hiring the services of factors of produc-
tion.
Implicit cost = These are the cost of self owned and self-employed factors of production by a firm.
Real Cost : If refers to scarifise, discomfort and pain involved in supplying factors of production by their owners.

Short Run Cost :

In short run some factors are variable. For e.g., labour, raw material and the cost incurred on it is known as variable cost
some factors are fixed. For e.g., land, building, cost incurred on it as fixed cost.
Short run constitutes fixed cost and variable cost. There are three types of short run cost :

(i) Total cost (TC) (ii) Average cost (AC) (iii) Marginal cost (MC)
Total Cost : It is the sum of total variable cost and total fixed cost.
TC = TFC + TVC
Total Fixed Cost : It is the cost of production which do not change with the change in level of output. It is also called
indirect cost or supplementary cost. For e.g., Rent of land and factor building, property tax, insurance charges, interest
on debentures.

Schedule : TFC

Total Variable Cost : It is the cost which change directly with the change in level of output. It is also known as direct cost,
prime cost. For e.g., cost incurred on raw material, labour, wear and tear of machines.

Schedule :

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Relationship between TC, TVC, TFC :

(i) At O level of output total fixed cost is equal to TC because TVC is O.
(ii) an increase in TC indicates increase in TVC only because TFC remains
constant.
(iii) TC and TVC curves have similar shape. The two curves remains parallel
to each other.
(iv) The distance between TC and TVC is TFC. Therefore RT = RT 

Schedule :

Average and Average Total Cost : It is the per unit cost of production of a commodity produced.
TC
ATC 
Q

Why ATC Curve U-Shaped : ATC curve is U-shaped because of law of variable proportion.
ATC falls in the beginning as TC increases at diminishing rate and rises as TC increases at increasing rate.

Average Fixed Cost : It is per unit fixed cost of producing a commodity.

TFC
AFC 
Q

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Why AFC downward Sloping Curve :

(i) AFC curve is a rectangle hyperbola shaped curve because fixed cost remains constant.
(ii) AFC cannot touch X or Y axis because fixed cost is constant.

Average Variable Cost : It is per unit variable of producing a commodity.

TVC
AVC 
Q

Why AVC Curve A U-shaped Curve : AVC a u-shaped curve due to law of variable proportion.

In the beginning AVC falls because TVC increases at diminishing rate, finally AVC rises because TVC increases at
increasing rate.
 ATC = AFC + AVC
Also TC = TFC + TVC dividing both sides by Q.

TC TFC TVC
i.e.  
Q Q Q

 ATC = AFC + AVC

Relationship Between ATC, AFC and AVC :

Schedule :

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(i) ATC and AVC are U-shaped curve.

(ii) AFC is a rectangular hyperbola shaped curve.
(iii) As ATC = AFC + AVC. Therefore the gap between ATC and AVC is AFC.
(iv) ATC and AVC narrows down (come closer to each other) because AFC does on declining with the increases in
level of output.
(v) ATC and AVC cannot meet each other because AFC cannot be zero or does not touch x-axis.
ATC = AFC + AVC
20 = 0.2 + 19.8
Marginal Cost : It is the addition to total cost when an additional unit of a commodity is produced in a given period of
time.
MCn = TCn – TCn – 1

or MCn = TVCn – TVCn – 1

ATC
MC 
Q
MC = TCn – TCn – 1 . . . .(i)
As we know TC = TFC + TVC
From (i) MC = (TFCn + TVCn) – (TFCn – 1 + TVCn – 1)

As fixed cost remains constant, MCn=TVCn-TVCn-1

Schedule :

Why MC curve A U-shaped Curve :

MC curve is a U-shaped curve due to law of variable proportion.
MC falls in the beginning as TVC increases at diminishing rate, MC rise because TV increases at increasing rate.

Relationship Between Average and Marginal Cost :

(i) When MC < AC, AC falls.
(ii) When MC = AC, MC is minimum and constant.
(iii) When MC > AC, AC rises.

Analysis : It is marginals which pulls average down and pushes average up.

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MC and AVC :
(i) MC < AVC, AVC falls (ii) MC = AVC, AVC is minimum and constant
(iii) MC > AVC, AVC rises

Analysis : It is the marginals which pulls average up and pushes average up.

PRACTICE QUESTIONS
1. Give reasons :
(a) When MC is less than AC, what happens to AC ?
(b) When AC is falling, what is the relation between MC and AC ?
(c) What happens to AVC, AFC and ATC as output increases ?
2. Why does the difference between average total cost and average variable cost decrease with increase in the level of
output ? Explain.
3. Do AVC curve and ATC curve intersect ? State reasons for your answer.
4. Does a firm get supernormal profit at break even point ? Give reasons in support of your answer.
5. Show the behaviour of AC when AVC per unit of output is constant.
6. Describe the nature of TC at zero level of production.
7. AC is the sum of AFC and AVC. Explain with the help of a schedule.
8. Give the reasons for U-shape of AC curve.

Numericals :
1. Calculate TC and AVC of a firm at each given level of output output.

2. Calculate MC and TC from the folllwing cost schedule of a firm whose total fixed costs are Rs.15.

3. Complete the following table if AFC of one unit of a production is Rs.60.

Find TVC, TFC, AVC, AFC, ATC, MC.

4. A firm is producing 20 units. At this level of output, ATC and AVC are respectively equal to Rs.40 and Rs.37. Find out
TFC of this firm.

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5. Calculate TFC, TVC, AFC, AVC and ATC from the following :

6. Calculate TVC and MC at given level of output :

7. A firm’s average fixed cost, when it produces 2 units is Rs.30. its average total cost schedule is given below. Calculate
its MC and AVC at each level of output

8. Complete the following table :

9. Complete the following table :

10. Calculate MC and AVC at each level of output :

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(d) Main Market Forms :

Market : It refers to the region in which buyers and sellers of a commodity are in close contact to sell and purchase of
a commodity.

Determinants of Market :
(i) No. of buyers and sellers
(ii) Nature of Commodity
(iii) Mobility of goods and factors
(iv) Perfect Knowledge

Perfect Competition : It is a market situation in which buyers and sellers operate freely and a commodity is sold at a
uniform price.
Features :
1. Very large number of buyers and sellers :
 The price of a commodity is determined by aggregate demand and aggregate supply in the whole industry.
Once the price is determined each firm and buyers has to accept it.

Effect/Importance :
 It means that the share of each seller in the
total market supply is so small that no single
seller can influence the price. Therefore, the
firm is said to be price taker.

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2. Homogeneous Product :
 Product sold in the perfect market are homogeneous. That is why they are identical in all respects
i.e. in quality, colour, size, weight, design etc. They are perfect substitute of one another.
Effect : All firms have to charge the same price for the product.

3. Free entry and exist of firms :

New firms induce by large profits can enter the industry whereas losses makes the inefficient firms to leave the
industry.
In case of abnormal profits new firms will be attracted to the industry, this will lead to increases in supply,
leading to fall in price and profit. Therefore the entry process of firms will continue till there are abnormal
profits.
In case of losses some firms quit leading to decrease in supply leading to increase in price. Exit process of firms
will continue till there are no losses.
Effect : Each firm earns just normal profit i.e. minimum profit which is necessary to run the business.
P = LMC = LAC
P = Long run
LMC = Long run marginal cost
LAC = Long run average cost

4. Perfect Knowlwdge :
The buyers and sellers have perfect knowledge which leads to emergence uniformity is price.
5. There is perfect mobility of goods and factors of production (land, labour, rent. . . . .)
6. Absence of transportation cost leads to uniformity in the price of the product.
7. Demand curve (AR) is perfectly elastic (Ed = ).

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Imperfect Competition
Monopoly Market : It is a market situation where there is a single firm selling the commodity and there is no close
substitute of the commodity sold by the monopolist.
Features :
(i) Single Seller of a Commodity : The monopoly firm has has full control over the supply of the commodity. He may be
a individual, a firm or a group of firms or a government itself or a government corporation.
Effect : The monopolist is a price maker.

(ii) Absence of close Substitutes of a Product : The consumer will buy the commodity from the monopolist or go
without it altogether. This is due to the monopolist having a patent right, forming a cartel, government monopoly or
the government corporation permission.

(iii) Difficult entry and exit of firms : The monopolist tries his utmost to block the entry of new firm.
Effect : A monopoly firm earns abnormal profits in the long run.

(iv) Negatively slopped Demand curve : The monopolist is the only seller in the market. Therefore the demand curve
facing is market demand curve. A monopoly firm decides he output in price itself. There is no supply curve.
The monopolist can sell more only by lowering the price makes AR downward sloping.

(v) Price maker with constraint : A monoplist has no competitor. Therefore he can fix the price partially. In monopoly
market as output increases price decreases. As output decreases output increases price decreases. As output decreases
price increases price decreases. As output decreases price increases. In accordance with what consumer are willing
to pay along the demand curve. The demand curve is inelastic because there are no close substitutes. A monopolist
firm can charge any price but it cannot sell any quantity at that price.

(vi) Price Discrimination : A monopolist can charge different price for his product from different persons and different
market areas.
For e.g. electricity charge is different for commercial and residential purpose, a surgean charging prices from rich
and poor.

2. Absence of close Substitutes of a Product :

 The consumer will buy the commodity from the monopolist or go without it altogether. This is due to the
monopolist having a patent right, forming a cartel, government monopoly or the government corporation
permission.
Effect : A monopolist has full control over price and therefore does not face competition.

3. Difficult entry and exit of firms :

 The monopolist tries his utmost to block the entry of new firm.
Effect : A monopoly firm earns abnormal profits in the long run.

4. Negatively Slopped Demand Curve :

 The monopolist is the only seller in the market. Therefore the demand curve facing is market demand curve.
A monopoly firm decides the output in price itself. There is no supply curve. The monopolist can sell more only
by lowering the price which makes AR downward sloping.

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5. Price maker with constraint :

 A monopolist has no competitor. Therefore he can fix the price partially. In monopoly market as output increases
price decreases. As output decreases price increases. In accordance with what consumers are willing to pay along
the demand curve. The demand curve is inelastic because there are no close substitutes. A monopolist firm can
charge any price but it cannot sell any quantity at that price.

6. Price Discrimination : A monopolist can charge different prices for his product from different persons and different
market areas for e.g., electricity charges is different for commercial and residential purpose, a surgean charging
prices from rich and poor.

Monopolistic Market : It refers to a market situation in which there are many firms which sell closely related but
differential products.
Features :
(a) A large number of firms :
 The number of firms selling similar product is large, each supplying a small percentage of total supply of the
product. The firm influence marginally the price of their product due to their brandnames.
For e.g., Among soaps of different brands, pears sells at a comparatively higher price.
Effect : A monopolistic is a price maker.

(b) Product Differentiation :

 There are variants of a given commodity. Each firm sells product which has a unique brand of the same product
which can be differentiated from brands of other firms. The commodity are close substitutes for one another.
Each firm enjoys a monopoly power over the brand of its product.
Effect : A monopolist has some control over price.

(c) Free entry and Exit of Firms :

Theory = same as perfect competition.
Effect: In long run, a monopolistic firm gets normal profit
i.e. MR = LMC (equilibrium condition) and P = LAC (normal profit)

4. Selling Cost :
 These are the expenses which are incurred for promoting sales and persuing customers to buy the commodity of
a particular brand. It is also known as advertisement cost. These are persuasive advertisement whose aim is to
lure away the customers from other brands.

5. Demand Curve :
 AR curve is negatively slopped because the firm can sell more only by lowering the price of its product.
The demand curve is elastic due to availability of close substitutes.

