EXPANDED TERTIARY EDUCATION EQUIVALENCY

AND ACCREDITATION PROGRAM

(ETEEAP)

BASIC MICROECONOMICS
REQUIREMENTS

SECOND SEMESTER, S.Y. 2020 - 2021

Submitted by:

ELVIS PAHIGO MARATA

BSBA- Operations Management

Submitted to:

JENNY LYN T. NALUPA, Ph.D., Ed. D.

Professor

JULY 24, 2021

 TABLE OF CONTENTS

LESSON A : The Nature and Importance of Economics

LESSON B : The Circular Flow of Economic Activity

LESSON C : Basic Elements of Demand and Supply

LESSON D : Consumer Behavior

LESSON E : The Concept of Elasticity

LESSON F : Production and Cost

LESSON G : Market Structures

LESSON H : Measuring National Output and Income

LESSON I : Consumption and Savings

LESSON J : The Investment Function

LESSON K : The Business Firm

LESSON L : Labor and Employment

LESSON M : Business Cycles and Inflation

LESSON N : Money and Monetary Policy

LESSON O : International Trade

LESSON P : Agrarian Reform and Taxation

LESSON A: The Nature and Importance of Economics

Economics activities permeate the lives of individual in almost every aspect.

Economic Decision is always involved.

Major Concerns of Economic Activities are the following:

1. Individual

2. Organizations

3. Institutions

4. Government

Economic Motive is always involved.

Economics

- is a social science concerned with using scare resources to obtain the

maximum satisfaction of the unlimited material wants of society. (Walstad,
Bingham, McConnel, and Brue)

- is the study of how societies use scare resources to produce valuable

commodities and distribute them among different people. (Samuelson and
Nordhaus)

- is the study of production, distribution, selling, and use of goods and services.
(Collin)

- is the study of how people use their limited resources to try to satisfy
unlimited human wants.

(Parkin and Bade)

The Nature of Economic Choice

1. Scarcity - is the imbalance between our desires and the

means of satisfying

those desires.

2. Opportunity Cost - means sacrificing something in exchange.

- the cost of choosing to use resources for

one purpose measured by
 the sacrifice of the next alternative for using
those resources.

The Fundamental Economic Problem

1. What goods and services must be produced and in what

quantities?

2. How shall theses goods and services be produced?

3. For whom shall these goods and services be produced?

Types of Economic System

1. Capitalism - is an economic system mainly characterized by

private individuals owning and operating the majority of
businesses that produce goods and services.

2. Communism - is an economic system in which the government

owns all the nation’s resources.

3. Socialism - is an economic system in which the government

owns and operates the basic industries

4. Mixed Economies - is one that has elements from more than

one economic system that contains both private and state
enterprises.

The Economic Resources

1. Land

2. Labor

3. Capital

4. Entrepreneurial Ability

Economic Goals

1. Economic Growth
 2. Full Employment

3. Economic Efficiency

4. Price Level Stability

5. Economic Freedom

6. An Equitable Distribution of Income

7. Economic Security

8. Balance Trade

9.

Division of Economics

1. Microeconomics - is concerned with the behavior and activities of

specific economic units such as:

 Individuals
 Households Firms
 Industries
 Resource Owners

2. Macroeconomics – is that division of economics that deals with the

behavior of the economy as a whole with respect to:

 Output
 Income
 The Price Level
 Foreign Trade
 Unemployment
 Other Aggregate Economic Variables
LESSON B: The Circular Flow of Economic Activity

Stock and Flow Concepts

Stock - refers to the measure of quantity at a point of time.

Flow - refers to the measure of quantity over a period of time.

The Circular Flow of Goods, Services and Income

Flow Involves:

 Raw Materials
 Intermediate Goods
 Final Goods

Raw Materials- are goods which are still unprocessed.

Examples: Wood, Sand, Iron Ore

Intermediate Goods - are partially processed and still need further processing
before they can finally consumed.

Examples: Flour, Microchips

Final Goods- are processed goods that are ready for final consumption or use.

Examples: Smart TV, Computer Machine, Ready-to-wear Clothing

ACTIVITY 1: Enumerate 20 Goods and identify its –

RAW MATERIALS INTERMEDIATE GOODS FINAL GOODS

1 GRAINS GRIND RICE PUTO

2 SWEET POTATO SMASHED SWEET PASTA/PANSIT
POTATO
3 PAPAYAS GRATED PAPAYA PAPAYA PICKLE/ATSARA
4 MILKFISH DEBONED MILKFISH DAING
5 SUGAR CANE EXTRACTED SUGAR SUGAR
CANE
6 CACAOS BRANCHED CACAO COFFEE
7 COCONUTS SHREDED COCONUT SWEETEND
COCONUT/BUKAYO
8 HYACINTS SILKED HYACINTS SILK CLOTH
9 UBE BOILED UBE UBE JAM
10 WHEATS FLOUR BREAD
11 SOYA TOASTED SOYA SOYSAUCE
12 TOMATOES EXTRACT TOMATOES CATSUP
13 COCONUT TREE FERMINTED COCONUT WHITE VINEGAR
14 ABACA LEAVES WOVED ABACA LEAVES BANIG
15 CASSAVAS GRATED CASSAVA CASSAVA CAKE
16 TREES FIBERED TREE PAPER
17 PEPPER CORNS MINCED CORNS BLACK PEPPER
18 MILKS ACIDIFY MILKS CHEESE
19 MEATS GRIND MEAT MEAT LOAF
20 MANGOES DRIED MANGOES MANGO CANDY

According to the types of goods they produce FIRMS MAY CLASSIFIED as

follows:

1. Raw Materials Producers – like those engage in producing agricultural

products used in manufacturing.
Examples: Fish, Wood, Sugarcane

2. Intermediate Goods Producers- like those producing construction

materials.

Examples: Guitar Strings, Food Seasoning

3. Final Goods Producers- like those producing all types of goods or

products that are ready to eat or to use.

Example: Chocolate Bars, Refrigerators, Automobiles, Apparels

Income Takes Two distinct Circular Flows:

1. Between Households and Firms

2. Between Firms

LESSON C: BASIC ELEMENTS OF DEMAND AND SUPPLY

The Market
Market- is where buyers wishing to exchange money for a good or services in
contact with sellers wishing to exchange goods and services for money.

How a Market Functions

Market Functions between:

1. Sellers and Buyers

2. Demand and Supply

Market Demand

Non- Price Determinants of Demand

1. Average Income of Consumers

2. Size of the Market

3. Price and Availability of Related Goods

4. Preferences or Taste

5. Special Influences

6. Expectations About Future Economic Conditions

Market Supply

LESSON D: CONSUMER BEHAVIOR

 THE CONCEPT OF UTILITY

Utility is a loose and sometimes controversial topic in microeconomics. Generally

speaking, utility refers to the degree of pleasure or satisfaction (or removed discomfort)
that an individual receives from an economic act. An example would be a consumer
purchasing a hamburger to alleviate hunger pangs and to enjoy a tasty meal, providing
her with some utility.

All economists would agree that the consumer has gained utility by eating the
hamburger. Most economists would agree that human beings are, by nature, utility-
maximizing agents; human beings choose between one act or another based on each
act's expected utility. The controversial part comes in the application and measurement
of utility.

KEY TAKEAWAYS
 Utility is a term in microeconomics that describes to the incremental satisfaction
received from consuming a good or service
 Cardinal utility attempts to assign a numeric value to the utility of an economic act,
while ordinal utility simply provides a rank ordering.
 Marginal utility is an important concept in understanding how the addition of just one
more unit change overall satisfaction.
 Utility is a useful concept, but is controversial in that human beings are not necessarily
rational utility maximizers in reality.

The Origins of Utility

The development of utility theory begins with a logical deduction. Voluntary
transactions only occur because the trading parties anticipate a benefit (ex-ante); the
transaction wouldn't happen otherwise. In economics, "benefit" means receiving more
utility.

Economists also say that human beings rank their activities based on utility. A laborer
chooses to go to work rather than skip it because he anticipates his long-run utility to be
greater as a result. A consumer who chooses to eat an apple rather than an orange must
value the apple more highly, and thus anticipates more utility from it.

Utility took hold in economics during the marginalist revolution, which tried to formalize
and mathematize economics based on incremental changes. Because mainstream
economists today have adopted a rational actor perspective, where their models
assume that individuals are driven entirely by self-interest utility maximization, the
concept of utility has been made prominent in microeconomics.

Cardinal and Ordinal Utility

The ranking of utility is known as an ordinal utility. It is not a controversial topic;
however, most microeconomic models also use cardinal utility, which refers to
measurable, directly comparable levels of utility.
Cardinal utility is measured in units called "utils" to transform the logical to the
empirical. The ordinal utility might say that, ex-ante, the consumer prefers the apple to
the orange. Cardinal utility might say that the apple provides 80 utils while the orange
only provides 40 utils. Economists sometimes employ what is known as an indifference
curve to elucidate the cardinal utility of two or more goods in graphical form.

Marginal Utility
Marginal utility looks at the added satisfaction that somebody gains (or loses) from
consuming just one additional unit of a good or service. For instance, eating a
hamburger when hungry provides a lot of utility. Eating a second hamburger perhaps a
bit less satisfaction. A third hamburger may even lower utility since you're already quite
full.
The law of diminishing marginal utility describes this effect, where adding one more unit
of something typically results in fewer and fewer gains in utility for the consumer.

The Usefulness of Utility

Utility theory has been quite useful in understanding the economic action of individuals,
households, and firms—but only in broad strokes. In reality, people may eat a third
hamburger for reasons that elude the rational actor assumption of standard economic
models. For instance, a leftover hamburger may be considered wasteful food, and in
order to prevent waste, it is eaten. This more ethical or qualitative evaluation of "utility"
is difficult to capture in mathematical models or formulae.
Behavioral economics has also revealed time and again how economic actors deviate
from rational expectations in everyday life and fail to maximize utility. Moreover,
empirical work shows that people have inconsistent preferences. While somebody may
prefer apples to oranges this week, next week oranges may be what is craved.
As a result of these and other factors, some have questioned the usefulness of utility in
practice.

The Bottom Line

Even though no economist truly believes that utility can be measured this way, some
still consider utility a useful tool in microeconomics. Cardinal utility places individuals on
utility curves and can track declines in marginal utility across time. Microeconomics also
performs interpersonal comparisons with cardinal utility.
Other economists argue that no meaningful analysis can come out of imaginary
numbers and that cardinal utility—and utils—is logically incoherent.

CONSUMER EQUILIBRIUM

When consumers make choices about the quantity of goods and services to consume, it
is presumed that their objective is to maximize total utility. In maximizing total utility,
the consumer faces a number of constraints, the most important of which are the
consumer's income and the prices of the goods and services that the consumer wishes
to consume. The consumer's effort to maximize total utility, subject to these constraints,
is referred to as the consumer's problem. The solution to the consumer's problem,
which entails decisions about how much the consumer will consume of a number of
goods and services, is referred to as consumer equilibrium.

Determination of consumer equilibrium. Consider the simple case of a consumer who

cares about consuming only two goods: good 1 and good 2. This consumer knows the
prices of goods 1 and 2 and has a fixed income or budget that can be used to purchase
quantities of goods 1 and 2. The consumer will purchase quantities of goods 1 and 2 so
as to completely exhaust the budget for such purchases. The actual quantities
purchased of each good are determined by the condition for consumer equilibrium,
which is 

This condition states that the marginal utility per dollar spent on good 1 must equal the
marginal utility per dollar spent on good 2. If, for example, the marginal utility per dollar
spent on good 1 were higher than the marginal utility per dollar spent on good 2, then it
would make sense for the consumer to purchase more of good 1 rather than purchasing
any more of good 2. After purchasing more and more of good 1, the marginal utility of
good 1 will eventually fall due to the law of diminishing marginal utility, so that the
marginal utility per dollar spent on good 1 will eventually equal that of good 2. Of
course, the amount purchased of goods 1 and 2 cannot be limitless and will depend not
only on the marginal utilities per dollar spent, but also on the consumer's budget.
An example. To illustrate how the consumer equilibrium condition determines
the quantity of goods 1 and 2 that the consumer demands, suppose that the price of
good 1 is $2 per unit and the price of good 2 is $1 per unit. Suppose also that the
consumer has a budget of $5. The marginal utility (MU) that the consumer receives from
consuming 1 to 4 units of goods 1 and 2 is reported in Table. Here, marginal utility is
measured in fictional units called utils, which serve to quantify the consumer's
additional utility or satisfaction from consuming different quantities of goods 1 and 2.
The larger the number of utils, the greater is the consumer's marginal utility from
consuming that unit of the good. Table also reports the ratio of the consumer's marginal
utility to the price of each good. For example, the consumer receives 24 utils from
consuming the first unit of good 1, and the price of good 1 is $2. Hence, the ratio of the
marginal utility of the first unit of good 1 to the price of good 1 is 12.

The consumer equilibrium is found by comparing the marginal utility per dollar spent
(the ratio of the marginal utility to the price of a good) for goods 1 and 2, subject to the
constraint that the consumer does not exceed her budget of $5. The marginal utility per
dollar spent on the first unit of good 1 is greater than the marginal utility per dollar
spent on the first unit of good 2(12 utils > 9 utils). Because the price of good 1 is $2 per
unit, the consumer can afford to purchase this first unit of good 1, and so she does. She
now has $5 − $2 = $3 remaining in her budget. The consumer's next step is to compare
the marginal utility per dollar spent on the second unit of good 1 with marginal utility
per dollar spent on the first unit of good 2. Because these ratios are both equal to 9
utils, the consumer is indifferent between purchasing the second unit of good 1 and first
unit of good 2, so she purchases both. She can afford to do so because the second unit
of good 1 costs $2 and the first unit of good 2 costs $1, for a total of $3. At this point,
the consumer has exhausted her budget of $5 and has arrived at the consumer
equilibrium, where the marginal utilities per dollar spent are equal. The consumer's
equilibrium choice is to purchase 2 units of good 1 and 1 unit of good 2.

The condition for consumer equilibrium can be extended to the more realistic case
where the consumer must choose how much to consume of many different goods.
 When there are N > 2 goods to choose from, the consumer equilibrium condition is to
equate all of the marginal utilities per dollar spent, 

subject to the constraint that the consumer's purchases do not exceed her budget.

SUBTITUTION
What Is a Substitute?
A substitute, or substitutable good, in economics and consumer theory refers to
a product or service that consumers see as essentially the same or similar-enough to
another product. Put simply, a substitute is a good that can be used in place of another.
Substitutes play an important part in the marketplace and are considered a benefit for
consumers. They provide more choices for consumers, who are then better able to
satisfy their needs. Bills of materials often include alternate parts that can replace the
standard part if it's destroyed.

KEY TAKEAWAYS
 A substitute is a product or service that can be easily replaced with another by
consumers.
 In economics, products are often substituting if the demand for one product increases
when the price of the other goes up.
 Substitutes provide choices and alternatives for consumers while creating competition
and lower prices in the marketplace.
Volume 75%
 
1:02
What are Substitute Goods?

Understanding Substitutes
When consumers make buying decisions, substitutes provide them with alternatives.
Substitutes occur when there are at least two products that can be used for the same
purpose, such as an iPhone vs. an Android phone. For a product to be a substitute for
another, it must share a particular relationship with that good. Those relationships can
be close, like one brand of coffee with another, or somewhat further apart, such as
coffee and tea.
 Giving consumers more choice helps generate competition in the market and lower
prices as a result. While that may be good for consumers, it may have the opposite
effect on companies' bottom line. Alternative products can cut into companies'
profitability, as consumers may end up choosing one more over another or see market
share diluted.

When you examine the relationship between the demand schedules of substitute

products, if the price of a product goes up the demand for a substitute will tend to
increase. This is because people will prefer to lower-cost substitute to the higher cost
one. If, for example, the price of coffee increases, the demand for tea may also increase
as consumers switch from coffee to tea to maintain their budgets.

Conversely, when a good's price decreases, the demand for its substitute may also
decrease. In formal economic language, X and Y are substitutes if demand for X
increases when the price of Y increases, or if there is positive cross elasticity of demand.
 
The availability of substitutes is one of Porter's 5 Forces, the others being competition,
new entrants into the industry, the power of suppliers, and the power of customers.
Examples of Substitute Goods

Substitute goods are all around us. As mentioned above, they are generally used for the
same purpose or are able to satisfy similar needs for consumers.

Here are just a few examples of substitute goods:

 Currency: a dollar bill for 4 quarters (also known as fungibility)
 Coke vs. Pepsi
 Premium vs. regular gasoline
 Butter and margarine
 Tea and coffee
 Apples and oranges
 Riding a bike versus driving a car
 E-books and regular books

There is one thing to keep in mind when it comes to substitutes: the degree to which a
good is a substitute for another can, and often will, differ.

Perfect vs. Less Perfect Substitutes

Classifying a product or service as a substitute is not always straightforward. There are
different degrees to which products or services can be defined as substitutes. A
substitute can be perfect or imperfect depending on whether the substitute completely
or partially satisfies the consumer.

A perfect substitute can be used in exactly the same way as the good or service it
replaces. This is where the utility of the product or service is pretty much identical. For
example, a one-dollar bill is a perfect substitute for another dollar bill. And butter from
two different producers is also considered perfect substitutes; the producer may be
different, but their purpose and usage are the same.

A bike and a car are far from perfect substitutes, but they are similar enough for people
to use them to get from point A to point B. There is also some measurable relationship
in the demand schedule.

Although an imperfect substitute may be replaceable, it may have a degree of difference

that can be easily perceived by consumers. So, some consumers may choose to stick
with one product over the other. Consider Coke versus Pepsi. A consumer may choose
Coke over Pepsi—perhaps because of taste—even if the price of Coke goes up. If a
consumer perceives a difference between soda brands, she may see Pepsi as an
imperfect substitute for Coke, even if economists consider them perfect substitutes.

Less perfect substitutes are sometimes classified as gross substitutes or net substitutes
by factoring in utility. A gross substitute is one in which demand for X increases when
the price of Y increases. Net substitutes are those in which demand for X increases when
the price of Y increases and the utility derived from the substitute remains constant.

Substitute Goods in Perfect Competition and Monopolistic Competition

In cases of perfect competition, perfect substitutes are sometimes conceived as nearly

indistinguishable goods being sold by different firms. For example, gasoline from a gas
station on one corner may be virtually indistinguishable from gasoline sold by another
gas station on the opposite corner. An increase in the price at one station will result in
more people choosing the cheaper option.
Monopolistic competition presents an interesting case that present complications with
the concept of substitutes. In monopolistic competition, companies are not price-takers,
meaning demand is not highly sensitive to price. A common example is a difference
between the store brand and name-branded medicine at your local pharmacy. The
products themselves are nearly indistinguishable chemically, but they are not perfect
substitutes due to the utility consumers may get—or believe they get—from purchasing
a brand name over a generic drug believing it to be more reputable or of higher quality.
THE BUDGET LINE
Economists typically use a different set of tools than those presented in the chapter up
to this point to analyze consumer choices. While somewhat more complex, the tools
presented in this section give us a powerful framework for assessing consumer choices.

We will begin our analysis with an algebraic and graphical presentation of the budget
constraint. We will then examine a new concept that allows us to draw a map of a
consumer’s preferences. Then we can draw some conclusions about the choices a
utility-maximizing consumer could be expected to make.

The Budget Line

As we have already seen, a consumer’s choices are limited by the budget available. Total
spending for goods and services can fall short of the budget constraint but may not
exceed it.
Algebraically, we can write the budget constraint for two goods X and Y as:
Equation 7.7
PXQX+PYQY≤BPXQX+PYQY≤B
where PX and PY are the prices of goods X and Y and QX and QY are the quantities of
goods X and Y chosen. The total income available to spend on the two goods is B, the
consumer’s budget. Equation 7.7 states that total expenditures on goods X and Y (the
left-hand side of the equation) cannot exceed B.
Suppose a college student, Janet Bain, enjoys skiing and horseback riding. A day spent
pursuing either activity costs $50. Suppose she has $250 available to spend on these
two activities each semester. Ms. Bain’s budget constraint is illustrated in Figure 7.9
“The Budget Line”.
For a consumer who buys only two goods, the budget constraint can be shown with a
budget line. A budget line shows graphically the combinations of two goods a consumer
can buy with a given budget.
The budget line shows all the combinations of skiing and horseback riding Ms. Bain can
purchase with her budget of $250. She could also spend less than $250, purchasing
combinations that lie below and to the left of the budget line in Figure 7.9 “The Budget
Line”. Combinations above and to the right of the budget line are beyond the reach of
her budget.
Figure 7.9 The Budget Line
The budget line shows combinations of the skiing and horseback riding Janet Bain could
consume if the price of each activity is $50 and she has $250 available for them each
semester. The slope of this budget line is −1, the negative of the price of horseback
riding divided by the price of skiing.
The vertical intercept of the budget line (point D) is given by the number of days of
skiing per month that Ms. Bain could enjoy, if she devoted all of her budget to skiing and
none to horseback riding. She has $250, and the price of a day of skiing is $50. If she
spent the entire amount on skiing, she could ski 5 days per semester. She would be
meeting her budget constraint, since:
$50 x 0 + $50 x 5 = $250
The horizontal intercept of the budget line (point E) is the number of days she could
spend horseback riding if she devoted her $250 entirely to that sport. She could
purchase 5 days of either skiing or horseback riding per semester. Again, this is within
her budget constraint, since:
$50 x 5 + $50 x 0 = $250
Because the budget line is linear, we can compute its slope between any two points.
Between points D and E the vertical change is −5 days of skiing; the horizontal change is
5 days of horseback riding. The slope is thus −5/5=−1. More generally, we find the slope
of the budget line by finding the vertical and horizontal intercepts and then computing
the slope between those two points. The vertical intercept of the budget line is found by
dividing Ms. Bain’s budget, B, by the price of skiing, the good on the vertical axis (PS).
The horizontal intercept is found by dividing B by the price of horseback riding, the good
on the horizontal axis (PH). The slope is thus:
Equation 7.8
Slope=−B/PSB/PHSlope=−B/PSB/PH
Simplifying this equation, we obtain
Equation 7.9
Slope=−BPS×PHB=−PHPSSlope=−BPS×PHB=−PHPS
After canceling, Equation 7.9 shows that the slope of a budget line is the negative of the
price of the good on the horizontal axis divided by the price of the good on the vertical
axis.
Heads Up!
It is easy to go awry on the issue of the slope of the budget line: It is the negative of the
price of the good on the horizontal axis divided by the price of the good on
the vertical axis. But does not slope equal the change in the vertical axis divided by the
change in the horizontal axis? The answer, of course, is that the definition of slope has
not changed. Notice that Equation 7.8 gives the vertical change divided by the horizontal
change between two points. We then manipulated Equation 7.8 a bit to get to Equation
7.9 and found that slope also equaled the negative of the price of the good on the
horizontal axis divided by the price of the good on the vertical axis. Price is not the
variable that is shown on the two axes. The axes show the quantities of the two goods.
Indifference Curves
Suppose Ms. Bain spends 2 days skiing and 3 days horseback riding per semester. She
will derive some level of total utility from that combination of the two activities. There
are other combinations of the two activities that would yield the same level of total
utility. Combinations of two goods that yield equal levels of utility are shown on
an indifference curve. Because all points along an indifference curve generate the same
level of utility, economists say that a consumer is indifferent between them.
Figure 7.10 “An Indifference Curve” shows an indifference curve for combinations of
skiing and horseback riding that yield the same level of total utility. Point X marks Ms.
Bain’s initial combination of 2 days skiing and 3 days horseback riding per semester. The
indifference curve shows that she could obtain the same level of utility by moving to
point W, skiing for 7 days and going horseback riding for 1 day. She could also get the
same level of utility at point Y, skiing just 1 day and spending 5 days horseback riding.
Ms. Bain is indifferent among combinations W, X, and Y. We assume that the two goods
are divisible, so she is indifferent between any two points along an indifference curve.
Figure 7.10 An Indifference Curve
The indifference curve A shown here gives combinations of skiing and horseback riding
that produce the same level of utility. Janet Bain is thus indifferent to which point on the
curve she selects. Any point below and to the left of the indifference curve would
produce a lower level of utility; any point above and to the right of the indifference
curve would produce a higher level of utility.
Now look at point T in Figure 7.10 “An Indifference Curve”. It has the same amount of
skiing as point X, but fewer days are spent horseback riding. Ms. Bain would thus prefer
point X to point T. Similarly, she prefers X to U. What about a choice between the
combinations at point W and point T? Because combinations X and W are equally
satisfactory, and because Ms. Bain prefers X to T, she must prefer W to T. In general, any
combination of two goods that lies below and to the left of an indifference curve for
those goods yields less utility than any combination on the indifference curve. Such
combinations are inferior to combinations on the indifference curve.
Point Z, with 3 days of skiing and 4 days of horseback riding, provides more of both
activities than point X; Z therefore yields a higher level of utility. It is also superior to
point W. In general, any combination that lies above and to the right of an indifference
curve is preferred to any point on the indifference curve.
We can draw an indifference curve through any combination of two goods. Figure 7.11
“Indifference Curves” shows indifference curves drawn through each of the points we
have discussed. Indifference curve A from Figure 7.10 “An Indifference Curve” is inferior
to indifference curve B. Ms. Bain prefers all the combinations on indifference curve B to
those on curve A, and she regards each of the combinations on indifference curve C as
inferior to those on curves A and B.
Although only three indifference curves are shown in Figure 7.11 “Indifference Curves”,
in principle an infinite number could be drawn. The collection of indifference curves for
a consumer constitutes a kind of map illustrating a consumer’s preferences. Different
consumers will have different maps. We have good reason to expect the indifference
curves for all consumers to have the same basic shape as those shown here: They slope
downward, and they become less steep as we travel down and to the right along them.
Figure 7.11 Indifference Curves

Each indifference curve suggests combinations among which the consumer is

indifferent. Curves that are higher and to the right are preferred to those that are lower
and to the left. Here, indifference curve B is preferred to curve A, which is preferred to
curve C.
The slope of an indifference curve shows the rate at which two goods can be exchanged
without affecting the consumer’s utility. Figure 7.12 “The Marginal Rate of
Substitution” shows indifference curve C from Figure 7.11 “Indifference Curves”.
Suppose Ms. Bain is at point S, consuming 4 days of skiing and 1 day of horseback riding
per semester. Suppose she spends another day horseback riding. This additional day of
horseback riding does not affect her utility if she gives up 2 days of skiing, moving to
point T. She is thus willing to give up 2 days of skiing for a second day of horseback
riding. The curve shows, however, that she would be willing to give up at most 1 day of
skiing to obtain a third day of horseback riding (shown by point U).
 Figure 7.12 The Marginal Rate of Substitution

The marginal rate of substitution is equal to the absolute value of the slope of an
indifference curve. It is the maximum amount of one good a consumer is willing to give
up to obtain an additional unit of another. Here, it is the number of days of skiing Janet
Bain would be willing to give up to obtain an additional day of horseback riding. Notice
that the marginal rate of substitution (MRS) declines as she consumes more and more
days of horseback riding.
The maximum amount of one good a consumer would be willing to give up in order to
obtain an additional unit of another is called the marginal rate of substitution (MRS),
which is equal to the absolute value of the slope of the indifference curve between two
points. Figure 7.12 “The Marginal Rate of Substitution” shows that as Ms. Bain devotes
more and more time to horseback riding, the rate at which she is willing to give up days
of skiing for additional days of horseback riding—her marginal rate of substitution—
diminishes.
The Utility-Maximizing Solution
We assume that each consumer seeks the highest indifference curve possible. The
budget line gives the combinations of two goods that the consumer can purchase with a
given budget. Utility maximization is therefore a matter of selecting a combination of
two goods that satisfies two conditions:
1. The point at which utility is maximized must be within the attainable region defined by
the budget line.
2. The point at which utility is maximized must be on the highest indifference curve
consistent with condition 1.
Figure 7.13 “The Utility-Maximizing Solution” combines Janet Bain’s budget line
from Figure 7.9 “The Budget Line” with her indifference curves from Figure 7.11
“Indifference Curves”. Our two conditions for utility maximization are satisfied at point
X, where she skis 2 days per semester and spends 3 days horseback riding.
Figure 7.13 The Utility-Maximizing Solution

Combining Janet Bain’s budget line and indifference curves from Figure 7.9 “The Budget
Line” and Figure 7.11 “Indifference Curves”, we find a point that (1) satisfies the budget
constraint and (2) is on the highest indifference curve possible. That occurs for Ms. Bain
at point X.
The highest indifference curve possible for a given budget line is tangent to the line; the
indifference curve and budget line have the same slope at that point. The absolute value
of the slope of the indifference curve shows the MRS between two goods. The absolute
value of the slope of the budget line gives the price ratio between the two goods; it is
the rate at which one good exchanges for another in the market. At the point of utility
maximization, then, the rate at which the consumer is willing to exchange one good for
another equals the rate at which the goods can be exchanged in the market. For any
two goods X and Y, with good X on the horizontal axis and good Y on the vertical axis,
Equation 7.10
MRSX.Y=PXPYMRSX.Y=PXPY
Utility Maximization and the Marginal Decision Rule
How does the achievement of The Utility Maximizing Solution in Figure 7.13 “The Utility-
Maximizing Solution” correspond to the marginal decision rule? That rule says that
additional units of an activity should be pursued, if the marginal benefit of the activity
exceeds the marginal cost. The observation of that rule would lead a consumer to the
highest indifference curve possible for a given budget.
Suppose Ms. Bain has chosen a combination of skiing and horseback riding at point S
in Figure 7.14 “Applying the Marginal Decision Rule”. She is now on indifference curve C.
She is also on her budget line; she is spending all of the budget, $250, available for the
purchase of the two goods.
Figure 7.14 Applying the Marginal Decision Rule

Suppose Ms. Bain is initially at point S. She is spending all of her budget, but she is not
maximizing utility. Because her marginal rate of substitution exceeds the rate at which
the market asks her to give up skiing for horseback riding, she can increase her
satisfaction by moving to point D. Now she is on a higher indifference curve, E. She will
continue exchanging skiing for horseback riding until she reaches point X, at which she is
on curve A, the highest indifference curve possible.
An exchange of two days of skiing for one day of horseback riding would leave her at
point T, and she would be as well off as she is at point S. Her marginal rate of
substitution between points S and T is 2; her indifference curve is steeper than the
budget line at point S. The fact that her indifference curve is steeper than her budget
line tells us that the rate at which she is willing to exchange the two goods differs from
the rate the market asks. She would be willing to give up as many as 2 days of skiing to
gain an extra day of horseback riding; the market demands that she give up only one.
The marginal decision rule says that if an additional unit of an activity yields greater
benefit than its cost, it should be pursued. If the benefit to Ms. Bain of one more day of
horseback riding equals the benefit of 2 days of skiing, yet she can get it by giving up
only 1 day of skiing, then the benefit of that extra day of horseback riding is clearly
greater than the cost.
Because the market asks that she give up less than she is willing to give up for an
additional day of horseback riding, she will make the exchange. Beginning at point S, she
will exchange a day of skiing for a day of horseback riding. That moves her along her
budget line to point D. Recall that we can draw an indifference curve through any point;
she is now on indifference curve E. It is above and to the right of indifference curve C, so
Ms. Bain is clearly better off. And that should come as no surprise. When she was at
point S, she was willing to give up 2 days of skiing to get an extra day of horseback
riding. The market asked her to give up only one; she got her extra day of riding at a
bargain! Her move along her budget line from point S to point D suggests a very
important principle. If a consumer’s indifference curve intersects the budget line, then it
will always be possible for the consumer to make exchanges along the budget line that
move to a higher indifference curve. Ms. Bain’s new indifference curve at point D also
intersects her budget line; she’s still willing to give up more skiing than the market asks
for additional riding. She will make another exchange and move along her budget line to
point X, at which she attains the highest indifference curve possible with her budget.
Point X is on indifference curve A, which is tangent to the budget line.
Having reached point X, Ms. Bain clearly would not give up still more days of skiing for
additional days of riding. Beyond point X, her indifference curve is flatter than the
budget line—her marginal rate of substitution is less than the absolute value of the
slope of the budget line. That means that the rate at which she would be willing to
exchange skiing for horseback riding is less than the market asks. She cannot make
herself better off than she is at point X by further rearranging her consumption. Point X,
where the rate at which she is willing to exchange one good for another equals the rate
the market asks, gives her the maximum utility possible.
Utility Maximization and Demand
Figure 7.14 “Applying the Marginal Decision Rule” showed Janet Bain’s utility-
maximizing solution for skiing and horseback riding. She achieved it by selecting a point
at which an indifference curve was tangent to her budget line. A change in the price of
one of the goods, however, will shift her budget line. By observing what happens to the
quantity of the good demanded, we can derive Ms. Bain’s demand curve.
Panel (a) of Figure 7.15 “Utility Maximization and Demand” shows the original solution
at point X, where Ms. Bain has $250 to spend and the price of a day of either skiing or
horseback riding is $50. Now suppose the price of horseback riding falls by half, to $25.
That changes the horizontal intercept of the budget line; if she spends all of her money
on horseback riding, she can now ride 10 days per semester. Another way to think about
the new budget line is to remember that its slope is equal to the negative of the price of
the good on the horizontal axis divided by the price of the good on the vertical axis.
When the price of horseback riding (the good on the horizontal axis) goes down, the
budget line becomes flatter. Ms. Bain picks a new utility-maximizing solution at point Z.
Figure 7.15 Utility Maximization and Demand

By observing a consumer’s response to a change in price, we can derive the consumer’s

demand curve for a good. Panel (a) shows that at a price for horseback riding of $50 per
day, Janet Bain chooses to spend 3 days horseback riding per semester. Panel (b) shows
that a reduction in the price to $25 increases her quantity demanded to 4 days per
semester. Points X and Z, at which Ms. Bain maximizes utility at horseback riding prices
of $50 and $25, respectively, become points X′ and Z′ on her demand curve, d, for
horseback riding in Panel (b).
The solution at Z involves an increase in the number of days Ms. Bain spends horseback
riding. Notice that only the price of horseback riding has changed; all other features of
 the utility-maximizing solution remain the same. Ms. Bain’s budget and the price of
skiing are unchanged; this is reflected in the fact that the vertical intercept of the budget
line remains fixed. Ms. Bain’s preferences are unchanged; they are reflected by her
indifference curves. Because all other factors in the solution are unchanged, we can
determine two points on Ms. Bain’s demand curve for horseback riding from her
indifference curve diagram. At a price of $50, she maximized utility at point X, spending
3 days horseback riding per semester. When the price falls to $25, she maximizes utility
at point Z, riding 4 days per semester. Those points are plotted as points X′ and Z′ on her
demand curve for horseback riding in Panel (b) of Figure 7.15 “Utility Maximization and
Demand”.
Key Takeaways
 A budget line shows combinations of two goods a consumer is able to consume, given a
budget constraint.
 An indifference curve shows combinations of two goods that yield equal satisfaction.
 To maximize utility, a consumer chooses a combination of two goods at which an
indifference curve is tangent to the budget line.
 At the utility-maximizing solution, the consumer’s marginal rate of substitution (the
absolute value of the slope of the indifference curve) is equal to the price ratio of the
two goods.
 We can derive a demand curve from an indifference map by observing the quantity of
the good consumed at different prices.
 LESSON E: THE CONCEPT OF ELASTICITY

WHAT IS ELASTICITY?

Elasticity is a measure of a
variable's sensitivity to a
change in another variable,
most commonly this
sensitivity is the change in
price relative to changes in
other factors. In business and economics, elasticity refers to the degree to which
individuals, consumers, or producers change their demand or the amount supplied in
response to price or income changes. It is predominantly used to assess the change in
consumer demand as a result of a change in a good or service's price.

