Principles of Economics (Micro & Macro)

Principles of Economics
1 Institution of Estate Managers & Appraisers

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IBBI Syllabus on Micro Economics
Sl. No. Coverage Weight (%)

1. Principles of Economics 4%
• Microeconomics
- Consumption: Indifference Curve,
Consumer’s Surplus, Elasticity
- Price Mechanism: Determinants of Price
Mechanism, Individual and Market Demand
Schedules, Law of Demand & its Conditions,
Exceptions and Limitations of Law of Demand,
Individual and Market Supply Schedules,
Conditions and Limitations, Highest, Lowest
and Equilibrium Price, Importance of Time
Element
- Pricing of Products under different market
conditions: Perfect and Imperfect Competition,
Monopoly
- Factors of Production and their pricing: Land,
Labour, Capital, Entrepreneur and other
factors
- Theory of Rent
- Capital and Interest: Types of Capital, Gross
Interest, Net Interest
- Organisation and Profit: Functions of
Entrepreneur, Meaning of Profit and Theories of
Profit

Consumption:Indifference Curve
Consumer Surplus,Elasticity
Topic List:
Theory of Cardinal Utility
The Law of Diminishing Marginal Utility
The Law of Equi-marginal Utility
Consumer’s Equilibrium
Theory of Ordinal Utility
Indifference Curve
Budget Line
Consumer’s Equilibrium
Price Effect
Price Consumption Curve
Income Consumption Curve
Concept of Demand
Consumer’s Surplus
Elasticity of Demand
Elasticity of Supply
The consumer is assumed to be rational in the sense that he/she wants

to attain the maximum possible level of satisfaction or utility. The term
utility denotes the satisfaction which can be derived from consumption.
There were two approaches to analyse the consumer behaviour – cardianl
or Marshallian approach and the ordinal approach.
The cardinal utility theory.

According to this approach utility can be measured quantitatively. There
are few assumptions in the cardinal approach as follows:-
1) Rationality: The consumer is assumed to be rational in the

sense that he/she wants to maximize his/her total satisfaction.
2) Cardinal utility: Utility is cardinal concept i.e. it is measurable.

It can be measured by the monetary units that the consumer
wants to pay for another unit of the commodity.
3) Constant Marginal Utility of Money: This assumption is

essential for money to be a standard measure of utility.
4) Diminishing marginal utility: Marginal utility is the additional

utility which the consumer gains from consuming an additional
unit of a commodity. The assumption states that as the
consumer consumes more and more units of the same
commodity its marginal utility decreases.

5) Total utility of a bundle of goods depends on the quantities of

each commodity. Suppose there are n number of goods, then
total utility is
U=f (x1,x2,…………xn)
In earlier version it was assumed that utility of each commodity
is independent of one another, i.e.
U= U1 (x1)+U2 (x1)+…………Un (Xn)
Consumers equilibrium
Suppose the consumer is consuming a single commodity. The
consumer is in equilibrium when the marginal utility of the
commodity x is equal to the price of x.
MUx=Px is the condition for consumer equilibrium.
If MUx>Px the consumer can increase his total satisfaction by

consuming more x. If, on the other hand MUx< Px the consumer
will cut down the consumption. The consumer’s utility will be
maximized by consuming that amount of x for which
MUx=Px
Law of Equi-marginal utility : Suppose the consumer consumes more

than one commodity. In this case the condition for the equilibrium of the
consumer is the equality of the ratios of the marginal utilities to their
prices.
MUx = MUy
Px Py
If there are 'n' commodities then the above condition becomes

MU1 = MU2 = MU3 …………….MUn
P1 P2 P3 Pn
This law indicates that by spending the last unit of money either on any
commodity the consumer will get the same level of marginal utility.
Criticism of the cardinal approach
1) Utility cannot be measured by cardinal numbers. This is the most

important criticism against cardinal approach. According to the
critiques the satisfaction derived from various commodities cannot be
measured objectively.
2) Constant utility of money: This is also an unrealistic assumption. The

utility of money always changes. So money cannot be used to measure
utility from any commodity.

The ordinal utility theory: According to this theory (based on the

analysis of Prof. Hicks and Allen) utility is not measurable but it can be
ranked ordinally. The consumer is able to rank different bundles of goods
according to the satisfaction derived from each bundle. There are certain
assumptions as follows:-
Assumptions
i) Completeness: Given any pair of bundles A and B, either A is

preferred to B (A>B) or B is preferred to A (B>A) or A is
indifferent to B (AIB).
ii) Transitivity: given any three commodity bundles if A is

preferred to B (A>B) and B is preferred to C (B>C) then A is
preferred to C (A>C). Or if A is indifferent to B (AIB) and B is
indifferent to C (BIC) then A is indifference to C (AIC).
iii) Consistency: The consumer is consistent in the sense that if

he prefers A over B, then he will not choose B over A.
iv) Non-satiation: For any two commodity bundles A and B, A

will be preferred to B if A contains more of at least one good
and no less of other. This assumption holds only for normal
goods.
v) Reflexivity: This means that any bundle of goods is as good

as it self. That is A≥A.
vi) Convexity: given any consumption bundle, its better set is

strictly convex.
Equilibrium of the Consumer: To show the equilibrium of the

consumer, the concepts of indifference curve and budget line must be
given.
Indifference curve: Indifference curve is a locus of points showing

different combinations of commodities which give the consumer the same
level of satisfaction so that he/she is indifference among the difference
combinations.

An indifference curve is shown in

dy
the figure. Two commodities Y and
X are measured on the vertical and
I
dx horizontal axis. Both of the
commodities can substitute one
another, but to a certain extent.
They are not perfect substitutes.
O X
The indifference curve is represented by the curve I in the above diagram.
Marginal Rate of substitution : For any two commodities x and y the

marginal rate of substitution means the rate at which one commodity can
be substituted for another so that the consumer maintains the same level
of satisfaction. The MRS is the absolute value of the slope of the
indifference curve..
So, MRS = dy/dx
Properties of the indifference curve:
1) Indifference curve is negatively sloped: The negative slope of an

indifference curve indicates that if the quantity of a commodity x
increased then there must be a decrease in y to keep the consumer on
the same level of satisfaction.
2) An indifference curve lying above and to the right of the other denotes
higher level of utility. In this figure the indifference curves I0 I1 and I2
represent different levels of satisfaction. For example I1 denotes higher
level of utility than I0 , I2 denotes higher level of utility than I1. Bundle
b is preferred to bundle a since it contains same amount of x and
more amount of y. By the same reason bundle c is preferred to bundle
b.

Y2 C
Y1 b I2
I1
Y0 a I0
O X0 X
3) Indifference curves do not intersect: Suppose two indifference curves

I0 and I1, intersect at point a. Now a is indifferent to b since they are
on the same indifferent curve Io. By the same way a is indifferent to c
since they are on the same indifference curve I1. So by the assumption
of transitivity if a is indifferent to b and a is indifferent to c, then b is
indifferent to c. Hence b and c must be on the same indifference
curve. So two indifference curves cannot intersect each other.
C I1
b
I0
O
X
4) Indifference curves are convex to the origin. It represents the declining

slope of the indifference curves (in absolute terms) as we move along
the curve from left to righ

Budget line: The consumer has a given income which acts as a

constraint to the utility maximizing behaviour of the consumer. The
budget constraint can be written as follows:-
M= Px X + Py.Y
Where= M= Money income of the consumer.
Px = Price of X
Py = Price of Y
The above equation maybe written in other way as
Y= M Px.x
Py Py
This is the equation of the budget line. If the consumer consumes only y,
then x=0 and the consumer consumes M/Py amount of Y. If on the other
hand Y=0 the consumer consumes M/Px amount of x. The slope of the
budget line is the ratio of the prices two commodities i.e. Px./Py
AB is the budget line where OA=M/Py

A i.e. the amount of Y when the consumer
M/Py
spends his total income on Y and OB
=M/Px i.e. the amount of x when the
consumer spends the total income on x.
Px/Py is the slope of the budget line AB.
O M/Px B X
The slope of the budget line changes if there is change in price of any one
commodity.
If Px falls the budget line becomes

A flatter. In this figure, the initial budget
line was AB, now Px falls and the new
M/Py
budget line is AB1
O M/Px B B1 X

(fall in Px)
Y
A1 In this diagram the initial budget line is

A AB. Now suppose py falls. This changes
the slope of the budget line, i.e. the
M/Py
price ratio px/py. The new budget line
is A1B which is steeper than the initial
budget line AB
O M/Px B
(fall in Py )
Consumer’s Equilibrium:
Consumer wants to maximize utility subject to a budget constraint.
Alternatively it may be said that the consumer wants to attain the
highest possible level of utility (i.e. the highest possible indifference
curve) given the budget constraint (shown by the budget line). The
equilibrium point (E) is defined as the point of tangency of the budget line
with the highest possible indifference curve. At the point of tangency the
slope of the indifference curve is equal to the slope of the budget line.
Ye E
I2
I1
I0
O
Xe X
So the necessary condition for consumer’s equilibrium is

1) MRSxy = Px/Py [ MRSxy= Slope of the indifference curve]
[Px/Py = Slope of the budget line]

The sufficient condition for consumer's equilibrium is
2) Indifference curve should be convex to the origin

The condition is fulfilled by the axiom of diminishing MRS
Effects of price change on consumer’s equilibrium. Price Effect:
When the price of any commodity changes and the consumer’s money
income and the price of other commodity remain the same, then the
effect of price change on the demand for that commodity is called the
price effect.
The price effect is shown by the diagram. Initially the consumer was in
equilibrium at point E1, where the initial budget line AB was tangent to
the indifference curve E1. The consumer consumes X1 amount of
commodity X. Now suppose the price of X falls. It leads to a change in the
slope of the budget line (Px/Py). New budget line is AB2. Now the
consumer is in equilibrium at point E2, where the new budget line is a
tangent to the higher indifference curve I2. The consumer is now able to
purchase more quantity of X (X2). The change in demand from X1 to X2
resulting from a fall in the price of X is called the price effect.
I1 I2
E1 E2
O X1 B X2 B2 X
Price Effect
The price effect may be split into two separate effects: income effect and
substitution effect.
Income effect of a price change: A change in price leads to a change in

real income or the purchasing power of the consumer. The change in
demand due to the change in the real income is called the Income Effect
of price change.

Substitution Effect: Suppose there is a fall in price of X, the price of

other goods remaining the same. So X becomes cheaper than other
goods. The consumer always prefers the cheaper good and the demand
for x will rise. The effect of the change in price of x on the demand of x
keeping the real income constant is called the substitution effect.
y
A
A2 I1 I3
E1
I2
E3
E2
O X1 B X2 X3 B2 B1 X
Slutsky theorem: B. Slutsky first decomposed the price effect into income
effect and substitution effect. This is known as Slutsky theorem.
Price effect = income effect + substitution effect.
Slutsky had shown the substitution effect keeping the real income
constant so that the consumer has the power to purchase the original
bundle of goods.
The budget line changes from AB to AB1 following a fall the price of X.
The consumer now consumers X3 amount by X. The change from X1 to
X3 is the price effect. Slutsky rotates the initial budget line around the
original commodity bundle E1. The rotated budget line is A2B2.
A2B2 passes through B (initial commodity bundle) but it becomes tangent

to a new indifference curve I2 at point E2. The consumer is now able to
purchase the original bundle but consumer higher quantity of X and
X2.X1X2 is called the substitution effect. The remaining part of the price
effect i.e. X2X3 is due to the increase in the real income and is thus
called income effect.

Hicksian decomposition of price effect: Hicks has shown substitution

effect in an alternative way. Hicksian substitution effect keeps the utility
constant. To keep the consumer at the original utility level Hicks used
the compensating variation of money income.
Y
A
A2 I2
I1
E1 E3
E2
O X1 X2 B X3 B2 B1 X
The compensating variation is shown graphically by a parallel shift of the

new budget line AB to A2B2. A2B2 becomes tangent to the original
indifference curve I, at point E2. The change in consumption of X from
X1 to X2 is the substitution effect while the change in consumption of X
from XL to X3 is the income effect.
Price effect = substitution effect+ income effect

X1X3 X1X2 X2 X3

Price Consumption Curve: It shows different combinations of X and Y

consumed by a consumer when the price of any commodity (say x)
changes keeping the price of Y and the money income of the consumer
constant.
A2 PCC
E1 E3
E2
O X1 X2 B X3 B2 B3 X
a
P1 D
P2
P3 D
O X1 X2 X3 X
b
Figure a show the price consumption curve (PCC). As the price of X falls
the consumer buys different bundles given by the equilibrium points
E1,E2 and E3. Joining different points of tangency of new budget lines and

indifference curves we get the price consumption curve. We draw the

demand curve in figure (b) which relates the quantity demanded of X at
various prices of X.
Income Consumption Curve: Income consumption curve shows the

utility maximizing combination of X and Y for different income levels.
Y
A1
A2 Income Consumption Curve
A3 E3
E2
E1
I1 I2 I3
O B1 B2 B3 X
Income
M1
M2
M3
O X1 X2 X3

As the income of the consumer changes with prices of commodities fixed

there is a shift in the budget line from A1B1 to A2B2 to A3B3. With the
change in budget line, equilibrium positions (tangency of budget lines
with indifference curves) also change from E1 to E2 to E3. If we join those
equilibrium points we get the income consumption curve (ICC).
Engel curve: Engel curves show the quantity consumed at different

income levels. We can construct Engel curve from the income
consumption curve. Income is measured on vertical axis and quantity of
any commodity is measured on horizontal axis. Points like a,b and c
show the quantity consumed of any commodity (say x) at different income
levels (M1,M2,M3). If we join the points we can get the Engel curve [Engel
curve is positively sloped for normal goods and negatively slopped for
inferior good since a consumer demands less amount of inferior good as
his/her income increases.
Consumer Surplus:
The consumer surplus is a concept introduced by Alfred Marshal. It can

be measured in monetary unit. It is the difference between the amount of
money that a consumer is willing to pay to buy a certain amount of
commodity and the amount of money that the consumer actually pays for
it. With the concept of consumer surplus the benefit a consumer can get
from participating in a market can be measured.Consumer surplus can
be measured with the help of demand curve. The area below the demand
curve and above the price measures the consumer surplus in the market.
Elasticity of demand and supply
Elasticity is a measure of responsiveness of one variable to

another. Elasticities of demand and supply measure the
responsiveness of demand supply to changes in the variables
which determine demand and supply.
Elasticity of Demand
Demand for a commodity depends on many things like price of the

commodity, income of the consumers and prices of related
commodities. Elasticity of demand can be broadly classified into
three groups.
i) Price elasticity of demand
ii) Income elasticity of demand
iii) Cross elasticity of demand

i) Price elasticity of demand
Price elasticity of demand can be defined as the percentage change

in the quantity demanded resulting from the percentage change in
price. The following formula represents the elasticity of demand:
Ep = % change in quantity demanded

% change in price
= .
∆q = Change in quantity demanded

∆p = Change in price
q = initial quantity
p = initial price
Price elasticity of demand is of five types:-
a) Relatively elastic demand: ep> 1
Price
D
P1
P2 D
O q1. q2. quantity

(a)
Here the change in quantity demanded is larger than the change in price.
The shape of the demand curve is relatively flatter. From this figure (a) we
see that a small change in price from P1 to P2 results in a large change
in quantity demanded from q1 to q2.
b) Relatively inelastic demand : ep<1

Price
D
P1
P2
D
O q1. q2. quantity

(b)
Sometime the change in the quantity demanded for some commodities

are smaller than the change in the price of the commodity. The demand
is then called relatively inelastic. The shape of the demand curve (fig. b) is
steeper. The large change in price from P1 to P2 results in a small change
in quantity from q1 to q2.
c) Unitary elastic demand: ep= 1
Price
d
P1
P2 d
0 q1 q2
Here the percentage change in quantity demanded is equal to the

percentage change in price. The shape of the demand curve is
rectangular hyperbola.
d) Infinitely elastic demand ep = ∞
Price
P1 D
O quantity
(d)

Here a small change in price leads to an enormous change in demand.

The demand curve is horizontal.
e) Completely inelastic demand : ep=0
Price D
O a quantity
Here the quantity demanded is fixed whatever may be the price. The
demand is called completely inelastic and shape of the demand curve is
vertical.
The price elasticity of demand is usually negative since there is an

opposite relation between the price of a commodity and the demand for it.
Price
D ep= ∞
ep=1
ep=0
O D1 quantity
A negatively sloped demand curve may have different elasticities at

different points on it. The elasticity at any point of the demand curve may
be found by the following formula.
ep= lower segment of the demand curve / upper segment of the demand
curve.
ep=∞ at the upper most point of the demand curve. ep=1 at the mid point
of the demand curve and it becomes zero at the lower most point of the
demand curve.
ii) Income elasticity of demand (em)

It measures the responsiveness of the demand with the change in
consumer's income
em = % change in quantity demanded
% change in income

= .
Where ∆m =change in income of the consumer

m =Initial income of the consumer
∆q = Change in quantity demanded
q = Initial quantity
The income elasticity of demand is positive for normal goods, but

negative for inferior goods since as consumer’s income increases he/she
prefers more amount of a normal good but in case of inferior good they
prefer to buy superior quality of goods instead of inferior good.
ii) Cross elasticity of demand
Cross elasticity of demand measures the responsiveness of a particular

commodity x with the price of a related commodity y
exy = % change in quantity demanded of x

% change in the price of y.
or exy = . py/qx
Where qx= change in quantity demanded of x

qx= initial quantity demanded of x
∆py = change in price of y
Py = initial price of y
Commodities are related in two ways. Either two commodities are

substitutes of one another (like coke and pepsi) or they are complements
of one another (like pen and ink). The cross elasticity of demand is
positive in case of substitutes since the rise in price of pepsi increases
the demand for coke. On the other hand the cross elasticity is negative
for complements since the rise in price of petrol may reduce the demand
for car.
Elasticity of supply: Elasticity of supply measures the responsiveness of

quantity supplied with the change in price. It may be defined as the
percentage change in quantity supplied resulted from the percentage
change in price.
es= % change in quantity supplied

% change in price

Elasticity of supply is of five types:-
i) Relatively elastic supply: es > 1
Price
S
P2
P1
O q1 q2 Quantity
Here the change in quantity supplied is much greater than the change in
price. The supply curve is relatively flatter. The small change in price
from P1 to P2 results in large change in the quantity supplied from q1 to
q2.
ii) Relatively inelastic supply es <1:
Price S
P2
P1
O S q1 q2 Quantity
Here the responsiveness of supply is smaller. A large change in price

from P1 to P2 results in a small change in quantity supplied from q1 to
q2. The supply curve is steeper.
iii) Unitary elastic supply es =1
Price S
P2
P1
O q1 q2 Quantity
Here the percentage change in quantity supplied is exactly equal to the

percentage change in price. Here the supply curve passes through the
origin.

d) Infinitely elastic supply : es = ∞
Price
P S
Quantity
Here the elasticity of supply is infinitely elastic. The supply curve is

horizontal.
e) Completely inelastic supply : es =0
Price
O a Quantity
Some commodities may be fixed in supply. There will be no change in the

quantity supplied whatever may be the change in price. The supply is
completely inelastic and the supply curve is parallel to the vertical axis.
The concept of elasticity of demand and supply is very much necessary

for different reasons. It helps the producer to set prices for the
commodity, it helps government to take various decisions like imposition
of sales tax. It also helps the labour union to take decision about the
demand for the increase in wage rate. The elasticity of demand is also
very useful for the devaluation policy taken by the government to solve
the problem of adverse balance of payment.

MICROECONOMICS PRACTICE TEST

MICROECONOMICS MULTIPLE – CHOICE QUESTIONS
1. Marginal rate of substitution is

a) Slope of the demand curve
b) ✔Slope of the indifference curve
c) Slope of the supply curve
d) Slope of TP curve
2. Shape of the indifference curve is

a) Straight line
b) Concave to the origin
c) ✔Convex to the origin
d) Positively sloped
3. Slope of budget line shows

a) ✔Price ratio of two commodities
b) Incomes of two consumers
c) Prices of factors of production
d) Incomes of factors of production
4. Budget line becomes flatter means

a) ✔Price of X falls
b) Price of X rises
c) Price of Y falls
d) Price of X remains the same
5. Consumer's equilibrium means

a) Maximisation of profit
b) Minimisation of cost
c) ✔Maximisation of Utility
d) Minimisation of profit
6. Price elasticity of demand measures the responsiveness of demand

due to the change in
a) ✔Price of the commodity
b) Income of the consumer
c) Price of related commodities
d) Population
7. Relatively elastic demand has the magnitude

a) ep<1
b) ep=1
c) ep=0
d) ✔ep>1

8. Unitary elastic demand has the shape

a) Relatively flat
b) Relatively steep
c) Parallel to the x axis
d) ✔Rectangular Hyperbola
9. Which of the following statements is false

a) Price elasticity of demand depends on the nature of the
commodity
b) Price elasticity of demand depends on the nature of the
commodity.
c) Price elasticity of demand depends on the availability of
substitutes
d) ✔Price elasticity of demand depends on cost of production
10. Which of the following commodities has less elasticity of

demand?
a) Valuable ornaments
b) Electricity
c) ✔Medicine
d) Soft drink
11. Which of the following commodity has perfectly inelastic

supply?
a) Cereals
b) Automobile
c) Digital camera
d) ✔Historical monuments

Price Mechanism
Topic List:
Determinants of Demand
Demand Function
Laws of Demand
Demand Curve
Change in Demand and Change in Quantity Demanded
Exceptions to the Laws of Demand
Concept of Supply
Determinants of Supply
Supply Function
Laws of Supply
Supply Curve
Change in Supply and Change in Quantity Supplied
Importance of Time Element
Market Mechanism
The prices and quantities of commodities are determined by the

interaction of demand and supply. Here we discuss the concepts of
demand and supply and the determination of equilibrium price and
quantity.
Concept of demand: Demand for a commodity means the desire to get

the commodity backed by the purchasing power of the consumer.
Determinants of demand:
a) Price of the commodity: The most important determinant of

demand is the price of the commodity. The demand for a
commodity is negatively related to its price. The consumer
demands more commodities when its price falls and less
when its price rises.
b) Income of the consumer: Demand for normal goods is

directly related to consumer's income. Given the price of the
commodity an increase in income induces the consumer to
buy more.
c) Prices of related commodities: Commodities are related in

two ways. Either they are substitutes like tea and coffee or
they are complements like pen and ink. The prices of related
commodities influence the demand for any commodity. For
example, the rise in the price of coffee results in the fall in
the demand for coffee and rise in the demand for tea.

d) Taste and Preference: The demand for any commodity is

influenced by the taste and preference of the consumer.
Sometimes the pattern of consumer’s preference may change
, this results in a change in the demand for a commodity.
e) Price expectations: If the consumer thinks that there will be

a rise in price for a commodity in future, then he/she will
demand more commodities at present.
The above five factors influence the individual demand. There

are some other factors which determine the aggregate
demand also.
f) Population: The aggregate demand of a country depends on
the total population of a country. Increase in population
leads to increase in total demand.
g) Income Distribution: It also influences the aggregate demand

of a country. If there is inequality in the income distribution
the demand for luxury items may increase. But if there is
equality in the income distribution demand for all items may
increase.
Demand function
The interdependence between demand for a commodity and the
other variables can be expressed in the following expression.
Dx = f (Px, Py, M,T,Pe)
Where
Dx = Demand for x
Px = Price of x
Py = Price of other commodities
M= Income of the consumer
T= Taste and preference of the consumer
Pe= Price expectation
To determine the effect of only price changes on demand we have to

assure that all other factors except the price of the commodity will
remain same. This condition is called ceteris paribus condition.
Under this assumption the above function become as follows:-
Dx = f (Px)
Law of Demand: The law of demand states that other things

remaining the same the demand for any commodity rises with the
fall in the prices and falls with the rise in the prices.
Demand schedule and demand curve

Individual demand schedule: It is a chart showing the quantity
demanded for a particular commodity at different prices. It shows
an individual’s demand.