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Oligopoly Market : It refers to market situation in which there are few big firms competing for their homogeneous
and differentiated products. They are interdependent in making decision regarding price and output.
Features :
1. A few firms :
 There are a few firms controlling the market where each firm produces a big part of total output of the industry.
The no. of firms is no small that each firm can incluence the price and provoke the rival firms to react.

2. Homogeneous Product :
 A product may be homogeneous or differentiated like steel, cement and automobilles respectively.

3. Entry of new firms is difficult :

 Due to difficult entry in long run a firm continuous to earn abnormal profits.

4. Price Rigidity :
 The firm generally keep the prices at similar level to avoid price war. There is a fear of competitors reaction.

5. Indeterminate Demand Curve :

 No form can be certain of demand for its product due to unsure reaction of rival firm. They can influence the
market price because of substantial share in output and can sell more only by lowering the price and therefore AR
is downward slopping.

6. Interdependency among Firms :

 There is interdependence of firms in deciding price and output. One firms action affect the other firm action.
The mutual interdependence helps to develop alternatives to price competition to earn abnormal profits.

7. Non Price Competition :

 When there are only few firm they are normally afraid of competing each other by lowering the price war.
Avoiding the price war the firms use other ways of competition like advertising, customer care, free gifts known
as non-price competition.

Short Terms
Perfect Oligopoly :
If the firms producing homogeneous products.
Example : Cement, Steel Industry

Imperfect Oligopoly :
If the firms produce differentiated products.
Example : Automobiles

Non-Collusive Oligopoly :
If the firm competing with each other.

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Price Determination Under Perfect Competition

Market Equilibrium : It is defined as equality between quantity demanded and quantity supplied.
Equilibrium Price : It is the price at which quantity demands is equal to quantity supplied.
Equilibrium Quantity : It is the quantity at which quantity demanded is equal to quantity supplied.
In a competitive market price is determined by interaction of market forces of demand and supply in the industry.

The market equilibrium is achieved at OP price and OQ quantity. If the price is OP1 i.e. above the market equilibrium then
quantity supplied is greater than QD.
OS1 > OD1
This creates excess supply equal to AB or D1S1. There is a competition among sellers. The sellers will reduce the price
which will increase the demand and reduce the supply leading to downward movement along the same demand and supply
curve. The price will finally settle when there is no excess supply.
If the price is OP0 i.e. below market equilibrium quantity demanded is greater than quantity supplied.
OD2 > OS2
There will be excess demand equal to CD or S2D2. There is competition among the buyers. The price will increase which
will decrease the demand and increase the supply. It will lead to upward movement along the same demand and supply
curve. The price will finally settles when there is no excess demand.
Analysis : The situation of zero excess demand and zero excess supply defines market equilibrium i.e. point E. The price
‘P’ is equilibrium price. The quantity ‘Q’ is equilibrium quantity.

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Effect of Shift in Demand and Supply on Equilibrium Price and Quantity :

1. When demand curve shifts rightward/when income increases for normal good/price of substitute good increases/
income decreases for inferior good/decrease of complementary good

At point E there is zero excess demand and zero excess supply. If the demand curve shifts rightward there creates a
excess demand i.e. EA. Excess demand will lead to rise in price. Rise in price will lead to increase in quantity
supplied. There is an upward movement along the same supply curve.

Analysis : Therefore with the rightward shift in the demand curve which will lead to increase in equilibrium price and
increase in equilibrium quantity.

2. When demand curve shift leftwards/income decreases for normal good/price rise for complementary good/income
increases for inferior goods/price decrease for substitute good.

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At point E there is zero excess demand and zero excess supply. If the demand curve shifts leftwards there creates a
excess supply i.e. EA. Excess supply will lead to fall in price. Fall in price will lead to decrease inquantity supplied.
There is a downward movement along the same supply curve.

Analysis : Therefore a leftward shift in the demand curve will lead to decrease in equilibrium price and decrease in
equilibrium quantity.

3. If tech. is upgraded, excise duty reduces, input price reduces, by reduces/supply shifts rightward.

At point E there is zero excess demand and zero excess supply. If supply curve shifts rightward then there creates
excess supply i.e. EA. It will lead to fall in price. Fall in price leads to increase in quantity demanded (not increase in
demand). It leads to downward movement along the same demand curve.

Analysis : A rightward shifts in supply curve will lead to fall in equilibrium price and increase in equilibrium quantity.

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4. Supply curve shifts leftward/and all other courses

At point E there is zero excess demand and zero excess supply. If supply curve shifts leftward then there creates a
problem of excess demand i.e. EA. It will lead to rise in price. Rise in price will lead to fall in quantity demanded (not
fall in downward). It will lead to upward movement along the same demand curve.

Analysis : A leftward shift in supply curve will lead to increase in equilibrium price and decrease in equilibrium
quantity.

Note : (a) With the increase in demand the equilibrium price and quantity increase, with the decrease in demand equilibrium
price and quantity decrease in price and quantity behaves directly with the change in demand.
(b) If supply increases equilibrium price falls but equilibrium quantity increases. If supply decreases equilibrium price
increase, equilibrium quantity falls i.e. with the change in supply equilibrium price behaves inversely while quantity
behaves directly.

Simultaneous Shifts in Demand and Supply

1. Effect on equilibrium price and quantity if both demand and supply increases. There are three possibilities :
(a) If demand increases equal to increase in supply then there will be no change in equilibrium price but equilibrium
quantity will increase.

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(b) If increase in demand is greater than increase in supply then the equilibrium price will rise and quantity will also rise.

(c) If demand increases lesser than increase in supply then equilibrium price will fall and equilibrium quantity will
increase.

2. Effect on equilibrium price if both demand and supply decreases. There are three possibilities :
(a) If demand decreases equal to decrease in supply then there will be no effect on equilibrium price and equilibrium
quantity will decrease.

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(b) If demand decreases greater than decrease in supply then the equilibrium price will fall and quantity will decrease.

(c) If demand decreases lesser than decrease in supply then the equilibrium price will rise and equilibrium quantity will
decrease.

3. If demand increases and supply decreases - effect on equilibrium price.

If demand increases and supply decreases equilibrium price willrise and quantity is indefinite.

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4. If supply increases and demand decreases.

If supply decreases and demand decreases the equilibrium price will fall and quantity is indefinite.

5. Effect on the equilibrium price and quantity :

(a) If demand curve is perfectly elastic and supply curve shifts out and in.
 If demand curve is perfectly elastic and supply curve shifts out (rightward) then the equilibrium price does not
change but equilibrium quantity increases.
If demand curve is perfectly elastic and supply curve shifts in (leftward) then the equilibrium price does not
change in but equilibrium quantity decreases.

(b) If demand curve is perfectly inelastic and supply curve shifts in and out.
 If demand curve is perfectly inelastic and supply shifts out (rightward) then the equilibrium quantity does not
change but equilibrium price decreases.
If demand curve is perfectly inelastic and supply shifts in (leftward) then equilibrium quantity does not change
but equilibrium price will increase.

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(c) If supply curve is perfectly elastic and demand curve shifts out and in.

 If supply curve is perfectly elastic and demand

curve shifts out (rightward) then equilibrium price
does not change and quantity increases.

If supply curve is perfectly elastic and demand

curve shifts in (leftward) then equilibrium price

does not change and quantity decreases.

(d) If supply curve is perfectly inelastic and demand curve shifts in and out.
 If supply curve is perfectly inelastic and demand curve shifts out (rightward) then equilibrium quantity does not
change and price increases.
If supply curve is perfectly inelastic and demand curve shifts in (leftward) then equilibrium quantity does not
change, price decreases.

Price Mechanism : It is a mechanism in which price is determined by the forces of demand and supply.
Merits : It is a self adjusting and self-correcting mechanism.

Demerits :
(a) It lacks social welfare as producer produces luxury goods whereas the poor was unable to get necessities of life.
(b) It does not change or bring about equal distribution of income.
(c) It favours large producers and the small producers are unable to complete them.

Types of Intervene :
(a) Indirect Intervention  Taxes and Subsidies
(b) Direct Intervention  Support and control price

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 Board Notes
Class XII

Macroeconomics
S.No.

(a) National Income & Related Aggregates [15 Marks] 70

(b) Money & Banking [8 Marks] 102
(c) Government Budget & Economy [8 Marks] 107
(d) Balance of Payments [7 Marks] 112
(e) Determination of Income & Employment [12 Marks] 132
- 1 Mark Questions of Micro & Macro-Economics
 Vidyamandir Classes Macro-Economics

(a) National Income

Important Terms :
(i) Private Income : It is the total of factor incomes and transfer incomes received from all sources by private sector
within and outside the country.
P.I. = IAPS + Net current transfers from rest of world + Net current transfer from govt. + Interest on public dept + NFIA.

(ii) Personal Income : It is the sum of earned income and transfer income received by households from all sources
within and outside the country. It shows the purchasing power of the households.
P.I = P.I – Corporate Tax – Undistributed Profit of Private sector

(iii) Personal Disposable Income : It is that part of personal income which is avaibale to the households for disposal.
P.D.I. = Personal Income – Direct Taxes – Misc Exp. of govt. administrative department.

(iv) National Disposable Income : It is the sum of earned and unearned incomes received by the residents of a
country.
NDI = National Product + Net Current Transfers from rest of the world

or
= C + S.

(v)

(vi)

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Closed Economy : It is the one which does not have economic relations with rest of the world. There are no experts/
imports of goods and services.

Open Economy : An open economy is the one which has economic relations with rest of the world. It exports goods and
services to rest of the world

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Real National Income and Nominal National Income : National Income at current prices also known as Nominal
income. When the goods and services produced in an year are valued at market prices prevailing in the year of their
production.
National Income at constant prices also known as Real National Income. When goods and services produced in
a year are valued at fixed prices i.e. value of base year.

GNP Deflater : It is used to measure the average level of prices of all goods and services that makes up GNP deflater.
P1  Nominal GNP 
GNP deflater   100   100 
P0  Real GNP 

Factors affecting nominal national income :

(i) Changes in Price (ii) Changes in Quantity / Physical Output

Real National Income :

Changes in quantity is effected by only factor as price remains constant.

Advantages of Real National Income :

(i) It truely reflects the real change in physical output.
(ii) RNI helps to make a year to year comparison of changes in volume of output of goods and services.
(iii) It is helpful in making international comparison of economic performance of different countries.

Green GNP : It is defined as GNP which should help to attain a sustainable use of natural environment and equitable
distribution of benefits of development.
Question :
1. GDP is considered as an index of welfare of the people.
Do you agree with the statement. Explain :
Ans : No, welfare includes economic and non-economic welfare but GDP only takes economic welfare :
(a) Distribution of GDP : An increase in GDP may not lead to increase in total welfare. If its distribution results in
concentration of income in hands of very few industrialists.
(b) Non-Monitary Transactions : The non-market/monitary transactions like services of housewife, leisure time activities
etc. Is not taken in calculating GDP.
(c) Externalities : Negative externalities occur such as smoke of factory pollutes the air, industrial waste occurs air
pollution etc. should not be included in GDP.
(d) Rate of Population Growth : It is the rate of population growth which is higher then the rate of growth of real GDP.

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1. Meaning of National Income

“National income is the sum of factor incomes earned by normal residents or a country in the form of rent, interest and profit
in an accounting year.

2. National Income at Current Prices and Constant Prices : (Nominal NI and Real NI)
National income can be measured in terms of money in two ways––at current prices and at constant prices.
(a) National inocme at current prices : If goods and services produced in a year are valued at current prices,
i.e. prices prevailing in that particular year, we get national income at current prices. Current price refer to the prices
prevailing in the year in which goods and services are produced. For example, when goods and services produced
during the year 2009-2010 are valued in prices of the same year, i.e., 2009-2010, it will be called national income at current
prices for the year 2009-2010.