KEY TAKEAWAYS
 Elasticity is an economic measure of how sensitive an economic factor is to another, for
example, changes in price to supply or demand, or changes in demand to changes in
income.
 If demand for a good or service is relatively static even when the price changes, demand
is said to be inelastic, and its coefficient of elasticity is less than 1.0.
 Examples of elastic goods include clothing or electronics, while inelastic goods are items
like food and prescription drugs.
Volume 75%
 
When the value of elasticity is greater than 1.0, it suggests that the demand for the
good or service is affected by the price. A value that is less than 1.0 suggests that the
demand is insensitive to price, or inelastic. Inelastic means that when the price goes up,
consumers’ buying habits stay about the same, and when the price goes down,
consumers’ buying habits also remain unchanged. If elasticity = 0, then it is said to be
'perfectly' inelastic, meaning its demand will remain unchanged at any price. There are
probably no real-world examples of perfectly inelastic goods. If there were, that means
producers and suppliers would be able to charge whatever they felt like and consumers
would still need to buy them. The only thing close to a perfectly inelastic good would be
air and water, which no one controls. 
Elasticity is an economic concept used to measure the change in the aggregate quantity
demanded of a good or service in relation to price movements of that good or service. A
product is considered to be elastic if the quantity demand of the product changes
drastically when its price increases or decreases. Conversely, a product is considered to
be inelastic if the quantity demand of the product changes very little when its price
fluctuates.

For example, insulin is a product that is highly inelastic. For people with diabetes who
need insulin, the demand is so great that price increases have very little effect on the
quantity demanded. Price decreases also do not affect the quantity demanded; most of
those who need insulin aren't holding out for a lower price and are already making
purchases.

On the other side of the equation are highly elastic products. Bouncy balls, for example,
are highly elastic in that they aren't a necessary good, and consumers will only decide to
make a purchase if the price is low. Therefore, if the price of bouncy balls increases, the
quantity demanded will greatly decrease, and if the price decreases, the quantity
demanded will increase.

DEMAND ELASTICITY
Is an economic measure of the sensitivity of demand relative to a change in another
variable. The quantity demanded of a good or service depends on multiple factors, such
as price, income, and preference. Whenever there is a change in these variables, it
causes a change in the quantity demanded of the good or service. For example, when
there is a relationship between the change in the quantity demanded and the price of a
good or service, the elasticity is known as price elasticity of demand. The two other main
types of demand elasticity are income elasticity of demand and cross elasticity of
demand.

Income Elasticity
Income elasticity of demand refers to the sensitivity of the quantity demanded for a
certain good to a change in real income of consumers who buy this good, keeping all
other things constant. The formula for calculating income elasticity of demand is the
percent change in quantity demanded divided by the percent change in income. With
income elasticity of demand, you can tell if a particular good represents a necessity or a
luxury.

Cross Elasticity
The cross elasticity of demand is an economic concept that measures the
responsiveness in the quantity demanded of one good when the price for another good
changes. Also called cross-price elasticity of demand, this measurement is calculated by
taking the percentage change in the quantity demanded of one good and dividing it by
the percentage change in the price of the other good.

SUPPLY ELASTICITY

Price elasticity of supply measures the responsiveness to the supply of a good or service

after a change in its market price. According to basic economic theory, the supply of a
good will increase when its price rises. Conversely, the supply of a good will decrease
when its price decreases.

Factors Affecting Demand Elasticity

There are three main factors that influence a good’s price elasticity of demand.
Availability of Substitutes

In general, the better substitutes there are, the more elastic the demand will be. For
example, if the price of a cup of coffee went up by $0.25, consumers might replace their
morning caffeine fix with a cup of strong tea. This means that coffee is an elastic good
because a small increase in price will cause a large decrease in demand as consumers
start buying more tea instead of coffee.

However, if the price of caffeine itself were to go up, we would probably see little
change in the consumption of coffee or tea because there may be few good substitutes
for caffeine. Most people, in this case, might not willingly give up their morning cup of
caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic
product. While a specific product within an industry can be elastic due to the availability
of substitutes, an entire industry itself tends to be inelastic. Usually, unique goods such
as diamonds are inelastic because they have few if any substitutes.
Necessity
As we saw above, if something is needed for survival or comfort, people will continue to
pay higher prices for it. For example, people need to get to work or drive for a number
of reasons. Therefore, even if the price of gas doubles or even triples, people will still
need to fill up their tanks.
Time
The third influential factor is time. If the price of cigarettes goes up $2 per pack, a
smoker with very few available substitutes will most likely continue buying their daily
cigarettes. This means that tobacco is inelastic because the change in price will not have
a significant influence on the quantity demanded. However, if that smoker finds that
they cannot afford to spend the extra $2 per day and begins to kick the habit over a
period of time, the price of cigarettes for that consumer becomes elastic in the long run.
The Importance of Price Elasticity in Business
Understanding whether or not the goods or services of a business are elastic is integral
to the success of the company. Companies with high elasticity ultimately compete with
other businesses on price and are required to have a high volume of sales transactions
to remain solvent. Firms that are inelastic, on the other hand, have goods and services
that are must-haves and enjoy the luxury of setting higher prices.
Beyond prices, the elasticity of a good or service directly affects the customer retention
rates of a company. Businesses often strive to sell goods or services that have inelastic
demand; doing so means that customers will remain loyal and continue to purchase the
good or service even in the face of a price increase.

Examples of Elasticity
There are a number of real-world examples of elasticity we interact with on a daily basis.
One interesting modern-day example of the price elasticity of demand many people
take part in even if they don't realize it is the case of Uber's surge pricing. As you might
know, Uber uses a "surge pricing" algorithm during times when there is an above-
average amount of users requesting rides in the same geographic area. The company
applies a price multiplier which allows Uber to equilibrate supply and demand in real-
time.
The COVID-19 pandemic has also shone a spotlight on the price elasticity of demand
through its impact on a number of industries. For example, a number of outbreaks of
the coronavirus in meat processing facilities across the US, in addition to the slowdown
in international trade, led to a domestic meat shortage, causing import prices to rise
16% in May 2020, the largest increase on record since 1993. 1
Another extraordinary example of COVID-19's impact on elasticity arose in the oil
industry. Although oil is generally very inelastic, meaning demand has a little impact on
the price per barrel, because of a historic drop in global demand for oil during March
and April, along with increased supply and a shortage of storage space, on April 20,
2020, crude petroleum actually traded at a negative price in the intraday futures
market.
In response to this dramatic drop in demand, OPEC+ members elected to cut production
by 9.7 million barrels per day through the end of June, the largest production cut ever. 2
Elasticity FAQs
What is meant by elasticity in economics?
 Elasticity refers to the measure of the responsiveness of quantity demanded or quantity
supplied to one of its determinants.
What is the elasticity of demand formula?
The elasticity of demand can be calculated by dividing the percentage change in the
quantity demanded of a good or service by the percentage change in price.
What are the 4 types of elasticity?
Four types of elasticity are demand elasticity, income elasticity, cross elasticity, and
price elasticity.
What is price elasticity?
Price elasticity measures how much the supply or demand of a product changes based
on a given change in price.
The Bottom Line
Understanding whether a good or service is elastic or inelastic, and what other products
could be tied to a good's elasticity can help consumers make informed decisions when
they are deciding if or when to make a purchase.
The price elasticity of supply is the measure of the responsiveness in quantity supplied
to a change in price for a specific good.
LEARNING OBJECTIVES
Differentiate between the price elasticity of demand for elastic and inelastic goods
KEY TAKEAWAYS
Key Points
 Elasticity is defined as a proportionate change in one variable over the proportionate
change in another variable: Elasticity=%Changeinquantity%ChangeinpriceElasticity=
%Changeinquantity%Changeinprice
 The impact that a price change has on the elasticity of supply also directly impacts the
elasticity of demand.
 Inelastic goods are often described as necessities, while elastic goods are considered
luxury items.
 The elasticity of a good will be labelled as perfectly elastic, relatively elastic, unit elastic,
relatively inelastic, or perfectly inelastic.
Key Terms
 luxury: Something very pleasant but not really needed in life.
 supply: The amount of some product that producers are willing and able to sell at a
given price, all other factors being held constant.
 demand: The desire to purchase goods and services.
In economics, elasticity is a summary measure of how the supply or demand of a
particular good is influenced by changes in price. Elasticity is defined as a proportionate
change in one variable over the proportionate change in another variable:
 Elasticity=%Changeinquantity%ChangeinpriceElasticity=%Changeinquantity
%Changeinprice
The price elasticity of supply (PES) is the measure of the responsiveness in quantity
supplied (QS) to a change in price for a specific good (% Change QS / % Change in Price).
There are numerous factors that directly impact the elasticity of supply for a good
including stock, time period, availability of substitutes, and spare capacity. The state of
these factors for a particular good will determine if the price elasticity of supply is elastic
or inelastic in regards to a change in price.
The price elasticity of supply has a range of values:
 PES > 1: Supply is elastic.
 PES < 1: Supply is inelastic.
 PES = 0: The supply curve is vertical; there is no response of demand to prices. Supply is
“perfectly inelastic.”
 PES = ∞∞ (i.e., infinity): The supply curve is horizontal; there is extreme change in
demand in response to very small change in prices. Supply is “perfectly elastic.”
Inelastic goods are often described as necessities. A shift in price does not drastically
impact consumer demand or the overall supply of the good because it is not something
people are able or willing to go without. Examples of inelastic goods would be water,
gasoline, housing, and food.
Elastic goods are usually viewed as luxury items. An increase in price for an elastic good
has a noticeable impact on consumption. The good is viewed as something that
individuals are willing to sacrifice in order to save money. An example of an elastic good
is movie tickets, which are viewed as entertainment and not a necessity.
The price elasticity of supply is determined by:
 Number of producers: ease of entry into the market.
 Spare capacity: it is easy to increase production if there is a shift in demand.
 Ease of switching: if production of goods can be varied, supply is more elastic.
 Ease of storage: when goods can be stored easily, the elastic response increases
demand.
 Length of production period: quick production responds to a price increase easier.
 Time period of training: when a firm invests in capital the supply is more elastic in its
response to price increases.
 Factor mobility: when moving resources into the industry is easier, the supply curve in
more elastic.
 Reaction of costs: if costs rise slowly it will stimulate an increase in quantity supplied. If
cost rise rapidly the stimulus to production will be choked off quickly.
The result of calculating the elasticity of the supply and demand of a product according
to price changes illustrates consumer preferences and needs. The elasticity of a good
 will be labelled as perfectly elastic, relatively elastic, unit elastic, relatively inelastic, or
perfectly inelastic.

Price elasticity over time: This graph illustrates how the supply and demand of a product
are measured over time to show the price elasticity.

Perfectly Inelastic Supply: A graphical representation of perfectly inelastic supply.

Measuring the Price Elasticity of Supply
The price elasticity of supply is the measure of the responsiveness of the quantity
supplied of a particular good to a change in price.
LEARNING OBJECTIVES
Calculate elasticities and describe their meaning
KEY TAKEAWAYS
Key Points
 The price elasticity of supply = % change in quantity supplied / % change in price.
 When calculating the price elasticity of supply, economists determine whether the
quantity supplied of a good is elastic or inelastic.
 PES > 1: Supply is elastic. PES < 1: Supply is inelastic. PES = 0: if the supply curve is
vertical, and there is no response to prices. PES = infinity: if the supply curve is
horizontal.
Key Terms
 mobility: The ability for economic factors to move between actors or conditions.
 capacity: The maximum that can be produced on a machine or in a facility or group.
The price elasticity of supply (PES) is the measure of the responsiveness of the quantity
supplied of a particular good to a change in price (PES = % Change in QS / % Change in
Price). The intent of determining the price elasticity of supply is to show how a change in
price impacts the amount of a good that is supplied to consumers. The price elasticity of
supply is directly related to consumer demand.
Elasticity
The elasticity of a good provides a measure of how sensitive one variable is to changes
in another variable. In this case, the price elasticity of supply determines how sensitive
the quantity supplied is to the price of the good.
Calculating the PES
When calculating the price elasticity of supply, economists determine whether the
quantity supplied of a good is elastic or inelastic. The percentage of change in supply is
divided by the percentage of change in price. The results are analyzed using the
following range of values:
 PES > 1: Supply is elastic.
 PES < 1: Supply is inelastic.
 PES = 0: Supply is perfectly inelastic. There is no change in quantity if prices change.
 PES = infinity: Supply is perfectly elastic. An decrease in prices will lead to zero units
produced.
Factors that Influence the PES
There are numerous factors that impact the price elasticity of supply including the
number of producers, spare capacity, ease of switching, ease of storage, length of
production period, time period of training, factor mobility, and how costs react.
The price elasticity of supply is calculated and can be graphed on a demand curve to
illustrate the relationship between the supply and price of the good.
 Supply and Demand Curves: A demand curve is used to graph the impact that a change
in price has on the supply and demand of a good.
Applications of Elasticities
In economics, elasticity refers to how the supply and demand of a product changes in
relation to a change in the price.
LEARNING OBJECTIVES
Give examples of inelastic and elastic supply in the real world
KEY TAKEAWAYS
Key Points
 To determine the elasticity of a product, the proportionate change of one variable is
placed over the proportionate change of another variable (Elasticity = % change of
supply or demand / % change in price ).
 For elastic demand, a change in price significantly impacts the supply and demand of the
product.
 For inelastic demand, a change in the price does not substantially impact the supply and
demand of the product.
 Economists use demand curves in order to document and study elasticity.
Key Terms
 elastic: Sensitive to changes in price.
 demand: The desire to purchase goods and services.
 inelastic: Not sensitive to changes in price.
 supply: The amount of some product that producers are willing and able to sell at a
given price, all other factors being held constant.
In economics, elasticity refers to the responsiveness of the demand or supply of a
product when the price changes.
The technical definition of elasticity is the proportionate change in one variable over the
proportionate change in another variable. For example, to determine how a change in
the supply or demand of a product is impacted by a change in the price, the following
equation is used: Elasticity = % change in supply or demand / % change in price.
The price is a variable that can directly impact the supply and demand of a product. If a
change in the price of a product significantly influences the supply and demand, it is
considered “elastic.” Likewise, if a change in product price does not significantly change
the supply and demand, it is considered “inelastic.”
For elastic demand, when the price of a product increases the demand goes down.
When the price decreases the demand goes up. Elastic products are usually luxury items
that individuals feel they can do without. An example would be forms of entertainment
such as going to the movies or attending a sports event. A change in prices can have a
significant impact on consumer trends as well as economic profits. For companies and
businesses, an increase in demand will increase profit and revenue, while a decrease in
demand will result in lower profit and revenue.
For inelastic demand, the overall supply and demand of a product is not substantially
impacted by an increase in price. Products that are usually inelastic consist of necessities
like food, water, housing, and gasoline. Whether or not a product is elastic or inelastic is
directly related to consumer needs and preferences. If demand is perfectly inelastic,
then the same amount of the product will be purchased regardless of the price.
Economists study elasticity and use demand curves in order to diagram and study
consumer trends and preferences. An elastic demand curve shows that an increase in
the supply or demand of a product is significantly impacted by a change in the price. An
inelastic demand curve shows that an increase in the price of a product does not
substantially change the supply or demand of the product.

Inelastic Demand: For inelastic demand, when there is an outward shift in supply and
prices fall, there is no substantial change in the quantity demanded.
 Elastic Demand: For elastic demand, when there is an outward shift in supply, prices fall
which causes a large increase in quantity demanded.

LESSON F: PRODUCTION AND COST

THE CONCEPT OF PRODUCTION

Production function is that part of an organization, which is concerned with the
transformation of a range of inputs into the required outputs (products) having the
requisite quality level.
Production is defined as “the step-by-step conversion of one form of material into
another form through chemical or mechanical process to create or enhance the utility of
the product to the user.” Thus, production is a value addition process. At each stage of
processing, there will be value addition.
Edwood Buffa defines production as ‘a process by which goods and services are
created’.
Some examples of production are: manufacturing custom-made products like, boilers
with a specific capacity, constructing flats, some structural fabrication works for selected
customers, etc., and manufacturing standardized products like, car, bus, motor cycle,
radio, television, etc. Schematic production system PRODUCTION SYSTEM.
The production system of an organization is that part, which produces products of a 19
organization.
It is that activity whereby resources, flowing within a defined system, are combined and
transformed in a controlled manner to add value in accordance with the policies
communicated by management. A simplified production system is shown above.
The production system has the following characteristics:
1. Production is an organized activity, so every production system has an objective.
2. The system transforms the various inputs to useful outputs.
3. It does not operate in isolation from the other organization system.
4. There exists a feedback about the activities, which is essential to control and improve
system performance.
Classification of Production System Production systems can be classified as Job Shop,
Batch, Mass and Continuous Production systems.

INTERMITTENT SYSTEM JOB SHOP PRODUCTION is characterized by manufacturing of

one or few quantities of products designed and produced as per the specification of
customers within prefixed time and cost. The distinguishing feature of this is low volume
and high variety of products. A job shop comprises of general-purpose machines
arranged into different departments. Each job demands unique technological
requirements, demands processing on machines in a certain sequence.

Characteristics of The Job-shop production system is followed when there is: 1. High
variety of products and low volume.
2. Use of general-purpose machines and facilities.
3. Highly skilled operators who can take up each job as a challenge because of
uniqueness.
4.Large inventory of materials, tools, parts.
5. Detailed planning is essential for sequencing the requirements of each product,
capacities for each work center and order priorities.

Following are the advantages of job shop production:

1. Because of general purpose machines and facilities variety of products can be
produced.
2. Operators will become more skilled and competent, as each job gives them learning
opportunities.
3. Full potential of operators can be utilized.
4. Opportunity exists for creative methods and innovative ideas.

Limitations Following are the limitations of job shop production:

1. Higher cost due to frequent set up changes.
2. Higher level of inventory at all levels and hence higher inventory cost.
3. Production planning is complicated.
4. Larger space requirements.
BATCH PRODUCTION is defined by American Production and Inventory Control Society
(APICS) “as a form of manufacturing in which the job passes through the functional
departments in lots or batches and each lot may have a different routing.” It is
characterized by the manufacture of limited number of products produced at regular
intervals and stocked awaiting sales.

Characteristics Batch production system is used under the following circumstances:

1. When there are shorter production runs.
2. When plant and machinery are flexible.
3. When plant and machinery set up is used for the production of item in a batch and
change of set up is required for processing the next batch.
4. When manufacturing lead time and cost are lower as compared to job order
production.

Advantages Following are the advantages of batch production:

1. Better utilization of plant and machinery.
2. Promotes functional specialization.
3. Cost per unit is lower as compared to job order production.
4. Lower investment in plant and machinery.
5. Flexibility to accommodate and process number of products.
6. Job satisfaction exists for operators.

Limitations Following are the limitations of batch production:

1. Material handling is complex because of irregular and longer flows.
2. Production planning and control is complex.
3. Work in process inventory is higher compared to continuous production. 4. Higher set
up costs due to frequent changes in set up.

MASS PRODUCTION Manufacture of discrete parts or assemblies using a continuous

process are called mass production. This production system is justified by very large
volume of production. The machines are arranged in a line or product layout. Product
and process standardization exists and all outputs follow the same path.

Characteristics Mass production is used under the following circumstances:

1. Standardization of product and process sequence.
2. Dedicated special purpose machines having higher production capacities and output
rates.
3. Large volume of products.
4. Shorter cycle time of production.
5. Lower in process inventory.
6. Perfectly balanced production lines.
7. Flow of materials, components and parts is continuous and without any back tracking.
8. Production planning and control is easy.
9. Material handling can be completely automatic.

Advantages Following are the advantages of mass production:

1. Higher rate of production with reduced cycle time.
2. Higher capacity utilization due to line balancing.
3. Less skilled operators are required.
4. Low process inventory.
5. Manufacturing cost per unit is low.

Limitations Following are the limitations of mass production:

1. Breakdown of one machine will stop an entire production line.
2. Line layout needs major change with the changes in the product design.
3. High investment in production facilities.
4. The cycle time is determined by the slowest operation.

CONTINUOUS PRODUCTION facilities are arranged as per the sequence of production

operations from the first operations to the finished product. The items are made to flow
through the sequence of operations through material handling devices such as
conveyors, transfer devices, etc. Characteristics

Continuous production is used under the following circumstances:

1. Dedicated plant and equipment with zero flexibility.
2. Material handling is fully automated.
3. Process follows a predetermined sequence of operations.
4. Component materials cannot be readily identified with final product.
5. Planning and scheduling is a routine action.

Advantages Following are the advantages of continuous production:

1. Standardization of product and process sequence.
2. Higher rate of production with reduced cycle time.
3. Higher capacity utilization due to line balancing.
4. Manpower is not required for material handling as it is completely automatic.
5. Person with limited skills can be used on the production line.
6. Unit cost is lower due to high volume of production.
 Limitations Following are the limitations of continuous production:
1. Flexibility to accommodate and process number of products does not exist.
2. Very high investment for setting flow lines.
3. Product differentiation is limited.

TRANSFORMING INPUTS INTO OUTPUTS

A transformation process is any activity or group of activities that takes one or more
inputs, transforms and adds value to them, and provides outputs for customers or
clients. Where the inputs are raw materials, it is relatively easy to identify the
transformation involved, as when milk is transformed into cheese and butter. Where the
inputs are information or people, the nature of the transformation may be less obvious.
For example, a hospital transforms ill patients (the input) into healthy patients (the
output).
Transformation processes include:
 changes in the physical characteristics of materials or customers
 changes in the location of materials, information or customers
 changes in the ownership of materials or information
 storage or accommodation of materials, information or customers
 changes in the purpose or form of information
 changes in the physiological or psychological state of customers.
Often all three types of input – materials, information and customers – are transformed
by the same organization. For example, withdrawing money from a bank account
involves information about the customer's account, materials such as cheques and
currency, and the customer. Treating a patient in hospital involves not only the
‘customer's’ state of health, but also any materials used in treatment and information
about the patient.
One useful way of categorizing different types of transformation is into:
 manufacture – the physical creation of products (for example cars)
 transport – the movement of materials or customers (for example a taxi service)
 supply – change in ownership of goods (for example in retailing)
 service – the treatment of customers or the storage of materials (for example hospital
wards, warehouses).
Several different transformations are usually required to produce a good or service. The
overall transformation can be described as the macro-operation, and the more detailed
transformations within this macro-operation as micro-operations. For example, the
macro operation in a brewery is making beer (Figure 2). The micro-operations include:
 milling the malted barley into grist
 mixing the grist with hot water to form wort
 cooling the wort and transferring it to the fermentation vessel
 adding yeast to the wort and fermenting the liquid into beer
 filtering the beer to remove the spent yeast
 decanting the beer into casks or bottles.

PRODUCTION FUNCTIONS

In economics, a production function relates physical output of a production process to

physical inputs or factors of production. It is a mathematical function that relates the
maximum amount of output that can be obtained from a given number of inputs –
generally capital and labor. The production function, therefore, describes a boundary or
frontier representing the limit of output obtainable from each feasible combination of
inputs.
Firms use the production function to determine how much output they should produce
given the price of a good, and what combination of inputs they should use to produce
given the price of capital and labor. When firms are deciding how much to produce, they
typically find that at high levels of production, their marginal costs begin increasing. This
is also known as diminishing returns to scale – increasing the quantity of inputs creates a
less-than-proportional increase in the quantity of output. If it weren’t for diminishing
returns to scale, supply could expand without limits without increasing the price of a
good.
Factory Production: Manufacturing companies use their production function to
determine the optimal combination of labor and capital to produce a certain amount of
output.
Increasing marginal costs can be identified using the production function. If a firm has a
production function Q=F(K,L) (that is, the quantity of output (Q) is some function of
capital (K) and labor (L)), then if 2Q<F(2K,2L), the production function has increasing
marginal costs and diminishing returns to scale. Similarly, if 2Q>F(2K,2L), there are
increasing returns to scale, and if 2Q=F(2K,2L), there are constant returns to scale.
Examples of Common Production Functions
One very simple example of a production function might be Q=K+L, where Q is the
quantity of output, K is the amount of capital, and L is the amount of labor used in
production. This production function says that a firm can produce one unit of output for
every unit of capital or labor it employs. From this production function we can see that
this industry has constant returns to scale – that is, the amount of output will increase
proportionally to any increase in the number of inputs.
Another common production function is the Cobb-Douglas production function. One
example of this type of function is Q=K 0.5L0.5. This describes a firm that requires the least
total number of inputs when the combination of inputs is relatively equal. For example,
the firm could produce 25 units of output by using 25 units of capital and 25 of labor, or
it could produce the same 25 units of output with 125 units of labor and only one unit of
capital.
Finally, the Leontief production function applies to situations in which inputs must be
used in fixed proportions; starting from those proportions, if usage of one input is
 increased without another being increased, output will not change. This production
function is given by Q=Min(K,L). For example, a firm with five employees will produce
five units of output as long as it has at least five units of capital.

COSTS OF PRODUCTION

Production costs refer to all the costs incurred by a business from manufacturing a
product or providing a service. Production costs can include a variety of expenses, such
as labor, raw materials, consumable manufacturing supplies, and general overhead.
KEY TAKEAWAYS
 Production costs refer to the costs incurred from manufacturing a product or providing
a service that generates revenue for that company.
 Production costs can include a variety of expenses, such as labor, raw materials,
consumable manufacturing supplies, and general overhead. 
 Total product costs can be determined by adding together the total direct materials and
labor costs as well as the total manufacturing overhead costs. 
Volume 75%

Production costs, which are also known as product costs, are incurred by a business
from manufacturing a product or providing a service. These costs include a variety of
expenses. For example, manufacturers have production costs related to the raw
materials and labor needed to create the product. Service industries incur production
costs related to the labor required to implement the service and any costs of materials
involved in delivering the service.1
Taxes levied by the government or royalties owed by natural resource-extraction
companies also are treated as production costs.1
Once a product is finished, the company records the product's value as an asset in
its financial statements until the product is sold. Recording a finished product as an
asset serves to fulfill the company's reporting requirements, as well as
inform shareholders.

LESSON G: MARKET STRUCTURES

WHAT IS MARKET?

A market is a place where two

parties can gather to facilitate the
exchange of goods and services. The
parties involved are usually buyers
 and sellers. The market may be physical like a retail outlet, where people meet face-to-
face, or virtual like an online market, where there is no direct physical contact between
buyers and sellers.

KEY TAKEAWAYS
 A market is a place where buyers and sellers can meet to facilitate the exchange or
transaction of goods and services.
 Markets can be physical like a retail outlet, or virtual like an e-retailer. Other examples
include the black market, auction markets, and financial markets.
 Markets establish the prices of goods and services that are determined by supply and
demand.

Understanding Market
The term market also takes on other forms. For instance, it may refer to the place where
securities are traded—the securities market. Alternatively, the term may also be used to
describe a collection of people who wish to buy a specific product or service such as the
Brooklyn housing market or as broad as the global diamond market.

Technically speaking, a market is any place where two or more parties can meet to
engage in an economic transaction—even those that don't involve legal tender. A
market transaction may involve goods, services, information, currency, or any
combination of these that pass from one party to another.

Markets may be represented by physical locations where transactions are made. These

include retail stores and other similar businesses that sell individual items to wholesale
markets selling goods to other distributors. Or they may be virtual. Internet-based
stores and auction sites such as Amazon and eBay are examples of markets where
transactions can take place entirely online and the parties involved never connect
physically.

Markets are arenas in which buyers and sellers can gather and interact. In general, only
two parties are needed to make a trade, at minimum a third party is needed to
introduce competition and bring balance to the market. As such, a market in a state of
perfect competition, among other things, is necessarily characterized by a high number
of active buyers and sellers.

The market establishes the prices for goods and other services. These rates are
determined by supply and demand. Supply is created by the sellers, while demand is
generated by buyers. Markets try to find some balance in price when supply and
demand are themselves in balance. But that balance can in itself be disrupted by factors
other than price including incomes, expectations, technology, the cost of production,
and the number of buyers and sellers in the market.

Markets may emerge organically or as a means of enabling ownership rights over goods,
services, and information. When on a national or other more specific regional level,
markets may often be categorized as “developed” markets or “developing” markets,
depending on many factors, including income levels and the nation or region’s openness
to foreign trade.
 
The size of a market is determined by the number of buyers and sellers, as well as the
amount of money that changes hands each year.

Types of Markets
Markets vary widely for a number of reasons, including the kinds of products sold,
location, duration, size, and constituency of the customer base, size, legality, and many
other factors. Aside from the two most common markets—physical and virtual—there
are other kinds of markets where parties can gather to execute their transactions.

Black Market
A black market refers to an illegal market where transactions occur without the
knowledge of the government or other regulatory agencies. Many black markets exist in
order to circumvent existing tax laws. This is why many involve cash-only transactions or
other forms of currency, making them harder to track.

Many black markets exist in countries with planned or command economies—wherein

the government controls the production and distribution of goods and services—and in
countries that are developing. When there is a shortage of certain goods and services in
the economy, members of the black-market step in and fill the void.

Black markets can also exist in developed economies as well. This is prevalent when
prices control the sale of certain products or services, especially when demand is high.
Ticket scalping is one example. When demand for concert tickets is high, scalpers will
step in and sell them at inflated prices on the black market.

Auction Market
An auction market brings many people together for the sale and purchase of specific
lots of goods. The buyers or bidders try to top each other for the purchase price. The
items up for sale end up going to the highest bidder.
The most common auction markets involve livestock and homes, or websites like eBay
where bidders may bid anonymously to win auctions.

Financial Market
The blanket term financial market refers to any place where securities, currencies,
bonds, and other securities are traded between two parties. These markets are the basis
of capitalist societies, and they provide capital formation and liquidity for businesses.
They can be physical or virtual.
The financial market includes the stock exchanges such as the New York Stock Exchange,
Nasdaq, the LSE, and the TMX Group. Other kinds of financial markets include the bond
market and the foreign exchange market, where people trade currencies.
Special Considerations: Regulating Markets
Other than black markets, most markets are subject to rules and regulations set by a
regional or governing body that determines the market’s nature. This may be the case
when the regulation is as wide-reaching and as widely recognized as an international
trade agreement, or as local and temporary as a pop-up street market where vendors
self-regulate through market forces.
In the United States, the Securities and Exchange Commission (SEC) regulates the stock,
bond, and currency markets. Although it may not have full control of the nation's
exchanges, it does have provisions in place to prevent fraud while ensuring traders and
investors have the right information to make the most informed decisions possible.

Frequently Asked Questions

How Markets Work?

Markets are arenas in which buyers and sellers can gather and interact. A market in a
state of perfect competition is necessarily characterized by a high number of active
buyers and sellers. The market establishes the prices for goods and other services.
These rates are determined by supply and demand. Supply is created by the sellers,
while demand is generated by buyers. Markets try to find some balance in price when
supply and demand are themselves in balance.

What Is a Black Market?

A black market refers to an illegal market where transactions occur without the
knowledge of the government or other regulatory agencies. Many black markets exist in
order to circumvent existing tax laws. This is why many involve cash-only transactions or
other forms of currency, making them harder to track. When there is a shortage of
certain goods and services in the economy, members of the black-market step in and fill
the void.
 How Are Markets Regulated?
Other than black markets, most markets are subject to rules and regulations set by a
regional or governing body that determines the market’s nature. This may be the case
when the regulation is as wide-reaching and as widely recognized as an international
trade agreement, or as local and temporary as a pop-up street market where vendors
self-regulate through market forces. In the United States, the Securities and Exchange
Commission (SEC) regulates the stock, bond, and currency markets. Although it may not
have full control of the nation's exchanges, it does have provisions in place to prevent
fraud while ensuring traders and investors have the right information to make the most
informed decisions possible.

KINDS OF MARKET STRUCTURE

In this reading, we have surveyed how economists classify market structures. We have
analyzed the distinctions between the different structures that are important for
understanding demand and supply relations, optimal price and output, and the factors
affecting long-run profitability.

We also provided guidelines for identifying market structure in practice. Among our
conclusions are the following:

 Economic market structures can be grouped into four categories: perfect competition,
monopolistic competition, oligopoly, and monopoly.
 The categories differ because of the following characteristics: The number of producers
is many in perfect and monopolistic competition, few in oligopoly, and one in monopoly.
The degree of product differentiation, the pricing power of the producer, the barriers to
entry of new producers, and the level of non-price competition (e.g., advertising) are all
low in perfect competition, moderate in monopolistic competition, high in oligopoly,
and generally highest in monopoly.
 A financial analyst must understand the characteristics of market structures in order to
better forecast a firm’s future profit stream.
 The optimal marginal revenue equals marginal cost. However, only in perfect
competition does the marginal revenue equal price. In the remaining structures, price
generally exceeds marginal revenue because a firm can sell more units only by reducing
the per unit price.
 The quantity sold is highest in perfect competition. The price in perfect competition is
usually lowest, but this depends on factors such as demand elasticity and increasing
returns to scale (which may reduce the producer’s marginal cost). Monopolists,
 oligopolists, and producers in monopolistic competition attempt to differentiate their
products so that they can charge higher prices.
 Typically, monopolists sell a smaller quantity at a higher price. Investors may benefit
from being shareholders of monopolistic firms that have large margins and substantial
positive cash flows.
 Competitive firms do not earn economic profit. There will be a market compensation for
the rental of capital and of management services, but the lack of pricing power implies
that there will be no extra margins.
 While in the short run firms in any market structure can have economic profits, the
more competitive a market is and the lower the barriers to entry, the faster the extra
profits will fade. In the long run, new entrants shrink margins and push the least
efficient firms out of the market.
 Oligopoly is characterized by the importance of strategic behavior. Firms can change the
price, quantity, quality, and advertisement of the product to gain an advantage over
their competitors. Several types of equilibrium (e.g., Nash, Cournot, kinked demand
curve) may occur that affect the likelihood of each of the incumbents (and potential
entrants in the long run) having economic profits. Price wars may be started to force
weaker competitors to abandon the market.
 Measuring market power is complicated. Ideally, econometric estimates of the elasticity
of demand and supply should be computed. However, because of the lack of reliable
data and the fact that elasticity changes over time (so that past data may not apply to
the current situation), regulators and economists often use simpler measures. 

LESSON H: MEASURING NATIONAL OUTPUT AND INCOME

WHAT IS NATIONAL INCOME?

National income means the

value of goods
and services produced by a
country during a financial
 year. Thus, it is the net result of all economic activities of any country during a period of
one year and is valued in terms of money. National income is an uncertain term and is
often used interchangeably with the national dividend, national output, and
national expenditure. We can understand this concept by understanding the national
income definition.

The National Income is the total amount of income accruing to a country from economic

activities in a years’ time. It includes payments made to all resources either in the form
of wages, interest, rent, and profits.