Price (Rs) Demand (Kg)
5 10
10 8
15 4
20 2
An individual demand schedule
Price
20 d
15
10
5 d
0 2 4 6 7 8 10 Quantity
Individual demand curve
Individual Demand Curve: Individual demand curve is drawn with the

help of individual demand schedule. The price of the commodity is drawn
on the vertical axis and the quantity of the commodity is drawn on the
horizontal axis. Each point of the demand curve shows the combination
of price and quantity demanded at the price. The demand curve slopes
downward from left to right. This downward sloping demand curve shows
the inverse relationship between the demand and price. When the price of
the commodity is Rs.20, the demand is 2 kg and when the price is Rs/15,
the demand is 4 kg. It shows that as the price falls the quantity
demanded rises and vice versa.
Market Demand Schedule: The market demand schedule shows the

total demand for a commodity in the market at different prices. Suppose
there are two individuals in the market each one of them demands
different quantities at different prices. Then we can get the market
demand by summing up the individual demands at different prices.

Price P (Rs) Demand of Price1 Demand of 2 D2 Market Demand

D1 (Kg) (Kg) DM=D1+D2
5 4 6 10
10 3 5 8
15 2 4 6
20 1 3 4
We can draw the market demand curve by horizontal summation of

individual demand curves. The following figure shows the market
demand curve which we can draw by summing up the individual demand
curve. Here D1 represents the demand curve of individual 1, and D2
represents the demand curve of individual 2 and Dm represents the
market demand curve.
Price
20 D1 D2 Dm
15
10
0 2 4 6 8 10 12 Quantity
Market demand curve from individual demand curve
Change in demand and change in quantity demanded:

There is difference in meaning between change in demand and
change in quantity demanded.
1) Change in quantity demanded: when the price of a commodity

increases its demand falls and when its price decrease its demand
rises. This is called the change in quantity demanded. In this
situation all other factors are assumed to remain the same. Change
in quantity demanded can be shown by the movement along the
demand curve.

Price
a
P1
P2 b
D
O Q1 Q2 Quantity
Suppose the price falls from P1 to P2 then there is an increase in

quantity demanded from Q1 to Q2. This can be shown by the movement
along the demand curve from point a to point b. the rise in the quantity
demanded is called extension of demand and fall in quantity demanded is
called contraction of demand.
2) Change in Demand: Suppose the price of the commodity remains fixed

and any one of the other factors change. Then there will be change in the
level of demand schedule and this is called the change in demand. It can
be shown by the shift of a demand curve.
Price
D2 D D1
D2 D D1
O q2 q q1
The change in demand is shown in the above figure. Initially the

demand curve was DD. The consumer demanded 0Q quantity OP

price. Now suppose the income of the consumer increases. The

consumer is able to purchase 0q1 quantity at the same price OP.
As a result the level of his demand changes. This is shown as the
rightward shift of the demand curve. This is called increase in
demand. Similarly if the consumer demand less quantity at the
same price then there is a decrease in demand and this is shown
as the leftward shift of the demand curve.
Exceptions to the laws of demand:
Some commodities do not follow the law of demand. They are called
the exception to the law of demand. Some of these commodities are
listed below.
i) Veblen effect: Some buyers think that commodities with

higher prices have better quality. The increase in prices
induces them to purchase those commodities.
ii) Bandwagon effect: Consumer’s demand is affected by the

taste and preferences of his neighbours, friend or the class
in which he belongs. In such a situation the consumer
may increase the demand for a particular commodity
which is very expensive.
iii) Snob effect: The snobbish nature of a consumer may

induce him to purchase commodities which have high
prices.
iv) Giffen effect: Giffen good is a special type of inferior good

for which the demand curve is upward sloping i.e. as the
price of good falls, the demand for it also falls and as the
price rises, the demand for it also risen. This effect was
observed by sir Robert Giffen.
Supply
Definition: By supply of a commodity we mean the quantity

of a commodity that a seller is willing to supply at a
particular price. This is the amount which the firm is willing
to sell, not the actual amount sold.
Determinants of supply
a) Price of the commodity: There is a direct relationship

between the price of a commodity and the quantity
supplied of that commodity. If there is a rise in price the
seller wants to supply more to earn higher profit.
b) Prices of Inputs: Different types of inputs are required to

produce a commodity. If prices of the inputs increase,

other things remaining the same, the firm will supply less
because the profitability of the product falls with the rise
in the input price.
c) Technology: Better technology improves the productivity

of any commodity and therefore supply will rise.
d) Government Policy: Government policy like imposition of

sales tax may influence supply.
e) Number of firms: Entry of new firm in the industry

increase industry supply.
Supply function: The interdependence between the supply of a

commodity and the other variables can be expressed in a
functional form.
Sx = f (Px, C, T,G)
Where
Sx= Supply of a commodity x
Px= Price of x
C= cost of production
T= Technology
G= Government policy
To determine the relation between the supply and the price of

a commodity we assume all other factors to remain constant.
Then the supply function becomes as follows:-
Sx= f (Px)
Law of supply: The law of supply states that other things

remaining the same the supply of a commodity rises with the rise
in price and falls with the fall in price.
Supply schedule: It is a chart showing the price of a commodity

and quantity supplied of it.
The following chart is an individual supply schedule which

shows the quantity supplied by an individual producer with
the change in price.
Individual supply schedule
Px (Rs) Sx (Kg)
5 10
10 20
15 30
20 40
25 50

Market supply schedule
We can find the market supply by summing up the individual supplies.

Suppose there are two individuals in the market each one of them
supplies different quantities at different prices. The market supply can be
determined by adding up the quantities supplied by two individuals.
The following schedule describes the market supply. Px is the price of a

commodity x. S1 is the supply of x by individual 1 and S2 is the supply of
x by individual 2. Sm = S1+ S2
Px (Rs) S1 (kg) S2 (kg) Sm=S1 +S2

10 1 3 4
20 2 4 6
30 3 5 8
40 4 6 10
50 5 7 12
Supply curve: Supply curve is a diagrammatical representation of the

relation between price of a commodity and quantity supplied of it. We can
draw the individual supply curve with the help of individual supply
schedule. Price of the commodity is drawn on the vertical axis and the
quantity supplied is drawn on the horizontal axis.
Price
S
25
20
15
10
0 10 20 30 40 50 Quantity
Individual supply curve
Market supply curve: Market supply curve shows the total supply
at different prices. It can be drawn by the horizontal summation of
the individual supply curves. We can draw the market supply curve

with the help of market supply schedule S1S1 is the supply curve
of individual 1, S2S2 is the supply curve of individual 2 and SmSm
is the market supply curve.
Price
S1 S2 Sm
50
40
30
20
10 S1 S2 Sm
0 1 2 3 4 5 6 7 8 9 10 1112 Quantity
Market supply curve
Change in quantity supplied and change in supply: Change in

quantity supplied and the change in supply are used for different
meanings.
Change in quantity supplied: when the price of a particular commodity

changes, there is a change in the quantity supplied. This is shown by the
movement along the supply curve. An increase in price results in an
increase in quantity supplied and this is called extension of supply. A
decrease in the price results in a fall in the quantity supplied which is
called contraction of supply. This is shown in the diagram below:

Price
s
P2
P1
0 q1 q2 Quantity
Change in supply: Sometimes it may happen that the price of a

commodity remains same but other factors (prices of inputs,
technology) may change. These changes induce the change in the
level of the supply schedule and it can be shown by the shift of the
supply curve. The rightward shift of the supply curve shows the
increase in supply and the leftward shift of the supply curve shows
the decrease in supply. The rise in input prices may cause the
decease in supply and the improvement of technology may increase
the supply.
Price
S2 S S1
S2 S S1
O q2 q q1 Quantity
Change in supply
Exceptions to the law of supply
1) Fixed supply: Some goods may be fixed in supply. For example, the
original paintings by Abanindranath Tagore. In that case the supply
remains fixed what ever may be the changes

P S
O S Q
2) Supply curve of labour:
Supply curve of labour shows a peculiar behavior of labourers. They

offer extra hours of labour as the wage rate increases. But after some
level of wage rate, further increase in wage rate induces them to prefer
more leisure hour than work hour. Thus the supply curve is upward
slopping up to some point (Up to wage rate w2) and then it becomes
negatively sloped. Therefore the supply curve of labour is backward
bending.
W
SL
w3
w2
w1
o L3 L1L2
Market mechanism: The market price is determined by the interaction of

supply and demand. The demand and supply curves show the choices of
consumers and producers. The equilibrium is reached when the supply
curve intersects the demand curve at point E. Equilibrium price is
determined when the market clears i.e. there is no excess supply or
excess demand. Pe is the equilibrium price where D=S. Any price other
than Pe results in either excess demand or excess supply.

Price
D S
Pe E
S D
O qe Quantity
Suppose the price P1 is higher than the equilibrium price Pe. At the
higher price there will be an excess supply. This leads the price to fall. As
a result the quantity demand increases, the quantity supplied decreases
until the equilibrium price is reached.
The opposite will happen when the price P2 is less than the equilibrium
price Pe. At a lower price consumers will demand more and producers
will reduce their supply. This leads to an excess demand.
Price
Excess Supply
D S
P1
Pe E
P2
S Excess Demand D
O qe Quantity

As a result the price is pushed up. This leads to fall in demand and rise
in supply until the price reached to the equilibrium level.
The effect of changes in demand and supply on equilibrium price

and quantity.
I)Change in demand: There maybe an increase or a decrease in demand.

The effect of this change can be explained with the help of the diagrams.
Figure A describes the effect of an increase in demand on equilibrium
price and quantity. The increase in demand leads to a rightward shift of
the demand curve to D1D1. The supply curve cuts D1D1 at point E1.
Price
D1
D S
P1 E1
Pe E
D1
S D
O
qe q1 Quantity
(a)
Price
D S
D2
Pe E
P2
E2
S D
D2
O q2 qe Quantity
(b)

Figure (b) shows the decrease in demand by the leftward shift of the
demand curve to D2D2. It leaders to a new equilibrium E2, where the
market clears at lower price P2 and lower quantity q2.
II) Change in supply: (i) Increase in supply: It leads to the rightward

shift of the supply curve to S1S1. At the new equilibrium E1 the price is
lower and the quantity is higher.
(II) Decrease in supply: There will be a leftward shift of the supply
curve. it leads to a new equilibrium position with higher price and lower
quantity.
Price
D S
S1
Pe E
P1 E1
S D
S1
O
qe q1 Quantity
Price
D S2
P2 E2
P1 E
S2 D
S
O
q2 q Quantity

III) Change in Both demand and supply: Generally price and

quantity will change depending on the change in demand and supply. In
this figure the increase in demand is more than the increase in supply. It
leads to a new equilibrium position where both price and quantity
increase.
Price
D1
D S
S1
P1 E1
Pe E
D1
S D
S1
O qe q1 Quantity


1. One example of the exception to the law of demand

a) Fish
b) ✔Jewellery
c) Train ticket
d) Fruits
2. Shift in demand curve of a particular commodity is caused by

a) Price of the commodity
b) ✔Change in price in related commodity
c) Fall in price of the commodity
d) Rise of the price of commodity
3. Movement along the individual demand curve for any commodity is

caused by
a) Change in consumers income
b) Change in the price of substitute
c) ✔Change in the price of the commodity
d) Change in taste and preference of the consumer
4. Give an example of substitute goods

a) Tea and sugar
b) Pen and ink
c) Car and petrol
d) ✔Coke and Pepsi
5. When the price of a commodity falls there is a

a) ✔Downward movement along the demand curve
b) Upward movement along the demand curve
c) Shift of the demand curve to the right
d) Shift of the demand curve to the left
6. Increase in the consumer’s income causes

a) Leftward shift of the demand curve
b) ✔Rightward shift of the demand curve
c) Downward movement along the demand curve
d) Upward movement along the demand curve
7. Give one example of the exception to the law of demand

a) Seasonal vegetables
b) Clothes for daily use
c) ✔Expensive car
d) Story book

8. Supply curve of a normal good is

a) ✔Upward sloping
b) Vertical
c) Horizental
d) Downward sloping
9. Rightward shift of a supply curve is caused by

a) Rise in the price of the commodity
b) ✔Fall in the price of inputs
c) Fall in the price of the commodity
d) Restrictive government policy
10. Movement along a supply curve indicates

a) ✔Change in the quantity supplied
b) Change in supply
c) Increase in supply
d) Decrease in supply
11. Supply curve of labour is

a) Upward sloping
b) Downward sloping
c) Vertical
d) ✔Backward bending
12. Vertical supply curve represents

a) Supply of normal good
b) Supply of labour
c) ✔Fixed supply
d) Unlimited Supply
13. When market price is higher than the equilibrium level, it

leads to
a) Excess demand
b) ✔Excess supply
c) Consumers surplus
d) Market equilibrium
14. When market price is below the equilibrium level, it leads to

a) Excess supply
b) ✔Excess demand
c) Producers surplus
d) Excess profit
15. Rightward shift of the demand curve is caused by

a) Fall in the price of the commodity
b) Fall in consumers income
c) ✔Rise in the price of substitute good

d) Rise in the price of complementary good
16. Leftward shift in the demand curve is caused by

a) ✔Fall in consumers income
b) Rise in the price of the commodity
c) Rise in the price of the substitute good
d) Fall in the price of complementary good
17. In case of inferior good rise in consumers income leads to

a) Demand for the commodity increases
b) ✔Demand for the commodity decreases
c) Demand for the commodity remains the same
d) Supply of the commodity rises
18. Equilibrium price is determined by the equality of

a) Market demand and cost of production
b) Market supply and consumers income
c) ✔Market demand and market supply
d) Consumer income and cost of production

Pricing of products under different

Market conditions
Topic List:
Perfect competition
Monopoly
Monopolistic Competition
Oligopoly
The Market is an institution where buyers and sellers interact with each
other to exchange a well defined product on the basis of a contract. From
the point of view of a buyer the market consists of numbers of sellers who
sell a well defined product and from the stand point of a seller the market
consists of a number of buyers to whom a well –defined product can be
sold. The main functions of a market for a commodity are to determine
the quantity of the commodity to be bought and sold and to determine
the price of the particular commodity at which the commodity can be
bought and sold.
Industry is a group of firms that sell a well defined product. For example
Iron and Steel industry, Aluminum Industry, Automobile Industry,
Pharmaceutical Industry etc. For convenience economists have categorize
different types of market forms like perfect competition, monopoly and
oligopoly.
In this chapter we will discuss perfect competition. Other forms of
markets will be discussed in chapter 7 and 8.
Total Revenue:
Average Revenue and Marginal Revenue in perfect Competition.

Total Revenue (TR) TR is the amount of money that a firm receives by
selling its output. Total Revenue is calculated by multiplying the total
quantity of output sold by the price per unit of output.
Therefore
TR = P x Q
Where Q = Total Quantity of output sold
P = Price of the output
In perfect competition a firm is a price taker. It means the price is fixed
by the market and the individual firm has to accept it.
Average Revenue: Average Revenue is the amount of money

received per unit of output.
AR = TR / Q = P x Q /Q = P
Average Revenue is the total revenue divided by the number of output

sold. So it in clear that average revenue is the price of the commodity.

Marginal Revenue (MR) It is the rate of change of total revenue due

to the change in the quantity of output sold.
Therefore,
MR = d R /d Q
The MR resulting from the sale of nth unit of output is thus
MRn = TRn – TRn – 1
The following table shows TR, AR, and MR of a firm under perfect
competition.
Q P TR AR MR
1 20 20 20 20
2 20 40 20 20
3 20 60 20 20
4 20 80 20 20
5 20 100 20 20
6 20 120 20 20
We can draw TR, AR and MR from the above data
TR
AR
MR
TR
120
100
80
60
40
20 AR =
MR
Total revenue is an upward sloping straight line from the origin. The AR =
MR and they are a straight line parallel to the horizontal axis. This is the
demand curve facing by the

firm under perfect competition. The shape of the demand curve indicates
that the firm can sell any amount of output at the prevailing market
price.
The model of perfect competition is based on some assumptions.
1) Number of buyers and sellers: There are large number of sellers and
buyers in perfectly competitive industry. For this reason neither the
sellers nor the buyers can influence the market price. The individual firm
under perfect competition is a price – taker.
2) Nature of the product: The products sold in the perfectly competitive

market is homogeneous in nature. For the homogeneity of the product
the buyers are indifferent to the firms from which they buy the products.
3) Entry and Exit of firms: There is no barrier to entry and exit of the firm
from the perfectly competitive industry. This freedom of entry and exit
ensures that only the efficient firm can survive in the long-run. The firms
can earn only normal profit in the long-run.
4) Goal of the Firm: The goal of the firm is profit maximization.
5) Perfect knowledge: All sellers and buyers have perfect knowledge about
the conditions of the market. This implies that there must be close
contact between sellers and buyers.
6) Perfect mobility of factors of profit: It is assumed that in perfect

competition there is perfect mobility of the factors of production. ie,
factors of production can move from one firm to another without any
restriction.
Profit Maximisation:
The principal goal of the firm under perfect competition is to maximize

profit. Profit is the difference between total revenue and total cost. Since
the normal profit is included in the cost of the firm, the difference of TR
and TC is above the normal rate of profit.
The firm is in equilibrium when it produces the output at which the

difference between TR and TC is maximum. In (fig 2) TR is the total
revenue curve of the firm. TC is the total cost curve of the firm.
TR is a straight line from the origin showing the constant price at all
levels of output. The slope of the TR curve is marginal revenue (MR)

which is equal to the price. TC curve reflects the laws of variable

proportion. The slope of TC curve is marginal cost (MC).
C TC TR
R
Profit (II)
O Q1 Q2 Q3 Q
Fig 2
The firm maximizes profit at Q2 level of output where the profit (II) (II =
TR – TC) i.e, the difference between TR and TC is greatest. The firm will
start production at the Q1 level of output where TR = TC since at a lower
level of output than Q1. TC>TR and the firm incurs loss. The firm will
product upto the level of Q3 because at the output larger than Q3 MC>MR
and the firm will make loss. Within Q1 Q3 level of output TR>TC and
there is positive level of profit. The firm earns maximum level of profit at
Q2 level of output. At Q2 the slope of TR curve = Slope of TC curve. So
the condition for profit maximization is
Slope of TR = Slope of TC
or MR = MC
Short – run equilibrium of a firm under perfect competition :
We have already discussed the condition for profit maximization (MR =

MC). Now we will explain this condition for attaining equilibrium. The

following figure shows MR and MC curves of a firm under perfect

competition.
P
C MC
R
MC>MR
(fig 3)
e’ e
P P=MR
MC<MR
O q0 qe q1
Fig 3
The firm is in equilibrium at point e where MC intersects with MR curve.

The output is qe at the equilibrium. To the left of e profit is not maximized
since at qe level of output MR>MC and the firm will expand its output. To
the right of e, ie, at output level q1, MC>MR and the firm will out down its
production. So only at point e, ie at qe level of output total profit is
maximized.
The first condition is thus

MC = MR
But sometimes it may happen the first condition is fulfilled and yet the
firm is not in equilibrium.
This situation is shown in (fig 3) at point e’. At point e’ the condition of

equality between MR and MC is fulfilled but still the firm is not in
equilibrium. At the left of e’ MC>MR, so the firm will cut down its
production and there is a further deviation from point e’. Similarly at the
right of point e’ MR>MC and the firm will expand its production and there
is a deviation from e’. So e’ cannot be considered as an equilibrium
position. So there must be a second condition for equilibrium. This
condition is MC must be rising at the point of equilibrium.
The slope of MC > The slope of MR

Or MC cuts MR from below. This is called the sufficient condition for
equilibrium.

The short run equilibrium of a firm under perfect competitor

requires two conditions.
i) MC = MR ( Necessary condition)
ii) (Slope of MC ) > (Slope of MR) (Sufficient condition)
Profit and Loss of a firm in the short –run
A firm can earn normal profit and super normal profit in the short
– run. The firm may incur loss in the short run but yet it may continue
its production as long as it covers its variable cost. The following section
will discuss the situation.
i) Firm earning super normal profit in the short. run
The firm will earn supernormal profit when the average revenue or price
is greater than the average cost of the firm.
P
C SMC
R SAC
P e MR=P
profit
A B
(fig 4)
O q Q
Fig 4
In (figure 4) the short- run equilibrium of a firm is at point e where SMC

(short-run marginal cost) curve cuts MR from below. The output level is
oq and price in op.
SAC is the short-run average cost curve. The average cost of the firm at
oq level of output is OA. So the total cost is

TC = AC x Q = OA x OQ
= The area of the rectangle OABq.
oq amount of output is sold at op price.

So the total revenue is
TR = op x oq = Area of OPeq.
Therefore supernormal profit earned by the firm is

= TR- TC = OPeq – OABq
= ApeB
ii) Firm earning normal profit in the short. run
Normal profit of a firm is included in the cost of production. So the firm

will earn normal profit when the price is equal to the average cost of
production. Figure (5) shows short run equilibrium of a firm earning
normal profit.
P
R SMC SAC
C
e
P MR = P
(fig 5)
O q Q
Fig 5
The firm is in equilibrium at point e where SMC cuts MR from below. The
output is oq. Ate, P = SAC. So the firm earns only normal profit.
iii) Firm incurring loss in the short. run

It is not necessary that the firm makes supernormal or normal
profit in the short-run. It may also incur loss and still continues its
production only if it covers its variable cost. The firm will close
down when price is equal to the average variable cost. The point of
equality between the price and AVC is called the ‘shut-down’ point.
Figure 6 shows the equilibrium situation of a firm incurring loss.

P
R
C SMC
SAC
D
C
SAVC
e P=MR
(fig 6) B
e*
A
O q Q
Fig
SAC curve lies above the price or MR curve. At equilibrium (point e) the
firm incurs loss since SAC>P. The loss is equal to the area BC DC. But
the firm will still continue its production because the price is above the
average variable cost. SAVC is the short-run average variable cost curve.
But if the price falls down to OA, the firm will close down because at e*8
P = OA (minimum average variable cost. Point e* is called the shut down
point.
Short- run supply curve of a firm under perfect competition
Supply curve of a firm shows the amount of output produced

at each level of price. The short – run supply curve is derived by the
equilibrium points (ie, the point of intersection of MC curve with
successive demand (MR) curves ) of the firm. The rising portion of the MC
curve above the minimum average variable cost curve is considered as
the short – run supply curve of a firm under perfect competition.

P
R MC
C
SAC
SAVC
e2
P2
P1 e1
P=AVC e
(fig 7)
Q
O q q1 q2
Fig 7
The firm will not supply any quantity if the price falls below P=AVC. If the
price is at P1 the firm will supply q1 level the output where the MC cuts
MR curve at e1. Similarly if price rises to P2 the supply of the firm (q2 ) is
determined by the point of intersection of MR with MC at e2. So MC
curves shows the amounts of supply by a firm at different levels of
output. So this is the short-run supply curve of a firm.
Short-run equilibrium of the industry
Given the market demand and market supply the equilibrium

of industry is determined when the market demand equals to the market
supply. The market supply curve is a straight line having positive slope.
It is the horizontal summation of the supply curves of firms in the
industry. The market demand

curve is a downward sloping straight line even though the demand curve
faced by the firm is horizontal to x axis. Short-run industry equilibrium
is shown in (fig 8).
D S
e
Pe
(fig 8)
S
D
O qe Q
Fig 8
Industry is in equilibrium at price Pe where quantity demanded and
supplied is qe.
Long – run equilibrium of the firm under perfect competition
The firms are in long-run equilibrium when they produce at the

minimum point of the long-run average cost curve. The LAC curve will be
tangent to the MR or demand curve at the point of equilibrium and the
firm will earn just normal profit.
We will discuss the long run equilibrium with the help of a diagram
in (figure 9). If the firm earns excess profit in the short-run, it will attract
new firms in the industry. There will be an increase in market supply and
this leads to a fall in price. This process will continue until the demand
curve defined by the market price will be tangent to the LAC curve. The
excess profit will be wiped out and the firm will earn just normal profit.