(b) National Income at Constant Prices : If goods and services produced in a year are valued at fixed prices,
i.e., prices of the base year, we get national income at constant prices. Constant prices refer to the prices prevailing in
the base year. A base year is a carefully chosen year which is a normal year free from price fluctuations. (In India now
2004-2005 is treated as base year.) For instance, if goods and services produced during the year 2008-2009 are valued
at the prices of the base year (i.e., 2004-2005), it will be called national income at constant prices for the year 2008-2009.
(c) Significance of Difference betweeen Current prices and Constant Prices :
(i) National income at current prices is affected by two factors, namely, (a) change in prices and (b) change in physical
output (amount of goods and services produced). For example, in 1979-80, India’s national income at current prices
increased by 9.1% but at constant prices decreased by 5.2%.

Advance of Real National Income/GNP

(ii) National income measured at constant prices truly reflects the real change in physical output of a country whereas
national income at current prices does not. It is useful in finding out the real development capacity of the economy.
(iii) Real national income (or for that matter GNP) enables us to make a year to year comparison of changes in the
volume of output of goods and services.
(iv) Real national income is also helpful in making international comparisons of economic performance of different
countries.

3. Basic Activities––Production, Consumption, Capital Formation

(a) Production : Production is generally defined as an activity which produces material goods and services or which
increases the value of commodities already produced. For instance, doctors, teachers, accountants, managers, judges,
electricians etc.
(b) Consumption : “The process of using up of goods and services for direct satisfaction of individual or human wants”
is called consumption. Exception since a house continues to produce housing services almost throughout life of its
owner.

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(c) Capital Formation (Investment) : “Capital formation is the net addition to the capital stock of an economy during a given
period. Increase in production leads to increase in consumption or capital formation or both. If whole of production is
consumed, there will be no capital formation and production, capacity will start decreasing.

4. Final Goods and Intermediate Goods

(i) Final goods : All goods which are meant either (a) for consumption by consumers or (b) for investment by firms are
called final goods. They are meant for final use and the final use of a product is only for consumption for investment.
(ii) Intermediate goods : All goods which are used (a) as row material for further production of other goods or (b) for resale
in the same year are known as intermediate goods.

5. Consumption goods and Capital Goods :

(i) Goods which are consumed by the ultimate consumers or which meet the immediate needs of consumers directly are
called consumption (or consumer) goods. For example, food, shirt, shoes, cigarettes, pen, TV set, radio etc. are all
consumer goods because when used, they satisfy immediate needs of the consumers.
Durable goods and those which can be used in consumption again and again over a considerable period of time,
e.g., chair, car, fridge, shoes, TV set. Non-durable goods are like single use goods which are used up by consumers in
a single act of consumption, e.g., milk, fruits, matches, cigarettes, coal, etc.

(ii) Capital goods : Goods which are bought for producing other goods but not for meeting immediate needs of the
consumer are called capital goods. In fact, all goods that are produced for use in future for productive processes are
called capital goods. E.g., tools, implements, machinery, plants, tractors, buildings, transformers, etc. Such goods are
used for generating income by production units.

6. Domestic (Economic) Territory of a Country : “Economic territory is the geographical territory administered by a
government within which persons, goods and capital circulate freely.”
What domestic (economic) territory includes :
(i) Territory lying within the political frontiers of a country. It includes territorial waters also.
(ii) Ships and aircrafts owned and operated by the residents between two or more countries. For instance, Indian ships
moving between UK and Pakistan regularly or passangers planes operated by Air India between Russia and Japan are
parts of domestic territory of India.
(iii) Fishing vessels, oil and natural gas rigs and floating platforms operated by the residents of a country in the internal
waters or engaged in extraction in areas where the country has exclusive rights of operation. For example, fishing boats
operated by Indian fishermen in the internal waters of the Indian Ocean will be considered as a part of domestic territory
of India.
(iv) Embassies, consulates and military establishments of the country located abroad. To illustrate, Indian embassies in
Russia, America and other countries will form parts of domestic territory of India. Similarly, embassies of other countries
like Japan, Russia, America in India are parts of domestic territories of their own countries and not of India.
What domestic territory does not include :
(i) Territorial enclaves (like embassies) used/administered by foreign governments.
(ii) International organisations which are physically located within goegraphical boundaries of a country. Their offices
form part of international territory.

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7. Resident (Normal Resident) of a Country : National income has also been defined as “Sum total of factor incomes earned by
the normal residents of a country during a year.”
A resident is said to be a person (or institution) who ordinarily resides in a country and whose centre of economic interest
lies in that country. He is called a normal resident since he normally lives in the country of his economic interest. The period
of stay should be at least one year or more. Following points need to be noted.
(i) Normal residents cover both individuals and institutions.
(ii) Normal residents include both citizens and non-citizens, i.e., foreigners who reside in a country for more than a year and
have economic interest in that country.
(iii) International bodies like World Bank, World Health Organisation or International Monetary Fund are not considered
residents of the country in which these organisations operate but are treated as residents of international territory.
However, the staff of these bodies are treated as normal residents of the country in which the international body
operates. For example, international body like World Health Organisation located in India is not normal resident of India
but Americans working in its office for more than a year will be treated as normal residents of India.
(iv) Local employees working in fogiren embassies located in their country are treated as normal resident s.
For example, Indians working in US embassy located in India are residents of India.
(v) Workers from across the border who cross border in the morning to work in the other country (like Indians who work
in Nepal) and return in the evening are not residents of the country where they work.
For example, normal residents of India include (i) Citizens (and institutions) of India, (ii) Citizens of other countries (i.e., non-
citizens) who normally reside in India for more than a year and whose centre of economic interest lies in India. (iii) Citnzens
of India working in (a) international bodies like I.M.F., (b) foreign bodies like banks, enterprises operating in India and (c)
foreign empassies located in India.
8. Investment (gross and net) : Investment means addition to the stock of capital goods such as buildings, equipment or
inventory that adds to the future productive capacity of the economy.
Gross Investment : That part of total final output which comprises capital goods constitutes gross investment of an
economy. It is addition to the capital which also includes replacement cost for the wear and tear that capital stock undergoes
over a period of fime. When investment is expressed as gross investment. It includes depreciation.
Depreciation : Depreciation or fall in value due to normal wear and tear is called consumption of fixed capital.
Net Investment : By deducting depreciation from gross investment, we get net investment. Symbolically:
Net investment = Gross investment – Depreciation
Note- The new addition to the capital stock in the econmy is measured by net investment (and not by gross investment).

12. Per Capita Income : Per capita is the average per capita national income. It is income per head of population.
National Income
Per Capita Income =
Mid  year Population

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13. Production for Sel-consumption and for Exchange :

(a) Production for self Consumption :
(i) Meaning : Production is for self-consumption if the producers themselves consume the entire output they
produce.
Barter system of exchange is one in which a commodity is exchange for any other commodity. Like goods, services are
also produced for self-consumption, e.g., a teacher teaching his son, a burse bringing up her can child.
(ii) A subsistence production unit is one which is able to produce that much which is just sufficient to meet his family
needs. It is called so because its production is just sufficient for subsistence or just adequate to meet the consumption
needs of the producer. An economy which is dominated by subsistence production units, is called a subsistence
economy. Should production for self-consumption be included in national income because its market value is not
know? Yes, its imputed value should be included because it is presumed that the producer, instead of selling in the
market, has sold his product to himself.

Factors of Production :

(i) Land : It refers to all natural resources which are free gifts of nature. Land, therefore, includes all gifts of nature available
to mankind––both on the surface and under the surface e.g., soil rivers, waters, forests, mountains, mines, deserts,
seas, climate, rains, air, sun, etc.
(ii) Labour : Human efforts done with the aim of earning income is known as labour. Thus, labour is a physical or mental
effort of human being in the process of production. The compensation given to labourers in return for their productive
work is called wages (or compensation of employees).
(iii) Capital : All man-made goods which are used for further production of wealth, are included in capital. Thus, it is man-
made material source of production. Alternatively, as capital. It is the produced means of production. Examples are ––
machines, trucks, factories, etc. An increase in the capital of the economy means an increase in the productive capacity
of the economy. Logically and chronologically, capital is derived from land and labour and has, therefore, been named
as stored-up labour.

(iv) Entrepreneur : An entrepreneur is a person who organises the other factors and undertakes the risks and uncertainities
involved in the production. He hires the other three factors,organises and coordinates them so as to earn be called an
entrepreneur. An entrepreneur acts as a boss and decides how the business shall run. He decides in proportion factors
should be combined. What and where he will produce and by what method.. Thus, entrepreneurship is a trait or quality
owned by the entrepreneur.
Some economists are of the opinion that basically there are only two factors of production––land and labour. Capital,
they say, is appropriated from gifts of nature by human primary and entrepreneur is only a special variety of labour.

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Land and labour are, therefore, primary factors whereas capital and entrepreneur are secondary factors.
The following statements further clarify it.
Net product = Gross Product – Depreciation
Net value added = Gross value added – Depreciation
Net domestic capital formation= Gross domestic capital formation – Depreciation
Capital Loss : Fall in value of fixed capital due to natural calamities (like earthquakes, floods, fires) and unforeseen
factors like war, thefts, etc. is called capital loss (and not depreciation). Provision of funds made by an enterprise for
replacement of worn out fixed capital over its expected life is called Depreciation Provision. Funds thus accumulated
over lifetime of the asset are used to replace the worn out assets with a new asset.

14. Factor Cost vs Market Price : (or Net Indirect Taxes)

Money value of final goods and services can be estimated in two ways––at Factor Cost (FC) and at Market Price (MP).
Briefly, the difference between FC and MP is ‘net indirect tax’. And net indirect tax is the difference between indirect tax and
subsidy.
(i) Factor cost refers to all factor payments made by the producing unit (firm) to the factors of production for rendering
productive services in the production of goods and services. It is called factor cost because it is cost to the producer
(firm) who pays to factors in the form of rent, wages, interest, etc.
(ii) Market price is the price at which a commodity is sold and purchased in the market. It is the price what the buyers pay
actually, not what the producers actually get. The point to be noted is that when a product goes to the market for sale,
government levies indirect taxes (like sales tax, excise duty, etc.) which is added to the factor cost of the commodity.
Consequently, market price becomes higher than factor cost. Similarly, sometimes government gives subsidy on sale of
cert ain goods (l ike sugar, r ice, kerosen e oil) which is subtract ed from fact or cost. As a result,
MP becomes lower than Factor Cost (FC). The difference between indirect tax and subsidy is known as net indirect as
net indirect tax as explained below:
(a) Indirect taxes : Taxes which are levied by the government on production and sale of commodities are called indirect
taxes. e.g., excise duty, sales tax, customs duty octrol, etc. These are called indirect taxes because buyer of a taxed
commodity pays the tax indirectly which in fact is included in the price. Leaving aside the aims of the government
in levying indirect taxes, we study here the effect of an indirect tax on the price of a commodity on which tax is
levied.
(b) These are cash grants given by the government to the enterprises to encourage production of certain commodities
or to promote exports or to sell goods at prices lower than the free market prices. Subsidies are opposite of indirect
taxes.

Significance of Net Indirect Taxes : (To differentiate between MP and FC) : Net Indirect Tax is the difference between the
indirect tax and subsidy. To find out Market Prices (MP), indirect taxes are added and subsidies are subtracted from Factor
Cost (FC) as explained above. Symbolically :
Market Price = Factor Cost + Indirect taxes – Subsidies
= Factor Cost + Net indirect taxes
In short, MP includes net indirect tax whereas FC does not. Thus, FC becomes MP when net indirect taxes are added to FC.
In the absence of indirect taxes and subsidies. MP and FC are the same.