The progress of a country can be determined by the growth of the national income of

the country
National Income Definition
There are two National Income Definition
 Traditional Definition
 Modern Definition
Traditional Definition
According to Marshall: “The labor and capital of a country acting on its natural
resources produce annually a certain net aggregate of commodities, material and
immaterial including services of all kinds. This is the true net annual income or revenue
of the country or national dividend.”
The definition as laid down by Marshall is being criticized on the following grounds.
Due to the varied category of goods and services, a correct estimation is very difficult.
There is a chance of double counting, hence National Income cannot be estimated
correctly.
For example, a product runs in the supply from the producer to distributor
to wholesaler to retailer and then to the ultimate consumer. If on every movement
commodity is taken into consideration then the value of National Income increases.
Also, one other reason is that there are products which are produced but not marketed.
For example, In an agriculture-oriented country like India, there are commodities which
though produced but are kept for self-consumption or exchanged with other
commodities. Thus there can be an underestimation of National Income.
Read more about Income and Expenditure Method here in detail
Simon Kuznets defines national income as “the net output of commodities and services
flowing during the year from the country’s productive system in the hands of the
ultimate consumers.”
Following are the Modern National Income definition
 GDP
 GNP
 Gross Domestic Product
The total value of goods produced and services rendered within a country during a year
is its Gross Domestic Product.
Further, GDP is calculated at market price and is defined as GDP at market prices.
Different constituents of GDP are:
1. Wages and salaries
2. Rent
3. Interest
4. Undistributed profits
5. Mixed-income
6. Direct taxes
7. Dividend
8. Depreciation
Gross National Product
For calculation of GNP, we need to collect and assess the data from all productive
activities, such as agricultural produce, wood, minerals, commodities, the contributions
to production by transport, communications, insurance companies, professions such (as
lawyers, doctors, teachers, etc). at market prices.

It also includes net income arising in a country from abroad. Four main constituents of
GNP are:
1. Consumer goods and services
2. Gross private domestic income
3. Goods produced or services rendered
4. Income arising from abroad.

IMPORTANT TERMS USED IN MEASURING NATIONAL INCOME

These three methods of calculating GDP yield the same result because National Product
= National Income = National Expenditure.

1. The Product Method:

In this method, the value of all goods and services produced in different industries
during the year is added up. This is also known as the value-added method to GDP or
GDP at factor cost by industry of origin. The following items are included in India in this:
agriculture and allied services; mining; manufacturing, construction, electricity, gas and
water supply; transport, communication and trade; banking and insurance, real estates
and ownership of dwellings and business services; and public administration and
defense and other services (or government services). In other words, it is the sum of
gross value added.

2. The Income Method:

The people of a country who produce GDP during a year receive incomes from their
work. Thus, GDP by income method is the sum of all factor incomes: Wages and Salaries
(compensation of employees) + Rent + Interest + Profit.

3. Expenditure Method:
This method focuses on goods and services produced within the country during one
year.

GDP by expenditure method includes:

(1) Consumer expenditure on services and durable and non-durable goods (C),
(2) Investment in fixed capital such as residential and non-residential building,
machinery, and inventories (I),
(3) Government expenditure on final goods and services (G),
(4) Export of goods and services produced by the people of country (X),
(5) Less imports (M). That part of consumption, investment and government
expenditure which is spent on imports is subtracted from GDP. Similarly, any imported
component, such as raw materials, which is used in the manufacture of export goods, is
also excluded.
Thus, GDP by expenditure method at market prices = C+ I + G + (X – M), where (X-M) is
net export which can be positive or negative.

(B) GDP at Factor Cost:

GDP at factor cost is the sum of net value added by all producers within the country.
Since the net value added gets distributed as income to the owners of factors of
production, GDP is the sum of domestic factor incomes and fixed capital consumption
(or depreciation).
Thus, GDP at Factor Cost = Net value added + Depreciation.
GDP at factor cost includes:
(i) Compensation of employees i.e., wages, salaries, etc.
(ii) Operating surplus which is the business profit of both incorporated and
unincorporated firms. [Operating Surplus = Gross Value Added at Factor Cost—
Compensation of Employees—Depreciation]
(iii) Mixed Income of Self- employed.
Conceptually, GDP at factor cost and GDP at market price must be identical/This is
because the factor cost (payments to factors) of producing goods must equal the final
value of goods and services at market prices. However, the market value of goods and
services is different from the earnings of the factors of production.
In GDP at market price are included indirect taxes and are excluded subsidies by the
government. Therefore, in order to arrive at GDP at factor cost, indirect taxes are
subtracted and subsidies are added to GDP at market price.
Thus, GDP at Factor Cost = GDP at Market Price – Indirect Taxes + Subsidies.

(C) Net Domestic Product (NDP):

NDP is the value of net output of the economy during the year. Some of the country’s
capital equipment wears out or becomes obsolete each year during the production
process. The value of this capital consumption is some percentage of gross investment
which is deducted from GDP. Thus Net Domestic Product = GDP at Factor Cost –
Depreciation.

(D) Nominal and Real GDP:

When GDP is measured on the basis of current price, it is called GDP at current prices or
nominal GDP. On the other hand, when GDP is calculated on the basis of fixed prices in
some year, it is called GDP at constant prices or real GDP.
Nominal GDP is the value of goods and services produced in a year and measured in
terms of rupees (money) at current (market) prices. In comparing one year with
another, we are faced with the problem that the rupee is not a stable measure of
purchasing power. GDP may rise a great deal in a year, not because the economy has
been growing rapidly but because of rise in prices (or inflation).
On the contrary, GDP may increase as a result of fall in prices in a year but actually it
may be less as compared to the last year. In both 5 cases, GDP does not show the real
state of the economy. To rectify the underestimation and overestimation of GDP, we
need a measure that adjusts for rising and falling prices.
This can be done by measuring GDP at constant prices which is called real GDP. To find
out the real GDP, a base year is chosen when the general price level is normal, i.e., it is
neither too high nor too low. The prices are set to 100 (or 1) in the base year.
Now the general price level of the year for which real GDP is to be calculated is related
to the base year on the basis of the following formula which is called the deflator
index:

Suppose 1990-91 is the base year and GDP for 1999-2000 is Rs. 6, 00,000 crores and the
price index for this year is 300.
Thus, Real GDP for 1999-2000 = Rs. 6, 00,000 x 100/300 = Rs. 2, 00,000 crores
(E) GDP Deflator:
GDP deflator is an index of price changes of goods and services included in GDP. It is a
price index which is calculated by dividing the nominal GDP in a given year by the real
GDP for the same year and multiplying it by 100. Thus,

It shows that at constant prices (1993-94), GDP in 1997-98 increased by 135.9% due to
inflation (or rise in prices) from Rs. 1049.2 thousand crores in 1993-94 to Rs. 1426.7
thousand crores in 1997-98.
(F) Gross National Product (GNP):
GNP is the total measure of the flow of goods and services at market value resulting
from current production during a year in a country, including net income from abroad.
GNP includes four types of final goods and services:
(1) Consumers’ goods and services to satisfy the immediate wants of the people;
(2) Gross private domestic investment in capital goods consisting of fixed capital
formation, residential construction and inventories of finished and unfinished goods;
(3) Goods and services produced by the government; and
(4) Net exports of goods and services, i.e., the difference between value of exports and
imports of goods and services, known as net income from abroad.
In this concept of GNP, there are certain factors that have to be taken into
consideration: First, GNP is the measure of money, in which all kinds of goods and
services produced in a country during one year are measured in terms of money at
current prices and then added together.
But in this manner, due to an increase or decrease in the prices, the GNP shows a rise or
decline, which may not be real. To guard against erring on this account, a particular year
(say for instance 1990-91) when prices be normal, is taken as the base year and the GNP
is adjusted in accordance with the index number for that year. This will be known as
GNP at 1990-91 prices or at constant prices.
Second, in estimating GNP of the economy, the market price of only the final products
should be taken into account. Many of the products pass through a number of stages
before they are ultimately purchased by consumers.
If those products were counted at every stage, they would be included many a time in
the national product. Consequently, the GNP would increase too much. To avoid double
counting, therefore, only the final products and not the intermediary goods should be
taken into account.
Third, goods and services rendered free of charge are not included in the GNP, because
it is not possible to have a correct estimate of their market price. For example, the
bringing up of a child by the mother, imparting instructions to his son by a teacher,
recitals to his friends by a musician, etc.
Fourth, the transactions which do not arise from the produce of current year or which
do not contribute in any way to production are not included in the GNP. The sale and
purchase of old goods, and of shares, bonds and assets of existing companies are not
included in GNP because these do not make any addition to the national product, and
the goods are simply transferred.
Fifth, the payments received under social security, e.g., unemployment insurance
allowance, old age pension, and interest on public loans are also not included in GNP,
because the recipients do not provide any service in lieu of them. But the depreciation
of machines, plants and other capital goods is not deducted from GNP.
Sixth, the profits earned or losses incurred on account of changes in capital assets as a
result of fluctuations in market prices are not included in the GNP if they are not
responsible for current production or economic activity.
For example, if the price of a house or a piece of land increases due to inflation, the
profit earned by selling it will not be a part of GNP. But if, during the current year, a
portion of a house is constructed anew, the increase in the value of the house (after
subtracting the cost of the newly constructed portion) will be included in the GNP.
Similarly, variations in the value of assets, that can be ascertained beforehand and are
insured against flood or fire, are not included in the GNP.
Last, the income earned through illegal activities is not included in the GNP. Although
the goods sold in the black market are priced and fulfill the needs of the people, but as
they are not useful from the social point of view, the income received from their sale
and purchase is always excluded from the GNP.
There are two main reasons for this. One, it is not known whether these things were
produced during the current year or the preceding years. Two, many of these goods are
foreign made and smuggled and hence not included in the GNP.
Three Approaches to GNP:
After having studied the fundamental constituents of GNP, it is essential to know how it
is estimated. Three approaches are employed for this purpose. One, the income method
to GNP; two, the expenditure method to GNP and three, the value added method to
GNP. Since gross income equals gross expenditure, GNP estimated by all these methods
would be the same with appropriate adjustments.
1. Income Method to GNP:
The income method to GNP consists of the remuneration paid in terms of money to the
factors of production annually in a country.
Thus GNP is the sum total of the following items:
(i) Wages and salaries:
Under this head are included all forms of wages and salaries earned through productive
activities by workers and entrepreneurs. It includes all sums received or deposited
during a year by way of all types of contributions like overtime, commission, provident
fund, insurance, etc.
(ii) Rents:
Total rent includes the rents of land, shop, house, factory, etc. and the estimated rents
of all such assets as are used by the owners themselves.
(iii) Interest:
Under interest comes the income by way of interest received by the individual of a
country from different sources. To this is added, the estimated interest on that private
capital which is invested and not borrowed by the businessman in his personal business.
But the interest received on governmental loans has to be excluded, because it is a
mere transfer of national income.
(iv) Dividends:
Dividends earned by the shareholders from companies are included in the GNP.
(v) Undistributed corporate profits:
Profits which are not distributed by companies and are retained by them are included in
the GNP.
(vi) Mixed incomes:
These include profits of unincorporated business, self-employed persons and
partnerships. They form part of GNP.
(vii) Direct taxes:
Taxes levied on individuals, corporations and other businesses are included in the GNP.
(viii) Indirect taxes:
The government levies a number of indirect taxes, like excise duties and sales tax.
These taxes are included in the price of commodities. But revenue from these goes to
the government treasury and not to the factors of production. Therefore, the income
due to such taxes is added to the GNP.
(ix) Depreciation:
Every corporation makes allowance for expenditure on wearing out and depreciation of
machines, plants and other capital equipment. Since this sum also is not a part of the
income received by the factors of production, it is, therefore, also included in the GNP.
(x) Net income earned from abroad:
This is the difference between the value of exports of goods and services and the value
of imports of goods and services. If this difference is positive, it is added to the GNP and
if it is negative, it is deducted from the GNP.
Thus GNP according to the Income Method = Wages and Salaries + Rents + Interest +
Dividends + Undistributed Corporate Profits + Mixed Income + Direct Taxes + Indirect
Taxes + Depreciation + Net Income from abroad.
2. Expenditure Method to GNP:
From the expenditure view point, GNP is the sum total of expenditure incurred on goods
and services during one year in a country.
It includes the following items:
(i) Private consumption expenditure:
It includes all types of expenditure on personal consumption by the individuals of a
country. It comprises expenses on durable goods like watch, bicycle, radio, etc.,
expenditure on single-used consumers’ goods like milk, bread, ghee, clothes, etc., as
also the expenditure incurred on services of all kinds like fees for school, doctor, lawyer
and transport. All these are taken as final goods.
(ii) Gross domestic private investment:
Under this comes the expenditure incurred by private enterprise on new investment
and on replacement of old capital. It includes expenditure on house construction,
factory- buildings, and all types of machinery, plants and capital equipment.
In particular, the increase or decrease in inventory is added to or subtracted from it. The
inventory includes produced but unsold manufactured and semi-manufactured goods
during the year and the stocks of raw materials, which have to be accounted for in GNP.
It does not take into account the financial exchange of shares and stocks because their
sale and purchase is not real investment. But depreciation is added.
(iii) Net foreign investment:
It means the difference between exports and imports or export surplus. Every country
exports to or imports from certain foreign countries. The imported goods are not
produced within the country and hence cannot be included in national income, but the
exported goods are manufactured within the country. Therefore, the difference of value
between exports (X) and imports (M), whether positive or negative, is included in the
GNP.
(iv) Government expenditure on goods and services:
The expenditure incurred by the government on goods and services is a part of the GNP.
Central, state or local governments spend a lot on their employees, police and army. To
run the offices, the governments have also to spend on contingencies which include
paper, pen, pencil and various types of stationery, cloth, furniture, cars, etc.
It also includes the expenditure on government enterprises. But expenditure on transfer
payments is not added, because these payments are not made in exchange for goods
and services produced during the current year.
Thus GNP according to the Expenditure Method=Private Consumption Expenditure (C) +
Gross Domestic Private Investment (I) + Net Foreign Investment (X-M) + Government
Expenditure on Goods and Services (G) = C+ I + (X-M) + G.
As already pointed out above, GNP estimated by either the income or the expenditure
method would work out to be the same, if all the items are correctly calculated.
3. Value Added Method to GNP:
Another method of measuring GNP is by value added. In calculating GNP, the money
value of final goods and services produced at current prices during a year is taken into
account. This is one of the ways to avoid double counting. But it is difficult to distinguish
properly between a final product and an intermediate product.
For instance, raw materials, semi-finished products, fuels and services, etc. are sold as
inputs by one industry to the other. They may be final goods for one industry and
intermediate for others. So, to avoid duplication, the value of intermediate products
used in manufacturing final products must be subtracted from the value of total output
of each industry in the economy.
Thus, the difference between the value of material outputs and inputs at each stage of
production is called the value added. If all such differences are added up for all
industries in the economy, we arrive at the GNP by value added. GNP by value added =
Gross value added + net income from abroad. Its calculation is shown in Tables 1, 2 and
3.
Table 1 is constructed on the supposition that the entire economy for purposes of total
production consists of three sectors. They are agriculture, manufacturing, and others,
consisting of the tertiary sector.
Out of the value of total output of each sector is deducted the value of its intermediate
purchases (or primary inputs) to arrive at the value added for the entire economy. Thus
the value of total output of the entire economy as per Table 1, is Rs. 155 crores and the
value of its primary inputs comes to Rs. 80 crores. Thus the GDP by value added is Rs. 75
crores (Rs. 155 minus Rs. 80 crores).

The total value added equals the value of gross domestic product of the economy. Out
of this value added, the major portion goes in the form wages and salaries, rent, interest
and profits, a small portion goes to the government as indirect taxes and the remaining
amount is meant for depreciation. This is shown in Table 3.
Thus we find that the total gross value added of an economy equals the value of its
gross domestic product. If depreciation is deducted from the gross value added, we
have net value added which comes to Rs. 67 crores (Rs. 75 minus Rs. 8 crores).
This is nothing but net domestic product at market prices. Again, if indirect taxes (Rs. 7
crores) are deducted from the net domestic product of Rs. 67 crores, we get Rs. 60
crores as the net value added at factor cost which is equivalent to net domestic product
at factor cost. This is illustrated in Table 2.

Net value added at factor cost is equal to the net domestic product at factor cost, as
given by the total of items 1 to 4 of Table 2 (Rs. 45+3+4+8 crores=Rs. 60 crores). By
adding indirect taxes (Rs 7 crores) and depreciation (Rs 8 crores), we get gross value
added or GDP which comes to Rs 75 crores.
If we add net income received from abroad to the gross value added, this gives -us,
gross national income. Suppose net income from abroad is Rs. 5 crores. Then the gross
national income is Rs. 80 crores (Rs. 75 crores + Rs. 5 crores) as shown in Table 3.

It’s Importance:
The value added method for measuring national income is more realistic than the
product and income methods because it avoids the problem of double counting by
excluding the value of intermediate products. Thus this method establishes the
importance of intermediate products in the national economy. Second, by studying the
national income accounts relating to value added, the contribution of each production
sector to the value of the GNP can be found out.
For instance, it can tell us whether agriculture is contributing more or the share of
manufacturing is falling, or of the tertiary sector is increasing in the current year as
compared to some previous years. Third, this method is highly useful because “it
provides a means of checking the GNP estimates obtained by summing the various types
of commodity purchases.”
It’s Difficulties:
However, difficulties arise in the calculation of value added in the case of certain public
services like police, military, health, education, etc. which cannot be estimated
accurately in money terms. Similarly, it is difficult to estimate the contribution made to
value added by profits earned on irrigation and power projects.
(G) GNP at Market Prices:
When we multiply the total output produced in one year by their market prices
prevalent during that year in a country, we get the Gross National Product at market
prices. Thus GNP at market prices means the gross value of final goods and services
produced annually in a country plus net income from abroad. It includes the gross value
of output of all items from (1) to (4) mentioned under GNP. GNP at Market Prices = GDP
at Market Prices + Net Income from Abroad.
(H) GNP at Factor Cost:
GNP at factor cost is the sum of the money value of the income produced by and
accruing to the various factors of production in one year in a country. It includes all
items mentioned above under income method to GNP less indirect taxes.
GNP at market prices always includes indirect taxes levied by the government on goods
which raise their prices. But GNP at factor cost is the income which the factors of
production receive in return for their services alone. It is the cost of production.
Thus GNP at market prices is always higher than GNP at factor cost. Therefore, in order
to arrive at GNP at factor cost, we deduct indirect taxes from GNP at market prices.
Again, it often happens that the cost of production of a commodity to the producer is
higher than a price of a similar commodity in the market.
In order to protect such producers, the government helps them by granting monetary
help in the form of a subsidy equal to the difference between the market price and the
cost of production of the commodity. As a result, the price of the commodity to the
producer is reduced and equals the market price of similar commodity.
For example if the market price of rice is Rs. 3 per kg but it costs the producers in certain
areas Rs. 3.50. The government gives a subsidy of 50 paisa per kg to them in order to
meet their cost of production. Thus in order to arrive at GNP at factor cost, subsidies are
added to GNP at market prices.
GNP at Factor Cost = GNP at Market Prices – Indirect Taxes + Subsidies.
(I) Net National Product (NNP):
NNP includes the value of total output of consumption goods and investment goods. But
the process of production uses up a certain amount of fixed capital. Some fixed
equipment wears out, its other components are damaged or destroyed, and still others
are rendered obsolete through technological changes.
All this process is termed depreciation or capital consumption allowance. In order to
arrive at NNP, we deduct depreciation from GNP. The word ‘net’ refers to the exclusion
of that part of total output which represents depreciation. So NNP = GNP—
Depreciation.
(J) NNP at Market Prices:
Net National Product at market prices is the net value of final goods and services
evaluated at market prices in the course of one year in a country. If we deduct
depreciation from GNP at market prices, we get NNP at market prices. So NNP at Market
Prices = GNP at Market Prices—Depreciation.
(K) NNP at Factor Cost:
Net National Product at factor cost is the net output evaluated at factor prices. It
includes income earned by factors of production through participation in the production
process such as wages and salaries, rents, profits, etc. It is also called National Income.
This measure differs from NNP at market prices in that indirect taxes are deducted and
subsidies are added to NNP at market prices in order to arrive at NNP at factor cost.
Thus
NNP at Factor Cost = NNP at Market Prices – Indirect taxes+ Subsidies
= GNP at Market Prices – Depreciation – Indirect taxes + Subsidies.
= National Income.
Normally, NNP at market prices is higher than NNP at factor cost because indirect taxes
exceed government subsidies. However, NNP at market prices can be less than NNP at
factor cost when government subsidies exceed indirect taxes.
(L) Domestic Income:
Income generated (or earned) by factors of production within the country from its own
resources is called domestic income or domestic product.
Domestic income includes:
(i) Wages and salaries, (ii) rents, including imputed house rents, (iii) interest, (iv)
dividends, (v) undistributed corporate profits, including surpluses of public
undertakings, (vi) mixed incomes consisting of profits of unincorporated firms, self-
employed persons, partnerships, etc., and (vii) direct taxes.
Since domestic income does not include income earned from abroad, it can also be
shown as: Domestic Income = National Income-Net income earned from abroad. Thus
the difference between domestic income f and national income is the net income
earned from abroad. If we add net income from abroad to domestic income, we get
national income, i.e., National Income = Domestic Income + Net income earned from
abroad.
But the net national income earned from abroad may be positive or negative. If exports
exceed import, net income earned from abroad is positive. In this case, national income
is greater than domestic income. On the other hand, when imports exceed exports, net
income earned from abroad is negative and domestic income is greater than national
income.
(M) Private Income:
Private income is income obtained by private individuals from any source, productive or
otherwise, and the retained income of corporations. It can be arrived at from NNP at
Factor Cost by making certain additions and deductions.
The additions include transfer payments such as pensions, unemployment allowances,
sickness and other social security benefits, gifts and remittances from abroad, windfall
gains from lotteries or from horse racing, and interest on public debt. The deductions
include income from government departments as well as surpluses from public
undertakings, and employees’ contribution to social security schemes like provident
funds, life insurance, etc.
Thus, Private Income = National Income (or NNP at Factor Cost) + Transfer Payments +
Interest on Public Debt — Social Security — Profits and Surpluses of Public
Undertakings.
(N) Personal Income:
Personal income is the total income received by the individuals of a country from all
sources before payment of direct taxes in one year. Personal income is never equal to
the national income, because the former includes the transfer payments whereas they
are not included in national income.
Personal income is derived from national income by deducting undistributed corporate
profits, profit taxes, and employees’ contributions to social security schemes. These
three components are excluded from national income because they do reach
individuals.
But business and government transfer payments, and transfer payments from abroad in
the form of gifts and remittances, windfall gains, and interest on public debt which are a
source of income for individuals are added to national income. Thus Personal Income =
National Income – Undistributed Corporate Profits – Profit Taxes – Social Security
Contribution + Transfer Payments + Interest on Public Debt.
Personal income differs from private income in that it is less than the latter because it
excludes undistributed corporate profits.
Thus Personal Income = Private Income – Undistributed Corporate Profits – Profit Taxes.
(O) Disposable Income:
Disposable income or personal disposable income means the actual income which can
be spent on consumption by individuals and families. The whole of the personal income
cannot be spent on consumption, because it is the income that accrues before direct
taxes have actually been paid. Therefore, in order to obtain disposable income, direct
taxes are deducted from personal income. Thus Disposable Income=Personal Income –
Direct Taxes.
But the whole of disposable income is not spent on consumption and a part of it is
saved. Therefore, disposable income is divided into consumption expenditure and
savings. Thus Disposable Income = Consumption Expenditure + Savings.
If disposable income is to be deduced from national income, we deduct indirect taxes
plus subsidies, direct taxes on personal and on business, social security payments,
undistributed corporate profits or business savings from it and add transfer payments
and net income from abroad to it.
Thus, Disposable Income = National Income – Business Savings – Indirect Taxes +
Subsidies – Direct Taxes on Persons – Direct Taxes on Business – Social Security
Payments + Transfer Payments + Net Income from abroad.
(P) Real Income:
Real income is national income expressed in terms of a general level of prices of a
particular year taken as base. National income is the value of goods and services
produced as expressed in terms of money at current prices. But it does not indicate the
real state of the economy.
It is possible that the net national product of goods and services this year might have
been less than that of the last year, but owing to an increase in prices, NNP might be
higher this year. On the contrary, it is also possible that NNP might have increased but
the price level might have fallen, as a result national income would appear to be less
than that of the last year. In both the situations, the national income does not depict the
real state of the country. To rectify such a mistake, the concept of real income has been
evolved.
In order to find out the real income of a country, a particular year is taken as the base
year when the general price level is neither too high nor too low and the price level for
that year is assumed to be 100. Now the general level of prices of the given year for
which the national income (real) is to be determined is assessed in accordance with the
prices of the base year. For this purpose, the following formula is employed.
Real NNP = NNP for the Current Year x Base Year Index (=100) / Current Year Index
Suppose 1990-91 is the base year and the national income for 1999-2000 is Rs. 20,000
crores and the index number for this year is 250. Hence, Real National Income for 1999-
2000 will be = 20000 x 100/250 = Rs. 8000 crores. This is also known as national income
at constant prices.
(Q) Per Capita Income:
The average income of the people of a country in a particular year is called Per Capita
Income for that year. This concept also refers to the measurement of income at current
prices and at constant prices. For instance, in order to find out the per capita income for
2001, at current prices, the national income of a country is divided by the population of
the country in that year.
Similarly, for the purpose of arriving at the Real Per Capita Income, this very formula is
used.

This concept enables us to know the average income and the standard of living of the
people. But it is not very reliable, because in every country due to unequal distribution
of national income, a major portion of it goes to the richer sections of the society and
thus income received by the common man is lower than the per capita income.
3. Methods of Measuring National Income:

There are four methods of measuring national income. Which method is to be used
depends on the availability of data in a country and the purpose in hand?
(1) Product Method:
According to this method, the total value of final goods and services produced in a
country during a year is calculated at market prices. To find out the GNP, the data of all
productive activities, such as agricultural products, wood received from forests, minerals
received from mines, commodities produced by industries, the contributions to
production made by transport, communications, insurance companies, lawyers, doctors,
teachers, etc. are collected and assessed at market prices. Only the final goods and
services are included and the intermediary goods and services are left out.
(2) Income Method:
According to this method, the net income payments received by all citizens of a country
in a particular year are added up, i.e., net incomes that accrue to all factors of
production by way of net rents, net wages, net interest and net profits are all added
together but incomes received in the form of transfer payments are not included in it.
The data pertaining to income are obtained from different sources, for instance, from
income tax department in respect of high-income groups and in case of workers from
their wage bills.
(3) Expenditure Method:
According to this method, the total expenditure incurred by the society in a particular
year is added together and includes personal consumption expenditure, net domestic
investment, government expenditure on goods and services, and net foreign
investment. This concept is based on the assumption that national income equals
national expenditure.
(4) Value Added Method:
Another method of measuring national income is the value added by industries. The
difference between the value of material outputs and inputs at each stage of production
is the value added. If all such differences are added up for all industries in the economy,
we arrive at the gross domestic product.
4. Difficulties or Limitations in Measuring National Income:

There are many conceptual and statistical problems involved in measuring national
income by the income method, product method, and expenditure method.
We discuss them separately in the light of the three methods:
(A) Problems in Income Method:
The following problems arise in the computation of National Income by income
method:
1. Owner-occupied Houses:
A person who rents a house to another earns rental income, but if he occupies the
house himself, will the services of the house-owner be included in national income. The
services of the owner-occupied house are included in national income as if the owner
sells to himself as a tenant its services.
For the purpose of national income accounts, the amount of imputed rent is estimated
as the sum for which the owner-occupied house could have been rented. The imputed
net rent is calculated as that portion of the amount that would have accrued to the
house-owner after deducting all expenses.
2. Self-employed Persons:
Another problem arises with regard to the income of self-employed persons. In their
case, it is very difficult to find out the different inputs provided by the owner himself. He
might be contributing his capital, land, labor and his abilities in the business. But it is not
possible to estimate the value of each factor input to production. So, he gets a mixed
income consisting of interest, rent, wage and profits for his factor services. This is
included in national income.
3. Goods meant for Self-consumption:
In under-developed countries like India, farmers keep a large portion of food and other
goods produced on the farm for self-consumption. The problem is whether that part of
the produce which is not sold in the market can be included in national income or not. If
the farmer were to sell his entire produce in the market, he will have to buy what he
needs for self-consumption out of his money income. If, instead he keeps some produce
for his self-consumption, it has money value which must be included in national income.
4. Wages and Salaries paid in Kind:
Another problem arises with regard to wages and salaries paid in kind to the employees
in the form of free food, lodging, dress and other amenities. Payments in kind by
employers are included in national income. This is because the employees would have
received money income equal to the value of free food, lodging, etc. from the employer
and spent the same in paying for food, lodging, etc.
(B) Problems in Product Method:
The following problems arise in the computation of national income by product
method:
1. Services of Housewives:
The estimation of the unpaid services of the housewife in the national income presents
a serious difficulty. A housewife renders a number of useful services like preparation of
meals, serving, tailoring, mending, washing, cleaning, bringing up children, etc.
She is not paid for them and her services are not including in national income. Such
services performed by paid servants are included in national income. The national
income is, therefore, underestimated by excluding the services of a housewife.
The reason for the exclusion of her services from national income is that the love and
affection of a housewife in performing her domestic work cannot be measured in
monetary terms. That is why when the owner of a firm marries his lady secretary, her
services are not included in national income when she stops working as a secretary and
becomes a housewife.
When a teacher teaches his own children, his work is also not included in national
income. Similarly, there are a number of goods and services which are difficult to be
assessed in money terms for the reason stated above, such as painting, singing, dancing,
etc. as hobbies.
2. Intermediate and Final Goods:
The greatest difficulty in estimating national income by product method is the failure to
distinguish properly between intermediate and final goods. There is always the
possibility of including a good or service more than once, whereas only final goods are
included in national income estimates. This leads to the problem of double counting
which leads to the overestimation of national income.
3. Second-hand Goods and Assets:
Another problem arises with regard to the sale and purchase of second-hand goods and
assets. We find that old scooters, cars, houses, machinery, etc. are transacted daily in
the country. But they are not included in national income because they were counted in
the national product in the year they were manufactured.
If they are included every time they are bought and sold, national income would
increase many times. Similarly, the sale and purchase of old stocks, shares, and bonds of
companies are not included in national income because they were included in national
income when the companies were started for the first time. Now they are simply
financial transactions and represent claims.
But the commission or fees charged by the brokers in the repurchase and resale of old
shares, bonds, houses, cars or scooters, etc. are included in national income. For these
are the payments they receive for their productive services during the year.
4. Illegal Activities:
Income earned through illegal activities like gambling, smuggling, illicit extraction of
wine, etc. is not included in national income. Such activities have value and satisfy the
wants of the people but they are not considered productive from the point of view of
society. But in countries like Nepal and Monaco where gambling is legalised, it is
included in national income. Similarly, horse-racing is a legal activity in England and is
included in national income.
5. Consumers’ Service:
There are a number of persons in society who render services to consumers but they do
not produce anything tangible. They are the actors, dancers, doctors, singers, teachers,
musicians, lawyers, barbers, etc. The problem arises about the inclusion of their services
in national income since they do not produce tangible commodities. But as they satisfy
human wants and receive payments for their services, their services are included as final
goods in estimating national income.
6. Capital Gains:
The problem also arises with regard to capital gains. Capital gains arise when a capital
asset such as a house, some other property, stocks or shares, etc. is sold at higher price
than was paid for it at the time of purchase. Capital gains are excluded from national
income because these do not arise from current economic activities. Similarly, capital
losses are not taken into account while estimating national income.
7. Inventory Changes:
All inventory changes (or changes in stocks) whether positive or negative are included in
national income. The procedure is to take changes in physical units of inventories for the
year valued at average current prices paid for them.
The value of changes in inventories may be positive or negative which is added or
subtracted from the current production of the firm. Remember, it is the change in
inventories and not total inventories for the year that are taken into account in national
income estimates.
8. Depreciation:
Depreciation is deducted from GNP in order to arrive at NNP. Thus, depreciation lowers
the national income. But the problem is of estimating the current depreciated value of,
say, a machine, whose expected life is supposed to be thirty years. Firms calculate the
depreciation value on the original cost of machines for their expected life. This does not
solve the problem because the prices of machines change almost every year.
9. Price Changes:
National income by product method is measured by the value of final goods and
services at current market prices. But prices do not remain stable. They rise or fall.
When the price level rises, the national income also rises, though the national
production might have fallen.
On the contrary, with the fall in the price level, the national income also falls, though
the national production might have increased. So price changes do not adequately
measure national income. To solve this problem, economists calculate the real national
income at a constant price level by the consumer price index.
(C) Problems in Expenditure Method:
The following problems arise in the calculation of national income by expenditure
method:
(1) Government Services:
In calculating national income by, expenditure method, the problem of estimating
government services arises. Government provides a number of services, such as police
and military services, administrative and legal services. Should expenditure on
government services be included in national income?
If they are final goods, then only they would be included in national income. On the
other hand, if they are used as intermediate goods, meant for further production, they
would not be included in national income. There are many divergent views on this issue.
One view is that if police, military, legal and administrative services protect the lives,
property and liberty of the people, they are treated as final goods and hence form part
of national income. If they help in the smooth functioning of the production process by
maintaining peace and security, then they are like intermediate goods that do not enter
into national income.
In reality, it is not possible to make a clear demarcation as to which service protects the
people and which protects the productive process. Therefore, all such services are
regarded as final goods and are included in national income.
(2) Transfer Payments:
There arises the problem of including transfer payments in national income.
Government makes payments in the form of pensions, unemployment allowance,
subsidies, interest on national debt, etc. These are government expenditures but they
are not included in national income because they are paid without adding anything to
the production process during the current year.
For instance, pensions and unemployment allowances are paid to individuals by the
government without doing any productive work during the year. Subsidies tend to lower
the market price of the commodities. Interest on national or public debt is also
considered a transfer payment because it is paid by the government to individuals and
firms on their past savings without any productive work.
(3) Durable-use Consumers’ Goods:
Durable-use consumers’ goods also pose a problem. Such durable-use consumers’ goods
as scooters, cars, fans, TVs, furniture’s, etc. are bought in one year but they are used for
a number of years. Should they be included under investment expenditure or
consumption expenditure in national income estimates? The expenditure on them is
regarded as final consumption expenditure because it is not possible to measure their
used-up value for the subsequent years.
But there is one exception. The expenditure on a new house is regarded as investment
expenditure and not consumption expenditure. This is because the rental income or the
imputed rent which the house-owner gets is for making investment on the new house.
However, expenditure on a car by a household is consumption expenditure. But if he
spends the amount for using it as a taxi, it is investment expenditure.
(4) Public Expenditure:
Government spends on police, military, administrative and legal services, parks, street
lighting, irrigation, museums, education, public health, roads, canals, buildings, etc. The
problem is to find out which expenditure is consumption expenditure and which
investment expenditure is.
Expenses on education, museums, public health, police, parks, street lighting, civil and
judicial administration are consumption expenditure. Expenses on roads, canals,
buildings, etc. are investment expenditure. But expenses on defense equipment are
treated as consumption expenditure because they are consumed during a war as they
are destroyed or become obsolete. However, all such expenses including the salaries of
armed personnel are included in national income.
5. Importance of National Income Analysis:

The national income data have the following importance:

1. For the Economy:
National income data are of great importance for the economy of a country. These days
the national income data are regarded as accounts of the economy, which are known as
social accounts. These refer to net national income and net national expenditure, which
ultimately equal each other.
Social accounts tell us how the aggregates of a nation’s income, output and product
result from the income of different individuals, products of industries and transactions
of international trade. Their main constituents are inter-related and each particular
account can be used to verify the correctness of any other account.

2. National Policies:
National income data form the basis of national policies such as employment policy,
because these figures enable us to know the direction in which the industrial output,
investment and savings, etc. change, and proper measures can be adopted to bring the
economy to the right path.

3. Economic Planning:
In the present age of planning, the national data are of great importance. For economic
planning, it is essential that the data pertaining to a country’s gross income, output,
saving and consumption from different sources should be available. Without these,
planning is not possible.

4. Economic Models:
The economists propound short-run as well as long-run economic models or long-run
investment models in which the national income data are very widely used.