S S1
D
SMC
e P SAC LMC LAC
P MR
e1
P1 P1 MR1
e
S
S1 D
(a) (b)
Industry Firm
Fig 9
Fig 9a shows that initially industry was in equilibrium at point e where

price was at P. At this price the firm was earning excess profit working
with the cost SAC. This excess profit induces the firm to expand its
production and it moves along its LAC curve. At the same time new firm
enter into the industry. The industry supply increases and the supply
curve shifts to the right at S1S1. New industry equilibrium (e1) will be
reached at price P1. The firm will be in long run equilibrium since at price
P1, LAC becomes tangent to the MR line and the firm will earn only
normal profit. So the condition for long –run equilibrium of the firm
under perfect competition is
LMC = LAC = P = MR
Long – run supply curve of the industry
We have already discussed the short –run supply curve of firm and
industry in previous section. In this section the shape of long –run
supply curve will be discussed.
Suppose initially the industry is in equilibrium at price P. Now the
demand increases for some reason and the demand curve shifts to the
right (fig10). This causes a rise in the price level to P1. The firm at this
higher level of price earns excess profit. This profit attracts new firms to
enter into the industry. The increased supply result in a rightward shift
of the supply curve. This leads to a fall in the market price. The price
may remain above the initial level as remains same as the initial level or
may fall below it. This depends on the cost conditions of the industry.

P
P
LMC LAC
D D1 S
P1 P1 MR1
e
P G
MR
P
S
O Q O Q
Fig 10
There are three types of industries, (i) Constant Cost, (ii) increasing cost
and (iii) decreasing cost. Constant cost industries are those industries
where the prices of factors of production remain unchanged as the
industry expands. An industry is increasing cost industry when the
prices of factors of production increase with the expansion of industry
output. An industry is decreasing cost industry when the prices of factors
of production decline when industry output expands.
Constant Cost Industry:
Figure (10) shows the derivation of the long-run supply curve. The
industry is in equilibrium at point E1 of 10b when market demand D1D1
intersects market supply. Now suppose the market demand increases
shifting the demand curve to D2D2. The price rises from P1 to P2 . The firm
will enjoy an excess profit at the high price. The excess profit induces the
existing firms to expand their output and new firms to enter in the
industry. This causes the shift in the supply curve to S1 S2. New industry
equilibrium is at point E2. The expansion of industry output results in an
increased demand for factors of production. But in a constant cost
industry this increased demand does not raise the price paid to the
factors of production. So the LAC curve does not shift upward. So the
new equilibrium E2 will be at the initial price level. By the same way we
can get other equilibrium points like C,D. Joining these points we can get
the long – run supply curve for a constant cost industry. It will be a
straight line parallel to the horizontal axis.

LMC
D1 D2 D3 D4
S1 S2 S3 S4 SMC
LAC
SAC
P1 P1
P LR P
MR
Supply curve e
E1 E2 E3 E4
( Fig 10)
O q q1 Q O
Q
(a) (b)
Industry Firm
Fig 11
Increasing Cost Industry
The long-run supply curve of an increasing cost industry is upward

slopping indicating the increased prices of factors of production or the
industry output expands.
This is shown in (figure 11). Here the increased demand for factors
of production shifts the LAC of all firms upward and the LMC of all firms
leftward with the increased factor prices. This will lead to a leftward shift
in the market supply. But at the same time new firms enter in the
industry shifting the supply curve rightwards. As a result the price will
fall but still it remains above the initial level since the increase in supply
will not be equal to the increase in demand. Joining different points ( E1,
E2, E3 ) of intersections of shifted demand and supply curve line get the
LR industry supply curve. The LR supply curve of increasing cost
industry is an upward sloping curve.

P P
D1 D2 D3 S1 S2 S3
LMC2
LAC2
P E3 P
LMC1
LAC1
E2 LR supply curve
E1 P1
e
(Fig 11)
S1 S2 S3 D1 D2 D3
O Q O
(a) (b)
Industry Firm
Fig 12
Decreasing Cost Industry

The long-run supply curve of a decreasing cost industry is negatively
sloped indicating the falling prices of factors of production as industry
output expands.
The derivation of long-run supply curve of a decreasing cost industry is

shown in figure 12. As the market demand increases there will be a rise
in the market price and individual firms will earn excess profit. This
induces the existing firms to increase their skill and new firma to enter in
the industry. This improved skill leads to a fall in the factor cost. The
firms enjoy external economies of scale. For this reason the cost curves of
individual firms move downwards. The rise in supply ( S1 to S2 ) is so
large in comparison with a rise in demand (D1 to D2 ) that the market
price falls. Joining different equilibrium points we get negatively sloped
long-run supply curve of a decreasing cost industry.

P P
LMC1
D1 D2 D3 LAC1
LAC2
(Fig 12) LMC2
E1 LRS
E2
E3
O Q O Q
( Industry) (Firm)
Fig 13
Effects of taxation:
Imposition of sales tax: This tax means a given amount of

money per unit of output produced.
The imposition of the tax shifts the MC curve of the firm which is also the
supply curve of the firm upward to the left by the amount of the tax. This
is shown in figure 13.
P
MC2 MC1
(fig 13) tax
e2 e1
P MR
O q2 q1 Q
Initially the MC curve of the firm is MC1 and the firm produces q1 level of
output at which its MR = MC1. Now amount sales tax is imposed. The MC
curve shifts upward by the amount t. MC2 = MC1 + t. Now the firm will
produce q2 level of output at which the new MC2 = MR.
The market supply curve which is the aggregate of different supply

curve of firms will shift upward. It will raise the market price. How much
will the price increased in determined by the elasticity of market supply
curve.

Figure 14 shows the effect of a tax on the price at different market

supplies with different elasticity.
P S1 S P
a S3 S2
A
tax
P1 P3 tax
p b P2
B
D D
O Q O Q
(a) (b)
(Figure 14)
Part (a) of figure 14 shows the supply curve which is relatively inelastic.
The imposition of ab amount of tax raises the price from P to P1 which is
much smaller than the amount of tax. The demand curve of fig (14 b) is
identical to (14 a), but the supply curve is relatively inelastic. Here the
change in price due to the imposition of tax is grater than that in figure
(14 a). So the tax burden is more to the consumers if the supply curve
has greater price elasticity.
Key terms
Perfect competition
Price taker
Short-run equilibrium
Long-run equilibrium
Short-run supply curve
Long-run supply curve
External economy
External diseconomy
Increasing Cost Industry
Decreasing Cost Industry
Constant Cost Industry
Effects of Tax
Tax burden

Monopoly
Monopoly can be defined by a market structure with single seller of the
product which has no close substitutes. The entry of other firms in the
market is completely restricted by the definition. ‘ The word ‘monopoly’
comes from the greek words monos polein which mean ‘alone to sell’.
Sources of Monopoly Power

The following factors give rise to monopoly.
1) Ownership of strategic Raw Materials or Exclusive knowledge

of production techniques :
The firm may own some raw materials which gives him the
exclusive right on the products like owner of some mines like
gold mines, coal mines etc. The firm may also have some
unique technique of production which is not known by other
firms. This leads to the monopoly power of the firm.
2) Patent Rights:
Patent is exclusive right to the production of an innovative
product. Patent law may lead to monopoly by giving the
patent holder the entire right to produce a particular good.
The firm may also get the right by trade license issued by the
government.
3) Natural Monopoly:
Economies of scale may also lead to monopoly. This is called
natural monopoly. In this case a single firm can produce at a
lower average cost than two or more firms. This is called
natural since it arises naturally from the type of product. In
natural monopoly a single firm can produce and supply the
entire range of output at a cheaper rate than multiple firms
can do. Indian Railway is one of the examples of natural
monopoly.
4) Government licensing, trade barriers:

Some times license issued by government to a particular
company may lead to monopoly. Government may also create
trade barrier by imposing import tariffs to restrict the entry
of foreign competitor. This can create monopoly power to
domestic producer.
5) Pricing Policy and other Policies of monopolist :

Sometimes monopoly firm can set a price called ‘limit price’
to prevent the entry of new firms. Other policies like
advertising, differential products may also be taken to
reserve the monopoly power of the firm.

Characteristics of the Monopoly market
1) Number of sellers and buyers:

There is a single seller and there are large number of buyers in a
monopoly market.
2) Nature of the product:

There are no close substitutes of the products produced by a
monopoly firm.
3) Entry and exit:

Entry of new firms is restricted.
4) Control over market:

The monopoly firms have substantial control over the market. The
monopoly firm has the power to
fix the price and hence the monopolist is called a ‘price maker’.
Average Revenue, Marginal Revenue and Price:
Total Revenue is the total amount of output produced multiplied by

the price per unit.
Therefore TR = P x Q
A
Average revenue is total revenue per unit of output.
Therefore AR = TR / Q =P x Q / Q = P
The AR curve is the demand curve effaced by the monopolist. In perfect

competition there is a distinction between demand curve faced by the
firm and the aggregate demand curve. The demand curve faced by the
firm in a perfectly competitive market is a straight line parallel to
horizontal axis but the aggregate demand curve is downward sloping.
But in Monopoly, since there is only one firm in the industry, there is no
distinction between firm’s demand curve and aggregate demand curve.
Therefore the monopolist faces the downward sloping demand curve.
The marginal revenue is the additional revenue earned from an extra unit
of production.
Therefore MR = dR / dQ
The shapes of total revenue, average revenue and marginal revenue are
shown in figure 1 (a) and 1(b).

TR
(1 a)
O Q
AR
MC
(1 b)
AR
O Q
MR
TR = P x Q
MR = dR /dQ = d (P x Q) / Dq
Or MR = P. dQ / dQ + Q. dQ / dQ
Or MR = P + Q dP / dQ
Now dP / dQ is the slope of the demand curve and therefore
dP / dQ < O.
Therefore under monopoly MR < P.

The relation between P, MR and elasticity of demand e.

We know that
MR = P + Q (dP / dQ ) (1)
We know that
e = -dQ / dP . P / Q
or 1 / e = -dP /dQ . Q / P
or dP / dQ = -1/e . P/Q
Substituting the value of dP /dQ in equation (1) we get
MR = P - .Q. P / Q. 1/e
= P (1 - 1/e)
Equilibrium of Monopolist :
Short – run equilibrium: The condition of equilibrium in the short

run is same in monopoly as in the perfect competition.
i) MR = MC
ii) Slope of MC > Slope of MR
But in perfect competition P = MC and in monopoly P > MC.
The equilibrium of monopolist is determined by point e at figure 2. Where
MC cuts MR from below. The equilibrium quantity is Oq and equilibrium
price is OP. P>AC and the monopolist earn excess profit equal to the
area PA CB. The monopolist has to face two decisions. Either he has to
set the price or to decide the quantity to be produced. He cannot take two
decisions at the same time.
SMC
P A SAC
B C
(FIG 2)
e
O Q Q
Long – run equilibrium of Monopolist:

In perfect competition firms can earn only normal profit in the long-
run. But in monopoly the entry is restricted and the firm may earn super
normal profit in the long-run. Figure 3 shows the long run equilibrium of
the monopolist.

LMC
P A
LAC
e
B
O Q MR Q
Long run equilibrium is determined at point e when LMC cuts MR from

below. In this figure we have shown that even if the LAC is minimum at
the equilibrium level of output, still the monopolist earns supernormal
profit (PA eB).
Monopoly Power, Learner Index and Mark up pricing:
In monopoly price is greater than marginal cost. So to determine the

degree of monopoly power we have to examine the extent to which the
equilibrium price exceeds the marginal cost. In 1934 economist Abba
Lerner introduced an index to measure the monopoly power. This is
called Lerner Index (L).
L = P – MC / P
The value of L varies between O and l. In perfect competition P = MC,
and L becomes O. The larger the value of L is, The greater the degree of
monopoly power. It can also be expressed in terns of elasticity of demand
facing by the firm as
L = P – MC / P = - l/e.
A monopolist should set his price according to the above relation. P – MC
/ P is the mark up of price over the marginal cost expressed as the
percentage of price. The price mark up should be equal to the inverse of
price elasticity of demand. The smaller the price elasticity is, the greater
the price mark-up.

Price Discrimination:
A monopolist can charge different prices from different buyers. This

is called price discrimination.
Price discrimination. is possible if the following conditions are fulfilled:
i) The market should be divided into sub-markets with

different price elasticity.
ii) The market should be properly separated so that no reselling
can take place
There are three types of price discrimination, first degree price

discrimination, second degree price discrimination and third degree price
discrimination.
First degree price discrimination is that type of price discrimination when

the monopolist firm charges different prices for different units of output.
The monopolist may charge different prices from different consumers or
may charge different prices for different units of output sold to the same
consumer. Example of perfect first degree price discrimination is rare in
real life situation. It may sometimes be possible for services of doctors,
tutors etc.
When different prices are charged for different ranges or levels of output
sold the second degree price discrimination takes place. In this case the
firm can discriminate according to the quantity consumed. There are
several examples of second degree price discrimination like the pricing of
electricity, telephone, natural gas etc.
Third degree price discrimination occurs when markets are divided into
two or more submarkets and different prices are charged from different
markets.
The firm has to decide the total output that is to be produced and the
quantity of output that is to be sold at each market and the prices at
different markets, so that profit is maximized.
The condition for profit maximization for a discriminating monopolist

selling his product in two different markets is:
MC = MR1 = MR2 where
MR1 = Marginal revenue of market 1
MR2 = Marginal revenue of market 2
The model is explained with the help of the following diagram. The
market is separated into two submarkets 1 and 2. Demand curve and
marginal revenue curve of market 1 are D1 and MR1 and those of market
2 are D2 and MR2. The optimal level of outputs and quantities are such
that MR1 = MR2 = MC. MRT is the horizontal summation of MR1 and MR2.

P1 MC
P2
D2
e1 e2
e
MRT
MR2
D1
O Q1 MR1 Q2 QT = Q1+ Q2
MC cuts MRT at point e. Total output is thus QT. Now we draw a

horizontal line from e to the Y axis. It cuts MR2 at e2 and MR1 and point
e1. e1 and e2 represents MR1 = C and MR2 = C. The monopolist will sell Q1 at
market 1 and Q2 at market 2. More price is charged at market 2 where
demand curve is relatively elastic. We can prove this from the equilibrium
condition:
MC = MR1 = MR2
We know that MR1 = P1 ( l – l/e 1 )
and MR2 = P2 ( l – l/e2 )
Therefore P1 (l – l/e1 ) = P2 ( l – l/e2 )
Now if l e1 l < l e2 l
Then
( l – l/e 1 ) < (l – l/e 2 )
Thus for quality of MR1 and MR2
P1 > P1
Thus monopolist should charge higher price at market 1 and lower price
at market 2.
Effects of Taxation
The imposition of a tax on output is same in monopoly as in the
perfect competition. The imposition of tax shifts the MC curve of the
monopolist upwards. The price will be higher and quantity lower than the
initial situation. This is shown in the following diagram.

MC2
P2 MC1
P1
e2 Tax
e1
AR
O e
Q2 Q1
MR
Initially the monopolist is in equilibrium at point e1 where MC1 cuts MR.
Price is P1 and quantity is q1. After the imposition of a tax shifts MC1
upward to MC2. New equilibrium is at point e1 where P2 ( P2 > P1 ) price
is charged for Q2 amount of commode.
Monopolistic Competition and OligopolDefinition of Monopolistic

‘Competition’
Perfect competition and monopoly are two extreme forms of market. In

real life there are other forms of markets which do not follow the
characteristics of either perfect competition of monopoly. Different
economist tried to solve this problem. Economist E chamberlain
introduced the concept of monopolistic competition in 1933. It is a
market structure characterized by a large number of sellers selling
products which are close substitutes of each other and differentiated. The
examples of such products are soap, shampoo, clothing etc of different
brands.
Features of Monopolistic Competition:
i) There are a large number of sellers and buyers in the market.
ii) Product differentiation: Products in monopolistic competition

are close substitute of one another. But they are differentiated.
This slight differentiation of products gives each firm some
monopoly power. The demand curve faced by each firm is

downward sloping and each firm can take their own price
decision.
iii) There is no barrier of entry and exit of the firms. New firms
attracted by the profit earned by the existing firms may enter
into the market without any restriction.
iv) Each firm in the market behaves in dependently in the sense
that decision of a single firm is spread evenly across the entire
group and the decision is unnoticed by other firms.
v) Finally, chamberlain assumed that both demand and cost
curves for all products are uniform in the group.
Proportional Demand Curve and Perceived Demand Curve
Chamberlin assumed that all firms in the group are identical and
face same demand and cost conditions. He also assumed that group
demand curve is downward sloping. In the following figure DD is the
proportional demand curve faced by each firm. It is obtained by
horizontally dividing the group demand curve by the number of firms. It
is also called the actual sale curve or the market share curve.
But the firm perceiver that dd is its demand curve assuming that
other competitors would not react to changes in the price by the firm.
The perceived demand dd is flatter than the actual sale or the
proportional demand curve DD.
P
D
(fig 1)
O Q
Short – run equilibrium
A firm under monopolistic competition faces a downward sloping

demand curve like monopolist because the firm is the only producer
of its differentiated product. The firm can earn supernormal profit in

the short – run. Equilibrium level of output is achieved where MC

cuts MR from below and the price set by the firm depends on the
perceived demand curve. But at equilibrium level perceived sale
should be equal to the actual sale. So the proportional demand curve
DD cuts the perceived demand curve dd at the equilibrium level of
output. The short – run equilibrium is shown in the following figure.
The supernormal profit earned by the firm is the shaded area. PBCF.
P MC
D
d
SAC
P B
F C
(Fig 2) E
d
D
MR
O Q Q
Fig (2) shows short – run equilibrium of a firm under monopolistic
condition. E is the equilibrium point where MC cuts MR from below. OQ
is the equilibrium level of output and OP is the equilibrium price. P>SAC
and firm enjoys supernormal profit equal to the area PBCF. At this level
of output share of the market demand DD cuts the perceived demand
curve dd.
Long – run equilibrium under monopolistic competition:
Supernormal profits earned by the existing firm in the short – run

attracts new firm to enter into the industry. As there is no barrier to
entry, new firms enter into the industry and the share of the market
curve (DD) of each firm shifts leftward. In this situation all firms try to
increase their sale by reducing the price level. It causes a downward shift
of the perceived demand curve. This process continues until the
perceived demand curve becomes tangent to the LAC curve and there is
no excess profit. At the equilibrium level the actual sale will be equal to
the planned sale. This long – run equilibrium is achieved through price
competition along with free entry.

The Long – run equilibrium is shown in figure (3). Point E is the long-run
equilibrium point where LMC cuts the MR from below. OQ is the
equilibrium level of output and OP is the equilibrium price.
LMC
P
D
d LAC
P A
(Fig 3)
d
E
O Q Q1 Q
Excess MR
Capacity
At the equilibrium level price = LAC since LAC is tangent to the perceived
demand curve at point A, and there is no excess profit. The actual sales
curve DD cuts the perceived demand curve dd at point A. The condition
for long –run equilibrium of a firm under monopolistic competition are as
follows:
i) LMC = MR
ii) (Slope of LMC) > (Slope of MR)
iii) P = LAC
iv) Actual sale = planned sale
The above 3 conditions are same as the condition for long-run

equilibrium of a firm under perfect competition. But there is a difference.
Under perfect competition firm reaches long –run equilibrium at the
minimum point of LAC but under monopolistic condition the firm
produces at the falling part of LAC in long – run equilibrium. So in
monopolistic competition Long – run equilibrium shows production with
excess capacity(QQ1 in figure 3)

Comparison of Monopolistic Competition with Perfect Competition

and Monopoly:
Monopolistic competition is a combination of monopoly and
competition. So same features of both perfect competition and monopoly
are present in monopolistic competition.
Similarities between perfect competition and monopolistic
competition are as follows
i) Both perfect competition and monopolistic competition have

large number of buyers and sellers.
ii) Entry and exit of firms are free in both markets.
iii) Individual firm earns normal profit in the long-run in both of
markets.
Difference between perfect competition and monopolistic

competition:
i) Product sold in perfect competition is homogeneous in nature

where as the product sold in monopolistically competitive
market is differentiated.
ii) Demand curve faced by individual firm under perfect
competition is horizontal. But each firm in monopolistic
competition faces downward sloping demand curve.
Similarities between monopoly and monopolistic competition are
i) Demand curve faced by the firm is downward sloping in both

the markets.
ii) Both the markets have large number of buyers.
iii) Each firm under monopolistic competition has some monopoly
power.
Oligopoly :
The number of firms in oligopoly market is more than one but
not many. The few number of firms can dominate the industry and
sometimes they are involved in open rivalry. Duopoly is a special case of
oligopoly where the numbers of firms are only two.
Different firms in an oligopolist market may come into a
collusive agreement about price and output. This form of oligopoly is
called collusive oligopoly. When there is no chance of such collusive
agreement among the firms then the market is characterized as non-
collusive oligopoly. Examples of oligopoly may be automobile industry,
petrochemicals etc.
Features of Oligopoly:
i) There are large number of buyers but few number of sellers
dominating the industry.

ii) The products may be either homogeneous in nature or

differentiated.
iii) The production and marketing strategies taken by the firms are
interdependent.
iv) Entry of new firms are difficult for some reasons like patent
right, huge initial investment etc.
The distinguishing feature of oligopoly is the interdependence

and interaction among the firms. Individual firm has to guess the
strategy taken by its rival firm and it has to make its strategy
accordingly. So there is no demand curve and MR curve facing by the
firm. The condition of equality between MC and MR curve for equilibrium
is not applicable here. Thus there is a problem of indeterminacy in
oligopoly market.