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NFIA = Factor income earned from abroad by residents – Factor income of non-residents in domestic territory

Components of net factor income from abroad : Following are its three main components:
(i) Net compensation of employees.
(ii) Net income from property and entrepreneurship (rent, interest, profit).
(iii) Net retained earning of resident companies abroad.
Net factor income from abroad = Net compensation of employees + Net income from property and entrepreneurship
+ Net retained earnings of resident companies abroad.

15. Value of Output vs Value Added

(i) Value of output : The goods and services produced by on enterprise during an accounting year constitute its output.
(Output is also called gross output because output includes depreciation).Value of output is the market value of all the
goods and services produced by an enterprise during an accounting year. (Mind, value of output means value of gross
output at MP unless stated otherwise). Money value of output of an enterprise is obtained by multiplying its physical
output of goods and services with its market price. Thus, it is equal to the quantity of output produced multiplied by
its market price per unit. Since output is evaluated at the prices prevailing in the market, therefore, it is called value of
output at market price. For example, if a shoe making enterprise produces 1,000 pairs of shoes annually and sells them
@ ` 175 per pair, the value of its output will be ` 1,75,000 (= 1.000 175). Symbolically:
Value of Output = Quantity of output  Price
Alternatively, value of output can be expressed as sum of sales and change in stock because output is either sold or
accumulated as unsold stock. Symbolically:
Value of Output = Sales + Change in stock
(ii) Value added : It refers to the addition of value to the raw material (intermediate goods) by a firm by virtue of its
productive activities.
Value added = Value of output – Intermediate consumption
(iii) Distinction between Value of output and value added : The difference between value of output and value added is
intermediate consumption which is included in value of output but excluded from value added. Intermediate
consumption means expenditure incurred on secondary inputs like raw material, power, etc. by a producing unit.
Following steps are taken to derive net value added at FC from value of output.
Value of output = Output x market Price (It is always at MP)

= Sales + Change in stock

Gross value added at MP = Value of output – Intermediate consumption
Net value added at MP = Gross value added at MP – Depreciation
Net value added at FC = Net value added at MP – Net indirect taxes

(Net value added at FC = Sum of factor incomes)

In short, by substracting intermediate consumption, depreciation and net indirect taxes from value of output, we get
NVA at FC.

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16. Factor Payments vs Transfer Payments : (or Factor Income vs Transfer Income)
(i) Factor Payment : Payment made to a factor of production in return for rendering productive (or factor) service is called
factor payment (or factor income). Examples are rent, wages, interest and profit. Income of land is rent,
of labour wages, of capital interest and of enterprise is profit.
(ii) Transfer Payment : Payment received without any good or service provided in return is called transfer payment
(or transfer income). Transfer income is a receipt concept as compared to factor income which is an earning concept.
Such payments for which no productive services are rendered are known as transfer payments.

Income Method
1. Income Method, Steps and Precautions :“Net domestic income is the income generated in the form of wages, rent, interest
and profit in the domestic territory of a country by all producers (normal residents and non-residents) in an accounting
year.”
(a) Method : The Income Method measures national income from the side of payments made to the primary factors of
production in the form of rent, wages, interest and profit for their productive services in an accounting year.
(i) Identify enterprises which employ factors of production (land, labour, capital and enterprise).
(ii) Classify factor payments into various categories like rent, wages, interest, profit and mixed income (or classify
factor payments into compensation of employees, mixed income and operating surplus).
(iii) Estimate amount of factor payments made by each enterprise.
(iv) Sum up all factor payments made within domestic territory to get Domestic Income (NDP at FC).
(v) Estimate net factor income from abroad which is added to Domestic Income to derive National Income.

2. Domestic Income and its Components:

(a) Meaning : Domestic income is the sum total of factor incomes generated by all the production units located within the
domestic territory of a country during a period of account.
(i) Wages and salaries paid both in cash and kind and (ii) Employer’s contribution to social security schemes.
Remuneration in cash includes wages and salaries, dearness allowance, bonus, city compensatory allowance, house
rent allowance, leave travelling allowance, etc., whereas in kind (i.e., in the form of goods and services) it includes rent-
free quarter, free water and electricity, free uniform, free services of vehicles (car, scooter), amount of interest on
interest-free loans, etc. Employer’s contribution to social security schemes consists of contribution to life insurance,
casually insurance, provident fund, pension schemes, etc. Mind, old-age pension is a transfer payments but retirement
pension is a part of compensation of employees.

Note : Compensation to injured worker, employer’s contribution to social security schemes, TA relating to business
promotion, amount of loan, etc. not included in compensation of employees.

Royalty, is amount a receivable by a landlord for granting leasing rights of sub-soil assets (deposits of coal, iron,
natural gas, etc.) and for use of patents, copyrights, etc., is also included in the rent.

3. Interest : Interest is the price for the funds borrowed. It is the amount that the debtor becomes liable to pay to the creditor
over a given period of time.

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Product accruing to product accruing to private sector

public sector = Income from property and entrepreneurship accruing to govt. administrative
departments + Savings of non-departmental enterprises.

Nationanl disposable income = NNP at MP + Net current transfers from rest of the world
= National income + net indirect taxes + net current transfer
from rest of the world
Gross NDI = GNP at MP + Net current transfers from ROW
Net NDI = NNP at MP + Net current transfers from ROW
= Gross NDI – Depreciation
Expenditure Method :
(a) Method : Expenditure measures final expenditure on ‘Gross Domestic Product at market price (GDP at MP)’ during a
period of account. Since all domestically produced goods and services are purchased for final use either by consumers
for consumption or by producers for investment, therefore, we take sum of final expenditure on consumption and
investment. This sum equals GDP at MP. Final expenditure is the expenditure made on purchase of domestically
produced goods and services for final use, i.e., for consumption and investment. By adding up all the items of final
consumption expenditure and final investment expenditure within the domestic economy, we get the aggregate called
GDP at MP. By subtracting depreciation and net indirect taxes from GDP at MP and adding to it net factor income from
abroad, we get NNP at FC or national income. Thus, under expenditure method, national income is measured at the
point of actual expenditure.
Mind, income generated by factors of production in the production process is spent by them on final goods.
Final use of a commodity is either for consumption or for investment and expenditure on them is called Final
Consumption Expenditure and Final Investment Expenditure, respectively. By adding up all the items of final
consumption expenditure and final investment expenditure within the domestic economy, we get the aggregate called
GDP at MP.
(b) Steps Involved : Expenditure method involves the following steps:
(i) Identification of economic units incurring final expenditure, e.g., household (or consuming) sector, firm
(or producing) sector and government sector.
(ii) Classification of final aggregate expenditure into following components:
1. Private final consumption expenditure.
2. Government final consumption expenditure.
3. Gross fixed capital formation.
4. Change in stocks.
5. Net exports.

(iii) Measurement of final expenditure on the above components. Sum total of the above five items gives us the value
of GDP at MP. By deducting depreciation and net indirect taxes from GDP at MP, we get NDP at FC.
(iv) Estimation of net factor income from abroad which is added to NDP at FC (Domestic Income) to obtain NNP at FC
(National Income).

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(c) Precautions : The following precautions need to be taken for correct estimation of national income by expenditure
method. Alternatively, following items of expenditure should not be included.
(i) To avoid double counting, expenditure on all intermediate goods and service is excluded. For example, purchase of
vegetables by a restaurant, expenses on electricity by a factory, etc., are not included as they are for intermediate
consumption.
(ii) Government expenditure on all transfer payments such as scholarships, unemployment allowance, old-age
pension, etc. is excluded because no productive service is rendered by the recipients in exchange.
(iii) Expenditure on purchase of secondhand goods is excluded from national income because this type of expenditure
is not on currently produced goods.
(iv) Expenditure on purchase of old shares/bonds or new shares/bonds, etc. is excluded because it is not payment for
goods or services currently produced. It shows mere transfer of property from one person to another. Likewise,
gifts from abroad which bring transfer payment are not included.
(v) Imputed expenditure on own account output (e.g., owner occupying his house, self-consumed output by a farmer)
should be included.

Circular Flow of Income :

Circular flow of Income leads to comsumption and consumption inturn induces more production. The process goes on and
is called circular flow of income.
The circular flow of income and product is based on four basic principles :
(i) Total production of goods and services by producing sector = Total consumption of goods and services by household
sector.
(ii) Consumption expenditure of households sector = Income of the household sector.
(iii) Factor payment by producing sector = Factor income of household sector.
(iv) Flow of goods and services = Flow of money.

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Product Market : It is a market where goods and services are sold and purchased.
Factor Market : It is a market where factor of production are sold and purchased.

Circular flow of Income has two flows :

(i) Real flow :
There is a flow of goods and services from purchasing sector to household sector and inturn flow of factor
services from household to producing sector.

(ii) Money flow :

There is a flow of goods and services from household sector to producing sector and inturn flow of factor
payments from producing sector to household sector.

Important Terms
Private Income : Private income refers to the income which accrues to the private sector from all sources whether
received or not. it is the sum of factor income and transfer incomes received by private sector. It also includes net factor
income from abroad. The main constituents of private income are as follows :
1. Income from domestic product accuring to private sector.
2. Net factor income from abroad.

Private Income : Income from domestic product accruing to Private Sector + Current Transfer Income form Government
+ Net Current Transfers from Rest of the World + Interest on National Debt + Net Factor Income from abroad.
Personal Income : The sum of total income actually received by the households or individuals from all sources is called
personal income. It includes transfer as well as factor incomes.
Personal Income : Private Income – Corporation Tax – Undistributed Profits.
OR

Personal Income : National Income – Income from Domestic Product Accruing to Public Sector – Corporation

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Tax – Undistributed Profits + Transfer Incomes.

Personal disposable income (PDI) : PDI is the part of income which may be spent or consumed by the households.
This income can be spent by households according to their desire.
PDI = Pesonal Income – Direct Taxes – Miscellaneous Receipts of the Government.
OR
PDI = Consumption + Saving
Questions :
1. When is the national income larger than domestic factor income ?
Ans : When NFIA is positive.

2. What is the effect of an indirect tax and a subsidy, on the price of the commodity ?
Ans : The effect of an indirect tax on a commodity is to increase the price and the effect of Subsidy is to reduce the price
in the market ?

3. Are the wages and salaries received by Indians working in American Embassy in India a part of Domestic Product of India?

Ans : No, because American embassy is not a part of domestic territory of India.

4. Why is the study of the problem of unemployment in India considered a macroeconomic study ?

Ans : The problem of unemployment in India is an economic issue at level of economy as a whole, hence considered as
macroeconomic study.

5. When is gross domestic product of an economy equal to gross national product ?

Ans : When NFIA is zero.

6. Is net export a part of NFIA ? Explain.

Ans : No, it is not. Net export, the difference between export and import (X – M), is a part of Expenditure on Domestic
product. While NFIA is the difference between tincome earned from abroad by the normal residents of a country and
income earned by non-residents in the domestic territory of that country. It is not included in the domestic product rather
it is a component of NI. Therefore both are different concepts.

7. All capital goods are producer goods, but all producer goods are not capital goods : Explain ?
Ans : Producer goods are all those goods which are used in the process of production. These goods may be raw material
or plant and machinery. Goods used as raw material are not durable goods because these goods can not be used in the
process of production again. So it is true that all capital goods are producer goods, but all producer goods are not capital
goods.

8. What is final goods ?

Ans : These are those goods which have crossed the boundary line of production and are ready for use by their final users.

9. Purchase of a machine is always a final goods. Do you agree ?

Ans : Machine purchased by a household is a final goods. Machine purchased by a firm is a final goods when it is used

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by the producer in the process of production but a machine purchased by one firm from the other for purchase of resale
is an intermediate goods.