5. Research:
The national income data are also made use of by the research scholars of economics.
They make use of the various data of the country’s input, output, income, saving,
consumption, investment, employment, etc., which are obtained from social accounts.

6. Per Capita Income:

National income data are significant for a country’s per capita income which reflects the
economic welfare of the country. The higher the per capita income, the higher the
economic welfare of the country.

7. Distribution of Income:
National income statistics enable us to know about the distribution of income in the
country. From the data pertaining to wages, rent, interest and profits, we learn of the
disparities in the incomes of different sections of the society. Similarly, the regional
distribution of income is revealed.
It is only on the basis of these that the government can adopt measures to remove the
inequalities in income distribution and to restore regional equilibrium. With a view to
removing these personal and regional daiquiris, the decisions to levy more taxes and
increase public expenditure also rest on national income statistics.
6. Inter-Relationship among different concept of National Income

The inter-relationship among the various concept of national income can be shown in
the form of equations as under:
 
 DISPOSABLE INCOME

What Is Disposable Income?

Disposable income, also known as disposable personal income (DPI), is the amount of
money that an individual or household has to spend or save after income taxes have
been deducted.
At the macro level, disposable personal income is closely monitored as one of the key
economic indicators used to gauge the overall state of the economy. 1
KEY TAKEAWAYS
 Disposable income is net income. It's the amount left over after taxes.
 Discretionary income is the amount of net income remaining after all basic necessities
are covered.
 Economists monitor these numbers at a macro level to see how consumers are saving,
spending, and borrowing.

A number of statistical measures and economic indicators derive from disposable

income. For example, economists use disposable income as a starting point to calculate
 metrics such as discretionary income, personal savings rates, marginal propensity to
consume (MPC), and marginal propensity to save (MPS). Here's what these metrics
indicate:

Discretionary income is disposable income minus all payments for necessities including a
mortgage or rent payment, health insurance, food, and transportation. This portion of
disposable income can be spent at will. Discretionary income is the first to shrink after a
job loss or pay reduction. Businesses that sell discretionary goods, like jewelry or
vacation packages, tend to suffer the most during recessions. Their sales are watched
closely by economists for signs of both recession and recovery.

The personal savings rate is the percentage of disposable income that goes into savings
for retirement or any other goal. For several months in 2005 and 2006, the average
personal savings rate dipped into negative territory for the first time since 1933. This
means that Americans spent all of their disposable income every month and still had to
tap into savings or debt to make up the difference.

Marginal propensity to consume is the percentage of each additional dollar of

disposable income that is spent immediately, while marginal propensity to save is the
percentage that is saved.

Disposable Income for Wage Garnishment

The federal government uses a slightly different method to calculate disposable income
for wage garnishment purposes. This is the seizure of a portion of a wage earner's
paycheck before it is paid on every payday until the amount due for back taxes or
overdue child support is repaid.

For this purpose, the government uses disposable income as a starting point to
determine how much of each paycheck to seize. The amount garnished may not exceed
25% of a person's disposable income or the amount by which a person's weekly income
exceeds 30 times the federal minimum wage, whichever is less. The amount paid into a
gross income retirement plan also is deducted from disposable income in this
calculation.

LESSON I: CONSUMPTION AND SAVINGS

WHAT IS CONSUMPTION
Consumption, in economics, the use of goods and services by
households. Consumption is distinct from consumption expenditure, which is the
purchase of goods and services for use by households. Consumption differs
from consumption expenditure primarily because durable goods, such as automobiles,
generate an expenditure mainly in the period when they are purchased, but they
generate “consumption services” (for example, an automobile provides transportation
services) until they are replaced or scrapped. (See consumer good.)

Neoclassical (mainstream) economists generally consider consumption to be the final

purpose of economic activity, and thus the level of consumption per person is viewed as
a central measure of an economy’s productive success.

The study of consumption behavior plays a central role in

both macroeconomics and microeconomics. Macroeconomists are interested
in aggregate consumption for two distinct reasons. First, aggregate consumption
determines aggregate saving, because saving is defined as the portion of income that is
not consumed. Because aggregate saving feeds through the financial system to create
the national supply of capital, it follows that aggregate consumption and saving
behavior has a powerful influence on an economy’s long-term productive capacity.
Second, since consumption expenditure accounts for most of national output,
understanding the dynamics of aggregate consumption expenditure is essential to
understanding macroeconomic fluctuations and the business cycle.

Microeconomists have studied consumption behavior for many different reasons, using
consumption data to measure poverty, to examine households’ preparedness for
retirement, or to test theories of competition in retail industries. A rich variety of
household-level data sources (such as the Consumer Expenditure Survey conducted by
the U.S. government) allows economists to examine household spending behavior in
minute detail, and microeconomists have also utilized these data to examine
interactions between consumption and other microeconomic behavior such as job
seeking or educational attainment.

DETERMINANTS OF THE LEVEL OF CONSUMPTION

Current income level and dynamics is the most relevant determinant of consumption.

Income comes from labor (employment and wages), capital (e.g. profits leading to
dividends, rents, etc.), remittances from abroad. Income from consumer's cumulative
bundle (including dividends and interests on wealth) provides an additional flow to
available income
.
Cumulated savings in the past can be squeezed in case of necessity and give rise to a
jump in consumption, similarly with what happens with wealth increase, due for
instance to stock exchange boom or house prices boom. Family debt can be boosted to
fund consumption, while repayments break its dynamics.

Expectations on future income, especially if concerning short-term credible events, may

also play an important role.

At household level, there are many possible rules set to control monthly, weekly or

even daily consumption expenditure, resulting from empirical and theoretical
approaches to consumers.

These routines relate not only to income but also to the following factors among
others:
1. general lifestyles, in particular attitudes toward savings or consumption and shopping
as "values" in itself;
2. a standard level of consumption the family tries to maintain over time;
3. decisions regarding active saving strategies, like an investment scheme for pension
aims;
4. the relative success of past investment in shares or other financial instruments; in
fact, a housing, a real estate or a stock-exchange boom are likely to promote
a euphoria tide with growing consumption;
5. opportunities of consumer credit, depending in turn by interest rates and marketing
strategies by banks and special consumer credit institutions;
6. past decisions on durables. For instance, a family having bought a car will reduce
expenditure on public transport in favor e.g., of fuel;
7. status symbols diffusion - "social musts" - that can be favored by a pro-diffusion-of-
innovation tax ;
8. new employment perspectives, also as far as the corresponding investments in
human and physical capital are concerned;
9. innovative sale proposals in terms of both new products and new services,
effectively advertised;
10. temporary money (cash) excess;
11. family debt management, with repayments tightening consumption;
12. fiscal conditions, with particular tax and subsidies impacting the timing and the
amount devoted to purchases; VAT expected increases, for instances, might lead to
anticipation to purchases.

According to age of the decision-maker, individual and household consumption varies,

both in values and composition. Thus, aggregate consumption may be influenced by
demographic factors, such as an older and older population, even though one should
not rely too much on these relationships since demographic variables are extremely
slow in changes, whereas consumption clearly reacts to economic climate.

Other things equal, a higher price level (inflation) reduces the real current income, thus
real consumption.

WHAT IS SAVINGS?

Saving, process of setting aside a portion of current income for future use, or the flow of
resources accumulated in this way over a given period of time. Saving may take the form
of increases in bank deposits, purchases of securities, or increased cash holdings. The
extent to which individuals save is affected by their preferences for future over
present consumption, their expectations of future income, and to some extent by the
rate of interest.

There are two ways for an individual to measure his saving for a given accounting
period. One is to estimate his income and subtract his current expenditures, the
difference being his saving. The alternative is to examine his balance
sheet (his property and his debts) at the beginning and end of the period and measure
the increase in net worth, which reflects his saving.

Saving is important to the economic progress of a country because of its relation to

investment. If there is to be an increase in productive wealth, some individuals must be
willing to abstain from consuming their entire income. Progress is not dependent on
saving alone; there must also be individuals willing to invest and thereby increase
productive capacity.

Savings is the portion of income not spent on current expenditures. Because a person
does not know what will happen in the future, money should be saved to pay for
unexpected events or emergencies. An individual’s car may breakdown, their
dishwasher could begin to leak, or a medical emergency could occur. Without savings,
unexpected events can become large financial burdens. Therefore, savings helps an
individual or family become financially secure. Money can also be saved to purchase
expensive items that are too costly to buy with monthly income. Buying a new camera,
purchasing an automobile, or paying for a vacation can all be accomplished by saving a
portion of income.

HOW MUCH MONEY SHOULD BE SAVED? To be considered financially secure, an

individual or household should save at least six months’ worth of expenses. For
example, a household that has $2,000 per month of expenses should have at least
$12,000 in savings ($2,000 multiplied by 6 months).

To reach this amount, it is recommended that 10- 20% of net income should be saved
until the appropriate amount of savings is reached. Net income is the amount of an
individual’s take-home pay after taxes and other deductions have been taken out of a
paycheck.

WHERE CAN MONEY BE SAVED? Some savers place their money in a jar, coffee can or a
piggy bank. For short periods of time and small amounts of money, the piggy bank
method may work, but long-term savers should use a safer method. It is wise to store
money at a depository institution.

A depository institution is a business that offers financial services to people, such as

savings and checking accounts. Unlike money stored at home which could be lost to a
fire, burglary, or some other type of disaster, money stored at a depository institution is
protected from loss. Depository institutions offer accounts that earn interest, allowing
customers to take advantage of the time value of money.

The time value of money means money paid out or received in the future is not
equivalent to money paid out or received today.

Interest is the price of money. When depositing money at a depository institution, an

individual may earn money from interest. The amount of interest earned is determined
by calculating a percent of the total amount of money deposited. This percentage rate is
known as the interest rate. Savings accounts, money market deposit accounts, and
Certificate of Deposits are the most common depository institution accounts that earn
interest.
A savings account is an account with a depository institution that holds money not spent
on current expenditures. Money can be kept in a savings account until the owner needs
to use it for emergencies or to purchase expensive items.
A money market deposit account is a type of account that pays a higher interest rate
than a savings account. However, money market deposit accounts usually require more
money to open and have limits on the number of times money can be withdrawn from
the account every month.

A Certificate of Deposit (CD) is an account that pays interest on a lump sum of money.
However, once money is placed into a CD, it is required to stay there for a specific
period of time. If money is withdrawn early, the owner will have to pay a penalty fee.
Once the time period is complete, the money and interest earned can be withdrawn.
The interest rate money earns in a CD is usually higher than a money market deposit
account and increases as the time period a person agrees to keep their money in the
account increases and as the amount of money placed in the CD increases.

When money is saved in one of these accounts, the owner of the money has to do
nothing and the value of money automatically increases! The higher the interest rate,
the more money is earned.

In addition to the interest rate, the amount of money saved and the length of time
money is saved affects the time value of money. The larger the amount of money saved,
the larger the amount of interest earned will be. The longer money is left in a depository
institution account, the longer money will have to earn interest. Table 1 shows how
$500.00 saved at 3% for five years increases to a total of $579.64.

Initial amount saved $500.00 HOW TO BEGIN SAVING MONEY To help a person choose
saving over spending money, money should not be viewed as what is remaining after
current needs and wants have been satisfied. Pay yourself first is a popular and very
effective saving strategy that can help individuals choose saving over spending money.

Paying yourself first means to set aside a portion of money (10-20% of net income is
recommended) for saving each time a person is paid before using any of the money for
spending. To successfully practice the pay yourself first strategy a person should set
personal goals. Setting goals helps a person choose to save rather than spend money.

A goal is defined as the end result of something a person intends to acquire, achieve, do,
reach, or accomplish. Financial goals are specific objectives to be accomplished through
financial planning and include saving money. Setting goals helps an individual identify
and focus on items that are most important to them and then make decisions that help
obtain those items. While in the process of setting goals, an individual should consider
 the trade-offs to those goals. A tradeoff is giving up one thing for another. Every
decision involves a trade-off.

Being more financially secure in the future by saving is a trade-off to spending money in
the present. If a person clearly understands what they are giving up in exchange for the
benefits of saving money, then their saving goals will become more attainable and
realistic. When considering the trade-offs to achieving savings goals, an individual
should examine their current spending as well.

Spending may have to be adjusted in order to reach a financial goal and practice the pay
yourself first strategy. Explore the value of saving money and learn strategies that help
people choose to save money over spend money. Learn the advantages of saving money
at a depository institution.

LESSON J: THE INVESTMENT FUNCTION

SOURCES AND USES OF INVESTMENT FUNDS

The statement of sources and uses of funds is a statement that condenses the financial
statements and financial plan in one statement.

It displays the sources from which an organization or a company manages to generate

cash and all the areas where the obtained cash is used during an accounting period.
This statement also shows a business’s cash inflow and outflow over an accounting
period, usually a year or a month.

Statement of source and use of the fund is normally preparing or use by the non-profit
organization rather than the profit organization. This statement is almost the same as
the income statement; however, it is used mostly for non-profit organizations.

Like other financial statements, it is generated annually but can be drawn up whenever

necessary. It also gives us information about the changes that have occurred in the cash
and cash equivalents of a business.

Large companies and businesses use the sources and uses of funds statement in their
annual report to show the creditors how much collateral is there, and what will be their
contributions.

Creating this statement is also how much businesses strategize their future financial
plans.

It is noteworthy that the statement of sources and uses of funds outlines the cash flow
over a period of time, unlike the balance sheet that provides us with an overview of how
the assets and liabilities look at a particular date.

The statement of sources and use of funds shows us the total sources available of new
funds that have been generated between the balance sheet dates, along with how those
funds have been put to use.

It also has a list of all the changes that have happened in all the Balance Sheet items
between any two balance sheet dates.
The statement of sources and uses of funds tells us the exact way a company has
generated cash or money from, and how those funds have been spent, which is really
helpful when it comes to figuring out if certain investment decisions were reasonable.
 What the statement of sources and uses of funds tells us?
The statement of sources and uses of funds tells us exactly where a company has
generated its money from and how it was spent or put to use.

The cash inflows into the company or the cash received, and the cash outflows from the
company, or the cash spent, are shown in this statement.

The statement of sources and uses of funds also shows us how changes in balance sheet
items can affect the cash available to a business.

The projections in the statement can help businesses do short-term planning, especially
when it comes to decisions involving funds available.

The company’s management or current and potential investors both can look at the
sources and uses of funds statements to distinguish between the healthy and
problematic
trends in a company’s transactions. It is also used to provide us with a great overview of
how much funding can be required for a project.

What is included in the statement of sources and uses of funds?

Basically, the statement consists of two sections: the source (where the money has been
generated from) and the application (what the money has been spent on).

The examples of sources where funds can originate from can be:
 A decrease in liabilities or an increase in assets
 Net income after tax
 The disposal or revaluation of fixed assets
 Proceeds of loans taken
 Proceeds of common stock issued
 Repayments received on loans previously granted by the company
 Any increase in net working capital
Examples of where the money is spent includes:
 Losses to be met by the company
 The purchase of fixed assets/investments
 The full or partial payment of loans
 Granting of loans
 Liability for taxes
 Dividends paid or proposed
 Any decrease in net working capital
 Statement of use and sources of fund
This is an example of what the statement of sources and uses of funds can look like. One
important requirement of the sources and uses statement is that the total sources of
funds must match the total uses of funds.

This is because if a company is generating money, it must also be going somewhere and
being put to use. If more cash is being spent, than being generated, the company would
require more capital in order to be efficient and work at full capacity or potential.

On the other hand, if a company has more sources from where cash is being generated,
and not much is being spent, then there is cash available to be invested or distributed to
shareholders.

The difference between the total of the uses of funds and the total funds you’ve spent
must be equal to the amount of financing needed.

THE RULE OF INVESTMENT

There's one golden investment rule that you should always keep in mind: Never invest
money that you can't afford to lose. Learn why this rule is important and how to protect
your assets from risk and volatility.

Key Takeaways
 Saving is a low-risk strategy of putting away money in a secure account until you need to
use it, even though it will not earn much interest.
 Investing is a higher-risk strategy of putting money in vehicles like stocks, bonds, and
mutual funds in order to receive interest or dividends or a gain in value.
 To avoid investing money that you can't afford to lose, first focus on building up your
savings to cover general and emergency expenses for several months.
 You can minimize investment risk by creating a financial portfolio that includes savings,
insurance, retirement accounts, and real estate.

Saving vs. Investing 

There's a significant difference between saving and investing. Saving is setting money
aside in a safe place, where it stays until you want to access it, whether that's in a few
days, a few months, or even several years. It might earn a little interest, depending on
where you put it, and it will be there for you in case of an emergency or to achieve the
goal you're saving for. 
 Common savings vehicles include:
 Savings accounts: These accounts are Federal Deposit Insurance Corporation (FDIC) or
National Credit Union Administration (NCUA) insured, which means that each account is
protected up to $250,000. 12 They tend to have very low interest rates, especially at
brick-and-mortar banks.
 Certificates of deposit (CDs): With these accounts, you leave your money in the CD for a
period ranging from months to years. The interest rates are low but typically better than
with regular savings accounts. You can withdraw funds before the CD matures, but you
would lose some or all of the interest you've earned.
 Money market accounts: These accounts allow you to spend funds using checks or a
debit card. They pay relatively low interest.
All of these accounts have virtually no risk, but you receive minimal interest.
Investing is the process of putting your money to work for you. It can typically make
more money for you than the interest you might earn in a savings account or CD when
done properly. But with reward comes risk. If you make poor choices, or if things
beyond your control go wrong, you could lose that money. It might not be there for you
in case of an emergency.

Common investment vehicles include:

 Stocks: With these, you invest in a company and share in its profits and losses.
 Bonds: With a bond, you're lending money to a company or government entity. Bonds
typically pay fixed interest rates. Government bonds are considered relatively low-risk
and may pay low interest rates, depending on economic conditions. While bonds are
relatively safe and could be used as savings vehicles, they do have some risk, depending
on the type of bond.
 Mutual funds: These are investment vehicles managed by money managers. They may
include stocks, bonds, or other assets. Buying shares in a mutual fund is a simple way to
diversify your investments, and you can find mutual funds that reflect a wide range of
interests and investment goals.

There are many more investment options, including collectibles, index funds, hedge
funds, and annuities.

The Challenges of the Investment Rule

If you remember the "Never invest money that you can't afford to lose" rule and never
violate it, you shouldn't have to worry about running out of funds during retirement.
You'll have the funds to handle something potentially catastrophic that occurs, like job
loss or illness. The key is to build up your savings before you start to invest. You
shouldn't invest money that you need to meet other responsibilities.
There's a natural human tendency to want to overreach, put in more money than you
can afford, and go for a huge payout. This trait tends to become magnified in the face of
losses. This is referred to as the sunk cost fallacy—the belief that you've invested too
much to walk away. Rather than selling in the face of losses, someone might hold on to
a stock that's underperforming or, worse, buy more.

Guarding Against Investment Risk

You shouldn't just look at your portfolio as the stocks you own. A portfolio encompasses
so much more—your emergency cash reserves, your insurance coverage, your
funded retirement accounts, your real estate holdings, and even your professional skills
that determine the income you could earn if you were to lose your job and have to start
over. 

You can avoid the pitfalls of what's called "the refrigerator problem" by keeping your
eyes on the big picture. This means you need to spend more time researching complex
financial decisions, even if they are harder for you to understand, as you would
something that is part of your everyday life.

For example, the same folks who spend weeks studying Consumer Reports ratings for a
new stove or refrigerator will sometimes put all of their savings into a stock or other
investment they don't entirely understand. Investments can be complicated, and a good
financial plan includes factors like your retirement plans and goals, your other financial
goals, and your risk tolerance. It's unlikely that investing in just one vehicle will meet
those goals.

When deciding how to invest in your portfolio, your first goal should always be to avoid
major losses. You can do that through patience, keeping your management costs low,
and seeking the advice of qualified, well-regarded advisors.

The Balance does not provide tax, investment, or financial services or advice. The
information is being presented without consideration of the investment objectives, risk
tolerance, or financial circumstances of any specific investor and might not be suitable
for all investors. Past performance is not indicative of future results. Investing involves
risk, including the possible loss of principal.

INVESTMENT AND THE MULTIPLIER EFFECT

 The term investment multiplier refers to the concept that any increase in public or
private investment spending has a more than proportionate positive impact on
aggregate income and the general economy. It is rooted in the economic theories
of John Maynard Keynes.

The multiplier attempted to quantify the additional effects of investment

spending beyond those immediately measurable. The larger an investment’s multiplier,
the more efficient it is in creating and distributing wealth throughout the economy.

KEY TAKEAWAYS
 The investment multiplier refers to the stimulative effects of public or private
investments.
 It is rooted in the economic theories of John Maynard Keynes.
 The extent of the investment multiplier depends on two factors: the marginal
propensity to consume (MPC) and the marginal propensity to save (MPS).
 A higher investment multiplier suggests that the investment will have a larger
stimulative effect on the economy.

Understanding the Investment Multiplier

The investment multiplier tries to determine the economic impact of public or private
investment. For instance, extra government spending on roads can increase the income
of construction works, as well as the income of materials suppliers. These people may
spend the extra income in the retail, consumer goods, or service industries, boosting the
income of the workers in those sectors.

As you can see, this cycle can repeat itself through several iterations; what began as an
investment in roads quickly multiplied into an economic stimulus benefiting workers
across a wide range of industries.

Mathematically, the investment multiplier is a function of two main factors:

the marginal propensity to consume (MPC) and the marginal propensity to save (MPS).

Real World Example of the Investment Multiplier

Consider the road construction workers in our previous example. If the average worker
has an MPC of 70%, that means they consume $0.70 out of every dollar they earn, on
average. In practice, they might spend that $0.70 on items such as rent, gasoline,
groceries, and entertainment. If that same worker has an MPS of 30%, that means they
would save $0.30 out of every dollar earned, on average.
These concepts also apply to businesses. Like individuals, businesses must “consume” a
significant portion of their income by paying for expenditures such as employees’
wages, facilities’ rents, and the leases and repairs of equipment. A typical company
might consume 90% of their income on such payments, meaning that its MPS—the
profits earned by its shareholders—would be only 10%.

The formula for calculating the investment multiplier of a project is simply:

1 / (1 - MPC)1/(1−MPC)

Therefore, in our above examples, the investment multipliers would be 3.33 and 10 for
the workers and the businesses, respectively. The reason the businesses are associated
with a higher investment multiple is that their MPC is higher than that of the workers. In
other words, they spend a greater percentage of their income on other parts of the
economy, thereby spreading the economic stimulus caused by the initial investment
more widely.

TYPES OF INVESTMENT

There are many types of Investment in the Economy. That helps the country to grow
the economy. Some are the following:

Business Fixed Investment

Business Fixed Investment means When the Businesspeople of the country start to
invest in machines, tools, and equipment to increase productivity and further
production of the products or goods. This kind of investment increase the value of the
company.

Residential Investment
Residential Investment means the investment which people spend on constructing or
buying new houses or for the purpose of staying or renting out to others. Residential
Investments helps the economy to grow from three to five percent of GDP (it also
depends on the economic conditions of the country.) The residential investment has
good value at both the market Primary and Secondary market.

Autonomous Investment
Autonomous Investment is also known as government investment. it refers to
the investment in houses, roads, public buildings, and other parts of public
infrastructure that will be utilized by the public. It does not depend on income because
the government has to invest in infrastructure, roads, etc.
Financial Investment
Financial Investment means buying new shares, bonds, or debentures that will be
considered as a financial investment. the buying of old bonds, shares or debentures will
not be considered the financial investment. the financial investment directly impacts on
the growth of the economy.

Planned Investment
Planned Investment means when the investor invests money to calculate every aspect
of the investment, which is called planned investment. Most of the time, the planned
investment gives positive results to the investors and it also helps the investors to make
faith in the company.

Induced Investment
Induced Investment means the investment which depends on the income level of the
people when the income increases then Entrepreneurs starts to invest more. When the
income level starts to decreasing then Entrepreneurs start investing less.

THE DETERMINANT OF INVESTMENT

Investment spending
Investment spending is an injection into the circular flow of income.

Investment refers to an increase in capital assets, and typically includes investment by

business, investment in property (‘dwellings’) and investment by governments in ‘social’
capital. Business investment comprises between 65% and 85% of total investment in the
majority of G7 countries.
 Firms invest for two primary reasons:
1. Firstly, investment may be required to replace worn out, or failing machinery,
equipment, or buildings. This is referred to as capital consumption, and arises from the
continuous depreciation of fixed capital assets.
2. Secondly, investment may be undertaken to purchase new machinery, equipment, or
buildings in order to increase productive capacity. This will reduce long-term costs,
increase competitiveness, and raise profits.
Gross investment includes both types of investment spending, but net investment only
measures new assets rather than the replacement of assets. This relationship is
expressed in the following equation:
NET INVESTMENT = GROSS INVESTMENT – DEPRECIATION
For example, if an airline replaces five worn out aircraft with identical new aircraft, and
purchases two more aircraft in order to be able to fly to more destinations, then gross
investment is seven, replacement investment is five, and net investment is two.
In economic theory, net investment carries more significance, as it provides the basis
for economic growth.

The determinants of investment

The level of investment in an economy tends to vary by a greater extent than other
components of aggregate demand. This is because the underlying determinants also
have a tendency to change.

The main determinants of investment are:

The expected return on the investment
Investment is a sacrifice, which involves taking risks. This means that businesses,
entrepreneurs, and capital owners will require a return on their investment in order to
cover this risk, and earn a reward. In terms of the whole economy, the amount of
business profits is a good indication of the potential reward for investment.

Business confidence
Similarly, changes in business confidence can have a considerable influence on
investment decisions. Uncertainty about the future can reduce confidence, and means
that firms may postpone their investment decisions until confidence returns.

Changes in national income

Changes in national income create an accelerator effect. Economic theory suggests
that, at the macro-economic level, small changes in national income can trigger much
larger changes in investment levels.
 Interest rates
Investment is inversely related to interest rates, which are the cost of borrowing and the
reward to lending. Investment is inversely related to interest rates for two main
reasons.

1. Firstly, if interest rates rise, the opportunity cost of investment rises. This means that a
rise in interest rates increases the return on funds deposited in an interest-bearing
account, or from making a loan, which reduces the attractiveness of investment relative
to lending. Hence, investment decisions may be postponed until interest rates return to
lower levels.
2. Secondly, if interest rates rise, firms may anticipate that consumers will reduce their
spending, and the benefit of investing will be lost. Investing to expand requires that
consumers at least maintain their current spending. Therefore, a predicted fall is likely
to discourage firms from investing and force them to postpone their investment
decisions.

General expectations
Because investment is a high-risk activity, general expectations about the future will
influence a firm’s investment appraisal and eventual decision-making. Any indication of
a downturn in the economy, a possible change of government, war or a rise in oil or
other commodity prices may reduce the expected benefit or increase the expected cost
of investment.
Corporation tax
Firms pay corporation tax on their profits, so a reduction in tax increases the profits
they retain after tax is paid, and this acts as an incentive to invest. There current rate of
20% will fall to 19% in 2017, and then to 18% in 2020.

The level of savings

Household and corporate savings provides a flow of funds into the financial sector,
which means that funds are available for investment. Increased saving may reduce
interest rates and stimulate corporate borrowing and investment.

The accelerator effects

Small changes in household income and spending can trigger much larger changes in
investment. This is because firms often expect new sales and orders to be sustained into
the long run, and purchase larger quantities of capital goods than they need in the short
run.
In addition, machinery is generally indivisible which means it cannot be broken into
small amounts and bought separately. Even small increases in demand can trigger the
need to buy completely new machines or build entirely new factories and premises,
even though the increase in demand may be relatively small.

The combined effect of these two principles creates what is called the accelerator effect.
For example, if in a given year national income rises by £20b, and investment rises by
£40b, the value of the accelerator is 2.
LESSON K: THE BUSINESS FIRM

DESCRIBING THE BUSINESS FIRM

A firm is a for-profit business organization—such as a corporation, limited liability

company (LLC), or partnership—that provides professional services. Most firms have just
one location. However, a business firm consists of one or more physical establishments,
in which all fall under the same ownership and use the same employer identification
number (EIN).

When used in a title, "firm" is typically associated with businesses that provide
professional law and accounting services, but the term may be used for a wide variety
of businesses, including finance, consulting, marketing, and graphic design firms, among
others.

Understanding Firms
In microeconomics, the theory of the firm attempts to explain why firms exist, why they
operate and produce as they do, and how they are structured. The theory of the firm
asserts that firms exist to maximize profits; however, this theory changes as the
economic marketplace changes. More modern theories would distinguish between firms
that work toward long-term sustainability and those that aim to produce high levels of
profit in a short time.

KEY TAKEAWAYS
 A firm is a for-profit business, usually formed as a partnership that provides professional
services, such as legal or accounting services.
 The theory of the firm posits that firms exist to maximize profits.
 Not to be confused with a firm, a company is a business that sells goods and/or services
for profit and includes all business structures and trades.
 A business firm has one or more locations which all have the same ownership and
report under the same EIN.

Firm vs. Company

Although they appear synonymous and are often used interchangeably, there is a
difference between a firm and a company. A company can be any trade or business in
 which goods or services are sold to produce income. Further, it encompasses all
business structures, such as a sole proprietorship, partnership, and corporation. On the
other hand, a firm typically excludes the sole proprietorship business; it generally refers
to a for-profit business managed by two or more partners providing professional
services, such as a law firm. In some cases, a firm can be a corporation.

FORMS OF BUSINESS ORGANIZATION

Types of Firms
A firm's business activities are typically conducted under the firm's name, but the
degree of legal protection—for employees or owners—depends on the type of
ownership structure under which the firm was created. Some organization types, such
as corporations, provide more legal protection than others. There exists the concept of
the mature firm that has been firmly established. Firms can assume many different
types based on their ownership structures:
 A sole proprietorship or sole trader is owned by one person, who is liable for all costs
and obligations, and owns all assets. Although not common under the firm umbrella,
there exists some sole proprietorship businesses that operate as firms.
 A partnership is a business owned by two or more people; there is no limit to the
number of partners that can have a stake in ownership. A partnership's owners each are
liable for all business obligations, and together they own everything that belongs to the
business.
 In a corporation, the businesses' financials are separate from the owners' financials.
Owners of a corporation are not liable for any costs, lawsuits, or other obligations of the
business. A corporation may be owned by individuals or by a government. Though
business entities, corporations can function similarly to individuals. For example, they
may take out loans, enter into contract agreements, and pay taxes. A firm that is owned
by multiple people is often called a company.
 A financial cooperative is similar to a corporation in that its owners have limited
liability, with the difference that its investors have a say in the company's operations.

FINANCING THE BUSINESS FIRM

Unless your business has the balance sheet of Apple, eventually you will probably need
access to capital through business financing. In fact, even many large-cap companies
routinely seek capital infusions to meet short-term obligations. For small businesses,
finding the right funding model is vitally important. Take money from the wrong source
and you may lose part of your company or find yourself locked into repayment terms
that impair your growth for many years into the future.
 KEY TAKEAWAYS
 There are a number of ways to find financing for a small business.
 Debt financing is usually offered by a financial institution and is similar to taking out a
mortgage or an automobile loan, requiring regular monthly payments until the debt is
paid off.
 In equity financing, either a firm or an individual makes an investment in your business,
meaning you don’t have to pay the money back, but the investor now owns a
percentage of your business, perhaps even a controlling one.
 Mezzanine capital combines elements of debt and equity financing, with the lender
usually having an option to convert unpaid debt into ownership in the company.

What Is Debt Financing?

Debt financing for your business is something you likely understand better than you
think. Do you have a mortgage or an automobile loan? Both of these are forms of debt
financing. It works the same way for your business. Debt financing comes from a bank or
some other lending institution. Although it is possible for private investors to offer it to
you, this is not the norm.

Here is how it works. When you decide you need a loan, you head to the bank and
complete an application. If your business is in the earliest stages of development, the
bank will check your personal credit.

For businesses that have a more complicated corporate structure or have been in
existence for an extended period time, banks will check other sources. One of the most
important is the Dun & Bradstreet (D&B) file. D&B is the best-known company for
compiling a credit history on businesses. Along with your business credit history, the
bank will want to examine your books and likely complete other due diligence.

Before applying, make sure all business records are complete and organized. If the bank
approves your loan request, it will set up payment terms, including interest. If the
process sounds a lot like the process you have gone through numerous times to receive
a bank loan, you are right.

Advantages of Debt Financing

There are several advantages to financing your business through debt:
 The lending institution has no control over how you run your company, and it has no
ownership.
 Once you pay back the loan, your relationship with the lender ends. That is especially
important as your business becomes more valuable.
 The interest you pay on debt financing is tax deductible as a business expense.
 The monthly payment, as well as the breakdown of the payments, is a known expense
that can be accurately included in your forecasting models.

Disadvantages of Debt Financing

However, debt financing for your business does come with some downsides:
 Adding a debt payment to your monthly expenses assumes that you will always have the
capital inflow to meet all business expenses, including the debt payment. For small or
early-stage companies that is often far from certain.
 Small business lending can be slowed substantially during recessions. In tougher times
for the economy, it can be difficult to receive debt financing unless you are
overwhelmingly qualified.
 
During economic downturns, it can be much harder for small businesses to qualify for
debt financing.

The U.S. Small Business Administration (SBA) works with certain banks to offer small

business loans. A portion of the loan is guaranteed by the credit and full faith of the
government of the United States. Designed to decrease the risk to lending institutions,
these loans allow business owners who might not otherwise be qualified to receive debt
financing. You can find more information about these and other SBA loans on the SBA’s
website.

What Is Equity Financing?

If you have ever watched ABC’s hit series “Shark Tank,” you may have a general idea of
how equity financing works. It comes from investors, often called “venture capitalists”
or “angel investors.”

A venture capitalist is usually a firm rather than an individual. The firm has
partners, teams of lawyers, accountants, and investment advisors who perform due
diligence on any potential investment. Venture capital firms often deal in large
investments ($3 million or more), and so the process is slow and the deal is often
complex.

Angel investors, by contrast, are normally wealthy individuals who want to invest a
smaller amount of money into a single product instead of building a business. They are
perfect for somebody such as the software developer who needs a capital infusion to
 fund the development of their product. Angel investors move fast and want simple
terms.
 
Equity financing uses an investor, not a lender; if you end up in bankruptcy, you do not
owe anything to the investor, who, as a part owner of the business, simply loses their
investment.

Advantages of Equity Financing

Funding your business through investors has several advantages:
 The biggest advantage is that you do not have to pay back the money. If your business
enters bankruptcy, your investor or investors are not creditors. They are partial owners
in your company and, because of that, their money is lost along with your company.
 You do not have to make monthly payments, so there is often more liquid cash on hand
for operating expenses.
 Investors understand that it takes time to build a business. You will get the money you
need without the pressure of having to see your product or business thriving within a
short amount of time.

Disadvantages of Equity Financing

Similarly, there are a number of disadvantages that come with equity financing:
 How do you feel about having a new partner? When you raise equity financing, it
involves giving up ownership of a portion of your company. The larger and riskier the
investment, the more of a stake the investor will want. You might have to give up
50% or more of your company. Unless you later construct a deal to buy the investor’s
stake, that partner will take 50% of your profits indefinitely.
 You will also have to consult with your investors before making decisions. Your company
is no longer solely yours, and if an investor has more than 50% of your company, you
have a boss to whom you have to answer.

What Is Mezzanine Capital?

Put yourself in the position of the lender for a moment. The lender is looking for the
best value for its money relative to the least amount of risk. The problem with debt
financing is that the lender does not get to share in the success of the business. All it
gets is its money back with interest while taking on the risk of default. That interest rate
is not going to provide an impressive return by investment standards. It will probably
offer single-digit returns.