1. Under which market form the firm is a price taker?

a) ✔Perfect competition
b) Monopoly
c) Monopolistic competition
d) Oligopoly
2. Number of firm in a monopoly market

a) Two
b) Many
c) ✔One
d) Three
3. The individual demand curve of a firm is infinitely elastic under

a) Monopoly
b) ✔Perfect competition
d) Oligopoly
4. The nature of the commodity under monopolistic competition is

a) Homogeneous
b) Unique (There is no close substitutes)
c) ✔Differentiated
d) Inferior
5. Price Discrimination is possible under

a) Perfect competition
b) ✔Monopoly
d) Oligopoly
6. One example of monopolistic competition is

a) Indian Railway
b) Wheat
c) ✔Shampoo
d) Automobile
7. The existence of selling cost is a unique feature of

b) Monopoly
c) ✔Monopolistic competition
d) Monopsony

8. The similarity of perfect competition and monopolistic competition

is
a) Both markets have homogeneous product
b) Both markets have proportional demand curve
c) ✔Both markets have large numbers of sellers and buyers
d) Both markets have selling cost
9. There is excess capacity in the long run equilibrium of the firm

under
b) Monopoly
c) ✔Monopolistic competition
d) Oligopoly
10. In monopoly
a) AR = MR
b) ✔AR > MR
c) AR < MR
d) AR=0
11. The goods are sold at uniform price under

a) ✔Perfect competition
b) Monopolistic competition
c) Monopoly
d) Oligopoly
12. Entry & exit are unrestricted in

a) Perfect competition & Monopoly
b) ✔Perfect competition & Monopolistic competition
c) Monopoly & Monopolistic competition
d) Oligopoly

Factor of Production and their Pricing
Topic list
Meaning of economic rent

Ricardian theory of rent
Modern theory of rent
Quasi – rent
Wage – determination
Interest
Profit
Concept of Rent : Rent means the payment for the use of natural
resource like land. Rent can be determined through the interaction of
demand and supply of land. The supply of land is fixed by nature. The
land is also a subject to diminishing return. So the demand curve of
land is downward sloping. (Figure 1) shows the determination of rent
by supply and demand for land. SS curve shows the fixed supply of
land and downward sloping DD is the demand for land. The rent is
OR, where demand for land equals the supply of land.
Rent S
D
E
R1
O S Land
(fig 1)
Ricardian theory of rent : British classical economist David Ricardo

believed that rent is the payment for land for the ‘original and
indestructible power of the soil’. In the language of Ricardo “rent is
that portion of the produce of the earth which is paid to the landlord
for the use of original and indestrutible power of soil”. He and his

followers thought that rent arises high because the high price of crop.
Given the fixed supply of land the price of land depends on the
demand for land which is dependent on the price of crop.
Ricardian theory of rent is based on same assumptions.

i) Land is fixed in supply
ii) Since land is a free gift of nature there is no cost in valued in its
production
iii) Land is subject to diminishing return.
iv) There is perfect competition in both produce and factor
markets.
v) Land has no alternative use than cultivation .
vi)
Ricardo gave two concepts of rent which explain the reason behind the
emergence of rent.
i) Scarcity rent and ii) Differential rent.
Scarcity rent: The supply of land is fixed. So it becomes scarce with the
increase in demand by growing population. Rent arises due to scarcity of
land and that in why it is called scarcity rent.
Differential rent: According to the Ricardian theory rent arises due to

the differences in the quality of land. The land with higher quality will
earn higher rent than the land of lower quality. The most inferiority
quality of land will not earn any rent. This is called ‘marginal land’. In
high quality land the average variable cost is relatively lower and in low
graded land the average variable cost is relatively higher. This situation is
shown in figure 1.
P P
MC2
MC1
AVC2
E1
P P
AVC1
O (a) Q O (b) Q
High quality land Low quality land

Figure (1a) shows high quality and figure (1b) shows low quality land.
The AVC1 is relatively low and AVC2 (average variable cost of low quality
land) is relatively high. In figure (1a) price is higher than the AVC and
surplus is the economic rent. In figure (1b) price = AVC and there is no
surplus and therefore zero economic rent.
Criticism of Recardian theory: Ricardian theory of rent can be criticized

on the following grounds.
i) Ricardo assumed that land has no alternative use than
cultivation. But this assumption is unrealistic. Land has many
alternative uses in reality.
ii) According to Ricardian theory the emergence of rent is due to
the fertility of land. But in fact the rent on land depends on
the demand for land. It is the demand which determines
whether a particular land will be cultivated or not.
iii) It is true that the supply of land is fixed from the view point of
an economy as a whole. But from the view point of an
individual the supply of land is not fixed.
iv) Ricardo made another unrealistic assumption that the
production cost of land is zero. But in fact land involves
production cost like the use of fertilizers, proper irrigation etc.
to prepare it for cultivation.
Modern theory of rent : Modern economists believe that there is rent

element in all the factors of production. According to this theory rent is
the surplus income of a factor of production over and above its
opportunity cost or transfer earning. A factor may be used in different
lines of production.If the factor is to be used in a particular line of
production, it must be paid at least that amount which it can earn in the
next best alternative uses. The minimum cost of transferring a factor of
production from its next best alternative uses to present use is defined as
the opportunity cost or transfer earning of the factor. Rent is thus the
difference between the actual earning and transfer earning of a factor of
production.
Rent = Present Income of the Factor ─ Opportunity Cost or Transfer

Earning of the Factor
Rent is the excess income above the actual income received at the
minimum supply price. It is shown in figure (2a) the supply is completely
inelastic. So its minimum supply price is zero. In this situation the actual
earning is the economic rent.

Price
S
D
P E
Fig 2a
D
Land
O S
SS is the supply curve which is completely inelastic. DD is the

downward sloping demand curve which cuts the supply curve at point E.
op is the equilibrium price. The entire amount of earning is OPES. In
trhis situation, since there is no minimum supply price, the entire
income is economic rent.
In figure (2b) the supply is completely elastic. The demand curve is

downward sloping which cuts the supply curve at E. op is the
equilibrium price which is also the minimum supply price. In this case
there is
P
E
P S
(fig 2b)
D
O A L

no economic rent because actual earning is equal to the minimum supply

price. There is no surplus.
P D
E
P
(fig 2c)
O Q Q
In figure (2c) supply curve SS is upward sloping and demand curve DD is

downward sloping. Equilibrium is at point E where DD cuts SS. op is the
equilibrium price and OQ is the quantity. Now, here OS is the minimum
supply price and OP>OS. The actual earning is equal to the area OPEQ
and the transfer earning is equal to the area OSEQ. The difference
between them is the economic rent. So economic rent is equal to the area
(OPEQ – OSEQ) = SPE:
Quasi rent: We know that in the short-run some factors are variable and
some factors are fixed. So there are fixed cost.The firm will continue
production if the price exceeds the average variable cost. The excess of
the total revenue over the total variable cost is called the rent earned by
the fixed factor of the firm According to Alfred Marshall the payment to a
factor whose supply is fixed in the short-run is called quasi-rent. Quasi
rent disappears in the long-run because in the long-run all factors of
production are variable. Quasi-rent is the difference between the total
revenue and total variable cost.
Quasi – rent = TR-TVC
Rent Element in other Factor Incomes
According to the modern theory of rent the difference between the actual
earning and the minimum supply price of a factor of production is
considered as rent. Following this theory economists noticed that there
are rent element in every factor of production.

Wages
The minimum supply price of a labour is the subsistence wage. The

actual wage of a skilled labour may be much more than this. The excess
of the actual wage over the minimum wage is the rent element of the
wage. This is called the ‘Rent of Ability’.
Interest
The minimum amount of money a lender demands as interest is the

minimum supply price. The increase in demand for loan may raise the
rate of interest. In this situation the excess of the interest than the
minimum amount demanded by the lender is the rent element of the
interest.
Profit
Normal profit is nothing but director’s remunerations and it is included
in the cost of production. But sometimes entrepreneurs earn profit which
is higher than the normal profit. This is known as excess profit or
supernormal profit. The level of profit above the normal level can be
called the rent earned by the entrepreneur.
Determination of Wage:
Wage is the price paid to labour. Given the demand for labour and the
supply of labour the wage rate can be determined by the intersection of
these two curves. To determine the wage rate we have therefore to know
the demand and supply of labour.
Demand for Labour: The marginal productivity theory
This is the most important theory of determining the factor price.

According to this theory the factor is paid the value of its marginal
product. The marginal product of labour is the change in total output
due to a change in the amount of labour.
MPL (Marginal Product of labour) = Q / L

VMPL (Value of marginal product of labour) = P.MPL
According to the theory the money wage rate equals the value of marginal
product.
W=V

Wage
W2 e2
W1 e1
e0
W0
(fig 3)
VMPL
O L2 L1 L0
Labour
Figure 3 shows the VMPL curve which is downward sloping. Initially W1 is

the wage rate. W1 = VMPL at e1 where L1 amount of labour is employed.
Now if there is an increase in wage rate at W2 then L2 amount of labour is
employed where W2 = VMPL. If on the other hand wage rate falls to W0, L0
labour will be employed. So VMPL curve shows the amount of labour
employed at different levels of wage rate. It gives an inverse relation
between the wage rate and the labour employed. So the VMPL curve can
be considered as the demand curve for labour for an individual firm. In
the theory of marginal productivity it is assumed the perfect competition
exists both in product market and factor market.
To determine the market wage rate the market demand for labour should
be determined. The market demand for labour is obtained by aggregating
the demand for labour of all individual firm. Figure 4 shows the market
demand curve for labour. It shows the market demand for labour at
different wage rate.

(fig 4)
O L L
Supply of Labour: We have already discussed the back ward bending

supply curve of labour in chapter 2. Figure 5 shows the individual supply
curve of labour which is backward bending (SL ) representing the
labourer’s preference for leisure above a certain level of high wage rate.
However the market supply curve of labour is positively sloped because
at the higher level of wage rate more labourers are attracted and join
into the labour force.
SL
W2
W1
(fig 5)
Labour
O L2 L1 L

Wage rate
S
W2
W1
(fig 6)
S
O L1 L2 Labour
Figure 6 shows the market supply curve of labour as SS. It is upward

sloping representing the positive relation between the wage rate and the
supply of labour.
Now we can determine the market wage rate through the interaction
between demand for labour and supply of labour.
Figure 7 shows the equilibrium rate of wage at which the demand for
labour is equal to the supply of labour. DD is the market demand and SS
is the market supply of Labour in
figure 7. Labour market is in equilibrium where demand for labour in

equal to the supply of labour at point E. We is the equilibrium wage.
Wage rate
D S
(fig 7)
E
We
D
S
Labour
O Le
at which the demand for labour is same as the supply of labour (Le ).

Role of Trade Union : The factor will get the payment as the value of
their marginal product. When there is perfect competition both in the
product and the factor market the wage of the labour is equal to the
VMPL. But if the firm has monopoly power in the product market the
labour is paid the wage which is equal to the MRPL. In perfect
competietion VMPL= MRPL. But in monopoly MRPL is less than VMPL.The
labour under this situation is paid the wage which is equal to the MRPL
and less than the VMPL.This is happened when there is monopoly in the
product market and monopsony in the factor market.The amount by
which wage rate is less than the VMPL is called Monopolistic Exploitation
by Joan Robinson. By forming trade union workers can counter this
exploitation.
Sometimes workers of different industries come together to form a

union for the purpose of collective bargaining to improve the economic
conditions of the labourers. Trade union acts like a monopolist who are
the single seller of labour force.Trade unions act as monopoly suppliers
of labour and create a pressure on the monopsonist power of the
employers. The trade union can raise wage in four ways ----
i) by collective bargaining with the firms,

ii) by restricting the labour supply
iii) by shifting the demand curve for labour rightward and
v) by setting the minimum wage above the equilibrium level.
Sometimes the trade unions may have other objectives like
maximizing employment, maximizing the wage bill or
maximizing the economic rent.
Interest
Capital
Capital is the only man-made factor of production. It is also called

Produced means of production.
Capital may be classified as
1. Physical capital like Building, Machine, Equipments, Raw
materials etc
2. Financial capital like Bonds, Shares etc
Types of Capital:
Broadly there are two types of capital
1. Fixed capital and circulating capital : The capital which
is used in the production process in many times constitute the
fixed capital Examples of fixed capital are factory building,
machine, furniture etc.

Those capital goods which are used in the single production

process constitute circulating capital. Examples of circulating
capital are raw materials, power consumption, fuel etc.
2. Sunk capital and floating capital : A type of capital
which is already been used for a particular line of production must
be continued to be used for that line of production only and cannot
be transferred to other line of production is called sunk capital.
Floating capital on the other hand can be transferred to different
lines of production.
3. Money capital and real capital: An amount of money
used for purchasing capital is called money capital.Real capital is
the real goods and services.
4. Human capital and material capital: Educated , trained
and skilled labour is sometimes called human capital. Through
education and training an unskilled labour becomes skilled labour
and therefore a skilled labour is a produced means of production
through the process of education and training.
Features of Capital:
1. Capital is not a free gift of nature. This is man made factor

of production.
2. Capital is transferable from one person/place to another.
3. Use of capital leads to depreciation.The physical depletion
of capital is called the depreciation of capital.
4. Supply of capital can be easily increased through
productive investment.
5. Capital increases the productivity of land and labour.
Interest is the price paid for the use of capital. It can be defined as the
price of a loan of money. Following theories can explain the
determination of interest.
Gross Interest and Net Interest
The amount of money paid for just the use of capital is called the Net
Interest. But there are some risks and other expenses which are borne by
the lender.Gross Interest is Net Interest plus these various costs.
Net Interest = Gross Interest − ( Cost of risk-bearing + Other

administrative cost)
Classical Theory of Interest
Classical economists explained the theory of interest in terms of

investment and saving.According to them Investment is considered to be
the demand for capital and Savings are considered to be the supply of

capital.The rate of interest is interpreted as the price of capital and is

determined by the equality of Investment and Savings.
Loanable Fund theory:
Interest is the price of the loanable fund. So interest can be determined

by interaction of demand and supply of loanable fund. Demand for
loanable fund depends on the volume of investment, the amount of
dissaving by households. The supply of loanable funds depends on the
saving made by households and from financial institutions.
Rate of interest
(fig 8)
S D
O M Loan able fund
Disinvestment is another source of supply of loanable fund. Figure 8

describes the equilibrium rate of interest r where the demand for
loanable fund is equal to the supply of loanable fund(M).
Another theory of interest rate determination is the Liquidity Preference

Theory by L. M .Keynes.
According to Keynes, since interest is the price of money the interest rate
is determined by demand for and the supply of money. Money supply is
determined by the Government or by the Central Bank. It does not
depend on the rate of interest.
The demand for money according to Keynes depends on three motives –

 Transaction Motive,
 Precautionary Motive
 Speculative Motive.
The Speculative Demand for money rises with the fall in the interest rate.
The demand curve for money is downward slopping. The equilibrium rate
of interest is determined by the intersection of the downward slopping
demand curve and the vertical supply curve of money.
Can The Rate Of Interest be Zero?
In real situation interest rate can never become zero or negative. But
there may be some theoretical possibilities in which interest may become
zero or negative. It may happen in two situations:
1. Absence of Investment or Saving: If there is no Investment
the demand for lonable fund is nil and thus the price paid for it
becomes zero.
2. Zero marginal productivity of Capital: According to the
Theory of Marginal Productivity each factor is paid according to its
marginal productivity. If the marginal productivity of capital is zero
then the price paid for it i.e, the interest rate may also be zero.
Profit :
The profit is the difference between total revenue and total cost. Profit
has some special characteristics, which are not present in other
factor prices. –
 Profit is not contractually fixed.
 Profit may be negative
The elements of profit are the reward for bearing risk and uncertainty,
monopoly profit and the remuneration for the own labour of the
entrepreneur and prices for own property used.
Difference between profit and other factor prices
Prices paid for land, labour and capital i.e , rent, wage and interest
are fixed before starting the production. So all other factor prices are
contractually fixed.But the entrepreneur does not know the actual
amount of profit she can earn. Instead of earning profit the
entrepreneur may incur loss in future. So the profit may be negative
also.
Normal and Super-normal profit
Normal profit: This is the income of the entrepreneur without which

she can not run the organization.This is an expected rate of profit .
This is included in the factor of production.
Super-normal profit: If the actual earning of the entrepreneur is

greater than the normal profit then it is called super-normal profit.

Normal profit is a part of the cost of production but super-normal

profit is not.
Different Theories about The Source of Profit
The Innovation Theory of Profit: Prof J Schumpeter
According to this theory profit is the reward for innovation.

Innovations are those products and process which increase national
income more than they increase national cost. The entrepreneur who
identifies new market opportunities, develops new products,
introduces cost reducing method gains the advantage over her
competitor and earns profit. According to Schumpeter profit must be
regarded as the return to innovators. The entrepreneur who developed
the new idea and converted it into marketable good or service receives
the surplus income over cost as her reward. There may be imitator of
the new innovation. So proper patent law should be made to protect
the innovation.
Risk-bearing Theory of Profit: Prof. Hawley
According to this theory profit is the reward for risk-bearing. There are
different types of risk like
a. Replacement risk:A machine used for production may be

depreciated over time and a time will come when the machine
should be replaced. Since the producer does not know the time of
depreciation with certainty a risk is always attached with an
investment. This is called replacement risk.
b. Obsolescence: The emergence of a new and better

technology may make an existing machine obsolete even before its
actual physical life span. This is called obsolescence risk.
c. Uncertainty : According to Hawley uncertainty is the type

of risk other than replacement and obsolescence risk and risk
proper.
d. Risk proper : It means the risk attached to the time lag between
investment and marketing. The larger the time lag the greater the risk
involved.
According to Hawley profit is the incentive given to the entrepreneur for

bearing these different types of risk. Hawley’s theory is very much
important to explain the source of profit. He clearly explained the
distinction between the risk-bearing and the day-to-day management

functions of an entrepreneur. Hawley considered profit as the reward for

only the risk-bearing.
Uncertainty-bearing Theory of Profit: Prof. Frank Knight
According to Knight profit is the reward for uncertainty-bearing not risk-

bearing. By uncertain events we mean events whose probabilities are not
known. Prof. Knight explained that some risks can be avoided through
insurance. The premium of insurance can be treated as the cost of risk-
bearing. But there are some risks for which there are no insurance
companies in the market. Prof Knight explained uncertainty may come
from different sources like change in the pattern of consumer’s demand,
change in Government policy, entry of new firms and growing
competitions, technological changes etc. For these types of events no
probabilities can be attached with certainty. So these types of risks can
be avoided through giving premium. Uncertainty is uninsurable. So the
reward for the uncertainty-bearing is not a cost. It is the profit.
Profit as Monopoly Return:
Monopoly power generates economic profit. In competitive industry

excess profit is completely disappeared in the long run due to new entry
of firms in the market. But in monopoly the firm has the sole power to
control the market price and due to entry restriction a monopolist may
keep the price higher than competitive level and earn excess profit even
in the long run.
A.P.Lerner has developed a measure of the degree of monopoly power
M═( P ─ MC)/P
Or M ═ 1/Ep
The above equation implies that the more inelastic the demand for a
commodity the more is the monopoly power and hence the monopoly
profit.
Monopoly Profit does not serve any social purpose. Rather it results in
some socially unproductive activities like rent – seeking activities.


1. According to modern theory rent is the difference between

a) Total Revenue and Total cost
b) Demand and supply
c) ✔Actual earning & transfer earning
d) Revenue and cost
2. Zero or negative factor income is possible in

a) Rent
b) Wage
c) Interest
d) ✔Profit
3. The supply curve of labour is

a) Upward sloping
b) Downward sloping
c) Vertical
d) ✔Backward Bending
4. Rent arises due to scarcity of land is called

a) Differential rent
b) ✔Scarcity rent
c) Quasi rent
d) Fixed rent
5. Rent arising from the different qualities of land is called

a) Fixed rent
b) Quasi rent
c) ✔Differential rent
d) Scarcity rent
6. (Total revenue - Total cost) is called

a) ✔Quasi rent
b) Scarcity rent
c) Differential rent
d) Fixed rent
7. Marginal product of labour multiplied by price of the commodity is

a) ✔VMPL
b) MPPL
c) APL
d) MRPL
8. VMPL curve shows

a) Supply of labour
b) ✔Demand for labour
c) Cost of labour
d) Product of labour
9. Trade union can raise wage

a) ✔By collective bargaining
b) By Reducing the price of commodity
c) By increasing the supply of commodity
d) By increasing the price of commodity
10. Interest is the price paid for

a) Land
b) Labour
c) ✔Capital
d) Organisation
11. The difference between total revenue and total cost is called
a) Rent
b) Wage
c) Interest
d) ✔Profit
12. ……… is not contractually fixed

a) Interest
b) ✔Profit
c) Wage
d) Rent
13. ………………..may be negative

a) ✔Profit
b) Rent
c) Wage
d) Interest

APENDIX : Theory of Production : Cost of Production
Theory Of Production
Topic List
 Short run and Long run Production Function
 Laws of Returns: Laws of Return to a variable factor,
 Laws of Return to scale
 Total Product,
 Average Product,
 Marginal Product.
 Production with two variable factors
 Isoquants: Concepts and properties
 Ridge line,
 Isocost Line,
 Producer's Equilibrium : Output maximization subject to cost

constraint
 Cost minimization subject to output constraint,
Expansion Path.
Short run and Long run Production Function:

Production function describes a techno logical relationship between
inputs (factors of productions like land, labour, capital etc) and
output (Final production For simplicity it is assumed that there are
only two factors of production labour (L) and Capital (k). Then the
production function takes the form as follows:
Q = f (L, K) where
Q = output produced
L= labour
K= capital
The above expression implies that the volume of production depends
on the volume of inputs.
Short-run production:
The short run can be defined as a period of time over which some
factors of production are fixed and some are variable. Usually the

capital input is assumed to be fixed and the labour input is

considered as variable input. The short run production function takes
the form as follows:
Q = f (L, K) (K=fixed factor capital)
Long-run can be defined as a time period when all factors can be

varied. Long-run has some special importance in the theory of
production since it describes the planning horizon of a production
firm in which the firm can change its level of production by changing
all the inputs. The production function in the long-run takes the
usual form as
X=f(L,K) Where Labour and both are variable.
Production with a single variable input:
Total Product, Average Product and Marginal Product:
Total product means total amount of output produced by a firm using

fixed and variable factors of production at a particular time period.
In the short-run capital is assumed to be the fixed factor and
labour the variable factor. Initially total product increases as more
and more amounts of labour are employed. After reaching a
maximum level the output starts declining. This is due to the law of
diminishing return of the variable factor which will be discussed
afterwards. Total product is represented by Q.
Average Product:
Average product means the amount of product per unit of the variable
factor. If labour is considered as the variable factor then average
product of labour is as follows:
APL= Q/L
The average product increases at the initial stage, then starts falling.
But it never becomes negative.
Marginal Product:
Marginal product of a single variable factor labour is the additional

output produced as the labour is increased by 1 unit. Mathematically
it can be written as MPL= dQ/dL (dQ=Change in output, dL
=Change in labour by 1 unit)
At the initial stage TP increases at an increasing rate and MP

increases. After that TP increases at a decreasing rate and MP
declines.

When TP reaches at the maximum level, MP becomes zero. After that TP

starts falling and MP becomes negative.The following table 1 shows TP,AP
and MP.
Amount Total Average Marginal

of Product Product Q / Product
Labour Q L dQ/dL
0 0
1 5 5 5
2 20 10 15
3 48 16 28
4 60 15 12
5 60 12 0
6 54 9 -6
From this table it is clear that total product increases with the increase
in labour input up to certain points. The table shows that TP reaches at
the maximum level 60 when 5 units of labour are employed. After that it
starts decreasing. Initially the AP increases, then reaches the maximum
level 16 and then decreases, but never becomes negative. The MP also
increases initially, then reaching the maximum level, it starts decreasing.
MP becomes zero when TP is maximum and becomes negative when TP is
diminishing.
Figure 1(a) shows the TP curve and 1(b) shows the AP and MP curves.
The AP and MP curves are closely related. When AP is increasing MP>AP
(between labour input L1 to L2 shown in figure 1b), When AP is
decreasing MP<AP (between labour input L2 to L3) and then MP becomes
negative.(After L3 )
The three stages of Production
Economists classified 3 stages of production on the basis of the

behaviour of MP and

TP
C
B
A
(1a)
Stage1 Stage2 Stage3
O L
L1 L2 L3
Stage1 Stage2
(1b)
AP MP
AP
O L1 L2 L3 MP L
This figure shows TP curve in 1(a) and AP and MP curves at 1(b). MP is

maximised at point A and AP is maximised at point B.
Three stages of production may be summarised as fallows.

Stage 1
It stays up to point L2 Here MP>O, AP is rising and MP >AP. AP reaches

at the maximum level at point B. MP=AP at the maximum level. This is
called increasing stage.
Stage 2
This stage is represented from point B to point C. Here AP is falling;

MP<AP but MP>O. TP is increasing. At point C TP reaches at the
maximum level and MP becomes O. This is called diminishing stage.
Stage 3 or Negative stage
After point C the stage of negative return starts operating. In this stage
TP is falling and MP becomes negative.
The economically meaningful range of production is under Stage 2.

Stage 1 is not economically meaningful since by employing one unit of
labour the average productivity increases. So it will be unwise for the
producer to stop production at this level. So he/she continues
production.