10. Are the following included in the estimation of National Income of India ?
(i) Profit earned by a foreign company/bank in India.
(ii) Money received from sale of shares.
(iii) Salary paid to Americans working in Indian embassy in America.
(iv) Salary paid to Indians working in Indian embassy in America.
(v) Remittances from abroad.
Ans :
(i) No, as it is a factor income paid abroad (it is earned by non-residents).
(ii) No, it is only a transfer of paper claims.
(iii) No, this factor income belongs to non-residents.
(iv) Yes, as it is a factor income paid to normal resident of India.
(v) No, it is only a transfer payments.
(vi) No, it is only a transfer payments. No commodity is sent or services rendered return for this.

11. Are the following included in the estimation of National Income a country ? Give reason.
(i) Services rendered by family members to each other.
(ii) Wheat growth by a farmer but used entirely for family’s consumption.
(iii) Expenditure government on providing free education.
(iv) Payment of fees to a lowyer engaged by a firm.
(v) Man of the match award to a player of the Indian cricket team.
(vi) Payment of the match fee to player of Indian cricket team.
Ans :
(i) Services rendered by family members to each other should not be included in NI because these are not rendered
for the purpose of earning income.
(ii) Imputed value of self-consumed wheat grown by a farmer must be included in NI, because it adds to in the flow
of goods.
(iii) It should be included in NI because the government expenditure on the free services is considered as a part of
government final consumption expenditure.
(iv) Yes, as it is factor income against the service of lawyer.
(v) It should be included in NI because it is a wind fall gain and it does not add in the flow of goods and services.
(vi) It should be included in NI of India because they render productive services as professionals.

12. Are the following included in the estimation of National Income a country ?
(i) Indirect Tax (Sale tax/Excise duty).
(ii) Salary received by the workers under NREGA.
(iii) Income Tax.
(iv) Corporation Tax.

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Ans :
(i) It is not included in NI because it does not add in the flow of goods and services.
(ii) It is a included in NI because it is a factor income.
(iii) It is a part of compensation of an employee (income). While calculating NI by income method, compensation of
employees is to be included while doing so, income tax to be paid by them should not be included separately.
(iv) It is a part of profit of corporate sector. While calculating NI by income method, profit is to be included while
doing so, Corporation tax should not be included separately.
13. Whether school/examination fee paid by students is included in national income not ?
Ans : It is included in national income as these are payments for the services rendered.

14. Whether purchase of those by the tenant of the house is included in national income or not ?
Ans : It is not included as it does not add to national product.

15. Whether expenditure on providing meals to the beggars is included in national income or not ?
Ans : It is not included as it is a transfer payment.

16. Whether salary of a defence personnel is included in national income or not ?

Ans : It is included as it is drawn for rendering productive service.

17. Whether increase in price of stock lying with a trader is included in national income or not ?
Ans : It will not be included in national income as there is no corresponding increase in output.

18. Whether value of interest foregone on loans provided by employer to employee is included in national income or not ?
Ans : It is included as it is a part of compensation of employees.

19. Whether government expenditure on street-lighting is included in national income or not ?

Ans : It is included as it is a part of govt. final consumption.

20. Whether gifts from abroad is included in national income or not ?

Ans : It is not included as it is a transfer payment.

21. Interest on national debt does not produce goods and services. It is only interest on borrowing.

22. Whether remittances by a NRI to his family in India are included in national income ?
Ans : It is not included as it is a transfer payment.

23. Whether sales tax is included in national income (NNP at FC) ?

Ans : It is included in NNP at MP but not in NNP at FC.

24. Whether free meals to workers are included in national income ?

Ans : Yes, it is included as it is wage in kind which is a part of compensation to employees.

25. Whether mineral wealth will be included which has been extracted in that particular year.
Ans : That part of mineral wealth will be included which has been extracted in that paticular year.

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26. Whether interest received by a household from a commercial bank is included in national income ?
Ans : Households both receive and pay interest. We include in national income only the net interest, that is the differences
between interest amount paid and the interest income received by households.

27. Whether commission received by a dealer of old car is included in national income or not ?
Ans : It is included as it is a productive service.

28. Whether expenditure on road construction is included in national income ?

Ans : It is included as it is a part of gross domestic fixed capital formation.

29. Whether payment of bus fare by a traveller is included in national income or not ?
Ans : It is included as it is a part of private final consumption expenditure.

30.(a) Can national income at constant prices be greater than national income at current prices ?
Ans : Yes national income at constant prices can be more than national income measured at current price under the
following two cases :
(a) When current year price index is low as compared to base year price index and output of goods and services
remains unchanged.
(b) When current output is less than the base year output, price index remaining the same.

(b) Does DNP measures economic welfare ?

Ans : GNP is not the measures of economic welfare as mere increase in national income does not lead to national welrafe.
Green GNP is the measure of economic welfare as it ensures sustainable use of national environment and equitable
distribution of the fruits of development.

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(b) Money and Banking

Barter System :
Direct exchange of goods against goods without use of money is called barter exchange.

For Example : When a weaver gives cloth to the farmer in return for getting wheat from the farmer, this is called barter
exchange.

Inconviences in Barter System :

(a) Lack of Double coincidence of wants of Exchange : It is necessary for a person who wants to trade his goods or
service to find some other person who is not willing to buy his good or service, but also possesses rice and wants to
exchange it for sugar. In the barter system, he has to find out a person who not only have sugar but also wants rice.
But ,such a double coincidence is a rare possibility.

(b) Problem of Storing Wealth : It is difficult to store value in the absence of money, the individuals have to store wealth
in the form of goods like horses, shoes, wheat etc, it is very expensive to store goods in this form for a long time.

(c) Lack of common measure of value : In the barter system, there is lack of common measure of value. One goods value
for one person is different from that goods value for other. The rate of exchange will be arbitrarily fixed.

(d) Lack of Standard of Deferred Payments : Another drawback of this is that it lacks a standard of future payments.
So, credit transactions cannot take place smoothly under barter trading. Both parties run the risk that the value of
goods to be repaid may decrease or increase in future.

Money : ‘Anything which is generally acceptable by the people in exchange of goods and service or in repayment of
debts’.

Features :
(i) Medium of Exchange : Money is a thing that acts as medium of exchange for the sale and purchase of of goods and
services.
(ii) Measure of Value : The value of all goods and service is expressed in terms of money, which is known as price, so
we can say that it is measure of value.
(iii) It is the most liquid form of assets.
(iv) Money possesses general acceptability.
(v) Money is a means and not an end in itself.

Functions of Money :
(i) Medium of Exchange : As money as the quality of general acceptability, therefore, all the exchanges in an
economy takes place in terms of money.
(ii) Measure in Value : The second function of money is that it acts as common measure of value. All the value of
goods and services can be measured and expressed in terms of money. It provides a basis for keeping accounts,
estimating national income, calculating profit and loss, costing etc.
(iii) Store of Value : Storing wealth has become easy with the introduction of money. It is a source of further
investment money can be stored easily as it remains stable as compared to other commodities. It does not need
much space.

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(iv) Standard of Deferred Payments : These are those payments which are made in future. When we borrow money
from somebody, we have to return both the principal as well as interest amount but it was difficult in barter system
but with the introduction of money, money performs this function most effectively.

Producer of Money : Producers of money refer to suppliers of money. They include :

(i) The government of the country.
(ii) The banking system of a country including both the central bank and commercial banks.

Fiat of Money : It refers to money by order or authority of the government.

It includes notes or coins.

Fiduciary Money : It refers to money backed up by trust between the payer and the payee. Cheques are fiduciary
money as these are accepted as a means of payment on the basis of trust.

Statutory Liduidity Ratio : Every bank is required to maintain a fixed percentage of its assets in the form of cash or
other liquid assets called SLR.

Question : Money acts as a yardstick of standard measure of value to which all other things can be compared. Explain :
Answer : Money service as a measure of value in terms of unit of account. Measurement of value was the main difficulty
of the barter system. It acts as a yardstick of standard measure of value to which all other things can be compared.
Money measures the value of everything or the prices of all goods and service can be expressed in terms of money.
This function of money also enables the trading firms to acertain their costs, reveness, profits and losses.

Question : The central bank acts as lender of last resort. How ?

Answer : The central bank also acts as lender of last resort for the other banks of the country. It means that if a commercial
bank fails to get financial accommodation from anywhere, it approaches the central bank as a last resort. It advances loan
against approved securities. As a lender of the last resort, central bank exercises central over the entire banking system of
the country.
Question : Central bank performs the function of a clearing houses. How ?
Answer : Every bank keeps cash reserves with the central bank. The claims of banks against one another can be easily and
convinently settled by simple transfers from and to their account. Supposing, Bank A receives a cheque of Rs.10,000
drawn on Bank B and Bank B receives a cheque of Rs.15,000 drawn on Bank A. The most convenient method of settling or
clearing their mutual claims is that Bank A should issue a cheque amounting to Rs.5000 in favour of Bank B, drawn on central
bank. As a result of this transference, a sum of Rs.5000 will be debited to the account of A and credited to B. There is no need
of each transactions between the banks concerned. It facilitates cash transactions across the entire banking system, it also
reduces requirement of cash reserves of the commercial banks.

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Central Bank Control Flow of Credit in Economy

Quantitative
(i) Bank rate Policy : The bank rate is the rate at which the central bank gives credit to the commercial banks. In order
to control the volume of credit, the central bank raised its bank rate. It will increase the cost of bourouring by
banks. It will reduce the volume of bank loans and advances. If central bank wants to increase volume of credit, the
central bank fall its bank rate, it will decrease the cost of borrouring by banks. It will increase the volume of banks
loans and advances.

(ii) Open Market Operations : The central bank buys and sells government securities in the open market. When the
central bank wants to contract credit it sells government securities which are sold by commercial banks and
households. It will increase the money of commercial bank and households by which credit creation will be
increased.

(iii) Cash Reserve Ratio : They are required under law to keep with central bank a minimum percentage of their
deposits as cash reserves. This is called CRR When central bank wants to reduces the flow of money, they can
increase the CRR by which there will be less amount remain with the commercial bank. On the other bank,
when central bank wants to increase the flow of money, they can decrease the CRR by which there will be more
amount remain with the commercial bank. It will increase credit creation.

Qualitative :
(i) Margin Requirements : It refers to the difference between the current value of the security offered for loans and
the value of loans granted.

(ii) Moral Suasion : It means persuasion, request and appeal by the central bank to the member banks to expand or
contract credit, as the situation demands. For eg., the central banks may request the commercial bank not to grant
loans for speculative purposes.

(iii) Rationing of Credit : It is another method of selective credit control. Under this, the reserve bank fixed credit
quota for member banks. If the member banks seek more loans than their fixed quota, they will have to pay high
interest.

Central Bank : It is an apex institution of the monetary and banking structure of the country. It regulates the entire
banking system of the country.

Functions :
(i) Bank of Note issue : It has the sole monopoly to issue currency notes. It has an issue department which is solely
responsible for the issue of notes and coins.
(ii) Banker to the Government : It manager accounts of the government banks across all in the country. It keeps
some cash balances of the commercial bank as a compulsory deposit.
(iii) Banker’s Bank : Central bank is the bank of all the banks which operates in the country. It keeps some cash
balance of the commercial bank as a compulsory deposit.
(iv) Lender of Last Resort : If a commercial bank fails to get financial accomodation from anywhere, can go to central
bank. It can give advance loans to such a bank.