Mezzanine capital often combines the best features of equity and debt financing.

Although there is no set structure for this type of business financing, debt capital often
 gives the lending institution the right to convert the loan to an equity interest in the
company if you do not repay the loan on time or in full.

Advantages of Mezzanine Capital

Choosing to use mezzanine capital comes with several advantages:
 This type of loan is appropriate for a new company that is already showing growth.
Banks are reluctant to lend to a company that does not have financial data. According to
Dr. Ajay Tyagi’s 2017 book Capital Investment and Financing for Beginners, Forbes has
reported that bank lenders are often looking for at least three years of financial
data.1 However, a newer business may not have that much data to supply. By adding an
option to take an ownership stake in the company, the bank has more of a safety net,
making it easier to get the loan.
 Mezzanine capital is treated as equity on the company’s balance sheet. Showing equity
rather than a debt obligation makes the company look more attractive to future lenders.
 Mezzanine capital is often provided very quickly with little due diligence.

Disadvantages of Mezzanine Capital

Mezzanine capital does have its share of disadvantages:
 The coupon or interest is often higher, as the lender views the company as high risk.
Mezzanine capital provided to a business that already has debt or equity obligations is
often subordinate to those obligations, increasing the risk that the lender will not be
repaid. Because of the high risk, the lender may want to see a 20% to 30% return.
 Much like equity capital, the risk of losing a significant portion of the company is very
real.
Please note that mezzanine capital is not as standard as debt or equity financing. The
deal, as well as the risk/reward profile, will be specific to each party.
 
Off-balance balance financing is good for one-time large purposes, allowing a business
to create a special purpose vehicle (SPV) that carries the expense on its balance sheet,
making the business seem less in debt.

Off-Balance Sheet Financing

Think about your personal finances for a minute. What if you were applying for a new
home mortgage and discovered a way to create a legal entity that takes your student
loan, credit card, and automobile debt off your credit report? Businesses can do that.
Off-balance sheet financing is not a loan. It is primarily a way to keep large purchases
(debts) off a company’s balance sheet, making it look stronger and less debt-laden. For
example, if the company needed an expensive piece of equipment, it could lease it
instead of buying it or create a special purpose vehicle (SPV)—one of those “alternate
families” that would hold the purchase on its balance sheet. The sponsoring company
often overcapitalizes the SPV in order to make it look attractive should the SPV need a
loan to service the debt.
Off-balance sheet financing is strictly regulated, and generally accepted accounting
principles (GAAP) govern its use. This type of financing is not appropriate for most
businesses, but it may become an option for small businesses that grow into much
larger corporate structures.

From Family and Friends

If your funding needs are relatively small, you may want to first pursue less formal
means of financing. Family and friends who believe in your business can offer simple
and advantageous repayment terms in exchange for setting up a lending model similar
to some of the more formal models. For example, you could offer them stock in your
company or pay them back just as you would a debt financing deal, in which you make
regular payments with interest.

Tapping Into Retirement Accounts

Whereas you may be able to borrow from your retirement plan and pay that loan back
with interest, an alternative known as a Rollover for Business Startups (ROBS) has
emerged as a practical source of funding for those who are starting a business. When
executed properly, ROBS allow entrepreneurs to invest their retirement savings into a
new business venture without incurring taxes, early withdrawal penalties, or loan
costs. However, ROBS transaction are complex, so it's essential to work with an
experienced and competent provider.

The Bottom Line

When you can avoid financing from a formal source, it will usually be more
advantageous for your business. If you do not have family or friends with the means to
help, debt financing is likely the easiest source of funds for small businesses. As your
business grows or reaches later stages of product development, equity financing or
mezzanine capital may become options. When it comes to financing and how it will
affect your business, less is more.
LESSON L: LABOR AND EMPLOYMENT

WHAT IS LABOR?
Labor is the amount of physical, mental, and social
effort used to produce goods and services in an
economy. It supplies the expertise, manpower, and
service needed to turn raw materials into finished
products and services.
Learn more about different types of labor, how it
works, how it is measured, and its impact on the
U.S. economy.

Definition and Examples of Labor

Labor is the number of workers in the economy, and the effort they put into producing
goods and services. 

Labor can be categorized in many different ways. First is by skill level; the most basic is
unskilled labor that does not require training. 1 Though it's usually manual labor, such as
farmworkers, it can also be service work, such as custodial staff. The next type is semi-
skilled labor, which may require some education or training. An example
is manufacturing jobs.

Labor can also be categorized by the nature of the relationship with the employer. Most
workers are wage employees.2 This means they are supervised by a boss. They also
receive a set weekly or bi-weekly wage and often receive. benefits.

Contract labor is when a contract specifies the work to be produced. It’s up to the
worker to define how it gets done. The amount paid is either commission or a set fee for
the work. Benefits are not paid.

How Labor Works

In return for their labor, workers receive a wage to buy the goods and services they
don't produce themselves. Those without desired skills or abilities often don't even get
paid a living wage. Many countries have a minimum wage to make sure their workers
earn enough to cover the costs of living.
 Labor is one of the four factors of production that drive supply. The other three are:
1. Land. This is short for the natural resources or raw materials in an economy. 
2. Capital. This is an abbreviation of the capital goods, such as machinery, equipment, and
chemicals that are used in production.
3. Entrepreneurship. This is the drive to profit from innovation.3 

In a market economy, companies use these components of supply to meet consumer

demand.

The economy runs most efficiently when all members are working at a job that uses
their best skills. It also helps when they are paid according to the value of the work
produced.

The ongoing drive to find the best match between skills, jobs, and pay keeps the supply
of labor very dynamic. For this reason, there's always some level of natural
unemployment. For example, frictional unemployment allows workers the freedom to
quit a job in search of a better one.4

How Labor Is Measured

Labor is measured by the labor force or labor pool. To be considered part of the labor
force, you must be available, willing to work, and have looked for work recently. The
size of the labor force depends not only on the number of adults but also on how likely
they feel they can get a job. It is the number of people in a country who
are employed plus the unemployed.5

Not everyone who is jobless is automatically counted as unemployed. Many are jobless
by choice and aren't looking for work. Examples include stay-at-home moms, retired
seniors, and students. Others have given up looking for work. These are discouraged
workers. 
The real unemployment rate measures everyone who would like a full-time job. 6 It
includes the discouraged workers. It also includes those who are working part-time only
because they can't get a full-time job. It's called the real unemployment rate because it
gives a broader measure of unemployment.

The labor force is used to help determine the unemployment rate. The unemployment
rate formula is the number of unemployed divided by the labor force. It tells you how
many people in the labor force are jobless but are actively looking for work.
 The labor pool shrinks during and after a recession. Even though many would like a job,
they aren't looking for work. They aren't counted in the labor force.

The labor force participation rate is the labor force divided by the civilian non-
institutionalized population. It tells you how many people are available and looking for
work.

The amount of goods and services that the labor force creates is called productivity. If a
certain amount of labor and a fixed amount of capital creates a lot, that's
high productivity. The higher the productivity, the greater the profit. High productivity
gives the worker, company, industry, or country a competitive advantage.

How Labor Affects the U.S. Economy

The U.S. has a highly skilled and mobile labor force that can respond quickly to changing
business needs. But it's facing more competitive labor from other countries that can pay
its workers less. They can do this because they have a lower standard of living. 7 
The U.S. Department of Labor manages compliance with labor laws and the U.S.
minimum wage. It also provides job training and enforces workplace safety. 
The U.S. Bureau of Labor Statistics is a DOL division that measures labor. It provides the
monthly employment report and the nation's unemployment rate.

Key Takeaways
 Labor is the amount of physical, mental, and social effort used to produce goods and
services in an economy. It supplies the expertise, manpower, and service needed to turn
raw materials into finished products and services.
 In return for their labor, workers receive a wage to buy the goods and services they
don't produce themselves.
 Labor is one of the four factors of production that drives supply.
 The economy runs most efficiently when all members are working at a job that uses
their best skills. It also helps when they are paid according to the value of the work
produced.

CHARACTERISTICS OF LABOR

Perishable in Nature
Labor is perishable in nature. This simply means that it has to storage capacity, i.e., labor
cannot be stored. If a worker does not turn up to work for one shift his labor of that shift
is lost completely. It cannot be stored and utilized the next day. That labor is lost
permanently. A laborer cannot store his labor to use at another time. So, we say labor as
a factor of production is highly perishable.

Labor is Inseparable from the Laborer

This means the physical presence of the laborer is compulsory. To sell his services the
laborer has to be physically present at the place of production of goods or services. We
cannot separate him and his labor power. So, we cannot expect a welder to do his work
from home, he has to present at the site of the work.

Human Effort
Labor is a unique factor of production in comparison with others. It is directly related to
human effort, unlike the others. So, there are certain special factors we must take into
consideration when it comes to labor. Fair treatment of workers, rest times, suitable
work environment, idle time, etc. are just some such factors.

Labor is Heterogeneous
We cannot expect labor to be uniform. Every laborer is unique and so his labor power
will also differ from the others. The quality and the efficiency of the labor will depend on
the skills, work environment, incentives and other inherent qualities of the laborer.

Labor has Poor Bargaining Power

Labor as a factor of production has a very week bargaining power with the buyer of the
services. It cannot be stored, isn’t very mobile and has no standard or reserve price. So
generally laborers are forced to work for whatever wages the employer offers. In
comparison to the employer, the laborers have very little bargaining power.

There is also the problem that laborers do not have any other reserves to fall back on.
They are usually poor and ignorant. And this labor work is their only source of income.
So, they accept whatever wages the employer offers.

Not Easily Mobile

Labor as a factor of production is mobile, i.e., the laborers can relocate to the site of
work. But there are many barriers to the movement of labor from one place to another.
So, we can say labor is not as mobile as some other factors of production like Capital.

Supply of Labor is relatively Inelastic

At any given point in time, the supply of
labor in the market is inelastic. It cannot be
increased instantly to keep up with the demand. So, say there is a shortage of skilled
labor in India, skilled laborers cannot be generated in a day, a week or even a year.
We may be able to import some labor for a short period. But generally, the supply of
labor is very inelastic, since we cannot increase or decrease it instantaneously.

KINDS OF LABOR

1. Physical and Mental Labor:

Such work in which physical labour and physical strength is more important in
comparison to mental labour is called physical labor. For example—The work of
Rickshaw Puller, workers working in factory, porter who carries luggage on the platform.
But mental Labor is that in which brain is applied or mental fatigue is more in
comparison to physical fatigue, For example—The work of an advocate, teacher, doctor,
chartered accountant etc. For better performance of work mental and physical labor is
essential.

2. Skilled and Unskilled Labour:

Skilled Labour is that in which special knowledge, learning, training and efficiency is
required in performing the work. For example—The Labor of engineer, doctor, teacher
and a scientist has been called as skilled Labor.

While the work in which special knowledge, training or learning is not required is known
as unskilled labor. For example—The work of rickshaw puller, porter carrying luggage on
platform is called unskilled. The remuneration of skilled worker is normally higher than
that of unskilled worker.

3. Productive and Unproductive Labor:

Productive Labor is that labor which adds net value to the product. While unproductive
labor is that which does not add net value. In other-words we can say that “Labor
producing material goods are productive and Labor producing perishable goods
including services of servants, teachers, doctors, lawyers etc. are unproductive.”

But according to Prof. Marshall all labor is productive. He saw- “no distinction in the
work of the baker who provides bread for a family and that of the cook who prepares
rice or boiled potatoes”. Modern economists following Marshall regard all Labor
whether material or non-material or services as productive.
Only that Labor is considered unproductive which is performed by anti-social persons
such as pickpockets, thieves, dacoits etc. But Labour used in constructing building, a
dam etc. is productive because the workers worked on them and receives wages.

In this connection Prof. Robbins has written “Whether Labor is productive or

unproductive does not depend upon its physical or mental nature of work. Rather it
depends upon its relative scarcity in relation to its demand. All kinds of Labor which has
a demand and receives a wage is regarded as productive.”

SUPPLY OF LABOR

Labor is the fundamental and active factor of production Labor has important
contribution to the production of commodities. Labor is the exertion of mind and body
undertaken with a view to some goods other than the pleasure directly derived from the
work. Like a commodity, Labor cannot be stored and withdrawn from the market for a
favorable time if the wage offered in low.

Further, Labor is inseparable from laborer and has to be delivered personally, working
conditions or environment are of great importance. If the place of work is congenial and
the management is kind hearted, even a lower wage can be acceptable. Labor has a
weak bargaining power; therefore, the employer has an upper hand in Labor
transactions and the wage given is lower than it is due.

The supply of Labor cannot quickly adjust to the change in demand. The wages
sometimes rule higher and at other times lower than need be. As the Labor has no
calculable cost of production, it has to be satisfied with the wage it can receive or it
receives.

Therefore, Karl Marx has said—” Capital is the collective shape of Labour performed in
the past. Land which has been made for productive purposes is the important effort of
Labor”. Hence, we cannot ignore the importance of Labor in Economics.

The demand for labor is one determinant of the equilibrium wage and equilibrium
quantity of labor in a perfectly competitive market. The supply of labor, of course, is the
other.

Economists think of the supply of labor as a problem in which individuals weigh the
opportunity cost of various activities that can fill an available amount of time and
choose how to allocate it. Everyone has 24 hours in a day. There are lots of uses to
 which we can put our time: we can raise children, work, sleep, play, or participate in
volunteer efforts.

To simplify our analysis, let us assume that there are two ways in which an individual
can spend his or her time: in work or in leisure. Leisure is a type of consumption good;
individuals gain utility directly from it. Work provides income that, in turn, can be used
to purchase goods and services that generate utility.

The more work a person does, the greater his or her income, but the smaller the
amount of leisure time available. An individual who chooses more leisure time will earn
less income than would otherwise be possible. There is thus a tradeoff between leisure
and the income that can be earned from work. We can think of the supply of labor as
the flip side of the demand for leisure. The more leisure people demand, the less labor
they supply.

PROBLEMS OF LABOR

When a job applicant is bargaining with an employer for a position, the applicant is
often at a disadvantage—needing the job more than the employer needs that particular
applicant. John Bates Clark (1847–1938), often named as the first great American
economist, wrote in 1907: “In the making of the wages contract the individual laborer is
always at a disadvantage. He has something which he is obliged to sell and which his
employer is not obliged to take, since he [that is, the employer] can reject single men
with impunity.”

To give workers more power, the U.S. government has passed a number of laws to
create a more equal balance of power between workers and employers. These laws
include some of the following:
 Setting minimum hourly wages
 Setting maximum hours of work (at least before employers pay overtime rates)
 Prohibiting child labor
 Regulating health and safety conditions in the workplace
 Preventing discrimination on the basis of race, ethnicity, gender, sexual orientation, and
age
 Requiring employers to provide family leave
 Requiring employers to give advance notice of layoffs
 Covering workers with unemployment insurance
 Setting a limit on the number of immigrant workers from other countries
Unemployment and underemployment are the Philippines’ most important problems
and the key indicators of the weaknesses of the economy. Today, around 4 million
workers (about 12% of the labor force) are unemployed and another 5 million (around
17% of those employed) are underemployed.

This Reserve Army of workers is a reflection of what happens in the economy,

particularly because of its incapacity to provide jobs (especially in the formal sector) to
its growing labor force. The social costs of this mass unemployment range from income
losses to severe social and psychological problems resulting from not having a job and
feeling insecure about the future. Overall, it causes a massive social inefficiency.

TYPES OF UNEMPLOYMENT

Economists call the variation in unemployment that the economy causes as it moves
from expansion to recession or from recession to expansion (i.e., the business
cycle) cyclical unemployment. 

Cyclical unemployment explains why unemployment rises during a recession and falls
during an economic expansion, but what explains the remaining level of unemployment
even in good economic times? Why is the unemployment rate never zero? Even when
the U.S. economy is growing strongly, the unemployment rate only rarely dips as low as
4%.

Moreover, the discussion earlier in this chapter pointed out that unemployment rates in
many European countries like Italy, France, and Germany have often been remarkably
high at various times in the last few decades. Why does some level of unemployment
persist even when economies are growing strongly? Why are unemployment rates
continually higher in certain economies, through good economic years and bad? Among
orthodox economists there is a term to describe the remaining level of unemployment
that occurs even when the economy is healthy: the natural rate of unemployment.

THE LONG RUN: THE NATURAL RATE OF UNEMPLOYMENT

The natural rate of unemployment is not “natural” in the sense that water freezes at 32
degrees Fahrenheit or boils at 212 degrees Fahrenheit. It is not a physical and
unchanging law of nature. Instead, it is only the “natural” rate because it is the
unemployment rate that would result from the combination of economic, social, and
political factors that exist at a time—assuming the economy was neither booming nor in
recession. These forces include the usual pattern of companies expanding and
contracting their workforces in a dynamic economy, social and economic forces that
affect the labor market, or public policies that affect either the eagerness of people to
work or the willingness of businesses to hire. Let’s discuss these factors in more detail.

FRICTIONAL UNEMPLOYMENT
In a market economy, some companies are always going broke for a variety of reasons:
old technology; poor management; good management that happened to make bad
decisions; shifts in tastes of consumers so that less of the firm’s product is desired; a
large customer who went broke; or tough domestic or foreign competitors. Conversely,
other companies will be doing very well for just the opposite reasons and looking to hire
more employees. In a perfect world, all of those who lost jobs would immediately find
new ones. However, in the real world, even if the number of job seekers is equal to the
number of job vacancies, it takes time to find out about new jobs, to interview and
figure out if the new job is a good match, or perhaps to sell a house and buy another in
proximity to a new job. Economists call the unemployment that occurs in the meantime,
as workers move between jobs, frictional unemployment. Frictional unemployment is
not inherently a bad thing. It takes time on part of both the employer and the individual
to match those looking for employment with the correct job openings. For individuals
and companies to be successful and productive, you want people to find the job for
which they are best suited, not just the first job offered.
In the mid-2000s, before the 2008–2009 recession, it was true that about 7% of U.S.
workers saw their jobs disappear in any three-month period. However, in periods of
economic growth, these destroyed jobs are counterbalanced for the economy as a
whole by a larger number of jobs created. In 2005, for example, there were typically
about 7.5 million unemployed people at any given time in the U.S. economy. Even
though about two-thirds of those unemployed people found a job in 14 weeks or fewer,
the unemployment rate did not change much during the year, because those who found
new jobs were largely offset by others who lost jobs.
Of course, it would be preferable if people who were losing jobs could immediately and
easily move into newly created jobs, but in the real world, that is not possible. Someone
who is laid off by a textile mill in South Carolina cannot turn around and immediately
start working for a textile mill in California. Instead, the adjustment process happens in
ripples. Some people find new jobs near their old ones, while others find that they must
move to new locations. Some people can do a very similar job with a different company,
while others must start new career paths. Some people may be near retirement and
decide to look only for part-time work, while others want an employer that offers a
long-term career path. The frictional unemployment that results from people moving
between jobs in a dynamic economy may account for one to two percentage points of
total unemployment.
The level of frictional unemployment will depend on how easy it is for workers to learn
about alternative jobs, which may reflect the ease of communications about job
prospects in the economy. The extent of frictional unemployment will also depend to
some extent on how willing people are to move to new areas to find jobs—which in turn
may depend on history and culture.
Frictional unemployment and the natural rate of unemployment also seem to depend
on the age distribution of the population. [link] (b) showed that unemployment rates
are typically lower for people between 25–54 years of age or aged 55 and over than
they are for those who are younger. “Prime-age workers,” as those in the 25–54 age
bracket are sometimes called, are typically at a place in their lives when they want to
have a job and income arriving at all times. In addition, older workers who lose jobs may
prefer to opt for retirement. By contrast, it is likely that a relatively high proportion of
those who are under 25 will be trying out jobs and life options, and this leads to greater
job mobility and hence higher frictional unemployment. Thus, a society with a relatively
high proportion of young workers, like the U.S. beginning in the mid-1960s when Baby
Boomers began entering the labor market, will tend to have a higher unemployment
rate than a society with a higher proportion of its workers in older ages.

STRUCTURAL UNEMPLOYMENT
Another factor that influences the natural rate of unemployment is the amount
of structural unemployment. The structurally unemployed are individuals who have no
jobs because they lack skills valued by the labor market, either because demand has
shifted away from the skills they do have, or because they never learned any skills. An
example of the former would be the unemployment among aerospace engineers after
the U.S. space program downsized in the 1970s. An example of the latter would be high
school dropouts.
Some people worry that technology causes structural unemployment. In the past, new
technologies have put lower skilled employees out of work, but at the same time they
create demand for higher skilled workers to use the new technologies. Education seems
to be the key in minimizing the amount of structural unemployment. Individuals who
have degrees can be retrained if they become structurally unemployed. For people with
no skills and little education, that option is more limited.

NATURAL UNEMPLOYMENT AND POTENTIAL REAL GDP

The natural unemployment rate is related to two other important concepts: full
employment and potential real GDP. Economists consider the economy to be at full
employment when the actual unemployment rate is equal to the natural unemployment
rate. When the economy is at full employment, real GDP is equal to potential real GDP.
By contrast, when the economy is below full employment, the unemployment rate is
greater than the natural unemployment rate and real GDP is less than potential. Finally,
when the economy is above full employment, then the unemployment rate is less than
the natural unemployment rate and real GDP is greater than potential. Operating above
potential is only possible for a short while, since it is analogous to all workers working
overtime.

PRODUCTIVITY SHIFTS AND THE NATURAL RATE OF UNEMPLOYMENT

Unexpected shifts in productivity can have a powerful effect on the natural rate of
unemployment. Over time, workers’ productivity determines the level of wages in an
economy. After all, if a business paid workers more than could be justified by their
productivity, the business will ultimately lose money and go bankrupt. Conversely, if a
business tries to pay workers less than their productivity then, in a competitive labor
market, other businesses will find it worthwhile to hire away those workers and pay
them more.
However, adjustments of wages to productivity levels will not happen quickly or
smoothly. Employers typically review wages only once or twice a year. In many modern
jobs, it is difficult to measure productivity at the individual level. For example, how
precisely would one measure the quantity produced by an accountant who is one of
many people working in the tax department of a large corporation? Because
productivity is difficult to observe, employers often determine wage increases based on
recent experience with productivity. If productivity has been rising at, say, 2% per year,
then wages rise at that level as well. However, when productivity changes unexpectedly,
it can affect the natural rate of unemployment for a time. Levels of unemployment will
tend to be somewhat higher on average when productivity is unexpectedly low, and
conversely, will tend to be somewhat lower on average when productivity is
unexpectedly high. However, over time, wages do eventually adjust to reflect
productivity levels.

PUBLIC POLICY AND THE NATURAL RATE OF UNEMPLOYMENT

Public policy can also have a powerful effect on the natural rate of unemployment. On
the supply side of the labor market, public policies to assist the unemployed can affect
how eager people are to find work. For example, if a worker who loses a job is
guaranteed a generous package of unemployment insurance, welfare benefits, food
stamps, and government medical benefits, then the opportunity cost of unemployment
is lower and that worker will be less eager to seek a new job.
What seems to matter most is not just the amount of these benefits, but how long they
last. A society that provides generous help for the unemployed that cuts off after, say,
six months, may provide less of an incentive for unemployment than a society that
provides less generous help that lasts for several years. Conversely, government
assistance for job search or retraining can in some cases encourage people back to work
sooner. See the Clear It Up to learn how the U.S. handles unemployment insurance.

INVESTMENT OF HUMAN CAPITAL

Human capital is an intangible asset or quality not listed on a company's balance sheet.
It can be classified as the economic value of a worker's experience and skills. This
includes assets like education, training, intelligence, skills, health, and other things
employers’ value such as loyalty and punctuality.
The concept of human capital recognizes that not all labor is equal. But employers can
improve the quality of that capital by investing in employees—the education,
experience, and abilities of employees all have economic value for employers and for
the economy as a whole.

Human capital is important because it is perceived to increase productivity and thus

profitability. So, the more a company invests in its employees (i.e., in their education
and training), the more productive and profitable it could be.
Understanding Human Capital

An organization is often said to only be as good as its people. Directors, employees, and
leaders who make up an organization's human capital are critical to its success.
Human capital is typically managed by an organization's human resources
(HR) department. This department oversees workforce acquisition, management, and
optimization. Its other directives include workforce planning and strategy, recruitment,
employee training and development, and reporting and analytics.

Human capital tends to migrate, especially in global economies. That's why there is
often a shift from developing places or rural areas to more developed and urban areas.
Some economists have dubbed this a brain drain, making poorer places poorer and
richer places richer. 

Calculating Human Capital

Since human capital is based on the investment of employee skills and knowledge
through education, these investments in human capital can be easily calculated. HR
managers can calculate the total profits before and after any investments are made. Any
return on investment (ROI) of human capital can be calculated by dividing the
company’s total profits by its overall investments in human capital.
 For example, if Company X invests $2 million into its human capital and has a total profit
of $15 million, managers can compare the ROI of its human capital year-over-year
(YOY) in order to track how profit is improving and whether it has a relationship to the
human capital investments.

KEY TAKEAWAYS
 Human capital is an intangible asset not listed on a company's balance sheet and
includes things like an employee's experience and skills.
 Since all labor is not considered equal, employers can improve human capital by
investing in the training, education, and benefits of their employees.
 Human capital is perceived to have a relationship with economic growth, productivity,
and profitability.
 Like any other asset, human capital can depreciate through long periods of
unemployment, and the inability to keep up with technology and innovation.

Special Considerations
Human Capital and Economic Growth
There is a strong relationship between human capital and economic growth. Because
people come with a diverse set of skills and knowledge, human capital can certainly help
boost the economy. This relationship can be measured by how much investment goes
into people’s education.

Some governments recognize that this relationship between human capital and the
economy exists, and so they provide higher education at little or no cost. People who
participate in the workforce who have higher education will often have larger salaries,
which means they will be able to spend more.

Does Human Capital Depreciate?

Like anything else, human capital is not immune to depreciation. This is often measured
in wages or the ability to stay in the workforce. The most common ways human capital
can depreciate are through unemployment, injury, mental decline, or the inability to
keep up with innovation.

Consider an employee who has a specialized skill. If they go through a long period of
unemployment, they may be unable to keep these levels of specialization. That's
because their skills may no longer be in demand when they finally reenter the
workforce.
Similarly, the human capital of someone may depreciate if they can't or won't adopt
new technology or techniques. Conversely, the human capital of someone who does
adopt them will.

A Brief History of Human Capital

The idea of human capital can be traced back to the 18th century. Adam Smith referred
to the concept in his book "An Inquiry into the Nature and Causes of the Wealth of
Nations," in which he explored the wealth, knowledge, training, talents, and experiences
for a nation. Adams suggests that improving human capital through training and
education leads to a more profitable enterprise, which adds to the collective wealth of
society. According to Smith, that makes it a win for everyone.
In more recent times, the term was used to describe the labor required to produce
manufactured goods. But the most modern theory was used by several different
economists including Gary Becker and Theodore Schultz, who invented the term in the
1960s to reflect the value of human capacities.

Schultz believed human capital was like any other form of capital to improve the quality
and level of production. This would require an investment in the education, training and
enhanced benefits of an organization's employees.

But not all economists agree. According to Harvard economist Richard Freeman, human
capital was a signal of talent and ability. In order for a business to really become
productive, he said it needed to train and motivate its employees as well as invest in
capital equipment. His conclusion was that human capital was not a production factor.

Criticism of Human Capital Theories

The theory of human capital has received a lot of criticism from many people who work
in education and training. In the 1960s, the theory was attacked primarily because it
legitimized bourgeois individualism, which was seen as selfish and exploitative. The
bourgeois class of people included those of the middle class who were believed to
exploit those of the working class.
The human capital theory was also believed to blame people for any defects that
happened in the system and of making capitalists out of workers.
LESSON M: BUSINESS CYCLE AND INFLATION

THE NATURE OF BUSINESS CYCLE

Business Cycle, also known as the economic cycle or trade cycle, is the fluctuations in

economic activities or rise and fall movement of gross domestic product (GDP) around
its long-term growth trend.
No era can stay forever. The economy too does not enjoy same periods all the time. Due
to its dynamic nature, it moves through various phases.

The change in business activities due to fluctuations in economic activities over a period
of time is known as a business cycle. Business cycle are also called trade cycle or
economic cycle. Business Cycle can also help you make better financial decisions. 
The economic activities of a country include total output, income level, prices of
products and services, employment, and rate of consumption. All these activities are
interrelated; if one activity changes, the rest of them also change.

The nature of business cycle helps the organisation to be prepared for facing

uncertainties of the business environment.
1. Cyclical nature

2. General nature
Nature of Business Cycle
Let us discuss the nature of business cycle in detail.

Cyclical nature
This is the periodic nature of a
business cycle. Periodicity
 signifies the occurrence of business cycle at regular intervals of time. However, periods
of intervals are different for different business cycle. There is a general consensus that a
normal business cycle can take 7 to 10 years to complete.

General nature
The general nature of a business cycle states that any change in an organization affects
all other organizations too in the industry. Thus, general nature regards the business
world as a single economic unit.

Types of Business Cycle

Following the writings of Prof. James Arthur and Schumpeter, we can classify business
cycle into three types based on the underlying time period of existence of the cycle as
follows:
1. Short Kitchin Cycle
2. Longer Juglar cycle
3. Very long Kondratieff Wave
Short Kitchin Cycle (very short or minor period of the cycle, approximately 40 months
duration)

Longer Juglar cycle (major cycles, composed of three minor cycles and of the duration of
10 years or so)

Business Cycle Theory

A business cycle is a complex phenomenon which is common to every economic system.
Several theories of business cycle have been propounded from time to time to explain
the causes of business cycle.
Business Cycle Theory are:
1. Hawtrey Monetary Theory
2. Innovation Theory

3. Keynesian theory
4. Hicks Theory

5. Samuelson theory
Business Cycle Theory
Hawtrey Monetary Theory
Hawtray was of opinion that in
depression monetary factors play a
 critical role. The main factor affecting the flow of money and money supply is the credit
position by the bank. He made the classical quantity theory of money as the basis of
his trade cycle theory.
According to him, both monetary and non-monetary factors also affect trade. His theory
is basically the product of the supply of money and expansion of credit. This expansion
of credit and other money supply instrument create a cumulative process of expansion
which in return increase aggregate demand.
According to this theory the only cause of fluctuations in business is due to instability of
bank credit. So it can be concluded that Hawtray’s theory of business cycle is basically
depend upon the money supply, bank credits and rate of interests.
Criticism of this Business Cycle theory
 Hawtray neglected the role of non-monetary factors like prosperous agriculture,
inventions, rate of profit and stock of capital.
 It only concentrates on the supply of money.
 Increase in interest rates is not only due to economic prosperity but also due to other
factors.
 Over-emphasis on the role of wholesalers.
 Too much confidence in monetary policy. vi. Neglect the role of expectations. vii.
Incomplete theory of trade cycles.
Innovation Theory
The innovation theory of business cycle is invented by an American Economist Joseph
Schumpeter. According to this theory, the main causes of business cycle are over-
innovations.
He takes the meaning of innovation as the introduction and application of such
techniques which can help in increasing production by exploiting the existing resources,
not by discoveries or inventions. Innovations are always inspired by profits. Whenever
innovations are introduced it results into profitability then shared by other producers
and result in a decline in profitability.
Criticism of this Business Cycle theory
 Innovation fails to explain the period of boom and depression.

 Innovation may be major factor of investment and economic activities but not the
complete process of trade cycle.

 This theory is based on the assumption that every new innovation is financed by the
banks and other credit institutions but this cannot be taken as granted because banks
finance only short term loans and investments.
Keynesian Theory
The theory suggests that fluctuations in business cycle can be explained by the
perceptions on expected rate of profit of the investors. In other words, the downswing
in business cycle is caused by the collapse in the marginal efficiency of capital, while
revival of the economy is attributed to the optimistic perceptions on the expected rate
of profit.
Moreover, Keynesian multiplier theory establishes linkages between change in
investment and change in income and employment. However, the theory fails to explain
the cumulative character both in the upswing and downswing phases of business
cycle and cyclical fluctuations in economic activity with the passage of time.
Hicks Theory
Hicks extended the earlier multiplier-accelerator interaction theory by considering real
world situation. In reality, income and output do not tend to explode; rather they are
located at a range specified by the upper ceiling and lower floor determined by the
autonomous investment.
In the theory, it is assumed that autonomous investment tends to grow at a constant
percentage rate over the long run, the acceleration co-efficient and multiplier co-
efficient remain constant throughout the different phases of the trade cycle, saving and
investment co-efficient are such that upward movements take away from equilibrium.

Criticism of this Business Cycle theory

Wrong assumption of constant multiplier and acceleration co-efficient.
Highly mechanical and mathematical device.
Wrong assumption of no-excess capacity.
Full-employment ceiling is not independent

Samuelson theory
According to this theory process of multiplier starts working when autonomous
investment takes place in the economy. With the autonomous investment income of
the people rises and there is increase in the demand of consumer goods. It directly
affected the marginal propensity to consume.

If there is no excess production capacity in the existing industry then existing stock of
capital would not be adequate to produce consumer goods to meet the rising demand.
Now in order to meet the consumer’s requirements, producers will make new
investment which is derived investment and the process of acceleration principle comes
into operation.

PHASES OF THE BUSINESS CYCLE

 Phases of Business Cycle
4 Phases of Business Cycle are:
1. Expansion

2. Peak
3. Contraction

4. Trough

Phases of Business Cycle

Let us discuss 4 phases of business cycle in detail:

Expansion
Expansion is the first phase of a business cycle. It is often referred to as the growth
phase.
In the expansion phase, there is an increase in various economic factors, such as
production, employment, output, wages, profits, demand and supply of products, and
sales. During this phase, the focus of organizations remains on increasing the demand
for their products/services in the market.

The expansion phase is characterized by:

 Increase in demand
 Growth in income
 Rise in competition
 Rise in advertising
 Creation of new policies
 Development of brand loyalty
In this phase, debtors are generally in a good financial condition to repay their debts;
therefore, creditors lend money at higher interest rates. This leads to an increase in the
flow of money.
 In the expansion phase, due to increase in investment opportunities, idle funds of
organizations or individuals are utilized for various investment purposes. The expansion
phase continues till economic conditions are favorable.

Peak
Peak is the next phase after expansion. In this phase, a business reaches at the highest
level and the profits are stable. Moreover, organizations make plans for further
expansion.
Peak phase is marked by the following features:
 High demand and supply
 High revenue and market share
 Reduced advertising
 Strong brand image
In the peak phase, the economic factors, such as production, profit, sales, and
employment, are higher but do not increase further.

Contraction
An organization after being at the peak for a period of time begins to decline and enters
the phase of contraction. This phase is also known as a recession.
An organization can be in this phase due to various reasons, such as a change in
government policies, rise in the level of competition, unfavorable economic conditions,
and labour problems. Due to these problems, the organization begins to experience a
loss of market share.

The important features of the contraction phase are:

 Reduced demand
 Loss in sales and revenue
 Reduced market share
 Increased competition

Trough
In Trough phase, an organization suffers heavy losses and falls at the lowest point. At
this stage, both profits and demand reduce. The organization also loses its competitive
position.
The main features of this phase are:
 Lowest income
 Loss of customers
 Adoption of measures for cost-cutting and reduction
  Heavy fall in market share
In this phase, the growth rate of an economy becomes negative. In addition, in trough
phase, there is a rapid decline in national income and expenditure.

LESSON N: MONEY AND MONETARY POLICY

WHAT IS MONEY?