Producing in stage 3 is also uneconomical. Since in this stage total

product falls and marginal product becomes negative.
Thus rational producers are only interested in stage 2 where TP is

rising and reaches at the maximum level.
When AP is maximum, MP=AP (point A at figure 1b)
The AP and MP curves can be drawn directly from the TP curve. The
AP curve of labour is given by the slope of the line from the origin of
TP curve to any point on the TP curve.
Similarly the marginal product of labour at any point on the total

product curve is given by the slope of the total product curve at that
point.
Laws of returns:
The law of variable proportion: Short run analysis of production:

This law is applicable in the short run when one of the factors of
production is fixed. The marginal product of the variable factor will
diminish after a certain range of production.
There may be three types of return to a variable factor:

increasing return, constant return and decreasing return.
When the rate of change of output is more than that of the variable
factor then we call it increasing return to a factor.
When the rate of change of output is equal to that of the variable

factor, then we call it constant return to a variable factor. When the
rate of change of output is less than that of the variable factor, we call
it decreasing return to a factor.
Reasons behind the laws of increasing return to a variable factor are

the efficient utilization of a fixed factor at the initial level and the
technical division of labour. If labour is the only variable factor the
more of amount of labour can use the fixed factor more efficiently and
as a result there is an increasing level of output. Larger amount of
labour can be divided more systematically to perform different jobs
which in turn raises the level of output.
But when more and more amounts of the variable factors are
employed then the efficiency of the factor reduces and there is
decreasing return of variable factor. The inefficient labour
management is another reason behind the decreasing return to a
variable factor.

Production With Two Variable Inputs:
In the long run all factors of productions are variable. Then the long
run production function can be stated as
Q = f (L, K)
Laws of Return to Scale:

This law is applicable only in the long run when all inputs are
variable. There are three types of return to scale: - increasing return
to scale, decreasing return to scale and constant return to scale.
When the change in output is in larger proportion than the change

in inputs then there is increasing return to scale.
When the change in output is in equal proportion to the change in

inputs then there is constant return to scale and when the change in
output is in smaller proportion than the change in inputs then there
is decreasing return to scale.
The increasing return to scale at the initial stage is due to the

internal and external economics of scale. With the expansion of the
scale of production, the producers get some advantages which reduce
the average cost of production. This is called economics of scale
which includes technological economy, managerial economies,
economies of information, and specialization.
After certain times, as more and more expansion of production

takes place some diseconomies of scales are faced by the producers.
This in turn results in decreasing return to scale. The diseconomies of
scale include managerial difficulty, limited markets, shortages of raw
materials etc. All the reasons act as the limiting factor to the increase
in production.
Isoquant : Concept and Properties
The word ‘iso’ means equal or same. Isoquant is a curve showing

same or equal level of output.
An isoquant is the locus of points showing different combinations of

factors of production for producing a particular level of output.

Generally the isoquant is a smooth convex curve showing continuous

substitutability of Capital (K) and Labour (L).
O L
Fig 2a
The above diagram shows a smooth, convex isoquant. The isoquant

may take different shapes also.
Linear isoquant is a negatively sloped line. It represents perfect

substitutability of capital and labour. The commodity may be
produced by using only capital or labour or an infinite combination of
K and L. Figure 2b shows linear isoquant.
O B L
Fig 2b
AB shows a particular level of output which may be produced lither

by using OA amount of capital or OB amount of labour or different
combinations of K and L on the linear isoquant.
L-Shaped Isoquant: This shape of the isoquant represents fixed
proportion production function. Only one combination of capital and
labour can be used to produce a particular level of output.

K A Q
O L
L
Fig 2c
Figure (2c) shows L-shaped isoquant Q. Point A represents that single

combination of capital and labour which can be used to produce a
particular level of output Q.
Properties of Isoquant: Marginal Rate of technical Substitution
Production function represents a set of isoquants each one of which

shows a different level of output.
The isoquant situated in the higher and right side of another shows
higher level of output. To Figure 3 shows a set of isoquants Q3 represents
higher level of output than Q2 and Q2 represents higher level of output
than Q1.
K
Q3
Q1 Q2
O L
Figure 3
Two isoquants cannot cut one another. The isoquants are negatively
sloped. The negative slope of the isoquant implies if more of one factor of
production (say L) is employed then the use of other factor (K) must be
reduced to keep the output level unchanged. The slope of the isoquant is
called marginal rate of technical substitution.

K1 K
K2 L
O L1 L2 L
Figure 4
The unit of capital that is reduced (dK) to employ an additional unit of

labour (dL) is called the Marginal rate of technical substitution.
Therefore MRTS= -- dK/ Dl
Ridge Line: The efficient range of output is the range over which the
marginal products of capital and labour are positive. To separate the
efficient region from the inefficient region we have to draw the ridge lines.
Ridge lines are the locus of points on the isoquants where the marginal
products of capital and labour are zero.
A Upper Ridge Line
B
Lower Ridge Line
Q3
Q2
Q1
O L
Fig 5
The locus of the points where the MP of capital is zero is the upper ridge
line (OA) and the locus of the points where the MP of labour is zero is the
lower ridge line (OB). The production method inside the ridge line are

efficient since the MP of labour and capital are positive inside the region.
The zone inside the ridge line is also known as economic zone. Outside
the ridge line the MPS of factors are negative and the methods of
production are inefficient.
Isocost line and Producers Equilibrium
The goal of the firm is profit maximization. Since profit = Revenue – Cost,
maximizing output subject to a given cost means maximising revenue
(because Revenue = output × price per unit) and therefore profit. But
when the output level is given, the producer has to minimize cost to
maximize the level of profit. So the major objective of the producer is
either maximizing the level of output given a cost constraint or
minimizing cost subject to a given output constraint.
Isocost line: Isocost line can be defined by the locus of points showing
all the combinations of inputs the firm can purchase with a given amount
of monetary cost.
The following equation describes the isocost line.

C = r. k + w L where
C = cost
r = price of capital
k = capital
w = price of labour or wage rate
L = Labour
The slope of the isocost line is the ratio of the prices of factors of
production.
Slope of isocost line = w/r
O c/w B L
Fig 6
AB represents an isocost line. OA is the amount of capital that a firm

can purchase if it spends all the amount of C by purchasing capital.
Therefore

OA = maximum amount of capital

= c/r
Similarly OB is the amount of labour that the firm can employ if it
spends all the amount of C by employing labour.
So OB = maximum number of labours
= c/w
The firm can employ any combination of inputs represented by any point
of the isocost line.
Slope of the isocost line = OA / OB
= c/r / c/w
= w/r
The slope of the isocost line reflects the rate of substitution of L for K.
Maximization of Output Subject to Cost Constraint
Addition: (changes in the slope of isocost line due

to a change in the input prices)
The producer is in equilibrium when he maximize
the output given the cost and the price’s of factors of production r and w.
K
A
K2 e
Q3
Q2
Q1
O Le B L
Fig 7
In fig 7 Q1, Q2, Q3 are different isoquants representing different levels of

output. Total cost is given by the isocost line AB. Q3 shows higher level of
output than Q2. Q2 shows higher level of output than Q1. The maximum
level of output Q2 is determined by the point of tangency of the given
isocost line AB with the highest possible isoquant Q2. The optimal input
combination is K2 and L2 given the factor prices w and r. The point of
tangency implies the equality between the slope of the iso-quant with the
slope of the isocost line. Therefore the condition of producers equilibrium
is
i) Slope of isoquant = slope of isocost line
=>MPL/MK = w/r
=>MRTSL,K= w/r
This is the necessary condition for producer's equilibrium.

ii) The sufficient condition for producers equilibrium is the

isoquant should be convex to the origin or the MRTSL,K
must be falling.
Minimization of Cost Subject to Output Constraint:
In this case the producer wants to produce a given level of output Q with
q combination of inputs that minimizes the level of cost. The given level of
output is represented by isoquant Q. A1B1, A2B2, A3B3 are different
isocost lines showing different levels of cost. Isocost lines are parallel to
each other since r and w are assumed to be fixed and so the ratio w/r or
the slope of the isoquant does not change.
A3
A2
A1
e
K2
O L2 B1 B2 B3
Fig 8
Conditions for Cost Minimization are same as in the case of output

maximization. Equilibrium will be attained at point e where the isocost
line A2B2 becomes tangent to the isoquant Q. K2L2 is the input
combination which minimizes the cost of production. The conditions for
Cost minimization are as follows :
1)Slope of the isocost line = Slope of the isoquant

=>w/r = MPL/MPK = MRTSL,K
This is the necessary condition
2) The sufficient condition is the convexity of the
isoquant.

Expansion Path:
In previous section we discussed the equilibrium of the producer. The

equilibrium level of output is achieved by using least-cost combinations
of inputs .The producer’s objective is to expand output optimally, ie. to
expand output levels using least cost combinations of inputs. The
optimal expansion path showing the optimum levels of output is
determined by the points of tangency of successive isocost lines and
successive isoquants.
Long-run expansion path
A3
A2
P
A1
e3
e2
e1
Q3
Q1 Q2
O B1 B2 B3 L
Fig 9
Figure 9 -- shows the long run expansion path. K and L both are variable
inputs. A1B1, A2B2 and A3B3 are the isocost lines which have the same
slopes implying the w/r ratio is the same for all isocost lines. Q1, Q2 and
Q3 are different isoquants showing different levels of output (Q3> Q2> Q).
e1, e2 and e 3 represent different equilibrium points (points of tangency of
isocost lines with isoquants). Joining these points we get the long-run
expansion path OP which is an upward sloping straight line through the
origin.
If the ratio of factor prices w/r change, the slope of the isocost lines
changes.

In fig 10 the factor price ratio changes to w’/r’. The isocost lines become
flatter and the optimal expansion path becomes OP’. The shape of the
expansion path depends on the shape of the isoquant which in turn
depends on the form of the production function.
A’3
P’
A’2
A’1
Q3
Q1 Q2
O B’1 B’2 B’3 L
Fig 10
If the production function is homogeneous the expansion path is a

straight line (OP or OP’ in the figure – and --) through the origin. The
slope of expansion path k/L ratio depends on the factor price ratio.
A homogenous production function is a function if all

the inputs are multiplied by k, then k can be completely factored out.
Consider the production function
Q = f (L, K)
Suppose Q* level of output can be produced by

increasing the inputs by the same proportion g.
Q* = f ( g L, g K )
If k can be completely factored out than the new level of output becomes
Q* = g r f (L,K)
Or Q* = g r f (Q)

This is called homogenous function of degree r. r is the degree of

homogeneity.
If the production function is non homogenous then the expansion path

not will be a straight line even if the ratio of factor prices remains
constant.
Fig 11 --- shows the Long-run expansion path for a non homogenous
production function. In this case the K/L ratio changes for each level of
output.
A4
A3
A2 L
A1 Q3 Q4
Q2
Q1
O B1 B2 B3 B4
Fig 11
Short-run expansion path: In short-run some inputs are fixed and some
are variable. We consider capital (K) to be fixed in the short-run. The
producer does not maximise the profit in the short-run due to the
constraint of the given capital.

k k
o L
Fig 12
Fig 12 -- shows the expansion path in the Short-run as k k when capital

is fixed at the level k. The optimal expansion path is OA, in the long-run
but the short-run expansion path k k is just a straight line parallel to
the horizontal axis.
Key Terms Used in this Chapter
 Production Function
 Total product
 Average Product
 Marginal product
 Laws of Returns
 Laws of Variable Proportion
 Stages of Production
 Fixed Input
 Variable Input
 Iso-Quant

 Ridge Line
 Economic Region
 Iso-cost Line
 Marginal Rate of Technical Substitution
 Profit Maximisation
 Cost Minimisation
 Expansion Path
 Homogeneous Production Function

Cost of Production
Topic List
Different types of cost

Short – run Cost: Fixed cost and variable cost, Total cost, Total fixed
Cost, Total variable cost, Average total cost, Average Fixed cost, Average
variable cost,
Marginal Cost
Relation between ATC, AFC and AVC
Relation between MC and ATC
Relation between Production and Cost
Long – run Average Cost curves
Long – run Marginal Cost curves
Different Concepts of cost:
Explicit Cost vs Implicit Cost:

Explicit Cost means the actual expenditure made by
the producer for producing output. The following costs can be
mentioned as explicit cost
(i) Cost of raw materials, (ii) Wages and Salaries, (iii) rent, interest, (iv)
depreciation cost etc.
Implicit Cost:
Implicit Costs are those costs which are not mentioned by the
accountants. Another name of implicit cost is opportunity cost.
Opportunity cost is very important for economic decision – making.
Explicit cost can easily be calculated from the market price’s at which
the resources are procured. But it is difficult to calculate the cost of self
– owned or self employed resources. The imputed cost of the self –
owned resources are called implicit cost. Opportunity cost can be
defined as the value of the self – owned resource in its next best uses.
The self – owned resources used in the production process may bring
in income if it were used for next best alternative uses. Thus by using it
in the present activity the producer is losing the opportunity of getting
income. So this type of cost is called opportunity cost.
Sunk – Cost:
It is an expenditure which is unavoidable and is not
affected by any decision regarding the production. Sunk – cost cannot
be recovered. Since it is irrevocable it should not influence any decision
made by the firm. Suppose the firm purchased a machine which is used
for a specific job. After completing the job, the machine will remain
unused, because there will be no market for selling the machine. The

cost of this machine can be regarded as sunk – cost. The sunk – cost is
related to the specificity of a resource. These resources don’t have any
alternative use. The opportunity cost of such resource is zero.
Private Cost and Social Cost:

Private Cost is that part of the cost which
occurs to the producer. The producer while making production decision
calculates the private cost only. But sometimes the production firms
impose other cost on the society, e.g, creating air pollution or water
pollution by a factory. This cost is called external cost. The social cost
includes both private cost and external cost.
Economic Cost and Accounting Cost:

Economists think of cost
differently from an accountant. Accounting cost is important for
making financial reports of a business firm. It includes actual
expenses or the explicit cost. Economists are concerned about the
profitability of the firm and thus want to minimize the cost in future.
They are therefore concerned with the opportunity cost or the cost
associated with foregone opportunities. Accounting costs value only
explicit cost whereas economic costs value both explicit and implicit
cost.
Cost in the Short – run:
Short run is considered as a time period when some factors of

productions are fixed and some are variable. The total cost of
production in the short run is split into total fixed cost and total
variable cost.
Total Cost ( TC ) = Total Fixed Cost ( TFC ) + Total Variable
Cost ( TVC )
Total Fixed costs are the expenditure made for employing fixed
factors. The fixed costs do not change with the change in output
There are fixed costs even if the output is zero. Examples of fixed
costs are maintenance of land and building, depreciation of
machinery, salaries of permanent staffs etc. Total variable cost varies
with the changing levels of output. TVC is zero when output level is
zero. Variable costs are the expenditures made for buying raw
materials, wages for direct labourers, running costs of fixed capital.
The graphical representations of total cost, total fixed cost and total
variable cost are given below.

C TFC
O Q
Fig1
C
TVC
O Q
Fig 2
C TC
TVC
C TFC
O Q
Fig 3
Figure 1 shows the TFC curve as a straight line parallel to the output
axis. The total fixed cost is constant at all levels of output.

Total variable cost is shown in figure 2. The shape of the TVC curve is
like inverted S. TVC rises at a slower rate at the initial stage of
production. This is due to the increasing return to a variable factor. After
reaching an optimum combination of fixed and variable factor, the
productivity of the variable factor declines. For this reason total variable
cost increases at a faster rate.
Figure 3 shows the total cost curve which is a vertical summation of total
fixed cost and total variable cost.
Average Fixed Cost, Average Variable Cost and Average Total Cost
Average Fixed cost is the fixed cost per unit of output. We get AFC by
dividing TFC by the level of output.
AFC = TFC / Q
Average variable cost is the variable cost per unit of output. AVC can be
obtained by dividing TVC by the level of output.
Therefore AVC = TVC / Q
Average total cost is the cost per unit of output. It can be obtained by
dividing total cost by the quantity of output.
ATC = TC / Q
Average total cost is the sum of average fixed cost and average variable
cost. We know that
TC = TFC + TVC
Above equation states that total cost is the sum of total fixed cost and
total variable cost.
Now dividing both sides of the above equation by Q, we get
TC / Q = TFC / Q + TVC / Q
ATC = AFC + AVC
Now we can show AFC, AVC and ATC graphically
Average Fixed Cost Curve :

We can draw AFC curve from TFC curve.
Since TFC is fixed for all levels of output, AFC will be declining but never
becomes O . It takes the shape of rectangular hyperbola.
AFC = TFC / Q
As Q rises AFC will fall, but AFC X Q = TFC will remain fixed.
TFC curve is a straight line parallel to output axis. To get AFC from TFC
curve we will draw some rays from the origin onto different points of TFC

curve. Then the slope of the rays indicate AFC at different levels of
output.
TFC
A B C D E F
C C
a)
O
1 2 3 4 5 6 Q
Fig 4
AFC
AFC1
b)
AFC2
AFC3
AFC4
AFC
O 1 2 3 4 5 6 Q
Fig 5
Fig ( 4a ) shows TFC curve as a straight line C parallel to X axis. We

draw different rays from the origin on different points of the TFC curves
for different levels of output. The rays are OA, OB, OC, OD.
The AFC curve is drawn in figure (4b). AFC at output level 1 is the slope
of the OA line. Similarly the AFC at output level 2, 3 and 4 are the slopes
of the lines OB, OC and OD. AFC curve has the shape of rectangular
hyperbola.

Average variable cost curve: (AVC curve )
AVC curve can also be derived from TVC curve.

AVC = TVC / Q
TVC increases at a slow rate at the initial stages of production. So

initially AVC declines. After certain level of production TVC rises at a
faster rate. As a result AVC starts rising. For this reason AVC curve is a
U – shaped curve. The reason behind the U – shape of the AVC curve is
the laws of returns to a variable factor.
Graphically AVC curve can be derived from the TVC curve. AVC at
each level of output is derived from the slope of the ray drawn from the
origin to the point on TVC curve at that level of output.
Figure 5 shows the derivation of AVC curve from the TVC curve. Fig
(5a) shows TVC curve. Different rays are drawn from the origin on the
TVC curves at different levels of output. OA line is drawn from the origin
at Q1 level of output. OB and OC rays are drawn at Q2 and Q3 levels of
output. The slope of the rays are the average variable costs at those levels
of output. Average variable costs are plotted on the vertical axis of figure
(5b) . Slope of OA is the average variable cost at Q1 output (AVC). Slope
of Ob is average variable cost at Q2 level of output and it reaches the
minimum level since OB becomes tangent to TVC curve. Slope of OC is
AVC3 at Q3 level of output. AVC3>AVC2. Thus at the initial level average
variable cost declines and after reaching a minimum level it starts rising.
So AVC curve is U-shaped. The U-shape of the short-run AVC curve can
be explained by the laws of return to a variable factor.
TC TVC
5a)
O Q
Q1 Q2 Q3
Fig 6

AVC
5b)
AVC1
AVC
AVC3
AVC2
O Q
Q1 Q2 Q3
Fig 7
At the initial stage there is an increasing return to a variable factor and

AVC declines. After a certain level of output there is a decreasing return
to a variable factor and for that reason AVC starts rising.
Average total cost (ATC) curve is a vertical summation of AFC and AVC
curve. This is shown in figure6. The ATC curve is determined by adding
the vertical distance of AFC with vertical distance of AVC at each level of
output. Both AFC and AVC are falling upto OQ1 level of output. After
that AVC rises but AFC still falls and ATC keeps on falling. After OQ2
level of output the fast rising AVC more than offsets the falling AFC and
for this reason ATC starts on rising. Thus the minimum point of ATC (B)
lies to the right of the minimum point of AVC (A).

ATC
AVC ATC
AFC AVC
AFC
O Q1 Q2 Q
Fig 8
Marginal Cost:
Marginal cost can be defined as the additional cost for producing an

additional unit of output. Mathematically it can be staled as
MC = C/ Q Where c = change in cost

and Q = change in output
Marginal cost can be derived from the total cost. It is the slope of the total
cost curve. It is same as the slope of TVC curve. Figure ( 7a ) shows TC
curve and ( 7b ) shows MC curve derived from TC curve. At output level
OQ1 MC is derived from the slope of the TC curve. At output OQ2 the
slope of the TC curve is minimum and thus the MC curve reaches at the
minimum point. The slope of TVC curve is rising at output OQ3 and thus
MC starts rising. The MC curve is also U – shaped.

TC
TC
7a)
O Q1 Q2 Q3 Q
MC
MC
7b)
O Q1 Q2 Q3 Q
Table 1 shows total costs, average costs and marginal Costs at different levels of
output.

Table 1
Q TFC TVC TC AFC AVC ATC MC

0 24 0 24
1 24 10 34 24 10 34 10
2 24 16 40 12 8 20 6
3 24 18 42 8 6 14 2
4 24 24 48 6 6 12 6
5 24 36 60 4.8 7.2 12 12
6 24 54 78 4 9 13 18
From table 1 we observe that TFC is constant and TFC = 24 at all levels
of output. Since TC is the sum of TFC and TVC TC curve has the same
shape as the TVC curve.
ATC is greater than AVC and AFC since ATC in the sum of AVC and AFC.
AFC declines continuously as output expands. AVC declines upto the
level of output 4 and then starts rising. ATC also declines upto the
output level 5 and then rises. Initially MC declines and reaches its
minimum level 2 at the output level 3 and then rises. MC<AVC when AVC
falls and MC>AVC when AVC rises. MC = AVC (6) at output level 4.
MC<ATC when ATC falls, MC>ATC when ATC rises and MC = ATC (12) at
output level 5. Relation between MC, AVC and ATC can be clearly shown
graphically.
AC
MC
MC
ATC
AVC
O Q1 Q2 Q
MC cuts both AVC and ATC at their minimum points. Thus when AVC is
minimum MC = AVC (at point A ) and when ATC is minimum MC=ATC (at

point B). The relationship between MC and AC may be summarized as

follows.
i) When AC falls MC<AC

ii) When AC rises MC>AC
iii) When AC is minimum MC=AC
Relationship between production and cost:
There is a relationship between productivity of factors and cost. Let

us assume that there is a single variable factor labour (L). The price of
labour is denoted by W (wage rate). Then total variable cost is the product
of wage rate and amount of labour.
TVC = W.L
AVC = TVC / Q = W.L / Q
Q / L = output / labour = Average product
of labour.
Therefore,
AVC = W / AP ( L/Q = 1/AP)
From this relation we may conclude that average product and average
cost are mirror image of one another.
By the same way we can show that marginal product and marginal
cost are mirror image of one another.
Marginal cost is the change in total variable cost due to a change in
output.
MC = TVC / Q = W. L / Q ( W in assumed to be fixed )
Q / L = Marginal product of labour.
Therefore MC = W/MP
The following diagram shows the relationship between AP, MP with AC

and MC.
AP
MP
AP
L1 L2 MP L

AC
MC
MC AC
O Q1 Q2 Q
This diagram shows when AP increases, AC decreases and when AP

decreases, AC increases. AC is minimum when AP is maximum. When
MP increases MC decreases. MC is minimum when MP is maximum and
when MP decreases, MC increases.
Long – run costs :
Long – run denotes a time period during which a firm can change all
of its factors of production. The exact length of the time period cannot be
stated clearly. It depends on the commodity that has to be produced by
the firm. There is no fixed cost in the long-run since there is no fixed
factor of production. All costs are variable in the long-run.
Long – run average cost curve :
The goal of every producer is to maximize profit. For a given level of

output the producer has to minimize the cost of production. Thus the
producer wants to achieve the minimum level of average cost. In the long-
run the producer has the opportunity of minimizing the cost with respect
to all inputs.
The LAC curve can be derived from the SAC curves. This can be
shown with the help of the following diagram.