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(v) Custodian of Foreign Exchange reserves : It also functions as the custodian of all the foreign exchange
reserves key currencies such as US-dollars.
(vi) Controller of Credit : The central bank establishes stability not only in the internal price level, but also in the
foreign exchange rates. It helps in economic growth and smooth functioning of the economy.
Functions of Commercial Bank :
(i) Internet Banking : It facilitates the account holder to operate his account through internet by using his personal
computer.
(ii) ATM Facilities : The ATM machines are being provided by the bank. These machines can be used by the account
holder within the country.
(iii) Credit Cards : Commercial banks issue credit cards to their customers. The card holders can purchase goods and
services from various shops without making cash payments. The card issuing banks make payments immediately
to the sellers but receive the amount from the buyer after 30 to 45 days.

Money and Near Money :

(i) Money consists of coins, currency notes etc near money includes financial assets like time deposits, bonds,
shares etc.
(ii) It possesses 100% liquidity whereas near money lacks perfect liquidity. It has to be converted into money before
spending.
(iii) Money is the common measure of value. Near money on the other hand, does not perform such functions.
(iv) Money does not yield any income whereas near money assets are income yielding assets.

Demand Deposits and Fixed Deposits :

(i) Demand Deposits can be withdrawn by their depositors at any time without notice. Fixed deposits can be
withdrawn only after the expiry of a certain fixed time period.
(ii) Demand Deposit can be withdrawn through cheque but fixed deposits are not chequeable.
(iii) No interest is paid on old and FD carry high rates of interest.
Supply of Money :
It is a stock concept. It refers to total stock of money held by the people of a country at a point of time. It does not include
stock of money held by the government and stock of money held by the banking of a country.

Functions of Money :
(i) Medium of Exchange : Money acts as a means of payments for exchange of goods and services. Goods and
services are exchanged for money when people sell things. Money is exchanged for goods and services when
people buy things. Therefore money reduces trading cost.
(ii) Unit of Value : Monetary unit is a unit in which the values of goods and services are expressed. The value of each
good or service can be expressed in terms of price i.e. the number of monetary units. For eg. If a notebook is worth
Rs.10 and a pen is worth Rs.5 then the note book is worth of 2 pens.
(iii) Store of Value : Money is a best form of reserve. The holders of money are the holders of generalised purchasing
power. It can be spent over a period of time. For eg., Money can be stored in the form of deposits in bank, purchase
of wants and shares, purchase of fixed assets etc. it can be liquified when required.

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(iv) Standard of Deferred Payments : The money can be used for making future payments. It helps in borrowings,
lendings and formulating capital market. For eg., The situation of future payments are pensions, principle and
interest on debt, salaries etc. Here once an agreement is made to pay a certain amount of money then the value
remains fixed as the value of money remains fixed.
Money Supply : It can be defined as total amount of money is the economy held by public at a given point of time.

Constituents of Money Supply :

(i) It is called legal tendor money because it is issued by government. It is of two types. Coins and paper currency
.The metallic value of coins or paper value is much less than their face value. In India Re.1 rupee note or the coins
are issued by Ministry of Finance Govt. of India. The other paper currency is issued by RBI.
(ii) Demand Deposit by Commercial Bank : It is known as bank money. Bank’s demand deposit are referred to as
money supply because they are transferable by cheques in the settlement of debts. Bank is agreed to pay money
on demand at any time.

Measures Adopted by RBI to Calculate money supply

M1, M2, M3, M4
M1 : C + DD + OD where C = currency held by public
DD = demand deposit of commercial bank and cooperative bank
OD = other deposits held by RBI
[Narrow definition of money supply]
M2 : M1 + Savings with the post office
M3 : M1 + Time deposits of all commercial and coorperative banks.
(known as aggregate monetary resources of India and in using it to calculate money supply)
M4 : M3 + total savings with post office saving organisations.

Credit Creation : It is the most important function of commercial banks. Credit plays an important role in the monetary
business system. It adds to the money supply in the economy.

Generally people open their current accounts in the commercial banks and can meet its obligations. But when credit is
granted by the bank, the bank do not give the cash money to the borrowers, they open a loan amount of the borrowers and
the money is transferred to the loan account. In this may bank create credit by advancing loans.

Example :
(a) Suppose banks has total deposit of Rs.1000 [primary deposit]. The bank can analyse that the whole of money is
not demanded at one time. But sum amount of money can be withdrawn anytime.
(b) So, 20% of the deposit that is 200 will be kept as reserve by the bank and the remaining will be given as a loan.
(c) Then remaining amount i.e. 800, will be transferred to the loan account of the borrowers.
(d) Then again 20% of 800 i.e. 160 will be kept as reserve and the remaining will be given as loan.
(e) So, at the end of this process with the primary deposit i.e. 1000, the bank can create the total deposit of 5000.

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1
Credit Creation = Primary deposit 
CRR
100
 1000  = Rs.5000.
20

(c) Government Budget and Economy

Budget : It means the annual financial statement containing an estimate of all anticipated revenue and expenditure of the
government for the coming financial year.

Features of a Budget :
(i) It is a statement of expected revenue and proposed expenditure.

(ii) It requires some authority to sanction it.

(iii) It is annually prepared.

Public Expenditure : It refers to the expenditure incurred by the government for the satisfaction of collective needs of
the people.

Types of Public Expenditure :

 Revenue Expenditure
 Capital Expenditure

(a) Revenue Expenditure : It is the expenditure incurred for the normal running of the government departments and
provision for various services. It includes expenditure like expenditure on civil administration, public health etc.

It neither creates assets for the government nor reduction in the libilities. It is of recurring nor reduction in the
liabilities. It is of recurring type. It is called non-development expenditure.

(b) Capital Expenditure : It refers to expenditure which leads to creation of assets or reduces liabilities. It is a
non-reducing type of expenditure. It is called development expenditure. Expenditure on acquisition of assets, land
and building etc.

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Difference between Tax and Price :

(i) Tax is a compulsory contribution to be paid by every citizen upon whom it is imposed, whereas the price is to be
paid by the persons who purchase goods and services produced by the government.
(ii) The payments made by tax is used in the public interest without specific person whereas goods and services are
available to those persons only who pay price.

Objectives of Government Budget :

(i) Increase in Government Activities : The activities of the government have increased. Therefore, large
resources have to be mobilized to meet the expenditure required to perform those activities. All this cannot be
conducted properly without a budget.
(ii) Solving Various Problems : Budget is an important instrument of promoting economic development and solving
various problem facing the economy like problem of inflation and deflect in the balance of payments etc.
(iii) Reduction in Inequalities of Wealth and Income : The budgetary policy can be used to reduce inequalities in
the distribution of wealth and income. The imposition of progressive taxes and death duties would secure funds
for the government which would be utilized for the welfare of weaker sections of the society.

How Deficit in Budget be Financed :

(a) Printing on New Notes : By printing of new notes deficit can be financed. The RBI issue currency to government
and government returns this money in the form of treasury bills.
(b) Borrouring from the Public : By borrouring from the public, deficit can be financed. This involves the burden of
interest payments.
(c) Disinvestment : The government may choose the sell its existing shares. This process is popularly known as
‘Privatisation’.
Tax : It is compulsory payments imposed on the persons or companies by the government to meet the expenditure
incurred on providing common benefits to the people.

Types of Taxes :
(i) Direct and Indirect Taxes (ii) Proportional, progressive and regressive
(iii) Specific and advalorem takes

Proportional Tax : Taxes in which the tax rate remains constant whatever size of the tax base may be.
Progressive Tax : Taxes in which the rate of tax increases are called progressive taxes. In India income tax is a progressive
tax.

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Regressive Tax : When the rate of tax decreases as the tax base increases the tax are called regressive tax.

Deficits in Government Budget :

Budgetary Deficit : It represents excess of all expenditure on both revenue and capital accounts over all receipts on
revenue and capital accounts including borrourings by the central government.
There are three types of depicit :
(a) Revenue Deficit : It refers to the excess of revenue expenditure over revenue receipts.
Recenue deficit = Total revenue expenditure – Total revenue receipts
(b) Fiscal Deficit : It refers to the excess of total expenditure both on revenue and capital accounts over revenue
receipts and only non-borrouring type of capital receipts.
Fiscal Deficit : Total budget expenditure – Revenue Receipts – non-debt Capital receipts

or Total budget expenditure – Total budget non-debt receipts

(c) Primary deficit :

Primary Deficit = Fiscal Deficit – Interest Payments

Balanced Budget : A budget is said to be balance when revenue and expenditure are equal.
Unbalanced Budget : If expenditure exceeds revenue, the budget will be unbalanced. The unbalanced may be due to
an excess of expenditure over revenue, this budget is called deficit budget or may be due to an excess of revenue over
expenditure, this budget is called surplus budget.

Components of Budget :
(i) Budget receipts (ii) Budget Expenditure

(i) Budget Receipt : It refer to the estimated money receipts of a government from all sources during a fiscal year.
Budget receipts can be of two types : revenue receipts and capital receipts.

(a) Revenue Receipts : These are those receipts of the government which neither create any liability for the
government nor cause any reduction in the assets of the government. For example : tax is a revenue receipts
as it does not create any liability for the government.

(b) Capital Receipts : These are those receipts of the government which either creates any liability for the
government or cause any reduction in the assets of the government. These include items of non-routine
nature.

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1mark Questions :
1. Why is tax-treated as revenue receipts ?
Ans: Because tax neither create a liability for the government nor reduces assets of the govt.
2. What indicates zero primary deficit ?
Ans: Zero primary deficits means that the government has to resort to borrourings only to make interest payments.
3. Classify the borrourings and recovery of loans into revenue and capital receipts of govt. budget ? Give reason.
Ans: Borrouring on capital receipts because the government is under obligation to return the amount along with
interest so it creates liability of the govt. Recovery of loans is also a capital receipt because these reduce assets
of the govt.
4. What indicates zero primary deficit ?
Ans: It means that the government has to resort to borrourings only to make interest payments.

5. What will be the value of fiscal deficit if primary deficit is Rs.53000 crores and intt. on borrourings is
Rs.5000 crores ?
Ans: Fiscal defifit = Primary deficit + Interest Payment
= 53000 + 5000
= 58000 crores

6. Can there be capital deficit without revenue deficit ?

Ans: Yes, this can happen and can prevail without revenue deficit. The possibilities are :
(i) Revenue budget is balanced with (Revenue Expenditure = Revenue Receipt)
and capital budget is in deficit (Capital Expenditure > Capital Receipt)
(ii) The surplus in revenue budget (Revenue Receipt > Revenue Expenditure)
is less than the deficit in capital budget (Capital Expenditure > Capital Receipt)
Classifications of Government Expenditure :
(a) Developmental : It refers to expenditure on activities that are related to economic and social development of the
country. It adds to the flow of goods and services in the economy. For eg. Expenditure on education, health,
rural development, scientific research etc.
(b) Non Developmental : It refers to expenditure incurred on essential general services of the government. It helps in
smooth functioning of an economy. It does not adds to flow of good and services.
(c) Planned : It is that public expenditure which represents current development and investment that arise due to plan
proposal. For eg., infrastructure development.
(d) Non-Planned : It refers to expenditure provided in the budget for routine functionining of the government. For eg.,
expenditure on emergency needs, subsidies, pensions etc.

How is Deficit Met by :

(i) Monetary expansion i.e. printing of currency notes by RBI.
(ii) By borrouring from internal sources (public) through issuing bonds and shares and external sources (IBRD, IMF).

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(iii) Disinvestment [a part or a whole of the govt. sector)

(iv) Reducing government expenditure.
(v) Increasing government revenue by increase in taxes.

Fiscal Deficit with its Implication :

It is defined as excess of total expenditure over total receipts excluding borrourings.
Fiscal Deficit = Total Expenditure – Total Receipts

Debt capital receipt = Borrourings

Non-debt capital receipt = Rocovery of Loans + Disinvestment

Implication :
(a) It measures the amount of borrourings required by the govt. and extent of govt. dependance on others to meet its
budget expenditure.