Money makes the world go around. Economies rely on the exchange of money for
products and services. Economists define money, where it comes from, and what it's
worth. Here are the multifaceted characteristics of money.

KEY TAKEAWAYS
 Money is a medium of exchange; it allows people to obtain what they need to live.
 Bartering was one way that people exchanged goods for other goods before money was
created.
 Like gold and other precious metals, money has worth because for most people it
represents something valuable.
 Fiat money is government-issued currency that is not backed by a physical commodity
but by the stability of the issuing government.
 Above all, a money is a unit of account - a socially accepted standard unit with which
things are priced.

Medium of Exchange
Before the development of a medium of exchange—that is, money—people would
barter to obtain the goods and services they needed. Two individuals, each possessing
some goods the other wanted, would enter into an agreement to trade.

Early forms of bartering, however, do not provide the transferability and divisibility that
makes trading efficient. For instance, if someone has cows but needs bananas, they
must find someone who not only has bananas but also the desire for meat. What if that
individual sees someone who has the need for meat but no bananas and can only offer
potatoes? To get meat, that person must find someone who has bananas and wants
potatoes, and so on.

The lack of transferability of bartering for goods is tiring, confusing, and inefficient. But
that is not where the problems end; even if the person finds someone with whom to
trade meat for bananas, they may not consider a bunch of bananas to be worth a whole
cow. Such a trade requires coming to an agreement and devising a way to determine
how many bananas are worth certain parts of the cow.

Commodity money solved these problems. Commodity money is a type of good that

functions as currency. In the 17th and early 18th centuries, for example, American
colonists used beaver pelts and dried corn in transactions. 1 Possessing generally
accepted values, these commodities were used to buy and sell other things. The
commodities used for trade had certain characteristics: they were widely desired and,
therefore, valuable, but they were also durable, portable, and easily stored.

Another, more advanced example of commodity money is a precious metal such as gold.
For centuries, gold was used to back paper currency—up until the 1970s. 2 In the case of
the U.S. dollar, for example, this meant that foreign governments were able to take
their dollars and exchange them at a specified rate for gold with the U.S. Federal
Reserve.

What's interesting is that, unlike the beaver pelts and dried corn (which can be used for
clothing and food, respectively), gold is precious purely because people want it. It is not
necessarily useful—you can't eat gold, and it won't keep you warm at night, but the
majority of people think it is beautiful, and they know others think it is beautiful. So,
gold is something that has worth. Gold, therefore, serves as a physical token of wealth
based on people's perceptions.

This relationship between money and gold provides insight into how money gains its
value—as a representation of something valuable.
Impressions Create Everything

The second type of money is fiat money, which does not require backing by a physical
commodity. Instead, the value of fiat currencies is set by supply and demand and
people's faith in its worth. Fiat money developed because gold was a scarce resource,
and rapidly growing economies growing couldn't always mine enough to back their
currency supply requirements.3 4 For a booming economy, the need for gold to give
money value is extremely inefficient, especially when its value is really created by
people's perceptions.
Fiat money becomes the token of people's perception of worth, the basis for why
money is created. An economy that is growing is apparently succeeding in producing
other things that are valuable to itself and other economies. The stronger the economy,
the stronger its money will be perceived (and sought after) and vice versa. However,
 people's perceptions must be supported by an economy that can produce the products
and services that people want.

For example, in 1971, the U.S. dollar was taken off the gold standard—the dollar was no
longer redeemable in gold, and the price of gold was no longer fixed to any dollar
amount.5 This meant that it was now possible to create more paper money than there
was gold to back it; the health of the U.S. economy backed the dollar's value. If the
economy stalls, the value of the U.S. dollar will drop both domestically through inflation
and internationally through currency exchange rates. The implosion of the U.S. economy
would plunge the world into a financial dark age, so many other countries and entities
are working tirelessly to ensure that never happens.
Today, the value of money (not just the dollar, but most currencies) is decided purely by
its purchasing power, as dictated by inflation. That is why simply printing new money
will not create wealth for a country. Money is created by a kind of a perpetual
interaction between real, tangible things, our desire for them, and our abstract faith in
what has value. Money is valuable because we want it, but we want it only because it
can get us a desired product or service.

How Is Money Measured?

But exactly how much money is out there, and what forms does it take? Economists and
investors ask this question to determine whether there is inflation or deflation. Money is
separated into three categories so that it is more discernible for measurement
purposes:

 M1 – This category of money includes all physical denominations of coins and currency;
demand deposits, which are checking accounts and NOW accounts; and travelers'
checks. This category of money is the narrowest of the three, and is essentially the
money used to buy things and make payments (see the "active money" section below).
 M2 – With broader criteria, this category adds all the money found in M1 to all time-
related deposits, savings accounts deposits, and non-institutional money market funds.
This category represents money that can be readily transferred into cash.
 M3 – The broadest class of money, M3 combines all money found in the M2 definition
and adds to it all large time deposits, institutional money market funds, short-term
repurchase agreements, along with other larger liquid assets.

By adding these three categories together, we arrive at a country's money supply or the
total amount of money within an economy.

Active Money
The M1 category includes what's known as active money—the total value of coins and
paper currency in circulation. The amount of active money fluctuates seasonally,
monthly, weekly, and daily. In the United States, Federal Reserve Banks distribute new
currency for the U.S. Treasury Department. Banks lend money out to customers, which
becomes active money once it is actively circulated.

The variable demand for cash equates to a constantly fluctuating active money total. For
example, people typically cash paychecks or withdraw from ATMs over the weekend, so
there is more active cash on a Monday than on a Friday. The public demand for cash
declines at certain times—following the December holiday season, for example. 6
How Money Is Created
We have discussed why and how money, a representation of perceived value, is created
in the economy, but another important factor concerning money and the economy is
how a country's central bank (the central bank in the United States is the Federal
Reserve or the Fed) can influence and manipulate the money supply.

If the Fed wants to increase the amount of money in circulation, perhaps to boost
economic activity, the central bank can, of course, print it. However, the physical bills
are only a small part of the money supply.

Another way for the central bank to increase the money supply is to buy government
fixed-income securities in the market. When the central bank buys these government
securities, it puts money into the marketplace, and effectively into the hands of the
public. How does a central bank such as the Fed pay for this? As strange as it sounds, the
central bank simply creates the money and transfers it to those selling the securities. 7
Alternatively, the Fed can lower interest rates allowing banks to extend low-cost loans
or credit—a phenomenon known as cheap money—and encouraging businesses and
individuals to borrow and spend.

To shrink the money supply, perhaps to reduce inflation, the central bank does the
opposite and sells government securities. The money with which the buyer pays the
central bank is essentially taken out of circulation. Keep in mind that we are generalizing
in this example to keep things simple.
 
A central bank cannot print money without end. If too much money is issued, the value
of that currency will drop consistent with the law of supply and demand.
Remember, as long as people have faith in the currency, a central bank can issue more
of it. But if the Fed issues too much money, the value will go down, as with anything
that has a higher supply than demand. Therefore, the central bank cannot simply print
money as it wants.

THE SIGNIFICANCE OF MONEY

Money is of vital importance to the operation of the national and international

economy. Money plays an important role in the daily life of a person whether he is a
consumer, a producer, a businessman, an academician, a politician or an administrator.
An individual need not be an economics to be actually aware that money plays an
important role in modern life; he need think only of his own experience. We study
below the importance of money in a modern economy.

Significance or Role of Money:

Money is of vital importance to an economy due to its static and dynamic roles. Its static
role emerges from its static or traditional functions. In its dynamic role, money plays an
important part in the life of every citizen and in the economic system as a whole.

Static Role of Money:

In its static role, the importance of money lies in removing the difficulties of barter in
the following ways:

(i) By serving as a medium of exchange, money removes the need for double
coincidence of wants and the inconveniences and difficulties associated with barter. The
introduction of money as a medium of exchange breaks up the single transactions of
barter into separate transactions of sales and purchases, thereby eliminating the double
coincidence of wants. Instead о exchanging commodities directly with commodities i.e.
С ↔ С, commodities as С → M → C, where С refers to commodities and M to money.

(ii) By acting as a unit of account, money becomes a comes a common measure of value.
The use о money as a standard of value eliminates the necessity of quoting the price of
apples in terms of oranges, the price of oranges in terms of nuts, and so on. Money is
the standard of measuring value and value expressed in money is price. The prices of
different commodities are expressed in terms of so many units of dollars, rupees,
pounds, etc. depending on the nature of monetary unit in a country. The measurement
of the values of goods and services in the monetary unit facilitates the problem of
measuring the exchange values of goods in the market.
(iii) Money acts as a standard of deferred payments. Under barter, it was easy to take
loans in goats or grains but difficult to make repayments in such perishable articles in
the future. Money has simplified both taking and repayment of loans because the unit
of account is durable. It also overcomes the difficulty of indivisibility of commodities.
(iv) By acting as a store of value, money removes the problem of storing of commodities
under barter. Money being the most liquid asset can be kept for long periods without
deterioration or wastage.

(v) Under barter, it was difficult to transfer value in the form of animals, grains, etc. from
one place to another. Money removes this difficulty of barter by facilitating the transfer
of value from one place to another. A person can transfer his money through draft, bill
of exchange, etc. and his assets by selling them for cash at one place and buying them at
another place.

Dynamic Role of Money:

In its dynamic role, money plays an important part in the daily life of a person whether
he is a consumer, a producer, a businessman, an academician, a politician or an
administrator. Besides, it influences the economy in a number of ways.

(1) To the Consumer:

Money possesses much significance for the consumer. The consumer receives his
income in the form of money rather than in goods and services. With money in hands,
he can get any commodity and service he likes, in whatever equalizer of marginal
utilities for the consumer. The main aim of a consumer is to maximize his satisfaction by
spending his limited income on different goods which he wants to purchase.
Since prices of goods indicate their marginal utilities and are expressed in money,
money helps in equalizing the marginal utilities of goods. This is done by substituting
goods with higher utilities for others having lower utilities. Thus, money enables a
consumer to make a rational distribution of his income on various commodities of his
choice.

(2) To the Producer:

Money is of equal importance to the producer. He keeps his account of the values of
inputs and outputs in money. The raw materials purchased, the wages paid to workers,
the capital borrowed, the rent paid, the expenses on advertisements, etc. are all
expenses of production which are entered in his account books. The sale of products in
money terms are his sale proceeds.
The difference between the two gives him profit. Thus, a producer easily calculates not
only his costs of production and receipts but also profit with the help of money. Further,
money helps in the general flow of goods and services from agricultural, industrial and
tertiary sectors of the economy because all these activities are performed in terms of
money.

(3) In Specialization and Divisions of Labor:

Money plays an important role in large scale specialization and division of labor in
modern production. Money helps the capitalist today wages to a large number of
workers engaged in specialized jobs on the basis of division of labor. Each worker is paid
money wages in accordance with the nature of work done by him. Thus, money
facilitates specialization and division of labor in modern production.
These, in turn, help in the growth of industries. It is, in fact, through money that
production on a large scale is possible. All inputs like raw materials, labor, machinery,
etc. are purchased with money and all output is sold in exchange for money. As rightly
pointed out by Prof. Pigou, “In the modern world industry is closely enfolded in a
garment of money.”

(4) As the Basis of Credit:

The entire modern business is based on credit and credit is based on money. All
monetary transactions consist of cheques, drafts, bills of exchange etc. These are credit
instruments which are not money. It is the bank deposits that are money. Banks’s issue
such credit instruments and create credit. Credit creation, in turn, plays a major role in
transferring funds from depositors to investors. Thus, credit expands investment on the
basis of public saving lying in bank deposits and helps in maintaining a circular flow of
income within the economy.

(5) As a Means to capital Formation:

By transforming savings into investment, money acts as a means to capital formation.
Money is a liquid asset which can be stored and storing of money implies savings, and
savings are kept in bank deposits to earn interest on them. Banks, in turn, lend these
savings to businessmen for investment in capital equipment, buying of raw materials,
labor, etc. from different sources and places. This makes capital mobile and leads to
capital formation and economic growth.

(6) As an Index of Economic Growth:

Money is also an index of economic growth. The various indicators of growth are
national income, per capita income and economic welfare. These are calculated and
measured in money terms. Changes in the value of money or prices also reflect the
growth of an economy. Fall in the value of money (or rise in prices) means that the
economy is not progressing in real terms. On the other hand, a continuous rise in the
value of money (or fall in prices) reflects retardation of the economy. Somewhat stable
prices imply a growing economy. Thus, money is an index of economic growth.

(7) In the Distribution and Calculation of Income:

The rewards to the various factors of production in a modern economy are paid in
money. A worker gets his wages, capitalist his interest, a landlord his rent, and an
entrepreneur his profit. But all are paid their rewards in money. An organizer is able to
calculate the marginal productivity of each factor in terms of money and pay it
accordingly. For this, he equalizes the marginal productivity of each factor with its price.
Its price is, in fact, its marginal productivity expressed in terms of money. As payments
are made to various factors of production in money, the calculation of national income
becomes easy.
(8) In National and International Trade:
ADVERTISEMENTS:
Money facilitates both national and international trade. The use of money as a medium
of exchange, as a store of value and as a transfer of value has made it possible to sell
commodities not only within a country but also internationally. To facilitate trade,
money has helped in establishing money and capital markets. There are banks, financial
institutions, stock exchanges, produce exchanges, international financial institutions,
etc. which operate on the basis of the money economy and they help in both national
and international trade.

Further, trade relations among different countries have led to international cooperation.
As a result, the developed countries have been helping the growth of underdeveloped
countries by giving them loans and technical assistance. This has been made possible
because the value of foreign aid received and its repayment by the developing countries
is measured in money.

(9) In Solving the Central Problems of an Economy:

Money helps in solving the central problems of an economy; what to produce, for whom
to produce, how to produce and in what quantities. This is because on the basis of its
function’s money facilitates the flow of goods and services among consumers,
producers and the government.

(10) To the Government:

Money is of immense importance to the government. Money facilitates the buying and
collection of taxes, fines, fees and prices of services rendered by the government to the
people. It simplifies the floating and management of public debt and government
expenditure on development and non-developmental activities. It would be impossible
 for modern governments to carry on their functions without the use of money. Not only
this, modern governments are welfare states which aim at improving the standard of
living of the people by removing poverty, inequalities and unemployment, and achieving
growth with stability. Money helps in achieving these goals of economic policy through
its various instruments.

(11) To the Society:

Money confers many social advantages. It is on the basis of money that the
superstructure of credit is built in the society which simplifies consumption, production,
exchange and distribution. It promotes national unity when people use the same
currency in every nook and corner of the country. It acts as a lubricant for the social life
of the people, and oils the wheels of material progress. Money is at the back of social
prestige and political power.

THE FUNCTIONS OF MONEY

Money is something that people use every day. We earn it and spend it but don't often
think much about it. Economists define money as any good that is widely accepted as
final payment for goods and services. Money has taken different forms through the
ages; examples include cowry shells in Africa, large stone wheels on the Pacific island of
Yap, and strings of beads called wampum used by Native Americans and early American
settlers. What do these forms of money have in common? They share the three
functions of money:

 First: Money is a store of value. If I work today and earn 25 dollars, I can hold on to the
money before I spend it because it will hold its value until tomorrow, next week, or even
next year. In fact, holding money is a more effective way of storing value than holding
other items of value such as corn, which might rot. Although it is an efficient store of
value, money is not a perfect store of value. Inflation slowly erodes the purchasing
power of money over time.
 Second: Money is a unit of account. You can think of money as a yardstick-the device we
use to measure value in economic transactions. If you are shopping for a new computer,
the price could be quoted in terms of t-shirts, bicycles, or corn. So, for instance, your
new computer might cost you 100 to 150 bushels of corn at today's prices, but you
would find it most helpful if the price were set in terms of money because it is a
common measure of value across the economy.
 Third: Money is a medium of exchange. This means that money is widely accepted as a
method of payment. When I go to the grocery store, I am confident that the cashier will
accept my payment of money. In fact, U.S. paper money carries this statement: "This
note is legal tender for all debts, public and private." This means that the U.S.
government protects my right to pay with U.S. dollars.

In order to appreciate the conveniences that money brings to an economy, think about
life without it. Imagine I am a musician-a bassoonist in an orchestra-who has a car that
needs to be repaired. In a world without money, I would need to barter for car repair. In
fact, I would need to find a coincidence of wants-the unlikely case that two people each
have something that the other wants at the right time and place to make an exchange.
In other words, I would need to find a mechanic who would be willing to exchange car
repairs for a private bassoon concert by 9 AM tomorrow so I can drive to my next
orchestra rehearsal. In an economy where people have very specialized skills, this kind
of exchange would take an incredible amount of time and effort; in fact, it might be
nearly impossible. Money reduces the cost of this transaction because, while it might be
very difficult to find a mechanic who would exchange car repairs for bassoon concerts, it
is not hard to find one who would exchange car repairs for money. In fact, without
money, every transaction would require me to find producers who would exchange
their goods and services for bassoon performances. In a money-based economy, I can
sell my services as a bassoon player in an orchestra to those who are willing to pay for
orchestra concerts with money. Then, I can take the money I earn and pay for a variety
of goods and services.

Economists say that the invention of money belongs in the same category as the great
inventions of ancient times, such as the wheel and the inclined plane, but how did
money develop? Early forms of money were often commodity money-money that had
value because it was made of a substance that had value. Examples of commodity
money are gold and silver coins. Gold coins were valuable because they could be used in
exchange for other goods or services, but also because the gold itself was valued and
had other uses. Commodity money gave way to the next stage-representative money.

Representative money is a certificate or token that can be exchanged for the underlying
commodity. For example, instead of carrying the gold commodity money with you, the
gold might have been kept in a bank vault and you might carry a paper certificate that
represents-or was "backed"-by the gold in the vault. It was understood that the
certificate could be redeemed for gold at any time. Also, the certificate was easier and
safer to carry than the actual gold. Over time people grew to trust the paper certificates
as much as the gold. Representative money led to the use of fiat money-the type used in
modern economies today.

Fiat money is money that does not have intrinsic value and does not represent an asset
 in a vault somewhere. Its value comes from being declared "legal tender"-an acceptable
form of payment-by the government of the issuing country. In this case, we accept the
value of the money because the government says it has value and other people value it
enough to accept it as payment. For example, I accept U.S. dollars as income because
I'm confident I will be able to exchange the dollars for goods and services at local stores.
Because I know others will accept it, I am comfortable accepting it. U.S. currency is fiat
money. It is not a commodity with its own great value and it does not represent gold-or
any other valuable commodity-held in a vault somewhere. It is valued because it is legal
tender and people have faith in its use as money. There have been many forms of
money in history, but some forms have worked better than others because they have
characteristics that make them more useful. The characteristics of money are durability,
portability, divisibility, uniformity, limited supply, and acceptability. Let's compare two
examples of possible forms of money:
 A cow. Cattle have been used as money at different points in history.
 A stack of U.S. 20-dollar bills equal to the value of one cow.
Let's run down our list of characteristics to see how they stack up.
1. Durability. A cow is fairly durable, but a long trip to market runs the risk of sickness or
death for the cow and can severely reduce its value. Twenty-dollar bills are fairly
durable and can be easily replaced if they become worn. Even better, a long trip to
market does not threaten the health or value of the bill.
2. Portability. While the cow is difficult to transport to the store, the currency can be easily
put in my pocket.
3. Divisibility. A 20-dollar bill can be exchanged for other denominations, say a 10, a 5, four
1s, and 4 quarters. A cow, on the other hand, is not very divisible.
4. Uniformity. Cows come in many sizes and shapes and each has a different value; cows
are not a very uniform form of money. Twenty-dollar bills are all the same size and
shape and value; they are very uniform.
5. Limited supply. In order to maintain its value, money must have a limited supply. While
the supply of cows is fairly limited, if they were used as money, you can bet ranchers
would do their best to increase the supply of cows, which would decrease their value.
The supply, and therefore the value, of 20-dollar bills—and money in general—are
regulated by the Federal Reserve so that the money retains its value over time.
6. Acceptability. Even though cows have intrinsic value, some people may not accept cattle
as money. In contrast, people are more than willing to accept 20-dollar bills. In fact, the
U.S. government protects your right to use U.S. currency to pay your bills.
Well, it seems "utterly" clear at this point that—based on the characteristics of money—
U.S. 20-dollar bills are a much better form of money than cattle.

To summarize, money has taken many forms through the ages, but money consistently
has three functions: store of value, unit of account, and medium of exchange. Modern
economies use fiat money-money that is neither a commodity nor represented or
"backed" by a commodity. Even forms of money that share this function may be more or
less useful based on the characteristics of money.

THE GOALS OF MONEY POLICY

What are the goals of monetary policy?

The goals of monetary policy are to promote maximum employment, stable prices and
moderate long-term interest rates. By implementing effective monetary policy, the Fed
can maintain stable prices, thereby supporting conditions for long-term economic
growth and maximum employment.

What are the tools of monetary policy?

The Federal Reserve’s three instruments of monetary policy are open market
operations, the discount rate and reserve requirements.

Open market operations involve the buying and selling of government securities. The
term “open market” means that the Fed doesn’t decide on its own which securities
dealers it will do business with on a particular day. Rather, the choice emerges from an
“open market” in which the various securities dealers that the Fed does business with –
the primary dealers – compete on the basis of price. Open market operations are
flexible, and thus, the most frequently used tool of monetary policy.
The discount rate is the interest rate charged by Federal Reserve Banks to depository
institutions on short-term loans.

Reserve requirements are the portions of deposits that banks must maintain either in
their vaults or on deposit at a Federal Reserve Bank.

What are the open market operations?

The Fed uses open market operations as its primary tool to influence the supply of bank
reserves. This tool consists of Federal Reserve purchases and sales of financial
instruments, usually securities issued by the U.S. Treasury, Federal agencies and
government-sponsored enterprises. Open market operations are carried out by the
Domestic Trading Desk of the Federal Reserve Bank of New York under direction from
the FOMC. The transactions are undertaken with primary dealers.

When the Fed wants to increase reserves, it buys securities and pays for them by
making a deposit to the account maintained at the Fed by the primary dealer’s bank.
When the Fed wants to reduce reserves, it sells securities and collects from those
accounts. Most days, the Fed does not want to increase or decrease reserves
permanently, so it usually engages in transactions reversed within several days. By
trading securities, the Fed influences the amount of bank reserves, which affects the
federal funds rate, or the overnight lending rate at which banks borrow reserves from
each other.

The federal funds rate is sensitive to changes in the demand for and supply of reserves
in the banking system, and thus provides a good indication of the availability of credit in
the economy.
What is the role of the Federal Open Market Committee (FOMC)?

he FOMC formulates the nation’s

monetary policy. The voting members of
the FOMC consist of the seven members
of the Board of Governors (BOG), the
president of the Federal Reserve Bank of
New York and presidents of four other
Reserve Banks who serve on a one-year rotating basis. All Reserve Bank presidents
participate in FOMC policy discussions whether or not they are voting members. The
chairman of the Board of Governors chairs the FOMC meeting.
The FOMC typically meets eight times a year in Washington, D.C. At each meeting, the
committee discusses the outlook for the U.S. economy and monetary policy options.

What occurs at a FOMC meeting?

First, a senior official of the Federal Reserve Bank of New York discusses developments
in the financial and foreign exchange markets, along with the details of the activities of
the New York Fed's Domestic and Foreign Trading Desks since the previous FOMC
meeting. Senior staff from the Board of Governors (BOG) present their economic and
financial forecasts. Governors and Reserve Bank presidents (including those currently
not voting) present their views on the economic outlook. The BOG’s director of
monetary affairs discusses monetary policy options (without making a policy
recommendation.) The FOMC members then discuss their policy preferences. Finally,
the FOMC votes.

How is the FOMC's policy implemented?

At the conclusion of each FOMC meeting, the Committee issues a statement that
includes the federal funds rate target, an explanation of the decision, and the vote tally,
including the names of the voters and the preferred action of those who dissented. To
 implement the policy action, the Committee issues a directive to the New York Fed’s
Domestic Trading Desk that guides the implementation of the Committee’s policy
through open market operations. Before conducting open market operations, the staff
at the Federal Reserve Bank of New York collects and analyzes data and talks to banks
and others to estimate the amount of bank reserves to be added or drained that day.
They then confer with Fed officials in Washington who do their own daily analysis and
reach a consensus about the size and terms of the operations. Then, a New York Fed
official sends a message to the primary dealers to indicate the Fed’s intention to buy or
sell securities, and the dealers submit bids or offers as appropriate.

The minutes of each FOMC meeting are published three weeks after the meeting and
are available to the public. Occasionally, the FOMC makes a change in monetary policy
between meetings.

While the Federal Reserve Bank presidents discuss their regional economies in their
presentations at FOMC meetings, they base their policy votes on national, rather than
local, conditions.

Why does the Fed typically conduct open market operations several times a week?
The vast majority of open market operations are not intended to carry out changes in
monetary policy. Instead, open market operations are conducted on a daily basis to
prevent technical, temporary forces from pushing the effective federal funds rate too far
from the target rate.

TOOLS OF MONEY POLICY

Central banks have four main monetary policy tools: the reserve requirement, open
market operations, the discount rate, and interest on reserves. 1 Most central banks also
have a lot more tools at their disposal. Here are the four primary tools and how they
work together to sustain healthy economic growth.

Key Takeaways
 Central banks have four primary monetary tools for managing the money supply.
 These are the reserve requirement, open market operations, the discount rate, and
interest on excess reserves.
 These tools can either help expand or contract economic growth.
 The Federal Reserve created powerful new tools to cope with modern recessions.  
Reserve Requirement
The reserve requirement refers to the money banks must keep on hand overnight. They
can either keep the reserve in their vaults or at the central bank. A low reserve
requirement allows banks to lend more of their deposits. It's expansionary because it
creates credit. 

A high reserve requirement is contractionary. It gives banks less money to lend. It's
especially hard for small banks because they don't have as much to lend in the first
place. That's why most central banks don't impose a reserve requirement on small
banks. Central banks rarely change the reserve requirement because it's difficult for
member banks to modify their procedures.
Open Market Operations
Open market operations are when central banks buy or sell securities. These are bought
from or sold to the country's private banks. When the central bank buys securities, it
adds cash to the banks' reserves. That gives them more money to lend. When the
central bank sells the securities, it places them on the banks' balance sheets and
reduces its cash holdings. The bank now has less to lend. A central bank buys securities
when it wants an expansionary monetary policy. It sells them when it
executes contractionary monetary policy.

The U.S. Federal Reserve uses open market operations to manage the fed funds rate.
Here's how the fed funds rate works. If a bank can't meet the reserve requirement, it
borrows from another bank that has excess cash. The amount borrowed is called fed
funds. The interest rate it pays is the fed funds rate. The Federal Open Market
Committee (FOMC) sets a target for the fed funds rate at its meetings.5 It uses open
market operations to encourage banks to meet the target.

The fed funds rate is the most well-known of the Fed's tools.

Quantitative easing (QE) is open market operations that purchase long-term bonds,
which has the effect of lowering long-term interest rates. Before the Great Recession,
the Fed maintained between $700 billion to $800 billion of Treasury notes on its balance
sheet. It added or subtracted to affect policy, but kept it within that range. 

In response to the recession, the Fed lowered the fed funds rate to its lowest level, a
range of between 0% and 0.25%. This rate is the benchmark for all short-term interest
rates. The Fed then needed to implement QE as a secondary tool, to keep long-term
interest rates low.6 As a result, it increased holdings of Treasury notes and mortgage-
backed securities to more than $4 trillion by 2014.
As the economy improved, it allowed these securities to expire, in the hopes of
normalizing its balance sheet. When the 2020 recession hit, the Fed quickly restored QE.
By May 2020, it increased its holdings to more than $7 trillion.

Discount Rate
The discount rate is the rate that central banks charge their member banks to borrow at
its discount window.8 Because it's higher than the fed funds rate, banks only use this if
they can't borrow funds from other banks.9
Using the discount window also has a stigma attached. The financial community
assumes that any bank that uses the discount window is in trouble. Only a desperate
bank that's been rejected by others would use the discount window.
Interest Rate on Excess Reserves

The fourth tool was created in response to the 2008 financial crisis. The Federal Reserve,
the Bank of England, and the European Central Bank pay interest on any excess reserves
held by banks1 If the Fed wants banks to lend more, it lowers the rate paid on excess
reserves. If it wants banks to lend less, it raises the rate.

Interest on reserves also supports the fed funds rate target. Banks won't lend fed funds
for less than the rate they're receiving from the Fed for these reserves. 12
How These Tools Work

Central bank tools work by increasing or decreasing total liquidity. That’s the amount

of capital available to invest or lend. It's also money and credit that consumers spend.
It's technically more than the money supply, known as M1 and M2. The M1 symbol
denotes currency and check deposits. M2 is money market funds, CDs, and savings
accounts. Therefore, when people say that central bank tools affect the money supply,
they are understating the impact.

Other Tools
Many central banks also use inflation targeting. They want consumers to believe prices
will rise so that they are more likely to buy now rather than later. The most common
inflation target is 2%. It's close enough to zero to avoid the painful effects of galloping
inflation but high enough to ward off deflation.

In 2020, the Fed launched the Main Street Lending Program to assist small and medium-
sized businesses affected by the COVID-19 pandemic.
 Many of the Fed's other tools were created to combat the 2008 financial crisis. These
programs provided credit to banks to keep them from closing. The Fed also supported
money market funds, credit card markets, and commercial paper.

LESSON O: INTERNATIONAL TRADE

REASONS FOR INTERNATIONAL TRADE

7 Reasons for International Trade

No matter how attractive and ‘must have’ your product or service seems to be, a strictly
limiting yourself to your domestic market will have a finite capacity. And once you have
reached saturation point, what then?  Because of these limitations wise business
owners are looking to go global and exploit the many international trade opportunities
– after all, in the global economy; practically every country is a potential customer.

Here are seven reasons for international trade:

1. Reduced dependence on your local market

Your home market may be struggling due to economic pressures, but if you go global,
you will have immediate access to a practically unlimited range of customers in areas
where there is more money available to spend, and because different cultures have
different wants and needs, you can diversify your product range to take advantage of
these differences.

2.Increased chances of success

Unless you’ve got your pricing wrong, the higher the volume of products you sell, the
more profit you make, and overseas trade is an obvious way to increase sales.  In
support of this, UK Trade and Investment (UKTI) claim that companies who go global are
12% more likely to survive and excel than those who choose not to export.

3 Increased efficiency
Benefit from the economies of scale that the export of your goods can bring – go global
and profitably use up any excess capacity in your business, smoothing the load and
avoiding the seasonal peaks and troughs that are the bane of the production manager’s
life.

4 Increased productivities
Statistics from UK Trade and Investment (UKTI) state that companies involved in
overseas trade can improve their productivity by 34% – imagine that, over a third more
with no increase in plant.

5 Economic advantages
Take advantage of currency fluctuations – export when the value of the pound sterling is
low against other currencies, and reap the very real benefits.  Words of warning though;
watch out for import tariffs in the country you are exporting to, and keep an eye on the
value of sterling.  You don’t want to be caught out by any sudden upsurge in the value of
the pound, or you could lose all the profit you have worked so hard to gain.

6 Innovation
Because you are exporting to a wider range of customers, you will also gain a wider
range of feedback about your products, and this can lead to real benefits.  In fact, UKTI
statistics show that businesses believe that exporting leads to innovation – increases in
break-through product development to solve problems and meet the needs of the wider
customer base.  53% of businesses they spoke to said that a new product or service has
evolved because of their overseas trade.

7 Growth
The holy grail for any business, and something that has been lacking for a long time in
our manufacturing industries – more overseas trade = increased growth opportunities,
to benefit both your business and our economy as a whole.

THE BASIS OF INTERNATIONAL TRADE

1.Explain the economic basis for international business.

International business encompasses all business activities that involve exchanges across
national boundaries. International trade is based on specialization, whereby each
country produces those goods and services that it can produce more efficiently than any
other goods and services. A nation is said to have a comparative advantage relative to
these goods. International trade develops when each nation trades its surplus products
for those in short supply.

A nation's balance of trade is the difference between the value of its exports and the
value of its imports. Its balance of payments is the difference between the flow of
money into and out of the nation. Generally, a negative balance of trade is considered
unfavorable.

2. Discuss the restrictions nations place on international trade, the objectives of these
restrictions, and their results.

Despite the benefits of world trade, nations tend to use tariffs and nontariff barriers
(import quotas, embargoes, and other restrictions) to limit trade. These restrictions
typically are justified as being needed to protect a nation's economy, industries, citizens,
or security. They can result in the loss of jobs, higher prices, fewer choices in the
marketplace, and the misallocation of resources.

3. Outline the extent of international trade and identify the organizations working to
foster it.

World trade is generally increasing. Trade between the United States and other nations
is increasing in dollar value but decreasing in terms of our share of the world market.
The General Agreement on Tariffs and Trade (GATT) was formed to dismantle trade
barriers and provide an environment in which international business can grow. Today
the World Trade Organization (WTO) and various economic communities carry on that
mission.
 4. Define the methods by which a firm can organize for and enter into international
markets.

A firm can enter international markets in several ways. It may license a foreign firm to
produce and market its products. It may export its products and sell them through
foreign intermediaries or its own sales organization abroad. Or it may sell its exports
outright to an export/import merchant. It may enter into a joint venture with a foreign
firm. It may establish its own foreign subsidiaries. Or it may develop into a multinational
enterprise. Generally, each of these methods represents an increasingly deeper level of
involvement in international business, with licensing being the simplest and the
development of a multinational corporation the most involved.

5. Describe the various sources of export assistance.

Many governments and international agencies provide export assistance to U.S. and
foreign firms. The export services and programs of the nineteen agencies of the U.S.
Trade Promotion Coordinating Committee (TPCC) can help U.S. firms compete in foreign
markets and create new jobs in the United States. Sources of export assistance include
U.S. Export Assistance Centers, the International Trade Administration, U.S. and Foreign
Commercial Services, Export Legal Assistance Network, Advocacy Center, National Trade
Data Bank, and other government and international agencies.

6. Identify the institutions that help firms and nations finance international business.

The financing of international trade is more complex than that of domestic trade.
Institutions such as the Exim bank and the International Monetary Fund have been
established to provide financing and ultimately to increase world trade for American
and international firms.

INTERNATIONAL TRADE BARRIER

Key Points
 Trade barriers cause a limited choice of products and, therefore, would force customers
to pay higher prices and accept inferior quality.
 Trade barriers generally favor rich countries because these countries tend to set
international trade policies and standards.
 Economists generally agree that trade barriers are detrimental and decrease overall
economic efficiency, which can be explained by the theory of comparative advantage.
 Key Terms
 quota: a restriction on the import of something to a specific quantity.
 tariff: A system of government-imposed duties levied on imported or exported goods; a
list of such duties, or the duties themselves.

Trade barriers are government-induced restrictions on international trade. Man-made

trade barriers come in several forms, including:
 Tariffs
 Non-tariff barriers to trade
 Import licenses
 Export licenses
 Import quotas
 Subsidies
 Voluntary Export Restraints
 Local content requirements
 Embargo
 Currency devaluation
 Trade restriction

Most trade barriers work on the same principle–the imposition of some sort of cost on
trade that raises the price of the traded products. If two or more nations repeatedly use
trade barriers against each other, then a trade war results.
 A port in Singapore: International trade barriers can take many forms for any number of
reasons. Generally, governments impose barriers to protect domestic industry or to
“punish” a trading partner.