AC
LAC
A SAC1
SAC4
B SAC2 SAC3
C D
Figure 10
O Q1 Q2 Q3 Q4 Q
The LAC curve is a lower envelop of all the SAC curves. Each point on
the LAC curve corresponds to a point on the SAC curve which is tangent
to the LAC curve at that point. In fig-10 we have shown different plant
size 1, 2, 3 and 4. SAC1 is the short-run average cost of size 1. Similarly
SAC2 and SAC3 and SAC4 devote short-run average costs of the plant size
2,3,4 respectively. LAC curves becomes tangent to SAC1 at point A. It is
clear from the figure that point A is not the minimum point of SAC1
curve. The point of tangency between the LAC and SAC curves is on the
falling part of LAC curve before the minimum point of LAC. Similarly the
point of tangency of SAC4 and LAC (point D) is on the rising part of the
LAC. Thus the falling part of the LAC curve shows the plant operating
with excess capacity. The rising part of the LAC curve, on the other hand,
implies that the plant is overworked. The minimum point of LAC curve
becomes tangent to the minimum point of SAC3 curve at point C. This
point shows that the plant is optimally worked.
If we relax the assumption of only 4 plant sizes and assume that there
is a very large number of plants, then the LAC curve becomes a smooth
envelop curve.
The LAC curve of a firm is called the ‘planning curve’ because in the
long-run the firm plans to choose the optimum level of output which can
be produced at the minimum level of average cost. On the other hand the
SAC curve of a firm is called a ‘plant curve’ since each SAC curve
corresponds to a given plant size.

AC
LAC
Figure 11
O Q
The U- shape of the LAC curve shows the laws of return to scale. At
initial level there is increasing return to scale and the LAC curve is
downward sloping. After reaching the minimum level of long-run cost, the
LAC starts rising due to the decreasing return to scale.
Long – run marginal cost :
Long – run marginal cost curve can also be derived from the short-run
marginal cost curves. But LMC curve is not an envelop of SMC curves.
LMC is derived from the point of intersection of SMC curves with the
vertical line drawn from the point of tangency of SAC curves with the LAC
curves. The LMC must be equal to the SMC at the optimal level of output.
The optimal level of output is determined by the least-cost combination of
factors of production. It is that level of output where SAC curves became
tangent to the LAC curve.
MC LMC
D
AC SMC1 LAC
a SAC1 SMC2 SMC3 SMC4
SAC4
SAC2 SAC3
b
c d
A C
B
Figure 12
O Q1 Q2 Q3 Q4
If the plant size is not optimal the SMC is either more or less than the
LMC.
If figure (10) the point of tangency of SAC1 with LAC is point a. We

draw a vertical line downwards from point a. It intersects with SMC1 at
point A. A is one of the points on the LMC curve. Repeating the same
procedure we get point B, C and D of the LMC curve. At the falling part of
LAC curve LMC<LAC. At the rising part of the LAC curve LMC>LAC. Only
at the minimum point of the LAC curve (point C in figure 10) LAC = LMC.
Key terms used in this chapter:
Explicit cost
Implicit cost
Opportunity cost
Sunk cost
Accounting cost
Economic cost
Private cost
External cost
Social cost
Fixed cost
Variable cost
Total cost
Average Fixed cost
Average Variable cost
Marginal cost
Short – run cost (SAC SMC)
Long - run
cost (LAC LMC)

IBBI Syllabus on Macro Economics
Sl. No. Coverage Weight (%)

1. Principles of Economics 4%
• Macroeconomics
- Functions & Role of Money
- Inflation: Types of Inflation, Causes, Effects,
Inflationary Gap, Control of Inflation, Monetary,
Fiscal and Direct Measures
- Deflation: Causes, Effects, Deflationary Gap,
Measures to Control Deflation, Deficit
Financing
- Savings and Investment: Savings and Types of
Savings, Determinants of Savings, Investment,
Types of Investment, Determinants of
Investment, Relationship between Savings and
Investment
- Components of Economy: Primary Sector, 2%
Secondary Sector, Tertiary Sector, Informal
Sector in Urban Economy, Parasitic
Components in Urban Economy
- Concepts of GDP and GNP, Capital Formation
• Parallel Economy
- Definition of Parallel Economy, Causes and
Effects of Parallel Economy on use of Land and
its Valuation
- Its impact on Real Estate Market
- Construction Industry and Parallel Economy

Function & Role of Money
Meaning of money and Functions of money

Different types of money
Supply of money
Money Value and Relative Value
Neutrality of Money
Definition of money
Money may be defined as the generally accepted medium of exchange.
Some definitions of money given by different economists are given below.
According to Prof. Walker ‘money is what money does’. More
comprehensive definition is given by Prof Crowthers. According to him
money is anything which is generally acceptable as a medium of
exchange and at the same time acts as a store of value.
Functions of money:
The functions of money have been classified into three groups: primary
function, secondary function and contingent function.
1) Primary function: are the most important function performed by
money.
i) Medium of exchange: money is a generally acceptable medium

of exchange we can purchase anything by money. It removes the
inconvenience of the barter system.
ii) Measure of value: money also acts as the measure of value or

unit of account. We can measure the value of any commodity or
service in terms of the amount of money. It means that prices of
all goods are expressed in terms of money.
2) Secondary Function: Functions of money which are derived

from the primary function are considered as the secondary functions
of money:
iii) Standard of deferred payment:
Future transaction can be done with the help of money. The

loan taken today can be repaid in money in future. So money
acts as a standard of deferred payment.
iv) Store of Value: Money is the most liquid form of wealth. We

can store the value of any asset in the form of money. So money
acts as the store of value. The value of any commodity can be
transferred from one person to other in the form of money.

3) Contingent Functions:
Money can help various economic agents (house hold, firms and
government) to take decisions. It is called the contingent function
of money.
V) Assisting Consumption decision:

The main determinants of consumption decision are the income of
the consumer and the price of the commodity. Each of these are
expressed in terms of money. So, money assists a consumer to take
his or her decision.
Vi) Assisting production decision:

The motive of the producer is to maximize profit. Profit is the
difference between total revenue earned by the producer and the
total cost of production. Both revenue and cost are expressed in
terms of money.
Vii) Assisting Distribution:

The total income is distributed among the factors of production.
Labor earns wage, land earns rent, capital earns interest and
entrepreneur earns profit. Each of these payments is done in terms
of money. So money also assists distribution of income.
Viii) Assisting credit operation:
The credit operation by banks and other financial institutions is

very important for the proper functioning of trade and commerce of
modern economy. Money is the basis of such credit.
Types of Money
1) Commodity money: In earlier society precious metals were

used as the medium of exchange. This was the idea behind
commodity money. Both precious metals like gold, silver and
cheaper items like shells, stones were used as medium of
exchange. With the advancement of trade and commerce
commodity money was replaced by representative money.
Representative money is money that consists of token coin,
paper notes etc which can be exchanged for a fixed quantity of
gold or silver.
2) Paper Money:
Paper money came into use after commodity money.
Businessman and traders sometimes kept gold with goldsmiths.

Goldsmiths promised to handover the gold to the bearer of the

receipt issued by the goldsmith. Gradually the receipt issued by
the goldsmith became acceptable in business transaction. So
this convenient medium of exchange (piece of paper) became
money. Early banks also stored gold and issued notes which
promised to pay back the gold on demand. These promissory
notes were called bank notes.
3) Fiat money:
Afterwards bank notes were issued by the central bank operated
by Government. Originally central bank issued fully convertible
currency notes. Convertible currency note means it is fully
convertible into gold. Between World War I and II all countries
abandoned gold convertibility. From that time government
declared inconvertible paper notes as legal tender. Fiat money is
inconvertible paper money that is declared by government order
to be legal tender for settlement of all debts. Today all notes and
all coins in circulation are fiat money.
4) Modern Deposit money:
Customers deposit paper notes to bank. Each deposit creates an

entry to the customers’ account. Now, in case of transfer of
money from one person to another, it is more convenient to have
the bank transfer claims to the money they hold on deposit.
Cheque is an instruction to the bank to make the payment or
transfer. Cheques are widely accepted in transfer or payments
for commodities. So deposit on which cheque is drawn became a
form of money called deposit money.
Near money:
Anything which acts as a store of value and easily converted
into medium of exchange is called near money. For example
time deposit on which cheques cannot be drawn is called near
money for it acts as a store of value (earns interest also) and can
be converted into medium of exchange.
Money Substitutes:
Anything which acts as a temporary medium of exchange but
does not act as a store of value is called ‘money substitutes’.
The most suitable example is credit card through which money
transactions are done without cash or cheque. But this is only a
temporary function; the final medium of exchange is money.

Supply of Money:
The total quantity of money held by the people of an economy at

a particular point of time is called the supply of money in the
economy. However the term money does not only mean cash. It
consists of demand deposit, time deposits held by commercial
banks, and other deposits in the economy.
There are different concepts of money supply. One of them
includes cash and demand deposits held by commercial banks
and other deposits as money supply. Another group of
economists believe that since loans are granted against time
deposit (fixed) and are used to purchase goods and services,
time deposit should also be included in money supply.
Different components of money supply are described briefly as

follows:
M1 = currency held by the people (C) + demand deposit with the
commercial banks (DD) + other deposit with the reserve bank
(OD)
So M1 = C+ DD+ OD
M2 = M1 + postal savings bank deposit.
Since people can withdraw money from postal savings deposit

on demand, it is included in the supply of money.
M3 = M1 + time deposit with the commercial bank.

M4 = M 3 + total deposit with the postal savings organisation
(excluding NSC)
In India M1 and M2 are called narrow money since they include

lesser constituents of money supply. M3 and M4 are called broad
money since they include larger constituents of money supply.
Generally M3 is treated as the aggregate supply of monetary
resource.
High powered money or monetary base of a country refers to the

total liability of the monetary authority (central bank) of a
country. It includes currency held by the public, cash reserve
with the commercial bank, with central bank and other deposit
with central bank.
The Nominal and Real Money supply:
It is also useful to distinguish the nominal from the real money

supply. The nominal money supply is the money supply
measured in monetary units. The real money supply is the

money supply measured in purchasing power units and

expressed in constant prices-prices that were ruling in some
base year. To obtain the real money supply, the nominal money
supply is deflated by an index of the general price level.
Money Values and Relative Values:
Money is the measuring rod in most economic activities.

Wealth, incomes, what we buy and what we sell are all valued in
money terms. When we think of a commodity’s market value, we
usually think of its money price. Money prices are measure of
economic value. Money prices allow us to compare different
values at any point of time.
Early economists believed that money value is not important in

itself. The value of money is always relative. A simple money
price is meaningless unless it can be compared to the price of
something else. What matters, therefore, is the comparison of
two or more money values. So we may conclude that relative
values are more important than money values.
Adam Smith, writing in 1776, stated that individual sums of

money, and individual money prices, each looked at in isolation,
convey no useful information. Instead, the comparison of two or
more monetary values is what conveys significant information.
Such comparisons allow us to look behind individual money
prices to find real opportunity costs: how much of one thing
must be given up to obtain a stated amount of something else.
The Neutrality of Money:
Out of this realization grew the doctrine of the neutrality of

money. Correctly stated, this doctrine says that the units
chosen to measure values have no effect on ‘real values’ – real
values are ‘relative values’, and it is relative values that affect
behavior.
It follows from the doctrine of the neutrality of money that,
when all monetary values are changed by the same proportion,
nothing real happens.

MACROECONOMICS PRACTICE TEST

MACROECONOMICS MULTIPLE – CHOICE QUESTIONS
1. Medium of exchange and Measure of value are

a) ✔Primary function of money
b) Secondary function of money
c) Contingent function of money
d) Not a function of money
2. One of the Primary Function of money is

a) Store of value
b) ✔Medium of Exchange
c) Assisting production
d) Assisting Distribution
3. Standard of deferred payment and store of value are

a) Primary function of money
b) ✔Secondary function of money
c) Contingent function of money
d) Function of Industry
4. 'Assisting Consumption Decision' is

a) Primary function of money
b) Secondary function of money
c) ✔Contingent function of money
d) Function of Government
5. One of the contingent function of money is

a) Store of value
b) Measure of value
c) ✔Assisting production decision
d) Medium of exchange
6. One of the secondary function of money is

a) Assisting Distribution
b) Medium of exchange
c) ✔Standary of deferred payment
d) Medium of exchange

Inflation & Deflation
Definition of Inflation
Different degree of Inflation
Quantity Theory of Money
Demand-Pull Inflation
Cost-Push Inflation
Effects of Inflation
Anti Inflation measures
Definition of Inflation:
Inflation is a situation where general level of price is rising. Two points
should be noted here:
i) Inflation means not merely high prices, but rising prices.
ii) The rise in price should be sustained. If it is a temporary rise, then
the situation is not called an inflationary situation.
We can calculate inflation with the help of price index.
Consumer price index (CPI) means the cost of a basket of consumer

goods at the current market price relative to the cost of that bundle
during a particular base year. GDP deflator is another price index
which measures the average price of the components in GDP relative
to base year.
The rate of inflation is the percentage change in the price level.
So,
Rate of inflation in the year t
Pt - Pt- 1
= X 100
P t -1
Different degrees of inflation:
Inflation can be categorized according to the degree of severity: Low

inflation, galloping inflation and hyper inflation.
i) Low Inflation: In this situation price rises slowly and predictably.

The annual inflation rate is single digit. People can trust money because
in low inflation situation money can retain its value. Some economists
believe that low rate of inflation is sometimes helpful to encourage
producers to produce more.
ii) Galloping Inflation: It is very high inflation and the rate of
inflation is double digit and sometimes triple digit percent per year. This

situation can emerge in different countries at the time of war, revolution

or other disturbing situations.
In the situation of galloping inflation serious economic distortions arise.
Money loses its value rapidly, people holds goods, buy land and house
rather than holding money, financial market breaks down and capital
flees abroad.
iii) Hyper inflation: Worst form of inflation is hyper inflation. In this

situation the rate of inflation is million trillion percent per year.
According to J.M Keynes, “As inflation proceeds and the real value of
currency fluctuates widely from month to month, all permanent
relations between debtors and creditors, which form the ultimate
foundation of capitalism, become so utterly disordered as to be almost
meaningless, and the process of wealth getting degenerates into a game
and a lottery.”
Quantity Theory of money:

According to classical economists there is a positive relation between
price level and quantity of money. This hypothesis called ‘quantity theory
of money’ predicts that changes in price level is proportionate to changes
in the quantity of money.
The Quantity Equation of Exchange
M V=P T (1)
This equation shows the link between the volume of transaction and
quantity of money.
M represents the quantity of money.

V represents the transaction velocity of money which means the number
of times a unit of money circulates in the economy.
P is the number of rupees exchanged per transaction.
T shows the total number of transaction in an economy during a
particular period (1 year)
Income Equation of Exchange:
It is difficult to measure the volume of transaction. So T is replaced by
the total volume of output Y. Although T and Y are not the same, there is
a link between the two. If Y increase T will also increase.
Replacing T by Y in equation (1) we get another equation of exchange.
MV = PY (2)
Here V represents the income velocity of money.
Demand Function for Money and Quantity Equation:
Real Money Balance: Sometimes economists express the quantity of
money in terms of goods and services it can buy. This is known as real
money balance (M/P) which measures the purchasing power of money in
circulation.
(M/P)d = KY (3)
This is the money demand function K is the fraction of income people
want to hold for the purpose of transaction.

In equilibrium in the money market the demand for real balance would
be equal to the amount of real balance existing in the market.
M
So = KY
P
Rearranging we get
1
M = PY
K
Or MV = PY
Where P
V=
K
When people want to hold large fraction of income for transaction (k is

larger), income velocity of money (V )is low, i.e, money changes hands
slowly. The opposite is also true.
Some assumptions are made by the economists to make the hypothesis

of quantity theory of money.
i) The income velocity of money V remains constant .
ii) Y = GDP is determined by factors of production.
It follows from the assumption that the nominal value of output PY is

determined by the money supply M.
The general price level is the ratio of the nominal value of output PY to
the level of output Y.
It is known that real GDP, Y remains constant in the short run since
factor supply and technology are fixed in the short run.
For the equation

MV = PY
V and Y are assumed to be fixed in the short run.
So any change in the supply of money M brings a proportionate change
in the general price level P.

Modern Inflation Theory
Demand pull inflation:
Demand pull inflation occurs when aggregate demand in an economy

exceeds aggregate supply.
This theory developed by J.M Keynes can be described with the help of
the concept of inflationary gap. This can be defined as the excess of
aggregate demand over aggregate supply at the level of full employment.
(C+I+G)1
C+I+G A
(C+I+G)
O Y
YF
This can be described with the help of a diagram. We measure

consumption (C), investment (I) and government spending (G) on the
vertical axis and output Y on the horizontal axis. (C+I+G) represents the
AD curve. At point B, AD cuts the 450 line and economy reaches at the
full employment level of output. Now, suppose for any reason aggregate
demand rises over aggregate supply. AD curve shifts to (C+I+G)1. But
output cannot be increased since it already reaches the full employment
level. AB is called the inflationary gap.
As demand is more than the supply of commodities prices of the

commodity increase.
One of the causes of demand pull inflation is the policy of deficit
financing of the govt. For financing the budget deficit govt. prints money.
This creates rapid growth of money in the economy and increases the
aggregate demand.

P AS
E1
P1
AD
P E
AD
O Q
Demand pull inflation is explained with the help of the above figure.
Initial equilibrium was at point E where aggregate demand was equal to
aggregate supply. If aggregate demand rises for some reason AD curve
shifts from AD to AD1. New equilibrium shifts from E to E1. Price level will
be increased from p to p1.
Cost Push Inflation:
Rising cost is another cause behind inflation. This is called cost push
inflation. Sometimes it leads to a situation where output falls, economy
shows down but price level vises. This is called ‘stagflation’ or inflation
with stagnation. Cost push inflation can be shown diagrammatically with
AD and AS curve.
P AS
E1
P1
E
AD

For increase in cost of production AS curve shifts upward to AS1. Price

level rises from P to P1.
Expected & Unexpected Inflation:
Inflation may be of two types: expected or anticipated or unexpected or

unanticipated.
For example over some decades, the general price level of the US rose an
average around 3% per year.
People form an expected rate of inflation which tends to persist until a
shock causes it to move up or down.
Unanticipated inflation is caused by some shocks like excess demand
(demand pull inflation) or shortage of supply, or increase in production
cost (cost push inflation).
Unanticipated or unexpected inflation has much sever effects on an
economy than expected inflation.
The social Cost of Inflation:

Inflation refers to a rise in absolute price (which gets reflected in the
overall price index), not a change in relative prices. But economic well –
being depends on relative prices, not on the general price level.
The social cost of inflation depends on its rate. Mild inflation is less costly
than hyper inflation. Only a persistent rise in price poses a social
problem.
 The Costs of Expected Inflation
The most serious consequence of the expected inflation is the

distortion created by the inflation on people’s demand for money. In
this context the following costs can be referred.
1. Shoe-Leather costs:
Money loses its value due to inflation. For that reason people hold
lower money balance. So they are required to go to banks more
frequently than when prices remain stable. The inconvenience of
reducing money holding is known as shoe –leather costs of inflation.
Shoes are very costly in Western countries. There is no scope of
repairing shoes. So as people go to bank more and more frequently
they have to replace their shoes again and again at a high cost.
2. Menu costs:
High inflation induces firms to change their printed prices every now
and then. But frequent price changes create confusion among buyers
and adversely affect consumer psychology and emotion. Price changes
are also costly. There is need to print new prices, announces price
changes through newspapers and T.V. commercials and distribute
catalogues. These costs are known as menu costs. The truth is that

the higher the rates of inflation, the more often eating house have to
print new menus.
3. Tax laws and tax liabilities:

Tax laws, of most countries except where there is indexation, do
not take into account inflation. Inflation can alter tax liabilities of
individuals in ways not desired by the tax authorities.
4. Inconvenience:
Money is the measuring rod of everything. During inflation it fails
to perform this function because the unit of account itself changes.
For example, during inflation people cannot do proper financial
planning. They do not know much to consume and how much to
save.
 The Costs of Unexpected Inflation
The main costs of unexpected inflation are redistribution of income in

undesirable ways and generation of uncertainties. The following points
may be noted in this context:
1. Income redistribution:
Unexpected inflation arbitrarily redistributes wealth among individuals.

Since most loan agreements are made at a nominal rate of interest and
there is no inflation clause (adjustment of nominal rate against actual
rate of inflation), debtors gain and creditors lose if the actual rate of
inflation turns out to be higher than the expected rate.
If the rate of inflation falls below what people expect, the shoe is on the
other foot. It is because the repayment is greater than what was expected
by both the parties. People having fixed income such as most wage-
earners, pensioners, renter class and holders of government bond suffer
loss of real income (purchasing power) during inflation. They are robbed
by people whom they cannot see or indentify.
2. Uncertainty:
The greater is variability of the rate of inflation the greater is the

uncertainty faced by both debtors and creditors. The unpredictable
nature of highly volatile rate of inflation hurts most risk – adverse people
who do not want to learn to live with inflation. They never develop any
taste for uncertainty which traders and speculators often love to cherish.
In short, volatile inflation is something which most people find
unpalatable. Since they cannot digest it, they do not want to swallow it
either.

3. Variability:
Finally high inflation, being highly volatile and variable in nature,

increases uncertainty of both lenders and borrowers by subjecting them
to arbitrary and potentially large redistributions of wealth.
Anti- Inflation policies:
Anti – inflationary policies may be grouped under three headings:
(i) Monetary policy
(ii) Fiscal policy and
(iii) Non – monetary policy. Let us discuss them one by one.
(i) Monetary Policy:
Inflation is caused either due to the rise in aggregate demand or due

to the rise in cost of production. The former is called demand-pull
inflation and the later is called cost-push inflation. To control the
demand-pull inflation the aggregate demand should be reduced. If the
supply of money of an economy can be decreased the prices are
expected to fall. The major part of the money supply is bank deposit or
bank credit. The Central bank of a country can reduce the lending of
commercial banks. This called credit control policy of the Central
bank.
The measures usually taken by the central bank for controlling the
volume of credit are as follows:
(a) Changes in the bank rate,
(b) Changes in the reserve ratio to be maintained by the commercial
banks with the central bank,
(c) Open market operations
(d) Selective methods of credit control.
Changes in the bank rate
In case of India the bank rate indicates the interest rate at which the
commercial banks borrow money from Reserve Bank of India.The bank
rate should be increased during a period of inflation. This is called dear
money policy because cost of borrowing credit money becomes higher for
the commercial banks. So commercial banks are permitted to increase
their lending rates. The increase in the bank rate will increase the long
term market rate of interest thereby discouraging investment. This will
reduce the inflationary gap.
Changes in the reserve ratio
Commercial banks have to keep a certain minimum cash reserve with

the Central bank. Cash reserve ratio is the amount of cash reserve as a
percent of the net demand and time deposit of the commercial banks.The
reserve ratio of the commercial banks will have to be increased by the
Central bank during the period of inflation. When the reserve ratio is
raised, this will reduce the excess reserves of the commercial banks
thereby reducing their credit creating capacity.
Open market operations
The purchase and sale of Govt. securities by Central bank is called the
open market operation by Central bank.The pressure of excess
demand during a period of inflation results from excess purchasing
power. To check the inflationary pressure the Central bank sells Govt.
securities in the open market to pump out some amount of money
from circulation. Most of the securities are purchased by commercial
banks and other financial institutions. By open market operation
Central bank tries to check the continuous expansion of money in the
economy.This would reduce the quantity of money in circulation.
Selective methods of credit control
Similarly, to control credit in some selective sectors of the economy

the selective methods of credit control like regulation of margin
requirements or regulation of consumer credit may be used.
The main difficulty with the monetary policy is that these methods
affect the economy’s aggregate demand only indirectly. Hence the
result to be obtained by adopting monetary policy would require some
time lag.
Fiscal Policy:
Fiscal policy can also be used to check inflation. The fiscal policy refers to
the income expenditure process of the government. Different fiscal
parameters like the changes in the government expenditure, changes in
transfer payments, changes in taxes or changes in the public borrowing
can directly affect aggregate demand. During a period of inflation the
government can like the Following steps:
(a) Government expenditure on goods and services should be reduced,

taxes remaining the same thereby having a surplus in the budget. A
reduction in government expenditure directly reduces aggregate demand.
(b) Taxes should be increased, govt. expenditure remaining the same.
An increase in taxes will reduce the disposable income of the public
thereby reducing aggregate consumption expenditure. It should be
noted that as anti- inflationary measures direct taxes are superior to
indirect taxes. Since indirect taxes can be shifted, imposition of
indirect taxes will lead to further increase in the price level.
(c) The government should borrow from the public during a period of
inflation by selling new government bonds. Government borrowing
may also take the form of compulsory saving. When people purchase
government bonds, they surrender purchasing p[ower5 which may
otherwise have been spent on consumption or investment.