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(b) Govt. borrours from RBI i.e. deficit financing which leads to increase in circulation of money and causes inflation.
(c) Indebatness : govt. borrourings from rest of the world which increases the dependance on other countries and effect
the growth and development. This increases the financial burden on future generation to pay loans and interest
amount.
(d) Debt Trap : As the govt. expanditure increases, its liability in future to repayloan with interest also increases.
The increase in interest amount leads to increase in revenue expenditure. Increase in revenue expenditure leads to
increase in revenue deficit. The gap between revenue receipt is met by borrourings.

Revenue Deficit with its Implication : It refers to excess of total revenue expanditure of the government over its
total revenue receipts.
Revenue Deficit = Total Revenue Receipt – Total Revenue Expenditure

Implication :
(a) It indicates the dissavings on government account because the government has to make the uncovered gap by
drawing capital receipts i.e. either through borrourings or disinvestment.

(b) Revenue deficit results in government liabilities and decrease in government assets and therefore increases the
repayment burden in future.

(d) Balance of Payments

Foreign Exchange Rate
Foreign Exchange : It refers to all the currencies other than domestic currency of a given country.

Foreign Exchange Rate : The rate at which one currency can be converted into another currency. Suppose 1 US dollar can
be obtained by paying INR 50, then the foreign exchange rate is 1 US dollar = 50 INR ,
1 pound = 70 INR.

Types of Exchange Rates : The conversion rate between two currencies is decided by :
(i) Government (ii) Market

(a) Fixed Exchanged Rate : If the government decides the conversion rate, it is called fixed exchanged rates. Such a rate
does not vary with changes in demand and supply of foreign currency. Only government has the power to change it.
(b) Floating Exchange Rate : If the market forces determined the conversion rate, it is called floating exchange rate,
this rate varies with changes in demand and supply of foreign currencies. There is a well organised foreign exchange
market in a country having floating exchange rate.
(c) Managed Flating Rate : This system of exchange rate have emerged recently. This is essentially a floating rate, it is
called managed because the centralbank tries to influence the rate by entering the market as a bulk buyer or seller.
When the central bank finds floating rate too high, its start selling foreign exchange from it reserves to bring down the
rate.
When it finds the rate too low it starts buying to raise the rate. This kind of floating is also called dirty floating rate.

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Sources of Demand and Supply of Foreign Exchange

(i) Sources of Demand of Foreign Exchange : India’s demand for US dollar arises because Indians want to buy things
whose prices are quoted in US dollar. Those who demand US dollars in India are holders of Indian rupee seeking them
to exchange them for US dollar.
 There are many sources of demand :
 For improving goods and services.
 For making transfer payments in form of gifts, donations etc.
 For making income payments in form of profit, dividend etc.
 For making investment abroad in financial and physical assets.
 For lending money and for making the payments to foreign countries.

(ii) Source of Supply in Exchange Rate : The supply of US dollars in India comes from those who earn these dollars by
selling goods and services to the countries to make payments in US dollars. There are many sources of supply of
foreign exchange :
 From exporting goods goods and services.
 From transfer payments in the form of gifts, remittances.
 From income receipts.
 From investments in financial and physical assets from rest of the world.
 From borrouring money and receiving re-payements from foreign currencies.

Determination of Foreign Exchange Rate in Free Market :

It is determined by demand for and supply of a given currency on foreign exchange rate (market).

Relation of Price and Demand :

There is an inverse relation between price of foreign exchange and demand for that foreign exchange in terms of domestic
currency.
The higher the price, the lower is the demand for foreign exchange and the lower the price, higher is the demand
eg. : The higher price of US dollars in India, the lower is likely to be its demand.
At a lower price of US dollar India is likely to buy more goods from USA, this raises the demand for US dollars so, lower the
price of US dollars, the higher is the demand for US dollars.

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Demand curve is normally downward sloping at price OP0, demand for foreign exchange is (PO), at lower price OP1, demand
is (F1) which is higher. At higher price (P2), demand is lower (F2).

Relation betwen Supply and Price : There is a direct relationship between price of exchange and supply of that foreign
exchange. The higher the price, the higher is the supply, the lower the price, the lower will be supply.

The supply curve is normally upward sloping at price PO, supply for foreign exchange is F0, at lower price P1, supply is
F1 i.e. lower. At higher price P2 supply is F2 is higher.

Determination for Foreign Exchange Rate : Like the price of a good foreign exchange is also determined by the
forces of demand and supply of foreign exchange. There are organised foreign exchange markets in every country where
buyers and sellers meet and bargain.
The price that prevails at a particular point of time is the equilibrium exchange rate. This equilibrium occurs at that rate at
which the quantity demanded by a foreign currency equals the quantity supplied of that currency.

The price of foreign exchange is determined at the intersection of demand and supply curves relating to foreign exchange.
OP is the market demand and OF is the demand and supply of foreign exchange at this rate.

Appreciation of Currency : It means rise in the external value of a currency. If today 1 dollar can be exchange at Rs.45
and after one month, 1 dollar is exchanged at Rs.40 then we can say that there is appreciation in the value of an Indian
currency.

Depreciation of Currency : It means falls in the external value of a currency. If today 1 dollar can be exchanged at
Rs.45 and after one month, 1 dollar is exchanged at Rs.50 then we can say that there is depreciation in the value of
Indian currency.

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Balance : Means the difference between the sum of credits and sum of debits.

Balance of Trade : Expert of goods – Import of goods

Balance on current account = sum of credits – Sum of debits

 A deficit in BOP occurs when during the year autonmous inflow of foreign exchange.

Autonomous Transaction (Above the line – Current account)

A BOP transaction independent of all other BOP transactions.

Accommodating Transaction (Below the line – Capital account)

Questions :
1. Why is supply curve a positive sloped curve ?
Ans : As rate of exchange increases the demand for US $ also increases and vice versa. It is become as rate increases the
home country’s goods become more cheaper for the foreigners and supply is more for US $.

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As the rate increases from Rs.46 to Rs.47, then the supply of US $ also increases from 8 to 10 units, Here units the increases
in exchange rate, the rupee value is depreciating.

2. Define depreciation of currency ?

Ans : It is defined as decrease in the value of currency in terms of another currency.
1 US $ = Rs.46
US $ = Rs 47
Here, rupee value is depreciating

3. Define appreciation of currency.

Ans : It is defined as increase in the value of currency in terms of another currency.
1 US $ = Rs.46
US $ = Rs 47

4. Define balance of capital account.

Ans : It records the changes in financial assets and financial liabilities at a particular point of time. It includes :
(a) Investment : It comprises of investments from abroad in share of Indian companies in real state.
(b) Borrouring and lending : It includes all borrourings and lendings from and to abroad by private individuals,
institutions, government etc. It also include loan repayment by foreigners etc.
(c) Changes in foreign exchange reserve : There are the financial assets of the government held in the central bank which
consists of gold, foreign exchange and special drawing rights.

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5.

6.

(e) Determination of Income & Employment

Assumptions
(a) It is a theory of short period i.e. the concept of EXANTE (Planned) and EXPOST (Actual).
(b) Price is constant (perfect competition) and constant marginal physical product.
(c) Supply is perfectly elastic.
(d) Demand creates supply.
(e) No foreign sector (NFIA = 0)

Aggregate Demand :
It is defined as the total demand for final goods and services planned to be purchased by all sectors of economy at a given
level of income in a period of time.

Components :
AD = Consumption + Investment
These components can be understood in four parts :
(a) Private consumption demand (b) Government demand for goods and services

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(c) Private Investment demand (d) Demand for net exports

(a) Private Consumption Demand : It means planned demand for final consumer goods and services by
households during a period of time. It is influenced by the disposable income of the households. From the income
the consumer consumes and the rest he saves.

(b) Govt. Demand for Goods and Services : It means planned consumption expenditure of general government
on providing free services to the people and on capital formation during a period. Eg. services of law and order,
defence, education, health, sanitation, roads, flyovers, railways etc.

(c) Private Investment Demand : It means planned expenditure on making addition to capital goods by private
producers during a period of time. For eg. expenditure on fixed assets and inventeries. Investment is categorised
into two parts :
(i) Induced (ii) Autonomous

(d) Demand for Net Exports : It means the planned net foreign demand for the goods and services produced in the
country during a period. Generally net export demand is a small proportion. Therefore, the Keynes has ignored this
component.

Aggregate Supply : Total value of final goods and services produced in the given period of time.

Component :
National Income = Consumption + Savings

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The value of this output is equal to the cost planned to be incurred on producing this output which the producer expects
to recover during this period. The cost includes the payments to the factors of production i.e. rent, wages, interest, profit.
Rent + Wages + Intt. + Profit = NNPFC ignoring NFIA

Propensity to Consume : It is a functional between consumption and income.

c = f (y)
c = Consumption
f = function
y = Income
(i) When income is zero, consumption is positive. It is known as autonomous consumption.
(ii) When income increases, consumption also increases but at a lesser rate.

Schedule :

It is known as kenes fundamental psychological law.

Propensity to consume can be explained through following equation.
c  c  by
where c : Consumption function
c : Autonomous consumption
b : Rate of change in consumption in respect to
y : Level of income

Schedule :

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Behaviour of MPC :
MPC changes between 0 to 1
0<b<1
(i) When income is zero consumption is positive. Therefore, MPC can never be zero.
(ii) When income increases, consumption also increases but at a slower rate.
Therefore, MPC can never be 1 or greater than it.

Propensity to Save : It is a fundamental relationship between saving and income

C = f (y)
(i) When income in zero, consumption is positive and saving is negative.
(ii) When income increases, consumption increases at a lesser rate, saving increase at a higher rate. This can be explained
through equation.
y=C+S
S= y–C


S = y  C  by 
S = y  C  by
S =  C  y  by

S =  C  y 1  by 
when income is zero.

Propensity to consume is studied into two parts :

(i) Marginal propensity to consume (MPC) (ii) Average propensity to consume (APC)

Marginal Propensity to Consume : The ratio of change in consumption to change income.

C
MPC 
y

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For eg., If the national income of the country increases from 1000 crores to 1200 crores and the consumption increases from
800 crores to 900 crores.
100
Then, MPC   0.5
200
Therefore, a rupee change income causes 0.5 rupee change in consumption.

Average Propensity to Consume : It is the ratio of consumption to income i.e. the proportion of income spend on
consumption.
C
APC 
y
For eg., If nationalincome of the country is 1000 crores and the consumption is 800 crores.
800
APC   0.8
1000
Therefore, the economy 80% of its income.

S   C  y 1  by 
whereas S = Savings function

C = Dissaving
(1 – b) = Rate of change in saving in respect to

y = level of income

Propensity to save to divided into two parts :

(i) Marginal propensity to save (MPS)
(ii) Average propensity to save (APS)

Marginal Propensity to Save : It is the ratio of change in saving in income.

For eg., If national income of the country increases from 1000 crores to 1200 crores, and the saving increases from
200 crores to 300 crores, then
300  200 100
MPS    0.5
1200  1000 200
Therefore from a rupee earned 0.5 rupee is saved.

Average Propensity to Save : It is the ratio of savings to income.

S
APS 
y
For eg., If the national income of the country is Rs.1000 crores and the saving is Rs.200 crores, then
200
APS   0.2
1000

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Therefore the economy saves 20% of its income.

Questions :
1. Can APC can greater than 1 or equal to 1 or less than 1 Yes or No. Prove the statement.

Ans :

APC is greater than 1 before the break even point (point B) where consumption is greater than income.

APC is equal to 1 at break even point where C = I.

APC is less than 1 after break even point.