Economists generally agree that trade barriers are detrimental and decrease overall
economic efficiency. This can be explained by the theory of comparative advantage. In
theory, free trade involves the removal of all such barriers, except perhaps those
considered necessary for health or national security. In practice, however, even those
countries promoting free trade heavily subsidize certain industries, such as agriculture
and steel. Trade barriers are often criticized for the effect they have on the developing
world. Because rich-country players set trade policies, goods, such as agricultural
products that developing countries are best at producing, face high barriers. Trade
barriers, such as taxes on food imports or subsidies for farmers in developed economies,
lead to overproduction and dumping on world markets, thus lowering prices and hurting
poor-country farmers. Tariffs also tend to be anti-poor, with low rates for raw
commodities and high rates for labor-intensive processed goods. The Commitment to
Development Index measures the effect that rich country trade policies actually have on
the developing world. Another negative aspect of trade barriers is that it would cause a
limited choice of products and, therefore, would force customers to pay higher prices
and accept inferior quality.

In general, for a given level of protection, quota-like restrictions carry a greater potential
for reducing welfare than do tariffs. Tariffs, quotas, and non-tariff barriers lead too few
of the economy’s resources being used to produce tradeable goods. An export subsidy
can also be used to give an advantage to a domestic producer over a foreign producer.

Export subsidies tend to have a particularly strong negative effect because in addition to
distorting resource allocation, they reduce the economy’s terms of trade. In contrast to
tariffs, export subsidies lead to an over allocation of the economy’s resources to the
production of tradeable goods.

Ethical Barriers
Despite international trading laws and declarations, countries continue to face
challenges around ethical trading and business practices

Key Points
 Although some argue that the increasing integration of financial markets between
countries leads to more consistent and seamless trading practices, others point out that
capital flows tend to favor the capital owners more than any other group.
 With increased international trade and global capital flows, critics argue that income
disparities between the rich and poor are exacerbated, and industrialized nations grow
in power at the expense of under-capitalized countries.
 Anti- globalization groups continue to protest what they view as the unethical trading
practices of multinational businesses and capitalist nations, often targeting groups such
as the WTO and IMF.

Key Terms
 GDP: Gross Domestic Product (Economics). A measure of the economic production of a
particular territory in financial capital terms over a specific time period.
 neoliberalism: A political movement that espouses economic liberalism as a means of
promoting economic development and securing political liberty.

International trade is the exchange of goods and services across national borders. In
most countries, it represents a significant part of gross domestic product (GDP). The rise
of industrialization, globalization, and technological innovation has increased the
importance of international trade, as well as its economic, social, and political effects on
the countries involved. Internationally recognized ethical practices such as the UN
Global Compact have been instituted to facilitate mutual cooperation and benefit
between governments, businesses, and public institutions. Nevertheless, countries
continue to face challenges around ethical trading and business practices, especially
regarding economic inequalities and human rights violations.

Arguments Against International Trade

Capital markets involve the raising and investing money in various enterprises. Although
some argue that the increasing integration of these financial markets between countries
leads to more consistent and seamless trading practices, others point out that capital
flows tend to favor the capital owners more than any other group. Likewise, owners and
workers in specific sectors in capital-exporting countries bear much of the burden of
adjusting to increased movement of capital. The economic strains and eventual
hardships that result from these conditions lead to political divisions about whether or
not to encourage or increase integration of international trade markets. Moreover,
critics argue that income disparities between the rich and poor are exacerbated, and
industrialized nations grow in power at the expense of under-capitalized countries.

Anti-Globalization Movements
The anti-globalization movement is a worldwide activist movement that is critical of the
globalization of capitalism. Anti-globalization activists are particularly critical of the
undemocratic nature of capitalist globalization and the promotion of neoliberalism by
 international institutions such as the International Monetary Fund (IMF) and the World
Bank. Other common targets of anti- corporate and anti-globalization movements
include the Organization for Economic Co-operation and Development (OECD), the
WTO, and free trade treaties like the North American Free Trade Agreement (NAFTA),
Free Trade Area of the Americas (FTAA), the Multilateral Agreement on Investment
(MAI), and the General Agreement on Trade in Services (GATS). Meetings of such bodies
are often met with strong protests, as demonstrators attempt to bring attention to the
often-devastating effects of global capital on local conditions.

On November 30, 1999, close to fifty thousand people gathered to protest the WTO
meetings in Seattle, Washington. Labor, economic, and environmental activists
succeeded in disrupting and closing the meetings due to their disapproval of corporate
globalization. This event came to symbolize the increased debate and growing conflict
around the ethical questions on international trade, globalization and capitalization.

Criticism of the Global Capitalist Economy: Demonstrations, such as the mass protest at
the 1999 WTO meeting in Seattle, highlight ethical questions on the effects of
international trade on poor and developing nations.

Cultural Barriers
It is typically more difficult to do business in a foreign country than in one’s home
country due to cultural barriers.

Key Points
 With the process of globalization and increasing global trade, it is unavoidable that
different cultures will meet, conflict, and blend together. People from different cultures
find it is hard to communicate not only due to language barriers but also cultural
differences.
 It is typically more difficult to do business in a foreign country than in one’s home
country, especially in the early stages when a firm is considering either physical
investment in or product expansion to another country.
 Expansion planning requires an in-depth knowledge of existing market channels and
suppliers, of consumer preferences and current purchase behavior, and of domestic and
foreign rules and regulations.
 Recognize useful strategic frameworks and tools for assessing variance in cultural
predisposition, such as Hofstede’s Cultural Dimensions Theory.

Key Terms
 red tape: A derisive term for regulations or bureaucratic procedures that are considered
excessive or excessively time- and effort-consuming.
 individualism: The tendency for a person to act without reference to others, particularly
in matters of style, fashion or mode of thought.

Technological Barriers
Standards-related trade measures, known in WTO parlance as technical barriers to trade
play a critical role in shaping global trade.

KEY TAKEAWAYS
Key Points
 Governments, market participants, and other entities can use standards -related
measures as an effective and efficient means of achieving legitimate commercial and
policy objectives.
 Significant foreign trade barriers in the form of product standards, technical regulations
and testing, certification, and other procedures are involved in determining whether or
not products conform to standards and technical regulations.

Key Terms
 standard: A level of quality or attainment.
 enterprise: A company, business, organization, or other purposeful endeavor.
U.S. companies, farmers, ranchers, and manufacturers increasingly encounter non- tariff
trade barriers in the form of product standards, testing requirements, and other
technical requirements as they seek to sell products and services around the world. As
tariff barriers to industrial and agricultural trade have fallen, standards-related
measures of this kind have emerged as a key concern. Governments, market
participants, and other entities can use standards-related measures as an effective and
efficient means of achieving legitimate commercial and policy objectives. But when
standards-related measures are outdated, overly burdensome, discriminatory, or
otherwise inappropriate, these measures can reduce competition, stifle innovation, and
create unnecessary technical barriers to trade. These kinds of measures can pose a
particular problem for small- and medium-sized enterprises (SMEs), which often do not
have the resources to address these problems on their own. Significant foreign trade
barriers in the form of product standards, technical regulations and testing, certification,
and other procedures are involved in determining whether or not products conform to
standards and technical regulations.

These standards-related trade measures, known in World Trade Organization (WTO)

parlance as “technical barriers to trade,” play a critical role in shaping the flow of global
trade. Standards-related measures serve an important function in facilitating global
trade, including by enabling greater access to international markets by SMEs. Standards-
related measures also enable governments to pursue legitimate objectives, such as
protecting human health and the environment and preventing deceptive practices. But
standards-related measures that are non-transparent, discriminatory, or otherwise
unwarranted can act as significant barriers to U.S. trade. These kinds of measures can
pose a particular problem for SMEs, which often do not have the resources to address
these problems on their own.

Members of the World Trade Organization: Most countries are now part of the World
Trade Organization. Those that are not are concentrated in northeast Africa, Oceania,
and the Middle East. The European Union is its own bloc within the W.T.O.
The Argument for Barriers
Some argue that imports from countries with low wages has put downward pressure on
the wages of Americans and therefore we should have trade barriers.

KEY TAKEAWAYS
Key Points
 Economy -wide trade creates jobs in industries that have a comparative advantage and
destroys jobs in industries that have a comparative disadvantage.
 Trade barriers protect domestic industry and jobs.
 Workers in export industries benefit from trade. Moreover, all workers are consumers
and benefit from the expanded market choices and lower prices that trade brings.

Key Terms
 comparative advantage: The concept that a certain good can be produced more
efficiently than others due to a number of factors, including productive skills, climate,
natural resource availability, and so forth.
 inflation: An increase in the general level of prices or in the cost of living.
It is asserted that trade has created jobs for foreign workers at the expense of American
workers. It is more accurate to say that trade both creates and destroys jobs in the
economy in line with market forces.
Economy-wide trade creates jobs in industries that have comparative advantage and
destroys jobs in industries that have a comparative disadvantage. In the process, the
economy’s composition of employment changes; but, according to economic theory,
there is no net loss of jobs due to trade. Over the course of the last economic expansion,
from 1992 to 2000, U.S. imports increased nearly 240%. Over that same period, total
employment grew by 22 million jobs, and the unemployment rate fell from 7.5% to 4.0%
(the lowest unemployment rate in more than 30 years.). Foreign outsourcing by
American firms, which has been the object of much recent attention, is a form of
importing and also creates and destroys jobs, leaving the overall level of employment
unchanged. There is no denying that with international trade there will be short-run
hardship for some, but economists maintain the whole economy’s living standard is
raised by such exchange. They view these adverse effects as qualitatively the same as
those induced by purely domestic disruptions, such as shifting consumer demand or
technological change. In that context, economists argue that easing adjustment of those
harmed is economically more fruitful than protection given the net economic benefit of
trade to the total economy. Many people believe that imports from countries with low
wages has put downward pressure on the wages of Americans.

There is no doubt that international trade can have strong effects, good and bad, on the
wages of American workers. The plight of the worker adversely affected by imports
comes quickly to mind. But it is also true that workers in export industries benefit from
trade. Moreover, all workers are consumers and benefit from the expanded market
choices and lower prices that trade brings. Yet, concurrent with the large expansion of
trade over the past 25 years, real wages (i.e., inflation adjusted wages) of American
workers grew more slowly than in the earlier post-war period, and the inequality of
 wages between the skilled and less skilled worker rose sharply. Was trade the force
behind this deteriorating wage performance? Some industries, or at least components
of some industries, are vital to national security and possibly may need to be insulated
from the vicissitudes of international market forces. This determination needs to be
made on a case-by-case basis since the claim is made by some who do not meet national
security criteria. Such criteria may also vary from case to case. It is also true that
national security could be compromised by the export of certain dual-use products that,
while commercial in nature, could also be used to produce products that might confer a
military advantage to U.S. adversaries. Controlling such exports is clearly justified from a
national security standpoint; but, it does come at the cost of lost export sales and an
economic loss to the nation. Minimizing the economic welfare loss from such export
controls hinges on a well- focused identification and regular re-evaluation of the subset
of goods with significant national security potential that should be subject to control.

Korea International Trade Association: KITA attempts to protect South Korean

producers while finding international export markets.
The Argument Against Barriers
Economists generally agree that trade barriers are detrimental and decrease overall
economic efficiency.

KEY TAKEAWAYS
Key Points
 Trade barriers are often criticized for the effect they have on the developing world.
 Even countries promoting free trade heavily subsidize certain industries, such as
agriculture and steel.
 Most trade barriers work on the same principle: the imposition of some sort of cost on
trade that raises the price of the traded products. If two or more nations repeatedly use
trade barriers against each other, then a trade war results.

Key Terms
 trade war: The practice of nations creating mutual tariffs or similar barriers to trade.
Most trade barriers work on the same principle: the imposition of some sort of cost on
trade that raises the price of the traded products. If two or more nations repeatedly use
trade barriers against each other, then a trade war results
Economists generally agree that trade barriers are detrimental and decrease overall
economic efficiency, this can be explained by the theory of comparative advantage. In
theory, free trade involves the removal of all such barriers, except perhaps those
considered necessary for health or national security. In practice, however, even those
countries promoting free trade heavily subsidize certain industries, such as agriculture
and steel.

International trade: International trade is the exchange of goods and services across
national borders. In most countries, it represents a significant part of GDP.
Trade barriers are often criticized for the effect they have on the developing world.
Because rich-country players call most of the shots and set trade policies, goods, such as
crops those developing countries are best at producing, still face high barriers. Trade
barriers, such as taxes on food imports or subsidies for farmers in developed economies,
lead to overproduction and dumping on world markets, thus lowering prices and hurting
poor-country farmers. Tariffs also tend to be anti-poor, with low rates for raw
commodities and high rates for labor-intensive processed goods.

If international trade is economically enriching, imposing barriers to such exchanges will

prevent the nation from fully realizing the economic gains from trade and must reduce
welfare. Protection of import-competing industries with tariffs, quotas, and non-tariff
 barriers can lead to an over-allocation of the nation’s scarce resources in the protected
sectors and an under-allocation of resources in the unprotected tradeable goods
industries. In the terms of the analogy of trade as a more efficient productive process
used above, reducing the flow of imports will also reduce the flow of exports. Less
output requires less input. Clearly, the exporting sector must lose as the protected
import-competing activities gain. But, more importantly, from this perspective the
overall economy that consumed the imported goods must also lose, because the more
efficient production process–international trade–cannot be used to the optimal degree,
and, thereby, will have generally increased the price and reduced the array of goods
available to the consumer. Therefore, the ultimate economic cost of the trade barrier is
not a transfer of well-being between sectors, but a permanent net loss to the whole
economy arising from the barriers distortion toward the less efficient the use of the
economy’s scarce resources.

FOREIGN EXCHANGE

Foreign Exchange (forex or FX) is the trading of one currency for another. For example,
one can swap the U.S. dollar for the euro. Foreign exchange transactions can take place
on the foreign exchange market, also known as the forex market.
The forex market is the largest, most liquid market in the world, with trillions of
dollars changing hands every day.1 There is no centralized location. Rather, the forex
market is an electronic network of banks, brokers, institutions, and individual traders
(mostly trading through brokers or banks).
KEY TAKEAWAYS
 Foreign Exchange (forex or FX) is a global market for exchanging national currencies with
one another.
 Foreign exchange venues comprise the largest securities market in the world by nominal
value, with trillions of dollars changing hands each day. 1
 Foreign exchange trading utilizes currency pairs, priced in terms of one versus the other.
 Forwards and futures are another way to participate in the forex market.
Volume 75%
 
Understanding Foreign Exchange
The market determines the value, also known as an exchange rate, of the majority of
currencies. Foreign exchange can be as simple as changing one currency for another at a
local bank. It can also involve trading currency on the foreign exchange market. For
example, a trader is betting a central bank will ease or tighten monetary policy and that
one currency will strengthen versus the other.
When trading currencies, they are listed in pairs, such as USD/CAD, EUR/USD, or
USD/JPY. These represent the U.S. dollar (USD) versus the Canadian dollar (CAD), the
euro (EUR) versus the USD, and the USD versus the Japanese yen (JPY).
There will also be a price associated with each pair, such as 1.2569. If this price was
associated with the USD/CAD pair, it means that it costs 1.2569 CAD to buy one USD. If
the price increases to 1.3336, then it now costs 1.3336 CAD to buy one USD. The USD
has increased in value (CAD decrease) because it now costs more CAD to buy one USD.
In the forex market currencies trade in lots, called micro, mini, and standard lots. A
micro lot is 1,000 worth of a given currency, a mini lot is 10,000, and a standard lot is
100,000. This is different than when you go to a bank and want $450 exchanged for your
trip. When trading in the electronic forex market, trades take place in set blocks of
currency, but you can trade as many blocks as you like. For example, you can trade
seven micro lots (7,000) or three mini lots (30,000) or 75 standard lots (7,500,000), for
example.

The foreign exchange market is unique for several reasons, mainly because of its
size. Trading volume in the forex market is generally very large. As an example, trading
in foreign exchange markets averaged $6.6 trillion per day in April 2019, according to
the Bank for International Settlements, which is owned by 62 central banks and is used
to work in monetary and financial responsibility. 23 The largest trading centers are
London, New York, Singapore, Hong Kong, and Tokyo. 3
Trading in the Foreign Exchange Market

The market is open 24 hours a day, five days a week across major financial centers
across the globe. This means that you can buy or sell currencies at any time during the
day.
The foreign exchange market isn't exactly a one-stop shop. There are a whole variety of
different avenues that an investor can go through in order to execute forex trades. You
can go through different dealers or through different financial centers which use a host
of electronic networks.

From a historical standpoint, foreign exchange was once a concept for governments,
large companies, and hedge funds. But in today's world, trading currencies is as easy as
a click of a mouse—accessibility is not an issue, which means anyone can do it. In fact,
many investment companies offer the chance for individuals to open accounts and to
trade currencies however and whenever they choose.

When you're making trades in the forex market, you're basically buying or selling the
currency of a particular country. But there's no physical exchange of money from one
hand to another. That's contrary to what happens at a foreign exchange kiosk—think of
a tourist visiting Times Square in New York City from Japan. He may be converting his
(physical) yen to actual U.S. dollar cash (and may be charged a commission fee to do
so) so he can spend his money while he's traveling.

But in the world of electronic markets, traders are usually taking a position in a specific

currency, with the hope that there will be some upward movement and strength in the
currency that they're buying (or weakness if they're selling) so they can make a profit. 
Differences in the Forex Markets

There are some fundamental differences between foreign exchange and other markets.
First of all, there are fewer rules, which means investors aren't held to as strict
standards or regulations as those in the stock, futures, or options markets. That means
there are no clearing houses and no central bodies that oversee the forex market.

Second, since trades don't take place on a traditional exchange, you won't find the same
fees or commissions that you would on another market. Next, there's no cutoff as to
when you can and cannot trade. Because the market is open 24 hours a day, you can
trade at any time of day. Finally, because it's such a liquid market, you can get in and out
whenever you want and you can buy as much currency as you can afford.

Spot Market
Spot for most currencies is two business days; the major exception is the U.S. dollar
versus the Canadian dollar, which settles on the next business day. Other pairs settle in
two business days. During periods that have multiple holidays, such as Easter or
Christmas, spot transactions can take as long as six days to settle. The price is
established on the trade date, but money is exchanged on the value date.
The U.S. dollar is the most actively traded currency. 4 The most common pairs are the
USD versus the euro, Japanese yen, British pound and Australian dollar.5 Trading pairs
that do not include the dollar are referred to as crosses. The most common crosses are
the euro versus the pound and yen.

The spot market can be very volatile. Movement in the short term is dominated by
technical trading, which focuses on direction and speed of movement. People who focus
on technical are often referred to as chartists. Long-term currency moves are driven by
fundamental factors such as relative interest rates and economic growth.

The Forward Market

A forward trade is any trade that settles further in the future than spot. The forward
price is a combination of the spot rate plus or minus forward points that represent
the interest rate differential between the two currencies. Most have a maturity less than
a year in the future but longer is possible. Like with a spot, the price is set on the
transaction date, but money is exchanged on the maturity date.
A forward contract is tailor-made to the requirements of the counterparties. They can
be for any amount and settle on any date that is not a weekend or holiday in one of the
countries.

The Futures Market

A futures transaction is similar to a forward in that it settles later than a spot deal, but is
for standard size and settlement date and is traded on a commodities market. The
exchange acts as the counterparty.
Example of Foreign Exchange

A trader thinks that the European Central Bank (ECB) will be easing its monetary policy
in the coming months as the Eurozone’s economy slows. As a result, the trader bets that
the euro will fall against the U.S. dollar and sells short €100,000 at an exchange rate of
1.15. Over the next several weeks the ECB signals that it may indeed ease its monetary
policy. That causes the exchange rate for the euro to fall to 1.10 versus the dollar. It
creates a profit for the trader of $5,000.

By shorting €100,000, the trader took in $115,000 for the short sale. When the euro fell,
and the trader covered their short, it cost the trader only $110,000 to repurchase the
currency. The difference between the money received on the short-sale and the buy to
cover is the profit. Had the euro strengthened versus the dollar, it would have resulted
in a loss.

Frequently Asked Questions

How Big Is the Foreign Exchange Market?
The foreign exchange market is extremely liquid and dwarfs, by a huge amount, the
daily trading volume of the stock and bond markets. According to the latest triennial
survey conducted by the Bank for International Settlements (BIS), trading in foreign
exchange markets averaged $6.6 trillion per day in 2019. By contrast, the total notional
value of U.S. equity markets on March 10, 2021 was approximately $688 billion. The
largest forex trading centers are London, New York, Singapore, Hong Kong, and Tokyo.
What Is Foreign Exchange Trading?
When you're making trades in the forex market, you're basically buying the currency of
a particular country and simultaneously selling the currency of another country. But
there's no physical exchange of money from one hand to another. Traders are usually
taking a position in a specific currency, with the hope that there will be some strength in
the currency, relative to the other currency, that they're buying (or weakness if they're
selling) so they can make a profit. In today’s world of electronic markets, trading
currencies is as easy as a click of a mouse

How Does Foreign Exchange Differ from Other Markets?

There are some fundamental differences between foreign exchange and other markets.
There are no clearing houses and no central bodies to oversee the forex market which
means investors aren't held to the strict standards or regulations as those in the stock,
futures, or options markets. Second, there aren't the fees or commissions that exist for
other markets that have traditional exchanges. There is no cutoff time for trading, aside
from the weekend, so one can trade at any time of day. Finally, its liquidity lends to its
ease of trading access.
LESSON Pl AGRARIAN REFORM AND TAXATION

THE COMPREHENSIVE AGRARIAN REFORM PROGRAM

REPUBLIC ACT NO. 6657

AN ACT INSTITUTING A COMPREHENSIVE AGRARIAN REFORM PROGRAM TO
PROMOTE SOCIAL JUSTICE AND INDUSTRIALIZATION, PROVIDING THE MECHANISM
FOR ITS IMPLEMENTATION, AND FOR OTHER PURPOSES

CHAPTER I

Preliminary Chapter
SECTION 1. Title. – This Act shall be known as the Comprehensive Agrarian Reform Law
of 1988.
SECTION 2. Declaration of Principles and Policies. — It is the policy of the State to pursue
a Comprehensive Agrarian Reform Program (CARP). The welfare of the landless farmers
and farmworkers will receive the highest consideration to promote social justice and to
move the nation toward sound rural development and industrialization, and the
establishment of owner cultivator ship of economic-size farms as the basis of Philippine
agriculture.

To this end, a more equitable distribution and ownership of land, with due regard to the
rights of landowners to just compensation and to the ecological needs of the nation,
shall be undertaken to provide farmers and farmworkers with the opportunity to
enhance their dignity and improve the quality of their lives through greater productivity
of agricultural lands.
The agrarian reform program is founded on the right of farmers and regular
farmworkers, who are landless, to own directly or collectively the lands they till or, in
the case of other farm workers, to receive a just share of the fruits thereof. To this end,
the State shall encourage and undertake the just distribution of all agricultural lands,
subject to the priorities and retention limits set forth in this Act, having taken into
account ecological, developmental, and equity considerations, and subject to the
payment of just compensation. The State shall respect the right of small landowners,
and shall provide incentives for voluntary land-sharing.

The State shall recognize the right of farmers, farmworkers and landowners, as well as
cooperatives and other independent farmers’ organizations, to participate in the
planning, organization, and management of the program, and shall provide support to
agriculture through appropriate technology and research, and adequate financial
production, marketing and other support services.
The State shall apply the principles of agrarian reform, or stewardship, whenever
applicable, in accordance with law, in the disposition or utilization of other natural
resources, including lands of the public domain, under lease or concession, suitable to
agriculture, subject to prior rights, homestead rights of small settlers and the rights of
indigenous communities to their ancestral lands.

The State may resettle landless farmers and farmworkers in its own agricultural estates,
which shall be distributed to them in the manner provided by law.
By means of appropriate incentives, the State shall encourage the formation and
maintenance of economic-size family farms to be constituted by individual beneficiaries
and small landowners.

The State shall protect the rights of subsistence fishermen, especially of local
communities, to the preferential use of communal marine and fishing resources, both
inland and offshore. It shall provide support to such fishermen through appropriate
technology and research, adequate financial, production and marketing assistance and
other services. The State shall also protect, develop and conserve such resources. The
protection shall extend to offshore fishing grounds of subsistence fishermen against
foreign intrusion. Fish workers shall receive a just share from their labor in the
utilization of marine and fishing resources.

The State shall be guided by the principles that land has a social function and land
ownership has a social responsibility. Owners of agricultural lands have the obligation to
cultivate directly or through labor administration the lands they own and thereby make
the land productive.
The State shall provide incentives to landowners to invest the proceeds of the agrarian
reform program to promote industrialization, employment and privatization of public
sector enterprises. Financial instruments used as payment for lands shall contain
features that shall enhance negotiability and acceptability in the marketplace.

The State may lease undeveloped lands of the public domain to qualified entities for the
development of capital-intensive farms, and traditional and pioneering crops especially
those for exports subject to the prior rights of the beneficiaries under this Act.

SECTION 3. Definitions. – For the purpose of this Act, unless the context indicates
otherwise:
(a) Agrarian Reform means the redistribution of lands, regardless of crops or fruits
produced to farmers and regular farmworkers who are landless, irrespective of tenurial
arrangement, to include the totality of factors and support services designed to lift the
economic status of the beneficiaries and all other arrangements alternative to the
physical redistribution of lands, such as production or profit-sharing, labor
administration, and the distribution of shares of stocks, which will allow beneficiaries to
receive a just share of the fruits of the lands they work.
(b) Agriculture, Agricultural Enterprise or Agricultural Activity means the cultivation of
the soil, planting of crops, growing of fruit trees, raising of livestock, poultry or fish,
including the harvesting of such farm products, and other farm activities and practices
performed by a farmer in conjunction with such farming operations done by persons
whether natural or juridical.
(c) Agricultural Land refers to land devoted to agricultural activity as defined in this Act
and not classified as mineral, forest, residential, commercial or industrial land.
(d) Agrarian Dispute refers to any controversy relating to tenurial arrangements,
whether leasehold, tenancy, stewardship or otherwise, over lands devoted to
agriculture, including disputes concerning farmworkers’ associations or representation
of persons in negotiating, fixing, maintaining, changing, or seeking to arrange terms or
conditions of such tenurial arrangements.
It includes any controversy relating to compensation of lands acquired under this Act
and other terms and conditions of transfer of ownership from landowners to
farmworkers, tenants and other agrarian reform beneficiaries, whether the disputants
stand in the proximate relation of farm operator and beneficiary, landowner and tenant,
or lessor and lessee.
(e) Idle or Abandoned Land refers to any agricultural land not cultivated, tilled or
developed to produce any crop nor devoted to any specific economic purpose
continuously for a period of three (3) years immediately prior to the receipt of notice of
acquisition by the government as provided under this Act, but does not include land that
has become permanently or regularly devoted to non-agricultural purposes. It does not
include land which has become unproductive by reason of force majeure or any other
fortuitous event, provided that prior to such event, such land was previously used for
agricultural or other economic purpose.
(f) Farmer refers to a natural person whose primary livelihood is cultivation of land or
the production of agricultural crops, either by himself, or primarily with the assistance of
his immediate farm household, whether the land is owned by him, or by another person
under a leasehold or share tenancy agreement or arrangement with the owner thereof.
(g) Farmworker is a natural person who renders services for value as an employee or
laborer in an agricultural enterprise or farm regardless of whether his compensation is
paid on a daily, weekly, monthly or “pakyaw” basis. The term includes an individual
whose work has ceased as a consequence of, or in connection with, a pending agrarian
dispute and who has not obtained a substantially equivalent and regular farm
employment.
(h) Regular Farmworker is a natural person who is employed on a permanent basis by an
agricultural enterprise or farm.
(i) Seasonal Farmworker is a natural person who is employed on a recurrent, periodic or
intermittent basis by an agricultural enterprise or farm, whether as a permanent or a
non-permanent laborer, such as “dumaan”, “sacada”, and the like.
(j) Other Farmworker is a farmworker who does not fall under paragraphs (g), (h) and (i).
(k) Cooperatives shall refer to organizations composed primarily of small agricultural
producers, farmers, farmworkers, or other agrarian reform beneficiaries who voluntarily
organize themselves for the purpose of pooling land, human, technological, financial or
other economic resources, and operated on the principle of one member, one vote. A
juridical person may be a member of a cooperative, with the same rights and duties as a
natural person.

WHAT IS TAXATION?

Taxation is a term for when a taxing authority, usually a government, levies or imposes a
financial obligation on its citizens or residents. Paying taxes to governments or officials
has been a mainstay of civilization since ancient times.
The term "taxation" applies to all types of involuntary levies, from income to capital
gains to estate taxes. Though taxation can be a noun or verb, it is usually referred to as
an act; the resulting revenue is usually called "taxes."

KEY TAKEAWAYS
 Taxation occurs when a government or other authority requires that a fee be paid by
citizens and corporations, to that authority.
 The fee is involuntary, and as opposed to other payments, not linked to any specific
services that have been or will be provided.
 Tax occurs on physical assets, including property and transactions, such as a sale of
stock, or a home. 
 Types of taxes include income, corporate, capital gains, property, inheritance, and sales.
Volume 75%
 
Taxation
Understanding Taxation
Taxation is differentiated from other forms of payment, such as market exchanges, in
that taxation does not require consent and is not directly tied to any services rendered.
The government compels taxation through an implicit or explicit threat of force.
Taxation is legally different than extortion or a protection racket because the imposing
institution is a government, not private actors.
Tax systems have varied considerably across jurisdictions and time. In most modern
systems, taxation occurs on both physical assets, such as property and specific events,
such as a sales transaction. The formulation of tax policies is one of the most critical and
contentious issues in modern politics.

Taxation in the United States

The U.S. government was originally funded on very little direct taxation. Instead, federal
agencies assessed user fees for ports and other government property. In times of need,
the government would decide to sell government assets and bonds or issue an
assessment to the states for services rendered. In fact, Thomas Jefferson abolished
direct taxation in 1802 after winning the presidency; only excise taxes remained, which
Congress repealed in 1817. Between 1817 and 1861, the federal government collected
no internal revenue.

An income tax of 3% was levied on high-income earners during the Civil War. It was not
until the Sixteenth Amendment was ratified in 1913 that the federal government
assessed taxes on income as a regular revenue item. As of 2020, U.S. taxation applies to
a wide range of items or activities, from income to cigarette and gasoline purchases to
inheritances and when winning at a casino or even Nobel Prize.
 
In 2012, as part of ruling on the Affordable Care Act (ACA), the U.S. Supreme Court ruled
that failure to purchase specific goods or services, such as health insurance, was
considered a tax and not a fine.
 Purposes and Justifications for Taxation

The most basic function of taxation is to fund government expenditures. Varying

justifications and explanations for taxes have been offered throughout history. Early
taxes were used to support the ruling classes, raise armies, and build defenses. Often,
the authority to tax stemmed from divine or supranational rights.

Later justifications have been offered across utilitarian, economic, or moral

considerations. Proponents of progressive levels of taxation on high-income earners
argue that taxes encourage a more equitable society. Higher taxes on specific products
and services, such as tobacco or gasoline, have been justified as a deterrent to
consumption. Advocates of public goods theory argue taxes may be necessary in cases
in which the private provision of public goods is considered sub-optimal, such as with
lighthouses or national defense.
Different Types of Taxation
As mentioned above, taxation applies to all different types of levies. These can include
(but are not limited to): 
 Income tax: Governments impose income taxes on financial income generated by all
entities within their jurisdiction, including individuals and businesses.
 Corporate tax: This type of tax is imposed on the profit of a business.
 Capital gains: A tax on capital gains is imposed on any capital gains or profits made by
people or businesses from the sale of certain assets including stocks, bonds, or real
estate. 
 Property tax: A property tax is asses by a local government and paid for by the owner of
a property. This tax is calculated based on property and land values. 
 Inheritance: A type of tax levied on individuals who inherit the estate of a deceased
person. 
 Sales tax: A consumption tax imposed by a government on the sale of goods and
services. This can take the form of a value-added tax (VAT), a goods and services tax
(GST), a state or provincial sales tax, or an excise tax. 

OBJECTIVES OF TAXATION

The primary goal of a national tax system is to generate revenues to pay for the
expenditures of government at all levels. Because public expenditures tend to grow at
least as fast as the national product, taxes, as the main vehicle of government finance,
should produce revenues that grow correspondingly. Income, sales, and value-added
taxes generally meet this criterion; property taxes and taxes on nonessential articles of
mass consumption such as tobacco products and alcoholic beverages do not.

In addition to producing revenue, tax policy may be used to promote economic stability.
Changes in tax liabilities not matched by changes in expenditures
cushion cyclical fluctuations in prices, employment, and production. Built-in flexibility
occurs because liabilities for some taxes, most notably income taxes, respond strongly
to changes in economic conditions. A more-active approach calls for changes in the tax
rates or other provisions to increase the anticyclical effects of tax receipts.
Some economists propose tax policies to promote economic growth. This approach may
imply a qualitative restructuring of the tax system (for example, the substitution of taxes
on consumption for taxes on income) or special tax advantages to
stimulate saving, labor mobility, research and development, and so on. There is,
however, a limit to what tax incentives can accomplish, especially in promoting
economic development of specific industries or regions. An emphasis on economic
growth implies the need to avoid high marginal tax rates and the tax-induced diversion
of resources into relatively unproductive activities.

The incidence of a tax rests on the person(s) who’s real net income is reduced by the
tax. It is fundamental that the real burden of taxation does not necessarily rest upon the
person who is legally responsible for payment of the tax. General sales taxes are paid by
business firms, but most of the cost of the tax is actually passed on to those who buy
the goods that are being taxed. In other words, the tax is shifted from the business to
the consumer. Taxes may be shifted in several directions. Forward shifting takes place if
the burden falls entirely on the user, rather than the supplier, of the commodity or
service in question—e.g., an excise tax on luxuries that increases their price to the
purchaser. Backward shifting occurs when the price of the article taxed remains the
same but the cost of the tax is borne by those engaged in producing it—e.g., through
lower wages and salaries, lower prices for raw materials, or a lower return on
borrowed capital. Finally, a tax may not be shifted at all—e.g., a tax on business profits
may reduce the net income of the business owner.

Tax capitalization occurs if the burden of the tax is incorporated in the value of long-
term assets—e.g., a decline in the price of land that offsets an increase
in property taxes. Capitalization can result where there is forward shifting, backward
shifting, or no shifting. Thus, an increase in the price of gasoline resulting from higher
motor fuel taxes may reduce the value of high-consumption automobiles, a tax on the
production of coal that cannot be shifted forward would reduce the value of coal
deposits, and a tax that reduces after-tax corporate profits may reduce the value of
corporate stock. In all these cases the present owner of the asset takes a capital loss
because the value of the asset will be lower by the capitalized value of the tax.

It can be difficult to determine the incidence of a tax; indeed, the tax may be partly
borne by the taxpayer and partly shifted. In many cases the problem can be adequately
resolved by using what economists call partial equilibrium analysis, which involves
focusing on the market for the taxed product and ignoring all other markets. For
example, if a small tax were to be imposed on an addictive substance, there is little
doubt that it would be borne by the users of the substance, who would pay the tax
rather than forgo use of the substance. More generally, the incidence of taxation
depends on all of the market forces at work. In a market economy the introduction of
any tax triggers a whole series of adjustments in consumption, production, the supply of
productive factors, and the pattern of foreign trade. These adjustments in turn will
have repercussions on the prices of various commodities, productive factors, and assets
that may be far removed from the area of the initial impact. In other words, a tax levied
on a certain object may affect the prices of nontaxed goods and services that are not
even used in the production of the object. Thus, the initial impact of a tax does not
indicate where the ultimate burden will rest unless one knows what repercussions the
tax will have throughout the system of interrelated economic variables—i.e., unless
recourse is made to what is called general equilibrium theory, a method of analysis that
attempts to identify and incorporate the economy-wide repercussions
and implications of taxation. In what follows, an attempt will be made to isolate some of
the factors involved.