Apart from the monetary and fiscal measures non-monetary measures

may also be adopted to control the inflationary situation. The non –
monetary measures include output adjustments, wage policy, price
control and rationing etc. Inflation may arise because of shortage of
output. So to control inflation the level of output should be increased
in real terms. The volume of production should be increased.
Similarly to control an inflationary situation that arises from cost side,
attempts should be made to check the rate of increase in money
wages. The measures to control price and rationing are actually short
run measures. Price control means fixation of legal upper limit. Mere
price control may lead to the creation of black market. Rationing to
the highest number of consumers functions as a device of stabilizing
consumer prices and of assuring distributive justice. However,
rationing by weak administration will lead to black market and
corruption.
Different anti-inflationary policies should not be regarded as

competitive. They are rather complementary. All of them should be
used at the same time to get the best results.
Deflation
A deflationary gap: An excess supply situation in an economy leads to a
continuous fall in the price level, aggregate output and employment in an
economy. This is considered as economic deflation in any country. Thus,
if the aggregate desired expenditure or the aggregate demand becomes
less than the aggregate supply available at the full – employment level of
output, there arises a deflationary gap.
Deflationary gap Y=C+I

(C+I)F C+I)P
E ●
●
Deflationary
gap
45O
0 YF Y

In the figure, we see that at the full-employment level of national output

YF, present aggregate desired expenditure [(C = I)p] becomes less than the
aggregate desired expenditure required to maintain that full –
employment level of output by an amount of EF. This gap of EF shows
the deflationary gap.
The basic reasons for the emergence of a deficient demand or a
deflationary gap
(a) A fall in the aggregate desired private consumption
expenditure: If there is a fall in the aggregate desired private
consumption expenditure (C) at6 each level of national output, then it
would lead to a fall in the aggregate demand in an economy. In fact,
the people may be inclined to save more and consume less at each
level of national output.
(b) A fall in the aggregate desired private investment
expenditure: Again, if there is a fall in the aggregate desired private
investment expenditure (I) in an economy at each level of national
output, then aggregate demand will fall. This may happen due to
bleak business prospects in an economy.
If we now consider an open economy with positive government

intervention in economic activities, then we get the following
additional reasons for the emergence of a deficient demand
situation or a deflationary gap.
(a) A fall in net export earnings

(b) A fall in government expenditure
(c)An increase in tax rates
The consequences of deficient demand situation

(a) A pilling up of the stock of inventories
(b) A fall in the level of output and employment
(c)A fall in the general price level
Measures to combat the deficient demand conditions

If an economy suffers from the problem of deficient demand or a
deflationary gap, then some measures are to be adopted to raise the level
of aggregate demand in the economy. The role of the fiscal policy or the
budgetary policy of the government for the correction of such deficient
demand situation was first emphasised by John Maynard Keynes.
The basic instruments of the fiscal policy are:
(i) Government expenditure
(ii) Taxes
(iii) Subsidy and transfer payments
(iv) Public debt or public borrowing and
(v)Deficit financing

Government expenditure: Government Expenditure is one of the

component of aggregate demand. The rise in aggregate demand can
combat the deflationary gap. If government increases the expenditure it
will have positive effect on aggregate demand. Increased aggregate
demand can control the deflationary situation.
Taxes: A reduction in direct tax increases disposable income of

individual. The rise in disposable income results in increased purchasing
power and ultimately the consumption expenditure will rise. In this way
the government can control the deflationary situation.
Subsidy and transfer payments : Government sometimes gives subsidy
to the producers. Such payment raises the income of the producer.
Similarly transfer payment by the government (old age pension, relief for
natural calamities, donation etc) raise the income and purchasing power
of the people. This will lead to rise in consumption expenditure and
ultimately the rise in aggregate demand.
Public Debt: Sometimes government takes loan from the public by

issuing government bond. This is called public borrowing or public debt.
If there is an inflationary situation, government sell securities to public.
People purchase the government securities by paying liquid cash. This
will reduce the excess supply of money from the economy. On the other
hand if there is a deflationary situation in the economy the government
wants to inject additional supply of money in the economy to raise the
aggregate demand. Then the government should purchase bonds from
the people. The additional money results in increased level of
consumption and in turn raises the aggregate demand.
Deficit financing: When the aggregate expenditure exceeds aggregate

revenue of the government, then there arises a deficit in the government
budget. The method of financing this deficit is called ‘deficit financing’.
The government can take loan from the Central Bank to cover this budget
deficit. The Central bank can print money against such government
securities. So, the supply of money will increase in the economy. The
purchasing power of the people will rise. As a result, the consumption
expenditure of the people will rise. So, the problem of deficient demand
can be solved.


1. The situation of rising price level is called

a) Deflation
b) Stagflation
c) ✔Inflation
d) Recession
2. Inflation means
a) ✔Rising price
b) High price
c) Falling price
d) Low price
3. If in a full employment situation Aggregate demand exceeds

aggregate supply then a situation arises which is called
a) Deflationary Gap
b) Budgetary Gap
c) ✔Inflationary Gap
d) Balance of payment
4. An inflationary gap arises in a full employment level when

a) ✔ Aggregate demand exceeds aggregate supply
b) Aggregate supply exceeds aggregate demand
c) Aggregate demand equals to aggregate supply
d) Aggregate demand=0
5. One of the causes of inflation

a) Fall in demand
b) Rise in supply
c) ✔Rise in demand
d) Fall in cost
6. Deficit financing is one of the causes of

a) Stagflation
b) Deflation
c) ✔ Inflation
d) Recession
7. Cost push inflation is caused by

a) Rise in Consumption
b) Rise in Investment
c) Fall in Wage rate
d) ✔Rise in Wage Cost
8. The price rise caused by the cost of production is
a) Demand- pull inflation
b) ✔Cost- push inflation

c) Stagflation
d) Depression
9. '………………….'gain from inflation

a) Lenders
b) Consumers
c) ✔Borrowers
d) Government
10. Inflation results in

a) Lower profit
b) Higher export
c) ✔Higher profit
d) High real income
11. One favourable impact of inflation is

a) Fall in real income
b) Inequality in the distribution of income
c) ✔Higher Production
d) Lower profit
12. One unfavourable impact of inflation

a) Higher Profit
b) Gain of the borrower
c) ✔ Fall in real income
d) Higher production
13. Which is not the cause of inflation

a) Deficit financing
b) Population Growth
c) Hoarding
d) ✔ Fall in demand
14. Which one is the cause of cost - push inflation

a) Increase in consumption
b) Increase in investment
c) ✔Rise in input price
d) Increase in saving
15. A continuos fall in the general price level is called

a) Inflation
b) ✔ Deflation
c) Stagflation
d) Recovery

16. A deflationary gap arises when

a) Aggregate demand is greater than Aggregate supply
b) ✔ Aggregate supply is greater than aggregate demand
c) Aggregate supply is equal to aggregate demand
d) Aggregate Supply =0
17. Which is not a cause of deficient demand?

a) A fall in the aggregate consumption expenditure
b) A fall in the aggregate investment expenditure
c) A fall in government spending
d) ✔Rise in consumption
18. Which is the consequence of deficient demand

a) A rise in general price level
b) A rise in profit
c) ✔A fall in the level of output and employment
d) Rise in production
19. Credit control by central Bank is

a) ✔A Monetary policy
b) Fiscal policy
c) Industrial policy
d) Trade policy
20. Change in bank rate is one of the measurer of

a) Credit creation
b) ✔ Credit Control
c) Deficit financing
d) Fiscal policy
21. Which is not an instrumnet of credit control

a) Change in resume ratio
b) ✔ Increase in indirect tax
c) Open market operation
d) Change in bank rate
22. One of the Fiscal policy measures is

a) Selective creadit control
b) Open market operation
c) ✔increase in income tax
d) Change in bank rate
23. Which is not a Fiscal policy measure

a) A decrease in government spending
b) An increase in income tax
c) A decrease in sales tax
d) ✔Increase in bank rate

24. Change in CRR is a measure of

a) Fiscal policy
b) Trade policy
c) ✔Monetary policy
d) Industrial policy
25. One measure of combating deficient demand is to

a) Increase bank rate
b) Increase CRR
c) ✔ Increase government expenditure
d) Increase investment
26. Which is not a measure to combat deflation?

a) Increase Govt. expenditure
b) Reduce income tax
c) Decrease bank rate
d) ✔ Reduce subsidy and transfer payment
27. Which is not instrument of monetary policy?

a) ✔ Deficit financing
b) Bank rate
c) Open market operation
d) CRR
28. Which is not a measure of Fiscal policy?

a) Govt. expenditure
b) Taxes
c) ✔ Open market operation
d) Deficit Financing
29. Public debt is a measure of

a) Monetary Policy
b) ✔ Fiscal Policy
c) Trade Policyd) Industrial Policy

Consumption Saving Investment
Introduction
Aggregate Demand (AD) & Aggregate Supply (AS)
Components of Aggregate demand
Aggregate Supply and its Components
Consumption function
Saving function
Investment
Equilibrium income: AD-AS approach
Saving investment approach
Investment or Output Multiplier
Introduction:
J.M. Keynes published his famous book – ‘The General Theory of
Employment, Interest and money’ in 1936 which is considered as the
pioneering work on Macroeconomics. His objective was to analyse the
causes of the great depression of 1929 and to suggest some measures to
overcome the situation.
The classical economists believed that supply creates its own demand
and full employment is automatically generated through the flexibility of
wage and price. Keynes opposed this idea and stated that employment
depends on aggregate output which in turn depends on aggregate
demand. He pointed out that the root cause of the great depression was
the deficiency of aggregate demand.
Aggregate Demand and Aggregate supply

In this chapter we will discuss the determination of equilibrium national
income. National income reaches its equilibrium value when the
aggregate supply equals to aggregate demand. The national income of an
economy is measured by aggregate expenditure. This aggregate
expenditure generates aggregate demand in a particular year. Aggregate
supply on the other hand is the total goods and services produced in the
economy in a particular year. At the equilibrium level of national income
Aggregate supply = Aggregate demand
AS = AD
Y = AD
Components of Aggregate Demand:
Aggregate demand of an economy during a particular year refers to the
planned or desired expenditure during the year. There are different parts
of the aggregate demand or expenditure as follows:
i) Private consumption expenditure (C)
ii) Privet investment expenditure (I)
iii) Government expenditure (G)
iv) Net export (X-M)

So, AD = C+ I + G + (X- M)
i) Private consumption Expenditure : (C)
One of the major components of aggregate demand is the aggregate

private consumption expenditure. It includes the expenditure made by
the household sectors for purchase of consumption goods during a
particular year. This is ‘planned’ or ‘desired’ consumption expenditure.
This expenditure generates private demand for consumption goods. The
consumption expenditure depends on the disposable income.
ii) Private Investment Expenditure (I)
Producers in the private sector spend money for purchasing investment

goods for production purpose. The ‘desired’ or planned expenditure
made by the private sector for the purchase of investment goods during
a particulars year are aggregated to get private Investment Expenditure
in an economy. This expenditure creates private demand for investment
goods. Some investment is autonomous and some investment depends
on the level of income. This is called induced investment. There is a
negative relation between investment and the rate of interest.
iii) Government Investment (G) :
This is the ‘planned’ or ‘desired’ expenditure of the government for the

purchase of both consumption and Investment goods during a particular
year. The govt. can purchase consumption goods like food grains,
clothing, houses etc for distribution purpose or for the use of Army and
other govt. employees. These expenditure made by govt is govt.
consumption expenditure. On the other hand govt can spend for the
construction of roads, railways, bridge, power station etc. These
expenditure constitute govt. investment expenditure. The govt.
expenditure is autonomous in nature. It does not depend on the level of
national income.
Net Export (X-M):
Net export is calculated by deducting import expenditure from export

earnings. It is an important component of aggregate demand since it
denotes the desired net foreign expenditure on the goods and services
produced by the country.
Therefore,
Aggregate demand (AD)
= Private Consumption Expenditure (C) + Private Investment
Expenditure (C) +Government Expenditure (G) + Net Export (X-M)
This is also called aggregate expenditure in the economy.

Aggregate supply and its components:
The total goods and service produced in an economy during a particular

year is considered as the aggregate supply (AS) of the economy.
The components of aggregate supply in the economy refer to the ways in
which the income earned in the economy is spent. The components are
as follows:
i) Aggregate consumption (C)
ii) Aggregate saving (S)
iii) Net Tax payment (T) (Tax payment to the govt. – Transfer payment
and subside by the govt.)
So, AS = C + S + T
Consumption Function:
Among various other factors income is the main factor affecting

consumption. According to Keynes consumption is a stable function of
disposable income.
C = f (Yd)
C = consumption
Yd = disposable income = Y – T
The Keynesian short run consumption function is expressed as
C = a + bYd
Average propensity to consume (A P C)
The proportion of aggregate consumption to aggregate income is called

the average propensity to consume.
C
APC =
Y
Marginal propensity to consume (MPC)
The change in aggregate consumption expenditure due to change in

national income is called marginal propensity to consume.
C
MPC=
Y
Keynes formulated the relationship between aggregate consumption and

income on the basis of the following assumption:
i) Real consumption expenditure is a function of real income.
ii) Consumption is a rising function of income. This means as income
increases consumption also increases.
iii) Marginal propensity to consume is positive but less than one. This
means that the consummation will rise as income rises but the increase
in consumption expenditure is less than the rise in income.

Therefore, O < MPC < I

iv) The consumption income ratio (C/Y) or APC declines as incomes
rises.
The graphical presentation of consumption function:
b C (Y)
a
O Y1 Y2 Y
Income Y is measured along the horizontal axis and consumption C is

measured on the vertical axis. C (Y) is the line representing consumption
function. Slope of the line is marginal propensity to consume.
Slope of the rays like oa, ob joining origin to any point of the
consumption line represents the average propensity to consume. It is
clear from the diagram that MPC or the slope of the consumption
function is positive but less than 1. It is also clear from the diagram that
as income rises from oy1, to oy2, the slope of the rays declines (slope of oa
> slope of ob) so it is clear that as income rises average propensity to
consume falls.
Saving function:
Saving is a rising function of income and the saving function can be

represented by
S = f (Y)
There is a close relation between consumption, income and saving.
Saving is that part of income which is not consumed.
S=Y–C
So we can derive saving function from consumption function.

C
S 450
C=Y
C a S (Y)
S
Y
S=O
In the above figure saving and consumption are measured on the vertical
axis and income is measured on the horizontal axis. C (Y) represents the
consumption function. OC is the level of consumption at the zero level of
income. A 45o line is drawn from the origin which cuts the consumption
function at point a. At this point income (Y) is equal to consumption. To
the left of this point income is less than consumption and there is
dissaving. Saving is zero where Y = C. After that income (Y) becomes
greater than consumption (C) and there is a positive level of saving. S (Y)
represents the saving function.
APS and MPS

Average propensity to save (APS) is the proportion of income which is
saved.
S
APS =
Y
Marginal propensity to save is the change in the desired saving due to a
change in income.
S
MPS =
Y

MPS is the slope of the saving function.

Relation between APC and APS
We have known that there is a close relation between income,
consumption and saving.
Y=C+S
Dividing both sides by Y we get
Y C S
Y Y Y
So, 1 = APC + APS

Or APS = 1- APC
and APC = 1- APS
If APC is 8, then APS is 2.
Relation between MPC and MPS

Y=C+S
If there is a change ( ) in income, a part of the income is consumed and
the remaining part is saved.
Y= C+ S
Dividing both sides by Y we get
Y C S
Y Y Y
Or, 1 = MPC + MPS
MPC = 1 – MPS
So, as MPC rises MPS falls and vice versa.
Investment Function
The main determinants of investment are the rate of interest and the level
of income. The investment function shows the functional relationship
between investment and its determinants. Privet investment can be
broadly divided into two types:
i) Autonomous Investment
ii) Induced Investment
Autonomous Investment is that part of investment which is

independent of the level of income. Here investment is fixed
autonomously: I = I
On the other hand induced investment is dependent on the level of

income. There is a positive relation between induced investment and the
level of income. Investment function takes the form as
I = I (Y)
Or investment is a function of the level of income.
Investment is related with rate of interest. There is a negative

relationship between investment and the rate of interest.
` I = I (r)
This three functions are shown in the following diagrams.

O (1) Y
Autonomous Investment: I = I
I
I (y)
O Y
(2)
Induced Investment: I = I (Y)+
dI
dY

I (r)
O I
Investment as a function of the rate of interest: I = I (r)

dI
dr
Equilibrium Income: AD-AS approach
The national income of a country reaches at the equilibrium level when

aggregate demand equals to aggregate supply or
AD = AS
We have already discussed about the components of aggregate demand:
AD = C+ I+ G Here C= Aggregate consumption,
I= Aggregate Investment and
G= Government expenditure
for a closed economy (without foreign sector)
Aggregate supply is the aggregate output or income: Y
So the condition for equilibrium is
Y = C+ I+ G
C+ I+ G is also called aggregate expenditure or AE.
Graphical presentation of the equilibrium income :-

We measure income on the horizontal axis and the components of
aggregate demand on the vertical areas.

C 450
I C+ I+ G
G E
C
O Y1 YE Y2 Y
We also draw a 450 line. The consumption function is shown as line C.

C+ I+ G is shown separately. This is a parallel line to the C line since I+G
is autonomous expenditures which are independent of income. 450 line
shows the equality between Y and C+ I+ G. In the figure, 450 line cuts the
C+ I+ G at point E. So E is the equilibrium point where aggregate demand
equals to aggregate supply
AD = AS
YE is the equilibrium level of national income. At the level of income Y1 AD
>AS. This induces the producer to produce more and this in turn raises
the national income. This process will continue until Y = C+ I+ G.
Similarly when the level of income is al Y2, AD < AS. An excess supply
situation induces the producer to reduce production. This process will
also continue until Y = C+ I+ G at YE level of income.
Saving Investment approach:
The equilibrium level of national income can also be determined when

desired aggregate investment plus govt. expenditure equals to desired
aggregate saving plus taxation.
I+ G = S+ T
From the 1st condition of equilibrium we know that at equilibrium level
Y = C+ I+ G
We also know that the component of aggregate supply is C+ S+ T.
There far C+ I+ G = C+ S+ T
Or, I+ G = S+ T
This is the 2nd equilibrium condition in simple Keynesian model.

Graphical Representation:
S+I
I+G S+T
E I+G
Y1 YE Y2
O Y
Here also income is measured on the horizontal axis and S+I and I+G are
measured on the vertical axis. Since I+G are independent of the level of
income, the I+G. schedule is a horizontal straight line parallel to x axis.
S+T is an upward sloping line showing the direct relation between saving
and income. At point E S+T line cuts I+G showing the equality between
S+ T and I+ G. Corresponding to this equality national income reaches at
equilibrium level at YE.
At Y1, I+G > S+T
This implies that aggregate demand exceeds aggregate supply. So there is
unintended inventory depletion. As a result producers will produce more.
This increases the aggregate supply. This process will continue until
aggregate demand in equal to aggregate supply.
On the other hand at income level Y2, I+G < S+T. This implies an excess
aggregate supply. A part of the total output will remain unsold resulting
in an unintended inventory accumulation. The producers will reduce
their production. This process will continue until aggregate demand will
be equal to aggregate supply.
Investment or Output multiplier
This theory developed by J. M Keynes states that increase in autonomous

expenditure have effects on equilibrium level of national output. The real
national income will increase by a multiple of the initial increase in
autonomous investment.
If increase in real national income is denoted by Y and increase in
autonomous investment is denoted by I then
Y = K= investment multiplier
I

The ratio of the increase in real national income to the increase in

autonomous investment is called the investment multiplier.
Gross investment
In any economy, the aggregate investment made during any year is called
gross investment. This gross investment includes-
(a) Inventory investment, and (b) Fixed investment
Inventory investment: Investment in raw materials, semi – finished

goods and finished goods during any accounting year by the
producers of a country can be regarded as inventory investment.
Inventory investment = ( Inventory stock at the end of an

accounting year) – ( Inventory stock at the beginning of the
accounting year)
Fixed investment: When the producers or the business firms spend

money for the purchase of fixed assets or capital goods (e.g., plant and
machinery ) during any accounting year, then that spending is
considered as fixed investment.
Gross investment = (Fixed Investment + Inventory investment during any

accounting year)
Net Investment:
Net investment = Gross investment (-) Depreciation allowance
Or, Net investment + Depreciation allowance = Gross investment
Causes of depreciation : There will be a depreciation or decay in the

value of a fixed asset due to the following reasons;
(a) Normal wear and tear ( requiring routine repair and maintenance);
(b) Normal rate of accidental damage;
(c) Expected obsolescence


1. Which are is true?

a) ✔Saving is a positive function of income
b) Saving is a negative function if income
c) Saving is not related to income
d) Consumption is a negative function of saving
2. Which one is true?

a) Income = Consumption – Saving
b) Income= Saving – Consumption
c) ✔Income = Consumption + Saving
d) Consumption = Saving – Income
3. At equilibrium level of national income

a) Saving = Income
b) ✔Saving = Investment
c) Investment = Income
d) Saving > Investment
4. 'The investment which is independent on the level of income' is

called
a) Induced Investment
b) Net Investment
c) ✔Autonomous Investment
d) Inventory Investment
5. The investment which depends on the level of national income is

called
a) Gross Investment
b) ✔Induced Investment
c) Autonomous Investment
d) Fixed Investment
6. These will be an Mint ended inventory accumulation if

a) Investment > Saving
b) Investment = Saving
c) ✔Saving > Investment
d) Saving = Consumption
7. In two sector model Aggregate Demand is

a) Consumption + Saving
b) Consumption + Tax
c) ✔Consumption + Investment
d) Saving + Investment

8. An increase in Capital Stock is called

a) ✔Investment
b) Saving
c) Consumption
d) Income
9. Port folio Investment means

a) An increase in the real Capital Stock of the country
b) An increase in the fixed asset
c) ✔The purchase of shares and debentures of a Company
d) An increase in income
10. The aggregate investment made during any year is called

a) Fixed Investment
b) ✔Gross Investment
c) Net Investment
d) Industry Investment
11. Spending of money for the purchase of fixed asset is called

a) Gross Investment
b) Inventory Investment
c) Fixed Investment
d) Port folio Investment

Concept of GDP GNP
National income of an economy is the value of total goods and

services produced in the economy in a particular time (usually 1
year). This is one of the most important concepts of
macroeconomics since NI is considered to be a good indicator of
economic growth. Macro economic analysis tries to analyse the
effects of public policies on NI. There are different national income
identities as follows:
1) GDP --- Gross domestic product
2) GNP --- Gross national product
3) NDP --- Net domestic product
4) NNP --- Net national product
Before explaining the concepts we explain the difference between

domestic income and national income. Domestic income is the income
earned by the residents and non-residents within the domestic boundary
of a country within a particular time (during 1 year).National income on
the other hand is the income earned by only the residents of a country
both within and outside the country. The difference between national
income and domestic income is the net factor income from abroad. The
income earned by the resident of a country in abroad is included in the
national income of a country whereas it is not included in the domestic
income of the country. On the other hand income earned by a foreigner
within the domestic boundary of a country is included in the domestic
income of the country whereas this is not included in the national income
of a country.
Thus net factor income from abroad
=Factor income earned abroad – factor income earned by the foreigners
within the domestic boundary of a country.
National Income Aggregates:
Important national income aggregates are discussed as follows:
i) Gross National Product at market price (GNPMP):
GNPMP is the market value of all goods and services produced by the
residents of a country during a particular time period (1 year usually).
ii) Gross Domestic Product at market price (GDPMP):
GDPMP is the market value of all goods and services produced within the
domestic boundary of a country in a particular time period.