2. What is the behaviour of MPS ?

Ans : MPS ranges between 0 to 1 because MPC also ranges between 0 to 1.
i.e. when income is zero, consumption is positive ; when income increases at a lesser rate ; if MPC is 0.8 then MPC is 0.2

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Therefore MPC + MPS = 1. It can be proved numerically :

3. APS is negative, APS is equal to 0, is positive but less than 1. Give reasons.
 S
Ans : APS can be negative when saving is negative,  APS  
 y
When it is before break even point.
Eg. y C S
80
100 180 –80  APS =   0.8
100
APS can be zero when saving is zero, at break even point
Eg. y C S
0
500 500 0  APS = 0
500
APS can be less than 1 but positive because saving is positive beyond break even point.
Eg. y C S
20
600 530 20  APS =  0.3
600

4. APS can never be greater than 1. Prove.

Ans : APS can never be greater than 1 because APC + APS = 1.
APS can never be zero or negative and therefore APS can never be greater than 1.

5. What is the relationship between APS and APS ?

Ans : y = C + S
Dividing both sides by common factor ‘y’ is income.
y C S
 
y y y
 1 = APC + APS

6. What is the relationship between MPC and MPS ?

Ans : y = C + S
Also y = C + S
Dividing both sides by the common factor ‘y’
y C S
 
y y y
 1 = MPC + MPS

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 Vidyamandir Classes Macro-Economics

Income Determination of an Economy

There are two approaches to explain the determination of national income :
At equilibrium : AD = AS
C+I=C+S . . . .(i)
 I=S
(a) Consumption and Investment Approach
(b) Saving and Investment Approach

Consumption and Investment Approach :

The line (C + I) i.e. aggregate demand and the 45line depicts the equilibrium level of national income. The 45 line enables
us the identify the equilibrium because here planned planned output (A.S.).
Important Terms :
(a) Exante Saving Investment : In an economy what we plan to save during a particular period, it is known as
planned saving whereas what we plan to invest during a particular period, it is known as planned investment.
(b) Expost Saving and Investment : In an economy what we actually save is export or realised saving and what are
actually invest is called export investment or realised investment.
Actual Investment = Planned Investment + Unplanned Investment
(c) Full Employment : It means maximum efficient utilisation of the economics available resources i.e. every able
body who is willing to work in the current wage rate is employed.
(d) Voluntary Unemployment : It refers to the population which prefer not to work at the prevailing wage rate.
They are not the part of labour force.

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(e) Involuntary Unemployment : It refers to a situation in which all able person who are willing at work at current
wage rate cannot get work. According to kenes it is due deficiency of aggregate demand. It is due to wage price
rigidity and constant marginal physical product.

Case 1 : A. D. > A.S.

The economy is at a level of output less than equilibrium level M i.e. loint P. At this point C + I line lies above the 45 line.
Here planned spending is greater than planned output. This would lead to unplanned decrease in stocks. Firm will increase
employment, output. This process of increase in output will continue till the economy reaches to equilibrium i.e. point M.
Here planned spending is equal to planned output.

Case 2 : A.D. < A.S.

The economy is at a level of output greater than equilibrium level M i.e. at point N. At this point C + I line lies below the
45 line. Here planned spending is less than planned output. This would lead to unplanned increase in unsold stock.
Firm will decrease employment, output. This process of decrease in output will continue till the economy reaches to
equilibrium i.e. point M. Here planned spending is equal to planned output.

Saving and Investment Approach :

Case 1 : S < I
The economy is at a level of output less than M i.e. point P. At this level of income, the saving function lies below the
investment schedule. At this level of income households are saving an amount less than firm’s plan to invest. The effect
of this is reduction in inventories. The firm will increase the production, employment. The economy returns to equilibrium
output level M. Here planned saving is equal to planned investment.

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Case 2 : S > I
The economy is at a level of output greater than M i.e. point N. The saving function lies above the investment schedule.
At this level of income the households are saving more then the firm’s plan to invest. The effect of this will lead to
unplanned increase in inventories. The firm will reduce the production, employment. The economy returns to equilibrium
output level M. Here planned saving is equal to planned investment.
Multiplier : It is a measure of change in national income as a result of initial change in investment.
y
k
I

Multiplier shows that a change in investment i.e. by I, income increases by a greater income i.e., y.
For eg., If an increase in investment is Rs.100 crores which causes an increase in income of Rs.300 crores then the
multiplier is
y 300
k   3times
I 100
Relationship between Multiplier and MPC
(i) The value of multiplier is determined by MPC. Higher the MPC, greater is the size of multiplier. Lower the MPC,
smaller is the size of multiplier.
1
k
1  MPC
(ii) Expenditure of one individual is the income of other. When investment increases, income of the people also
increases. They spend a part of the increased income on consumption and the rest they save.
(iii) How much of their income, the people would spend on consumption will depend on MPC.
(iv) If MPC is more, it will generate income for another.
(v) Therefore, increase in investment does not cause increase in income in the same same proportion rather increase
in income is more than initial increase in investment.
(vi) The factor by which the income increase depends upon MPC. Therefore, higher than MPC, higher is the value of
multiplier.

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Short Run fixed Price Analysis : Exante demand for final goods : In an economy without a government and foreign
trade, exante aggregate demand (planned aggregate demand) for final goods i.e. the sum total of exante consumption
expenditure and exante investment expenditure on final goods. AD = C + I.
It is measured by summing up the consumption f (x) and constant investment (autonomous investment)
AD = C + I

 AD  C  by  I

In case of exante investment expenditure, the assume constant price (rate of interest) over a short period of time to
determine level of aggregate demand
At equilibrium AS = AD
Income = AD
= C  by  I

C = Autonomous consumption
I = Autonomous investment

Deficient Demand : It can be when aggregate demand falls hort of aggregate output at full employment level.

Q* = Full employment output level

Point F = Full employment equilibrium
FG = Deflationary gap
Point E = Underemployment equilibrium
(a) At output level Q* the economy is at full employment level i.e. all the resources are fully utilised.
(b) Suppose the AD falls from point F to point G known as deficient demand will lead to unplanned increase in stock.
(c) This will create involuntary unemployment due to it ,the production will reduce.
(d) The national income will decline till the new equilibrium point is achieved i.e. point E known as underemployment
equilibrium.
(e) The gap due to deficient demand at full employment level is known as deflationary gap.

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Deflationery Gap : It is the difference between actual aggregate demand and required aggregate demand at full
employment level. It is negative for our economy.
Excess Demand : Where AD > AS, at full employment level, it is known as excess demand.

Q* = Output level
FG = Inflationery gap
Point F = Full employment equilibrium
Point E = Over employment equilibrium
(i) At output Q*, the economy is at full employment level. At point F is full employment equilibrium.
(ii) Suppose the AD increases at full employment level i.e. point from F to G. The economy will face inflationary
pressure.
(iii) The rise in price will lead to rise in national income.
(iv) This increase in national income is due to rise in price i.e. increase in nominal national income and not due to
increase in quantity produced i.e. real national income.
(v) The rise in national income will lead to new equilibrium position i.e. point E known as over employment
equilibrium.

Policies to Correct Deficient Demand :

1. Monetary Policy : It is the policy adopted by Central Bank (RBI) to control the supply of money and credit
availability in the economy to achieve economic stability.
(a) Quantitative :
(i) Bank Rate : It is the rate at which the Central Bank leads to the commercial bank. To check depression,
the central bank reduces the bank rate. It enables the commercial bank to take more loan from it and in
turn give more loans to the producer at a low rate of interest. It increase the investment demand and
therefore, aggregate demand which eliminates the deflationery gap.

(ii) Open Market operations : It refers to buying and selling of the securities by the Central Bank. Central
Bank purchases govt. bonds and securities from commercial bank by payment in cash, which increases
the cash stock with commercial bank. It increases the lending capacity and therefore increases the
investment and aggregate demand.

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(iii) Legal Reserves : There are two types of legal reserves : CRR and SLR
CRR : It is the minimum percentage of deposits kept by the commercial banks with the central bank.
In deficient demand, it is reduced.
SLR : It is the minimum percentage of deposits to be kept by the commercial bank with itself is called SLR.
The SLR is reduced to correct the problem of deficient demand.

(b) Quantitative :
(i) Margin requirements : It refers to the difference between the current value of the security offered for
loans and the value of loan granted. In case of deficient demand the central bank reduces the margin.
Thereby increasing investment demand and finally aggregate demand.
(ii) Moral Suasion : The central bank appeals to the commercial bank to encourage lending to the selected
sector to expand credit.

2. Fiscal Policy : It is a budgetary policy of the govt. related to revenue expenditure of the govt. to correct the problem
of deficient demand.

(i) Govt. Expenditure : Deficient demand can be corrected by increasing the level of govt. expenditure by an
amount equal to deflationery gap. The expenditure is either consumption or investment expenditure.

(ii) Deficit Financing : It is increased to increase the purchased power in the economy.
(iii) Taxes : The taxes are decreased in case of deficient demand. The govt. adopts progressive taxation policy i.e.
higher the income higher than taxes. The MPC of the rich people is lower as compared to the poor.
* Opposite of all deficient demand is for the excess demand.

Money Multiplier : New deposits in banks leads to creation of more deposits by banks. Total deposits is many times the
initial deposits. The multiple by deposits can increase due to an initial deposit in called money/deposit multiplier.
The value of money multiplier is determined by LRR.
1
Deposit multiplier =
LRR
20
It suppose LRR = 20%, deposit =  0.2
100
1 1 1 10
Multilier =    5
LRR 0.2 0.2 2
10

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Working :

1. New deposits of Rs.1000 is made in Bank. LRR = 20%. The bank keeps 20% deposits as cash, so Rs.200 as kept as cash
reserve and bank lends the remaining amount of Rs.800.
2. Lending means that bank create deposits of Rs.800 in the name of the borrouers. This is the first round creation and
is equal to 80% of the initial deposit.
3. Borrouer withdraw the entire amount of loan and spend the same on goods and services.

4. The seller of the goods and services receives Rs.800 of revenue and deposit the same in their respective bank.
5. The bank gets new deposits and keep the 20% and lend the remaining amount of Rs.640. This is the second round
increase. It is 80% of previous round increase.
Legal Reserve Ratio : It is that fraction of deposits with the commercial bank which is legally compulsory for the
banks to keep in the form of cash. Eg.: A bank has a deposit of 100 lakhs and the LRR = 20%, it means bank must hold
Rs.20 lakh as cash.

Concept of LRR with examples :

 When people make demand deposits, they are free to withdraw part of whole of the amount as and when they like.

 The bank do not keep the entire deposit in the form of cash as by doing so, it will not earn any profit.
 The banks keeps only a fraction of deposits as cash and use the remaining for giving loans.

 At any point of time, the bank has to meet the withdrawl demand of the depositor failing which a legal violation
of contract arises between depositor and bank.

 It is because from experience it is found that not only depositor withdraw money at the same time and that they
withdraw any fraction of deposits.
 At the same time, they continue to make new deposits. Therefore, there is no need for banks to keep the entire
amount as cash, they banks can easily meet the daily withdrawl of the depositors.

Components of Legal Reserve Ratio :

(i) SLR : The fraaction of deposits which banks are required to keep as cash within the bank itself.
(ii) SRR : The fraction of deposits the banks are required to keep with the central bank.
6. Like this creation in each of the further round will be 80% of the previous round. In each round, the increase becomes
smaller and smaller and ultimately, it becomes zero.

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8. The sum total of all deposits will ultimately be Rs.5000 i.e. 5 times the initial deposits.
Money Creation by Commercial Banks : There are two components of money :

Supply :
(i) Currency with public
(ii) Demand deposits with commercial banks currency is created by central bank of country because it has sole rights of
using notes. This currency is called high powered money. Demand deposits are created by commercial banks and are
called bank money.

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