The direction and extent of tax shifting is determined basically by one principle: The user
of a tax object can avoid the tax burden to a greater (lesser) extent the easier (the more
difficult) it is to find nontaxed or less-taxed alternatives or substitutes for the tax object;
the supplier of a production factor that is taxed or used in the production of a taxed
good can avoid the tax burden to a greater (lesser) extent the easier (the more difficult)
it is to find equivalent nontaxed or less taxed alternative employment opportunities for
this factor. Because the demand for substitute goods will increase, their prices may rise,
thus benefiting the producers of such goods and placing part of the tax burden on those
individuals who used them before the tax was imposed. Likewise, the productive factors
that seek alternative employments to avoid the tax will tend to receive lower returns in
those employments, thus placing part of the burden on individuals who supplied the
factors in those sectors before the tax was imposed. For example, if wine is taxed while
beer is not, then—if these two beverages are regarded as perfect substitutes and the
price of beer does not rise with increased demand—the tax burden will fall on the
owners of land used for viticulture and on the workers engaged in it. It will fall mainly on
the landowners if the soil is specific to grapevine growing and if labor has alternative
employment possibilities. If, on the other hand, wine drinkers are determined to drink
only wine, they will bear most of the tax burden. If some substitution of beer for wine
takes place and the price of beer rises somewhat, both wine and beer drinkers will bear
the burden and owners of resources specialized to the production of beer will benefit.

In addition to the substitution effect discussed above, one must take into account the
income effect. When taxation reduces real income, consumption of certain goods and
services (and of leisure) will be reduced, because people have less money to spend.
Furthermore, if a tax causes a significant redistribution of real income and if different
income classes have different propensities to save and different patterns of
consumption, then the income redistribution will influence the demand for various
goods, the supply of labor, and the demand for various resources.

Other considerations affect tax shifting, but they are derived from the basic principle of
substitution. The extent of shifting may vary over time, depending on how long it takes
to adjust consumption patterns, reallocate land and capital, retrain labor, and so on.
Those users and suppliers who have the most difficulty in adjusting will bear the largest
burden.

The breadth of the tax base affects tax incidence. The broader (narrower) the tax base—
i.e., the more (less) inclusive the scope of the tax—the more difficult it is to escape the
tax burden, since the range of nontaxed or less-taxed substitutes is narrower (wider).
Thus, an excise tax on only a few alcoholic beverages allows the tax to be escaped
through a change in the consumption pattern, while a tax on all such beverages does
not. In a similar fashion, the returns on capital will be affected less by the taxation of
corporation profits alone than by the taxation of both corporation and noncorporation
profits.

The smaller the jurisdictional unit imposing the tax, the easier it tends to be for a user to
obtain nontaxed or less-taxed substitutes from outside the jurisdiction and for a supplier
to find nontaxed or less-taxed outside employment opportunities for his goods and
services. Thus, a tax levied by a subnational government on the production of a
particular good is likely to be borne by suppliers of commodities and productive factors
that are immobile. This is particularly relevant to the determination of the incidence of
state income taxes and local property taxes, taxes that are often thought to be
“exported” to out-of-state consumers. In small communities the only really immobile
factors are likely to be real estate, certain local services, and perhaps poor families.
The rigidities of imperfect markets are likely to increase the uncertainty of the shifting
response. Thus, a monopolist may absorb part of a tax in lower profits rather than shift
all of the burden to the user of the product. In industries where there are few firms
(oligopoly), the price behavior of a firm is mainly determined by what it expects its
competitors to do. It may be especially easy for regulated public utilities to shift taxes
forward. Rigid product prices are likely to increase the incidence of taxes on
employment, unless monetary policy allows the tax-induced changes in relative prices to
take place in the setting of a generally rising price level.

All of these considerations are analytical and theoretical. Efforts have been made to

measure the impact of taxation by studying the actual effects of a particular tax on
income and employment. These studies reflect the obvious and inherent difficulty that
the tax impact cannot be easily isolated from the economic consequences of other
events. For example, studies of corporate income tax shifting vary in their results, from
the conclusion that the tax is not shifted at all to the conclusion that it is shifted by more
than 100 percent, depending mainly on the methods used to isolate the tax impact.

Objective # 1. Economic Development:

One of the important objectives of taxation is economic development. Economic
development of any country is largely conditioned by the growth of capital formation. It
is said that capital formation is the kingpin of economic development. But LDCs usually
suffer from the shortage of capital.
To overcome the scarcity of capital, governments of these countries mobilize resources
so that a rapid capital accumulation takes place. To step up both public and private
investment, government taps tax revenues. Through proper tax planning, the ratio of
savings to national income can be raised.

By raising the existing rate of taxes or by imposing new taxes, the process of capital
formation can be made smooth. One of the important elements of economic
development is the raising of savings- income ratio which can be effectively raised
through taxation policy.

However, proper care has to be taken, regarding investment. If financial resources or

investments are channelized in the unproductive sectors of the economy the economic
development may be jeopardized, even if savings and investment rates are increased.
Thus, the tax policy has to be employed in such a way that investment occurs in the
productive sectors of the economy, including the infrastructural sectors.

Objective # 2. Full Employment:

Second objective is the full employment. Since the level of employment depends on
effective demand, a country desirous of achieving the goal of full employment must cut
down the rate of taxes. Consequently, disposable income will rise and, hence, demand
for goods and services will rise. Increased demand will stimulate investment leading to a
rise in income and employment through the multiplier mechanism.

Objective # 3. Price Stability:

Thirdly, taxation can be used to ensure price stability—a short run objective of taxation.
Taxes are regarded as an effective means of controlling inflation. By raising the rate of
direct taxes, private spending can be controlled. Naturally, the pressure on the
commodity market is reduced.
But indirect taxes imposed on commodities fuel inflationary tendencies. High
commodity prices, on the one hand, discourage consumption and, on the other hand,
encourage saving. Opposite effect will occur when taxes are lowered down during
deflation.

Objective # 4. Control of Cyclical Fluctuations:

Fourthly, control of cyclical fluctuations—periods of boom and depression—is
considered to be another objective of taxation. During depression, taxes are lowered
down while during boom taxes are increased so that cyclical fluctuations are tamed.

Objective # 5. Reduction of BOP Difficulties:

Fifthly, taxes like custom duties are also used to control imports of certain goods with
the objective of reducing the intensity of balance of payments difficulties and
encouraging domestic production of import substitutes.

Objective # 6. Non-Revenue Objective:

Finally, another extra-revenue or non-revenue objective of taxation is the reduction of
inequalities in income and wealth. This can be done by taxing the rich at higher rate
than the poor or by introducing a system of progressive taxation.

CLASSES OF TAXES

Direct and indirect taxes

In the literature of public finance, taxes have been classified in various ways according
to who pays for them, who bears the ultimate burden of them, the extent to which the
burden can be shifted, and various other criteria. Taxes are most commonly classified as
either direct or indirect, an example of the former type being the income tax and of the
latter the sales tax. There is much disagreement among economists as to the criteria for
distinguishing between direct and indirect taxes, and it is unclear into which category
certain taxes, such as corporate income tax or property tax, should fall. It is usually said
that a direct tax is one that cannot be shifted by the taxpayer to someone else, whereas
an indirect tax can be.

Direct taxes
Direct taxes are primarily taxes on natural persons (e.g., individuals), and they are
typically based on the taxpayer’s ability to pay as measured by income, consumption, or
net wealth. What follows is a description of the main types of direct taxes.
Individual income taxes are commonly levied on total personal net income of the
taxpayer (which may be an individual, a couple, or a family) in excess of
some stipulated minimum. They are also commonly adjusted to take into account the
circumstances influencing the ability to pay, such as family status, number and age of
children, and financial burdens resulting from illness. The taxes are often levied at
graduated rates, meaning that the rates rise as income rises. Personal exemptions for
the taxpayer and family can create a range of income that is subject to a tax rate of zero.
Taxes on net worth are levied on the total net worth of a person—that is, the value of
his assets minus his liabilities. As with the income tax, the personal circumstances of the
taxpayer can be taken into consideration.

Personal or direct taxes on consumption (also known as expenditure taxes or spending

taxes) are essentially levied on all income that is not channeled into savings. In contrast
to indirect taxes on spending, such as the sales tax, a direct consumption tax can be
adjusted to an individual’s ability to pay by allowing for marital status, age, number of
dependents, and so on. Although long attractive to theorists, this form of tax has been
used in only two countries, India and Sri Lanka; both instances were brief and
unsuccessful. Near the end of the 20th century, the “flat tax”—which achieves economic
effects similar to those of the direct consumption tax by exempting most income from
capital—came to be viewed favorably by tax experts. No country has adopted a tax with
the base of the flat tax, although many have income taxes with only one rate.

Taxes at death take two forms: the inheritance tax, where the taxable object is
the bequest received by the person inheriting, and the estate tax, where the object is
the total estate left by the deceased. Inheritance taxes sometimes take into account the
personal circumstances of the taxpayer, such as the taxpayer’s relationship to the donor
and his net worth before receiving the bequest. Estate taxes, however, are generally
graduated according to the size of the estate, and in some countries, they provide tax-
exempt transfers to the spouse and make an allowance for the number of heirs
involved. In order to prevent the death duties from being circumvented through an
exchange of property prior to death, tax systems may include a tax on gifts above a
certain threshold made between living persons (see gift tax). Taxes on transfers do not
ordinarily yield much revenue, if only because large tax payments can be easily avoided
through estate planning.

Indirect taxes
Indirect taxes are levied on the production or consumption of goods and services or on
transactions, including imports and exports. Examples include general and
selective sales taxes, value-added taxes (VAT), taxes on any aspect of manufacturing or
production, taxes on legal transactions, and customs or import duties.
General sales taxes are levies that are applied to a substantial portion of consumer
expenditures. The same tax rate can be applied to all taxed items, or different items
(such as food or clothing) can be subject to different rates. Single-stage taxes can be
collected at the retail level, as the U.S. states do, or they can be collected at a pre-retail
(i.e., manufacturing or wholesale) level, as occurs in some developing countries.
Multistage taxes are applied at each stage in the production-distribution process.
The VAT, which increased in popularity during the second half of the 20th century, is
commonly collected by allowing the taxpayer to deduct a credit for tax paid on
purchases from liability on sales. The VAT has largely replaced the turnover tax—a tax
on each stage of the production and distribution chain, with no relief for tax paid at
previous stages. The cumulative effect of the turnover tax, commonly known as tax
cascading, distorts economic decisions.
Although they are generally applied to a wide range of products, sales taxes sometimes
exempt necessities to reduce the tax burden of low-income households. By
comparison, excises are levied only on particular commodities or services. While some
countries impose excises and customs duties on almost everything—from necessities
such as bread, meat, and salt, to nonessentials such as cigarettes, wine, liquor, coffee,
and tea, to luxuries such as jewels and furs—taxes on a limited group of products—
alcoholic beverages, tobacco products, and motor fuel—yield the bulk of excise
revenues for most countries. In earlier centuries, taxes on consumer durables were
applied to luxury commodities such as pianos, saddle horses, carriages, and billiard
tables. Today a main luxury tax object is the automobile, largely because registration
requirements facilitate administration of the tax. Some countries tax gambling, and
state-run lotteries have effects similar to excises, with the government’s “take” being, in
effect, a tax on gambling. Some countries impose taxes on raw materials, intermediate
goods (e.g., mineral oil, alcohol), and machinery.

Some excises and customs duties are specific—i.e., they are levied on the basis of
number, weight, length, volume, or other specific characteristics of the good or service
being taxed. Other excises, like sales taxes, are ad valorem—levied on the value of the
goods as measured by the price. Taxes on legal transactions are levied on the issue of
shares, on the sale (or transfer) of houses and land, and on stock exchange transactions.
For administrative reasons, they frequently take the form of stamp duties; that is, the
legal or commercial document is stamped to denote payment of the tax. Many tax
analysts regard stamp taxes as nuisance taxes; they are most often found in less-
developed countries and frequently bog down the transactions to which they are
applied.

Proportional, progressive, and regressive taxes

Taxes can be distinguished by the effect they have on the distribution of income and
wealth. A proportional tax is one that imposes the same relative burden on all taxpayers
—i.e., where tax liability and income grow in equal proportion. A progressive tax is
characterized by a more than proportional rise in the tax liability relative to the increase
in income, and a regressive tax is characterized by a less than proportional rise in the
relative burden. Thus, progressive taxes are seen as reducing inequalities in income
distribution, whereas regressive taxes can have the effect of increasing these
inequalities.
The taxes that are generally considered progressive include individual income taxes and
estate taxes. Income taxes that are nominally progressive, however, may become less so
in the upper-income categories—especially if a taxpayer is allowed to reduce his tax
base by declaring deductions or by excluding certain income components from his
taxable income. Proportional tax rates that are applied to lower-income categories will
also be more progressive if personal exemptions are declared.

Income measured over the course of a given year does not necessarily provide the best
measure of taxpaying ability. For example, transitory increases in income may be saved,
and during temporary declines in income a taxpayer may choose
to finance consumption by reducing savings. Thus, if taxation is compared with
“permanent income,” it will be less regressive (or more progressive) than if it is
compared with annual income.

Sales taxes and excises (except those on luxuries) tend to be regressive, because the
share of personal income consumed or spent on a specific good decline as the level of
personal income rises. Poll taxes (also known as head taxes), levied as a fixed amount
per capita, obviously are regressive.
It is difficult to classify corporate income taxes and taxes on business as progressive,
regressive, or proportionate, because of uncertainty about the ability of businesses to
shift their tax expenses (see below Shifting and incidence). This difficulty of determining
who bears the tax burden depends crucially on whether a national or a subnational (that
is, provincial or state) tax is being considered.

In considering the economic effects of taxation, it is important to distinguish between

several concepts of tax rates. The statutory rates are those specified in the law;
commonly these are marginal rates, but sometimes they are average rates.
Marginal income tax rates indicate the fraction of incremental income that is taken by
taxation when income rises by one dollar. Thus, if tax liability rises by 45 cents when
income rises by one dollar, the marginal tax rate is 45 percent. Income tax statutes
commonly contain graduated marginal rates—i.e., rates that rise as income rises.
Careful analysis of marginal tax rates must consider provisions other than the formal
statutory rate structure. If, for example, a particular tax credit (reduction in tax) falls by
20 cents for each one-dollar rise in income, the marginal rate is 20 percentage points
higher than indicated by the statutory rates. Since marginal rates indicate how after-tax
income changes in response to changes in before-tax income, they are the relevant ones
for appraising incentive effects of taxation. It is even more difficult to know the marginal
effective tax rate applied to income from business and capital, since it may depend on
such considerations as the structure of depreciation allowances, the deductibility of
interest, and the provisions for inflation adjustment. A basic economic theorem holds
that the marginal effective tax rate in income from capital is zero under a consumption-
based tax.

Average income tax rates indicate the fraction of total income that is paid in taxation.
The pattern of average rates is the one that is relevant for appraising the
distributional equity of taxation. Under a progressive income tax the average income tax
rate rises with income. Average income tax rates commonly rise with income, both
because personal allowances are provided for the taxpayer and dependents and
because marginal tax rates are graduated; on the other hand, preferential treatment of
income received predominantly by high-income households may swamp these effects,
producing
regressivity, as indicated by average tax rates that fall as income rises.

History of taxation
Administration of taxation
Although views on what is appropriate in tax policy influence the choice and structure of
tax codes, patterns of taxation throughout history can be explained largely by
administrative considerations. For example, because imported products are easier to tax
than domestic output, import duties were among the earliest taxes. Similarly, the simple
turnover tax (levied on gross sales) long held sway before the invention of the
economically superior but administratively more demanding VAT (which
allows credit for tax paid on purchases). It is easier to identify, and thus tax, real
property than other assets; and a head (poll) tax is even easier to implement. It is not
surprising, therefore, that the first direct levies were head and land taxes.

Although taxation has a long history, it played a relatively minor role in the ancient
world. Taxes on consumption were levied in Greece and Rome. Tariffs—taxes on
imported goods—were often of considerably more importance than internal excises so
far as the production of revenue went. As a means of raising additional funds in time of
war, taxes on property would be temporarily imposed. For a long time, these taxes were
confined to real property, but later they were extended to other assets. Real estate
transactions also were taxed. In Greece free citizens had different tax obligations from
slaves, and the tax laws of the Roman Empire distinguished between nationals and
residents of conquered territories.
Early Roman forms of taxation included consumption taxes, customs duties, and certain
“direct” taxes. The principal of these was the tribute, paid by citizens and usually levied
as a head tax; later, when additional revenue was required, the base of this tax was
extended to real estate holdings. In the time of Julius Caesar, a 1 percent general sales
tax was introduced (centesima rerum venalium). The provinces relied for their revenues
on head taxes and land taxes; the latter consisted initially of fixed liabilities regardless of
the return from the land, as in Persia and Egypt, but later the land tax was modified to
achieve a certain correspondence with the fertility of the land, or, alternatively, a 10th
of the produce was collected as a tax in kind (the tithe). It is noteworthy that at a
relatively early time Rome had an inheritance tax of 5 percent, later 10 percent;
however, close relatives of the deceased were exempted. For a long time tax collection
was left to middlemen, or “tax farmers,” who contracted to collect the taxes for a share
of the proceeds; under Caesar collection was delegated to civil servants.

In the Middle Ages many of these ancient taxes, especially the direct levies, gave way to
a variety of obligatory services and a system of “aids” (most of which amounted to gifts).
The main indirect taxes were transit duties (a charge on goods that pass through a
particular country) and market fees. In the cities the concept developed of a tax
obligation encompassing all residents: the burden of taxes on certain foods and
beverages was intended to be borne partly by consumers and partly by producers and
tradesmen. During the later Middle Ages some German and Italian cities introduced
several direct taxes: head taxes for the poor and net-worth taxes or, occasionally, crude
income taxes for the rich. (The income tax was administered through self-assessment
and an oath taken before a civic commission.) Taxes on land and on houses gradually
increased.

Taxes have been a major subject of political controversy throughout history, even
before they constituted a sizable share of the national income. A famous instance is the
rebellion of the American colonies against Great Britain, when the colonists refused to
pay taxes imposed by a Parliament in which they had no voice—hence the slogan, “No
taxation without representation.” Another instance is the French Revolution of 1789, in
which the inequitable distribution of the tax burden was a major factor.
Wars have influenced taxes much more than taxes have influenced revolutions. Many
taxes, notably the income tax (first introduced in Great Britain in 1799) and the turnover
or purchase tax (Germany, 1918; Great Britain, 1940), began as “temporary” war
measures. Similarly, the withholding method of income tax collection began as a
wartime innovation in France, the United States, and Britain. World War II converted the
income taxes of many countries from upper-class taxes to mass taxes.
It is hardly necessary to mention the role that tax policies play in peacetime politics,
where the influence of powerful, well-organized pressure groups is great. Arguments for
tax reform, particularly in the area of income taxes, are perennially at issue in the
domestic politics of many countries.

Modern trends
The development of taxation in recent times can be summarized by the following
general statements, although allowance must be made for considerable national
differences: The authority of the sovereign to levy taxes in a more or less arbitrary
fashion has been lost, and the power to tax now generally resides in parliamentary
bodies. The level of most taxes has risen substantially and so has the ratio of tax
revenues to the national income. Taxes today are collected in money, not in goods. Tax
farming—the collection of taxes by outside contractors—has been abolished, and taxes
are instead assessed and collected by civil servants. (On the other hand, as a means of
overcoming the inefficiencies of government agencies, tax collection has recently been
contracted to banks in many less-developed countries. In addition, some countries
are outsourcing the administration of customs duties.)

There has also been a reduction in reliance on customs duties and excises. Many
countries increasingly rely on sales taxes and other general consumption taxes. An
important late 20th-century development was the replacement of turnover taxes with
value-added taxes. Taxes on the privilege of doing business and on real property lost
ground, although they have persisted as important revenue sources for
local communities. The absolute and relative weight of direct personal taxation has
been growing in most of the developed countries, and increasing attention has been
focused on VAT and payroll taxes. At the end of the 20th century the expansion of e-
commerce created serious challenges for the administration of VAT, income taxes, and
sales taxes. The problems of tax administration were compounded by the anonymity of
buyers and sellers, the possibility of conducting business from offshore tax havens, the
fact that tax authorities cannot monitor the flow of digitized products
or intellectual property, and the spate of untraceable money flows.
Income taxation (of individuals and of corporations), payroll taxes, general sales taxes,
and (in some countries) property taxes bring in the greatest amounts of revenue in
modern tax systems. The income tax has ceased to be a “rich man’s” tax; it is now paid
by the general populace, and in several countries, it is joined by a tax on net worth. The
emphasis on the ability-to-pay principle and on the redistribution of wealth—which led
to graduated rates and high-top marginal income tax rates—appears to have peaked,
having been replaced by greater concern for the economic distortions and disincentives
caused by high tax rates. A good deal of fiscal centralization occurred through much of
the 20th century, as reflected in the kinds of taxes levied by central governments. They
now control the most important taxes (from a revenue-producing point of view): income
and corporation taxes, payroll taxes, and value-added taxes. Yet, in the last decade of
the 20th century, many countries experienced a greater decentralization of government
and a consequent devolution of taxing powers to subnational governments. Proponents
of decentralization argue that it can contribute to greater fiscal autonomy and
responsibility, because it involves states and municipalities in the broader processes of
tax policy; merely allowing lower-level governments to share in the tax revenues of
central governments does not foster such autonomy.

Although it is difficult to make general distinctions between developed and less-

developed countries, it is possible to detect some patterns in their relative reliance on
various types of taxes. For example, developed countries usually rely more on individual
income taxes and less on corporate income taxes than less-developed countries do. In
developing countries, reliance on income taxes, especially on corporate income taxes,
generally increases as the level of income rises. In addition, a relatively high percentage
of the total tax revenue of industrialized countries comes from domestic consumption
taxes, especially the value-added tax (rather than the simpler turnover tax). Social
security taxes—commonly collected as payroll taxes—are much more important in
developed countries and the more-affluent developing countries than in the poorest
countries, reflecting the near lack of social security systems in the latter. Indeed, in
many developed countries, payroll taxes rival or surpass the individual income tax as a
source of revenue. Demographic trends and their consequences (in particular, the aging
of the world’s working population and the need to finance public pensions) threaten to
raise payroll taxes to increasingly steep levels. Some countries have responded by
privatizing the provision of pensions—e.g., by substituting mandatory contributions to
individual accounts for payroll taxes.

Taxes in general represent a much higher percentage of national output in developed

countries than in developing countries. Similarly, more national output is channeled to
governmental use through taxation in developing countries with the highest levels of
income than in those with lesser incomes. Indeed, in many respects the tax systems of
the developing countries with the highest levels of income have more in common with
those of developed countries than they have with the tax systems of the poorest
developing countries.

Principles of taxation
The 18th-century economist and philosopher Adam Smith attempted to systematize the
rules that should govern a rational system of taxation. In The Wealth of Nations (Book V,
chapter 2) he set down four general canons:

Adam Smith
Adam Smith, paste medallion by James Tassie, 1787; in the Scottish National Portrait
Gallery, Edinburgh.
Courtesy of the Scottish National Portrait Gallery, Edinburgh
I. The subjects of every state ought to contribute towards the support of the
government, as nearly as possible, in proportion to their respective abilities; that is, in
proportion to the revenue which they respectively enjoy under the protection of the
state.…
II. The tax which each individual is bound to pay ought to be certain, and not arbitrary.
The time of payment, the manner of payment, the quantity to be paid, ought all to be
clear and plain to the contributor, and to every other person.…
III. Every tax ought to be levied at the time, or in the manner, in which it is most likely to
be convenient for the contributor to pay it.…
IV. Every tax ought to be so contrived as both to take out and keep out of the pockets of
the people as little as possible over and above what it brings into the public treasury of
the state.…

Although they need to be reinterpreted from time to time, these principles retain
remarkable relevance. From the first can be derived some leading views about what is
fair in the distribution of tax burdens among taxpayers. These are: (1) the belief that
taxes should be based on the individual’s ability to pay, known as the ability-to-pay
principle, and (2) the benefit principle, the idea that there should be some equivalence
between what the individual pays and the benefits he subsequently receives from
governmental activities. The fourth of Smith’s canons can be interpreted to underlie the
emphasis many economists place on a tax system that does not interfere
with market decision making, as well as the more obvious need to avoid complexity and
corruption.

Distribution of tax burdens
Various principles, political pressures, and goals can direct a government’s tax policy.
What follows is a discussion of some of the leading principles that can shape decisions
about taxation.

Horizontal equity
The principle of horizontal equity assumes that persons in the same or similar positions
(so far as tax purposes are concerned) will be subject to the same tax liability. In practice
this equality principle is often disregarded, both intentionally and unintentionally.
Intentional violations are usually motivated more by politics than by sound economic
policy (e.g., the tax advantages granted to farmers, home owners, or members of the
middle class in general; the exclusion of interest on government securities). Debate over
tax reform has often centered on whether deviations from “equal treatment of equals”
are justified.

The ability-to-pay principle
The ability-to-pay principle requires that the total tax burden will be distributed among
individuals according to their capacity to bear it, taking into account all of the relevant
personal characteristics. The most suitable taxes from this standpoint are personal
levies (income, net worth, consumption, and inheritance taxes). Historically there was
common agreement that income is the best indicator of ability to pay. There have,
however, been important dissenters from this view, including the 17th-century English
philosophers John Locke and Thomas Hobbes and a number of present-day tax
specialists. The early dissenters believed that equity should be measured by what is
spent (i.e., consumption) rather than by what is earned (i.e., income); modern
advocates of consumption-based taxation emphasize the neutrality of consumption-
based taxes toward saving (income taxes discriminate against saving), the simplicity
of consumption-based taxes, and the superiority of consumption as a measure of an
individual’s ability to pay over a lifetime. Some theorists believe that wealth provides a
good measure of ability to pay because assets imply some degree of satisfaction (power)
and tax capacity, even if (as in the case of an art collection) they generate
no tangible income.

The ability-to-pay principle also is commonly interpreted as requiring that direct

personal taxes have a progressive rate structure, although there is no way of
demonstrating that any particular degree of progressivity is the right one. Because a
considerable part of the population does not pay certain direct taxes—such as income
or inheritance taxes—some tax theorists believe that a satisfactory redistribution can
only be achieved when such taxes are supplemented by direct income transfers
or negative income taxes (or refundable credits). Others argue that income transfers
and negative income tax create negative incentives; instead, they favor public
expenditures (for example, on health or education) targeted toward low-income
families as a better means of reaching distributional objectives.

Indirect taxes such as VAT, excise, sales, or turnover taxes can be adapted to the ability-
to-pay criterion, but only to a limited extent—for example, by exempting necessities
such as food or by differentiating tax rates according to “urgency of need.” Such policies
are generally not very effective; moreover, they distort consumer purchasing patterns,
and their complexity often makes them difficult to institute.

Throughout much of the 20th century, prevailing opinion held that the distribution of
the tax burden among individuals should reduce the income disparities that naturally
result from the market economy; this view was the complete contrary of the 19th-
century liberal view that the distribution of income ought to be left alone. By the end of
the 20th century, however, many governments recognized that attempts to use tax
policy to reduce inequity can create costly distortions, prompting a partial return to the
view that taxes should not be used for redistributive purposes.
The benefit principle
Under the benefit principle, taxes are seen as serving a function similar to that of prices
in private transactions; that is, they help determine what activities the government will
undertake and who will pay for them. If this principle could be implemented,
the allocation of resources through the public sector would respond directly to
consumer wishes.

In fact, it is difficult to implement the benefit principle for most public services because
citizens generally have no inclination to pay for a publicly provided service—such as a
police department—unless they can be excluded from the benefits of the service. The
benefit principle is utilized most successfully in the financing of roads and highways
through levies on motor fuels and road-user fees (tolls). Payroll taxes used
to finance social security may also reflect a link between benefits and “contributions,”
but this link is commonly weak, because contributions do not go into accounts held for
individual contributors.

Economic efficiency
The requirement that a tax system be efficient arises from the nature of
a market economy. Although there are many examples to the contrary, economists
generally believe that markets do a fairly good job in making economic decisions about
such choices as consumption, production, and financing. Thus, they feel that tax policy
should generally refrain from interfering with the market’s allocation of economic
resources. That is, taxation should entail a minimum of interference with individual
decisions. It should not discriminate in favor of, or against,
particular consumption expenditures, particular means of production, particular forms
of organization, or particular industries. This does not mean, of course, that major social
and economic goals may not take precedence over these considerations. It may be
desirable, for example, to impose taxes on pollution as a means of protecting
the environment.

Economists have developed techniques to measure the “excess burden” that results
when taxes distort economic decision making. The basic notion is that if goods worth $2
are sacrificed because of tax influences in order to produce goods with a value of only
$1.80, there is an excess burden of 20 cents. A more nearly neutral tax system would
result in less distortion. Thus, an important postwar development in the theory of
taxation is that of optimal taxation, the determination of tax policies that will minimize
excess burdens. Because it deals with highly stylized mathematical descriptions of
economic systems, this theory does not offer easily applied prescriptions for policy,
beyond the important insight that distortions do less damage where supply and
demand are not highly sensitive to such distortions. Attempts have also been made to
incorporate distributional considerations into this theory. They face the difficulty that
there is no scientifically correct distribution of income.

Ease of administration and compliance

In discussing the general principles of taxation, one must not lose sight of the fact that
taxes must be administered by an accountable authority. There are four general
requirements for the efficient administration of tax laws: clarity, stability (or continuity),
cost-effectiveness, and convenience. Administrative considerations are especially
important in developing countries, where illiteracy, lack of commercial markets,
absence of books of account, and inadequate administrative resources may hinder
both compliance and administration. Under such circumstances the achievement of
rough justice may be preferable to infeasible fine-tuning in the name of equity.

Clarity
Tax laws and regulations must be comprehensible to the taxpayer; they must be as
simple as possible (given other goals of tax policy) as well as unambiguous and certain—
both to the taxpayer and to the tax administrator. While the principle of certainty is
better adhered to today than in the time of Adam Smith, and arbitrary administration of
taxes has been reduced, every country has tax laws that are far from being generally
understood by the public. This not only results in a considerable amount of error but
also undermines honesty and respect for the law and tends to discriminate against the
ignorant and the poor, who cannot take advantage of the various legal tax-saving
opportunities that are available to the educated and the affluent. At times, attempts to
achieve equity have created complexity, defeating reform purposes.

Stability
Tax laws should be changed seldom, and, when changes are made, they should be
carried out in the context of a general and systematic tax reform, with adequate
provisions for fair and orderly transition. Frequent changes to tax laws can result in
reduced compliance or in behavior that attempts to compensate for probable future
changes in the tax code—such as stockpiling liquor in advance of an increased tariff on
alcoholic beverages.
Cost-effectiveness
The costs of assessing, collecting, and controlling taxes should be kept to the lowest
level consistent with other goals of taxation. This principle is of secondary importance in
developed countries, but not in developing countries and countries in transition
from socialism, where resources needed for compliance and administration are scarce.
Clearly, equity and economic rationality should not be sacrificed for the sake
of cost considerations. The costs to be minimized include not only government expenses
but also those of the taxpayer and of private fiscal agents such as employers who collect
taxes for the government through the withholding procedure.

Convenience
Payment of taxes should cause taxpayers as little inconvenience as possible, subject to
the limitations of higher-ranking tax principles. Governments often allow
the payment of large tax liabilities in installments and set generous time limits for
completing returns.

Economic goals
The primary goal of a national tax system is to generate revenues to pay for the
expenditures of government at all levels. Because public expenditures tend to grow at
least as fast as the national product, taxes, as the main vehicle of government finance,
should produce revenues that grow correspondingly. Income, sales, and value-added
taxes generally meet this criterion; property taxes and taxes on nonessential articles of
mass consumption such as tobacco products and alcoholic beverages do not.

In addition to producing revenue, tax policy may be used to promote economic stability.
Changes in tax liabilities not matched by changes in expenditures
cushion cyclical fluctuations in prices, employment, and production. Built-in flexibility
occurs because liabilities for some taxes, most notably income taxes, respond strongly
to changes in economic conditions. A more-active approach calls for changes in the tax
rates or other provisions to increase the anticyclical effects of tax receipts.

Some economists propose tax policies to promote economic growth. This approach may
imply a qualitative restructuring of the tax system (for example, the substitution of taxes
on consumption for taxes on income) or special tax advantages to
stimulate saving, labor mobility, research and development, and so on. There is,
however, a limit to what tax incentives can accomplish, especially in promoting
economic development of specific industries or regions. An emphasis on economic
growth implies the need to avoid high marginal tax rates and the tax-induced diversion
of resources into relatively unproductive activities.

Shifting and incidence
The incidence of a tax rests on the person(s) who’s real net income is reduced by the
tax. It is fundamental that the real burden of taxation does not necessarily rest upon the
person who is legally responsible for payment of the tax. General sales taxes are paid by
business firms, but most of the cost of the tax is actually passed on to those who buy
the goods that are being taxed. In other words, the tax is shifted from the business to
the consumer. Taxes may be shifted in several directions. Forward shifting takes place if
the burden falls entirely on the user, rather than the supplier, of the commodity or
service in question—e.g., an excise tax on luxuries that increases their price to the
purchaser. Backward shifting occurs when the price of the article taxed remains the
same but the cost of the tax is borne by those engaged in producing it—e.g., through
lower wages and salaries, lower prices for raw materials, or a lower return on
borrowed capital. Finally, a tax may not be shifted at all—e.g., a tax on business profits
may reduce the net income of the business owner.
Tax capitalization occurs if the burden of the tax is incorporated in the value of long-
term assets—e.g., a decline in the price of land that offsets an increase
in property taxes. Capitalization can result where there is forward shifting, backward
shifting, or no shifting. Thus, an increase in the price of gasoline resulting from higher
motor fuel taxes may reduce the value of high-consumption automobiles, a tax on the
production of coal that cannot be shifted forward would reduce the value of coal
deposits, and a tax that reduces after-tax corporate profits may reduce the value of
corporate stock. In all these cases the present owner of the asset takes a capital loss
because the value of the asset will be lower by the capitalized value of the tax.
It can be difficult to determine the incidence of a tax; indeed, the tax may be partly
borne by the taxpayer and partly shifted. In many cases the problem can be adequately
resolved by using what economists call partial equilibrium analysis, which involves
focusing on the market for the taxed product and ignoring all other markets. For
example, if a small tax were to be imposed on an addictive substance, there is little
doubt that it would be borne by the users of the substance, who would pay the tax
rather than forgo use of the substance. More generally, the incidence of taxation
depends on all of the market forces at work. In a market economy the introduction of
any tax triggers a whole series of adjustments in consumption, production, the supply of
productive factors, and the pattern of foreign trade. These adjustments in turn will
have repercussions on the prices of various commodities, productive factors, and assets
that may be far removed from the area of the initial impact. In other words, a tax levied
on a certain object may affect the prices of nontaxed goods and services that are not
even used in the production of the object. Thus, the initial impact of a tax does not
indicate where the ultimate burden will rest unless one knows what repercussions the
tax will have throughout the system of interrelated economic variables—i.e., unless
recourse is made to what is called general equilibrium theory, a method of analysis that
attempts to identify and incorporate the economy-wide repercussions
and implications of taxation. In what follows, an attempt will be made to isolate some of
the factors involved.