Difference between GNPMP and GDPMP :
GNPMP measures all the goods and services produced by the residents of
a country either they earn it in the country concerned or abroad. For
example, if a resident of a country earns money from abroad, his/her
income will be included in the national product but it will not be included
in the gross domestic product.
On the other hand, gross domestic product measures the

market value of all goods and services produced within the domestic
territory of a country by either the residents of a country or a foreigner.
Suppose a foreigner working in the concerned country earns salary or
profit in the country. This income will be included in the gross domestic
product of the country but will not be included in the gross national
product of the country.
Thus the difference between GNPMP and GDPMP is the net

factor income from abroad.
Net factor income from abroad (F)

= GNPMP - GDPMP.
If GNPMP is greater than GDPMP then there will be a positive net factor
income from abroad. If, on the other hand GDPMP is greater than GNPMP,
net factor income from abroad is negative.
iii) Net domestic product at market price (NDPMP):
If we deduct allowance for the consumption of fixed capital or

depreciation allowance from the gross national product at market price
we will get net domestic product at market price.
So
NDPMP = GDPMP - Depreciation
iv) Net National Product at market price (NNPMP):
NDPMP is the market value of all produced goods and services by the
residents of a country after deducting depreciation allowance.
So
NNPMP = GNPMP – depreciation
Difference in the estimates between factor cost and market price:
Market price includes indirect business tax but factor income does not
include indirect business tax. On the other hand subsidy is not included

in market price but factor incomes include subsidy. Net indirect business
tax is the difference between indirect business tax and subsidy.
Net indirect business tax

= [Indirect business tax – subsidy]
If we deduct net indirect business tax from the national or domestic

aggregates at market price we get aggregates at factor cost.
v) Gross National Product at factor cost. GNPFC:
Gross national product at factor cost is the aggregates of all factor

incomes earned by the residents of a country. It is the difference between
GNP at market price and net indirect business tax.
GNPFC = GNPMP – Net Indirect Business Tax
vi) Gross Domestic Product at factor cost. GDPFC:
This is the aggregate of all factor incomes earned within domestic

boundary of a country. If we deduct net indirect business tax from the
GDPMP we will get GDPFC
GDPFC = GDPMP - Net Indirect Business Tax
vii) Net Domestic Product at factor cost. (NDPFC ):
This is the aggregate of all factor incomes within the domestic territory of
a country after deducting depreciation allowance. If we deduct net
indirect business tax from the net domestic product at market price we
will get net domestic product at factor cost.
NDPFC = NDPMP - Net Indirect Business Tax

viii) Net National Product at factor cost (NNPFC ):
It measures the value of all final goods and services produced by the
residents of a country at their factor cost. If we deduct net indirect
business tax from the NNPMP we will get NNPFC. NNPFC is termed as the
National Income of a country.
National Income = NNPFC = NNPMP - Net Indirect Business Tax
Private income and Personal income:
Private income:
It refers to the income accruing to the private sector
from all sources. This means the factor income earned by private
enterprises within the domestic territory and abroad. It also includes
transfer from the Govt. and net transfer income from the rest of the
world. If we deduct govt. income from property and entrepreneurship and
govt. savings from non-department enterprise then we get income

accruing to the private sector. To get private income net transfer income
from the rest of the world and from the govt. and interest income from
national debt should be added.
Personal income:
It refers to the income which individuals actually
receive from all sources. Personal income can be estimated from private
income by deducting undistributed profits of the enterprises, net retained
earnings of the foreign enterprises, contribution of the enterprises to the
social security scheme and the corporate tax paid by the enterprises.
Personal Disposable Income:

The households cannot spend the whole amount
of personal income. They have to pay tax to the govt. So the reaming part
of the personal income after paying tax is considered as the personal
disposable income.
So Personal Disposable Income = Personal Income – Taxes
paid by the households.
Differences in Private income & Personal income:
Private income is the income accruing to the private sector

of the economy whereas personal income is the income received by the
households of an economy from all sources.
Private income is a broader concept in the sense that it
includes the incomes accruing to the business sector as well as the
household sector. But personal income is a narrower concept in the
sense that it refers the incomes received only by the household sector.
Private income includes corporate savings and corporate
taxes but personal income does not include corporate savings or
corporate taxes.
Per capita Income:
Per capita income of a country is the average income of a person in that

country. It can be obtained by dividing the national income by the
population of a country.
So,
Per Capita Income = National Income/Population.
Nominal & Real GDP – GDP deflator:

Nominal GDP is the GDP measured at the current prices of the year. It
may change from year to year due to change in either the physical
volume of the output produced in the economy or the change in price
level from year to year. So nominal GDP cannot reflect the actual growth
of output. But real GDP is the GDP measured at constant prices or the
prices of some base year.

So real GDP is not affected by the fluctuations of the price level and it
can show the actual situation of the economy in respect of the growth of
output.
GDP deflator is a price index which shows the changes in the prices of
goods and services included in the GDP. It can be obtained by the ratio of
the nominal GDP to real GDP at a particular year.
GDP deflator = Nominal GDP/Real GDP x 100
Measurement of National Income:

There are 3 methods of calculating national income.
i) Product method or value added method
ii) Income method
iii) Expenditure method
Product method or value added method:
The market value of all produced goods and services in an economy in a

particular year is calculated in this method. A problem of double
counting arises in the product method. Double counting is an error
whereby a transaction is counted more than once. It may happen when
we aggregate the total values of goods and services in an economy. Some
commodities may be used as final product as well as intermediate
products. If we simply add up the market values of all goods prodused in
the economy, the total estimate would exceed the actual value of the
GNP. To avoid the problem of double counting value added method is
used to measure the national product. In this method only the value
added by all the sectors in the economy is added to get the total GNP. If
we deduct the value of intermediate goods from the value of final output
we can get the value added by any firm.
There are different steps involved in the value added

method.
i) First, we have to identity production in three broad sectors

in an economy. Primary sector consists of agriculture, forestry,
fishery etc.
Secondary sector consists of manufacturing sector, mining etc
and tertiary sector consists of service industries like trade,
business, transport communication, professional works etc.
ii) Next we have to take into account the net value added (NVA)
in each sector.
NVA = Gross value of output – value of intermediate goods –
depreciation – net indirect tax.
iii) If we add the NVA of each sector we can get the net domestic
product at factor cost.

iv) To get the estimate of national income net national product

at factor cost (NNPFC) we have to add the net factor income from
abroad.
Proper care should be taken in the measurement of national income by

output method. Some items must be included in the national income
while some others must be excluded from it.
Items which are included in the calculation of GDP
a) Some portion of agriculture products like food grains are

sometimes used for personal consumption by agricultural family. The
market value of those items must be included in the calculation of
national income.
b) The imputed cost of self owned factors should also be

included in the calculation. For example the imputed rent of the
owner occupied house should be included in GDP. Owner occupied
house may be a good example for this case.
c) Imputed values of all public services like defense service,

police service are included in NI measurement.
Items which are excluded from GDP measurement
a) Purchase and sales of second hand goods like old house,

cars etc should be exclude from the GDP calculation.
b) ‘Pure exchange transaction’ like old age pension,

unemployment allowance etc are excluded from NI calculations.
c) Services which are not made for market transaction are

excluded from the NI calculation. The household services done by
housewives are excluded in this respect. Social services which are
voluntarily given are also excluded from NI calculation.
The Income Method
In income method national income is calculated by aggregating incomes

of all income earning units of the economy.
The income is classified into three categories.

i) Compensation of employees:
This is the remunerations of the
employees. It includes salaries, wages, bonus and other benefits like
Dearness Allowance (DA), Medical Allowance (MA), House Rent Allowance
(HRA) and Leave Travel Concession (LTC).
ii) Operating surplus:

The basic components of operating surplus are
rent, interest, profit, royalty and corporation tax.
iii) Mixed income of the self employed:

The mixed income of the self
employed covers total income of the own account workers like doctors
and lawyers doing private practice, private tutors etc as well as the profit
generated in the unincorporated enterprises.
By income method we calculate the net domestic product at factor

cost.
NDP(FC) = Compensation of employees
+ operating surplus
+ mixed income of the self-employed.
The net national product at factor cost (NNPFC) or the national income
can be defined as the sum total of the factor income earned within
domestic territory and from abroad.
So
NNPFC = NDPFC + net factor income from abroad
The following income should be excluded in estimating the national

income by income method:
i) Income from voluntary services:

Incomes from the services of
households done by housewives or social worker done by voluntary social
workers are not generated through market. So they are excluded from
national income calculations.
ii) Transfer Income:

Transfer incomes of any type like old age
pension, unemployment compensation, grant, flood or draught relief are
excluded from the calculations of national income.

iii) Income from the sale of second hand good:

Any income earned from
selling second hand good is excluded from the national income
calculation.
iv) Illegal incomes like income from smuggling and any type of
windfall gains like lotteries are excluded from the calculation of national
income.
The Expenditure Method:
Another method of estimating national income is to calculate the total

expenditure made by the economy in a particular year. Expenditure is
another way of looking income since the expenditure made by one person
becomes income of another person.
So the total expenditure made by a country in a particular year can be

considered as the total income earned by the country in that year.
The total expenditure of a country can be divided into 4 parts
1) Consumption Expenditure (C)

2) Gross Investment (I)
3) Government Investment (G)
4) Net Export (X-M)
(Export – Import)
If we add the above items we can estimate gross domestic product at

market price (GDPMP)
GDPMP = C+I+G+X-M
To get the net national product at factor cost (NNPFC) or the national
income we have to deduct depreciation and indirect business tax from
GDPMP and add net factor income from abroad.
NNPFC = GDPMP - D – IBT + F

D = depreciation
IBT = indirect business tax
F = net factor income from abroad
The following items should be excluded in estimating national income by

expenditure method:
i) Expenditure on intermediate good

ii) Expenditure on second hand goods
iii) Government expenditure on transfer payment
iv) Expenditure on the purchase of bonds and shares

Circular Flow of Income:
The total income earned in an economy is equal to the total income

spent or total expenditure in the economy. The total income flows
into difference sectors of an economy in a circular way. This is
called the circular flow of income.
Circular flow of income in a two-sector economy:
Some simplified assumptions are made

in this model.
i) There are only two sectors in an
economy – household (H) and firm (F).
ii) Households are assumed to spend all
the incomes earned by them to buy goods and service
produced by the firm.
iii) Households are the supplier of the
factors of production to the firm.
iv) Firms are assumed to spend all the
revenues earned by them for the payment of factors of
production.
Factor Income
Factors of production
F
F H
H
Goods & Services
Expenditure on goods & services
The above diagram shows the interaction between household and firms.
There are two types of flow – one is real flow and other is money flow.
Factor services flow from household sector to firm. Goods and services
produced in the firm flow from firm to household sector. This is the real
flow. Money flows in opposite direction. Money flows from household to
firm as the payment goods and services purchased from firm. It also
flows from firm to household as the payment for facts of production.

Any other expenditure flow is not part of the basic circular flow. For
example Saving (S) expenditure made by household sector is not a part of
the basic circular flow. It is considered as a leakage or withdrawal from
the basic flow.
Investment (I) expenditure on the other hand creates income for the firms
that produce capital goods and for the factors they employ. So
investment is not a part of the basic circular flow. This income comes
from outside and therefore is considered as an injection into the circular
flow.
This simple two - sector model of circular flow of income can be extended
upto three or four sector model.
Three – Sector model of circular flow describes an economy having 3
sectors, household firm and Government sector. The expenditure made
by government is denoted by G and the revenue earned by the
government in terms of tax payments by household or firm is denoted by
T. T is considered as a leakage or withdrawal from the circular flow of
income whereas G is considered as the injection of income into the
model.
If we introduce the foreign sector in the circular flow model we can

describe the model as four sector model. Four sectors of an economy are
household, firm, government and foreign sector.
When a part of economy’s income is spent on import (M), it is considered

as a leakage from the circular flow. If on the other hand the economy’s
income increases through export (X) of goods and services in the foreign
country, it can be considered as the injection of income in the circular
flow.
The total amount of injection into the circular flow of income is

I+G+X
The total amount of withdrawal from the circular flow is

S+T+M
Withdrawal or leakages from the circular flow reduces the national
income whereas injection into the circular flow increases the national
income.
National income will be at equilibrium state when total leakage is equal
to total injection.
S+T+M=I+G+X
Or S + T = I + G + ( X – M )
From the above discussion it is clear that national income can be looked
in three different ways. In circular flow model national income is looked
at as a flow of goods & services produced in the economy. The national
income can also be considered as a flow of income or flow of expenditure
on the goods & services.

Parallel Economy
Parallel Economy
The parallel economy is also named as black economy. This economy
consists activities which generate black income. Black incomes are
those which are unreported and those which are not shown by the
income earners. No taxes are paid for it.
In a broader definition parallel economy includes
(a) Illegal economy
(b) Unreported economy
The term parallel economy is used in the sense that the black and white
economy is separate from each other. But in reality it is the opposite.
Particularly in India the black and white economy are mixed with each
other. From the same economic activity one generates black income as
well as white income. For example, in case of real estate business the
purchaser has to pay some part of the payment as black component and
remaining part as white component.
Illegal Economy :
The economic activities allowed by law are called legal. The economic
activities which are not allowed by law are called illegal activities. Income
generated from illegal activities is not counted in national income.
Incomes from illegal activity are not declared for tax purpose and thus
generate black money.
These activities include smuggling, human trafficking, arms trafficking as
well as normal economic activities without paying tax
Unreported economy:
But sometimes people engaged in legal activity sometimes do not declare

part of their income for tax evasion. This type of activity cannot be
considered as legal. The tax evasion also generates black money.
So in India the black money includes the entire illegal economy

generating black money as well as undeclared income generating by
normal activities.
Transfer Income:
There are two types of incomes in an economy. One is factor income
which is associated with the production and distribution process and
another is transfer income which is not associated in the production
process. This type of income is generated when there is a transfer of
property or asset from one person to another. Example of such income is
sale of an old property or the sale of a share in the secondary stock
market. The transfer income is not counted in the national income.

Since transfer income is not counted in the white economy it should also
not be counted in the black economy. For that reason capital gain in the
real estate or profit in the share market and bribes in all section of the
economy have to be kept out of any calculation of the black income in the
country.
It should be noted that the black income is generated mostly in the

service sector by manipulating accounts to show lower property income.
From the above discussion we can define black economy in the following
way:
“The black economy consists of all the activities in which black incomes
are generated and black incomes are factor incomes, property incomes,
not reported to direct tax authorities.”
Measurement of Black Economy
The measurement of black economy is very challenging work because the

black incomes are mostly unreported. It is argued that as there is no
reliable data it is impossible to analyse black economy and its impact on
the entire economy.
Another problem of measuring the black economy is the proper
methodology to be followed in the measuring process. The black economy
in aggregate is stated as a percentage of the GDP. The methods used in
measuring black economy are called trace methods. The four main trace
methods are
1. Survey Approach
2. Input-output method
3. Monetarist approach
4. Fiscal approach
Of all the methods the fiscal approach is the best approach as this
approach is based on the various institutional factors of the economy.
Reasons behind the existence and growth of parallel economy
(a) High tax rate and complicated payment procedure

(b) Real estate transaction is a significant source of generating black
money in India.
(c) Corrupt practices among Govt. Agencies and officials.
(d) Lack of implementation of legal procedures against those corrupt
practices.
(e) High rate of inflation which puts further burden on the tax payers.
The parallel or black market is a market where all business activities
are conducted without any regard to Laws, rules and regulations and
taxation. It is very challenging and difficult job for economist to
measure accurately the amount of black money. This is due to the
fact that activities under parallel economy are mostly unrecorded.

The adverse effect of black money and parallel economy

1) Misuse of national resource
2) Corruption in business
3) Corruption in political system.
4) Corruption in Govt. And Administrating machinery
5) Illegal activities
6) Huge unrecorded and unorganised economic sector.
Impact of parallel economy or black money on real estate market in

India
The parallel economy has an enormous effect on Indian economy.
Particularly in the real estate sector the use of black money has become
almost as a norm. It affects the real estate market in the following ways.
Black money plays a huge role in the real estate market of India. It is one
of the sectors where people with illegitimate income convert the black
money into white money. The effects of black money in real estate market
affect different people like buyers, promoters, politicians and bureaucrats
, Govt. in different ways. There are two types of purchasers. One types
are those who are honest and don’t have black money. And the other
types who have huge amount of black money which they want to convert
into white money through the payment as black of real estate property.
The promoters or builders always ask some part of the payment as black
money from the purchaser to avoid tax. So the honest purchasers
become deprived of getting a property in fair price and the people with
illegitimate income can buy huge amount of property. The builders or
promoters are most of the time encourage this corrupt system and
generate huge amount of black money by which they can bribe politicians
and bureaucrats. The honest businessman cannot survive in this system
because they don’t have huge amount of unaccounted money to bribe
politicians and Govt. Officials.
This system creates a huge problem to the Govt. of India to generated
Govt. Revenue. The tax department loses huge amount of tax revenue
from the buyers as well as capital gain tax from the sellers.
The value of a plot of land is fixed by the Govt. Which is called (DLC) rate
(District Level Committee) the actual rate is the rate at which properties
are bought and sold. Sometimes the actual rate is much higher than the
DLC rate. The Agreement amount or Registry amount is always as per
DLC rate. So the extra amount is paid as black money. The government
is therefore loosing huge revenue.
The black money generated by the promoters is used by them to make

illegal construction and make unsafe houses. Some of the amount is
spent to give bribes to corrupt politicians and bureaucrats.

Different sectors of an economy:
Different sectors of economy mean different areas in which the

population is employed, like agriculture, industry, different service etc.
The major economic sectors are as follows:
Primary Sector:
The primary sector includes primary activities like agriculture, mining,
forestry, hunting and gathering, fishing, grazing etc. The developed
countries are characterized by a decreasing proportion of population
engaged in the primary sector. Greater contribution of primary sector in
national income is a feature of underdevelopment.
Secondary sector:
The secondary sector produces manufactured goods. All manufacturing,
processing and construction jobs are within this sector. It includes all
industries producing manufactured goods. This becomes strongest sector
when the economy is on the way of transition from underdeveloped to
developed economy.
Tertiary sector:
This is also known as service sector since it provides services to
consumers and other businesses. The tertiary sector includes activities
like financial service, retail, healthcare etc. In modern developed economy
majority of the population are engaged in this sector.
Informal sector:
The informal sector is the part of an economy that is neither taxed, nor
monitored by any form of government. Unlike the formal sector the
activities of informal sector are not included in GNP and GDP of the
country.The urban sectors of the developing countries are facing the
problems with informal sector. In many third world countries the
informal sector provides most of the total employment. The growth of
informal sector in urban economy is due to rural urban migration.


1. The difference between GNP and NNP is

a) Net factor income from abroad
b) ✔Depreciation
c) Net indirect tax
d) Transfer Payment
2. The difference between GNPMP and GNPFC is

a) Net factor income from abroad
b) ✔Net indirect tax
c) Depreciation
d) Transfer Payment
3. The following income is excluded from the national income

a) Imputed Rent of the owner occupied house
b) Market value of agricultural products used for personal
consumption
c) ✔Transfer Payment
d) Gift
4. The following income is included in the NI

a) ✔Imputed value of self own factors under in production
b) Purchase of second hand car
c) Income from Lottery
d) Old age pension
5. Which one is excluded from national income accounting

a) The value of final goods and services
b) Net factor income from abroad
c) Compensation of employee
d) ✔Sale of an old house
6. Which one is included in the national income accounting?

a) Sale of an old car
b) Purchase of share and debenture
c) ✔Value of final goods
d) Value of intermediate goods
7. …………………. Transaction is a significant somes of generating

black money
a) Government
b) Market
c) ✔Real Estate
d) Bank

8. The activities under parallel economy are mostly

a) Written
b) Accounted
c) ✔Unrecorded
d) Recorded
9. Smuggling is one of the activities of

a) Rural Economy
b) Urban Economy
c) Agriculture Economy
d) ✔Parallel Economy
10. Promoters always charge some part of the payment as

a) Cheque
b) Card
c) ✔Black money
d) Cash
11. Promoters charge black money to avoid

a) ✔Tax
b) Profit
c) Rent
d) Interest
12. Genuine buyers sometimes suffer from the illegal practices of

the
a) Labour
b) ✔Promoter
c) Manager
d) Government
13. The rate fixed by the government of a plot of land is called

a) Actual Rate
b) Market Rate
c) Fixed Rate
d) ✔DLC (District Level Committee) Rate

Principles of Economics (Micro & Macro)

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Principles of Economics

1 Institution of Estate Managers & Appraisers

2 Institution of Estate Managers & Appraisers

INSTITUTION OF ESTATE MANAGERS & APPRAISERS

The team of Institution of Estate Managers & Appraisers

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IBBI Syllabus on Micro Economics

Sl. No. Coverage Weight (%)

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The consumer is assumed to be rational in the sense that he/she wants

The cardinal utility theory.

1) Rationality: The consumer is assumed to be rational in the

2) Cardinal utility: Utility is cardinal concept i.e. it is measurable.

3) Constant Marginal Utility of Money: This assumption is

4) Diminishing marginal utility: Marginal utility is the additional

5 Institution of Estate Managers & Appraisers

5) Total utility of a bundle of goods depends on the quantities of

If MUx>Px the consumer can increase his total satisfaction by

Law of Equi-marginal utility : Suppose the consumer consumes more

If there are 'n' commodities then the above condition becomes

Criticism of the cardinal approach

1) Utility cannot be measured by cardinal numbers. This is the most

2) Constant utility of money: This is also an unrealistic assumption. The

6 Institution of Estate Managers & Appraisers

The ordinal utility theory: According to this theory (based on the

i) Completeness: Given any pair of bundles A and B, either A is

ii) Transitivity: given any three commodity bundles if A is

iii) Consistency: The consumer is consistent in the sense that if

iv) Non-satiation: For any two commodity bundles A and B, A

v) Reflexivity: This means that any bundle of goods is as good

vi) Convexity: given any consumption bundle, its better set is

Equilibrium of the Consumer: To show the equilibrium of the

Indifference curve: Indifference curve is a locus of points showing

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An indifference curve is shown in

The indifference curve is represented by the curve I in the above diagram.

Marginal Rate of substitution : For any two commodities x and y the

Properties of the indifference curve:

1) Indifference curve is negatively sloped: The negative slope of an

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3) Indifference curves do not intersect: Suppose two indifference curves

4) Indifference curves are convex to the origin. It represents the declining

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Budget line: The consumer has a given income which acts as a

AB is the budget line where OA=M/Py

If Px falls the budget line becomes

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A1 In this diagram the initial budget line is

So the necessary condition for consumer’s equilibrium is

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The sufficient condition for consumer's equilibrium is

2) Indifference curve should be convex to the origin

Effects of price change on consumer’s equilibrium. Price Effect:

Income effect of a price change: A change in price leads to a change in

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Substitution Effect: Suppose there is a fall in price of X, the price of

A2B2 passes through B (initial commodity bundle) but it becomes tangent

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Hicksian decomposition of price effect: Hicks has shown substitution

The compensating variation is shown graphically by a parallel shift of the

Price effect = substitution effect+ income effect

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Price Consumption Curve: It shows different combinations of X and Y