E Notes Economics I Ballb 207

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E-notes - Economics-I Ballb 207
LLB (Guru Gobind Singh Indraprastha University)
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Chanderprabhu Jain College of Higher Studies

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An ISO 9001:2008 Certified Quality Institute
(Recognized by Govt. of NCT of Delhi, Affiliated to GGS Indraprastha University, Delhi)
Class : BA LLB – Third Semester
Paper Code : BALLB 207
Subject : Economics - I
UNIT I: INTRODUCTION TO ECONOMICS
1.1. Definition, Methodology, Scope of Economics
A. Definition: The word ‘Economics’ is derived from two Greek words, oikos
(a house) and nemein (to manage) which would mean ‘managing an
household’ using the limited funds available, in the most satisfactory manner
possible. Several economists have defined economics taking different
aspects into account:
a. Wealth Definition - Adam Smith (1723-1790), Father of Economics, in

his Book “An Inquiry into Nature and Causes of Wealth of Nations”
(1776) defined economics as the practical science of production and
distribution of wealth. He explained how a nation’s wealth is created.
b. Welfare Definition - Alfred Marshall (1842-1924) wrote a book

“Principles of Economics” (1890) in which he defined “Political
Economy” or Economics is a study of mankind in the ordinary business
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of life; it examines that part of individual and social action which is most
closely connected with the attainment and with the use of the material
requisites of well being”.
c. Scarcity Definition - Lionel Robbins published a book “An Essay on the

Nature and Significance of Economic Science” in 1932. According to
him, “economics is a science which studies human behaviour as a
relationship between ends and scarce means which have alternative
uses”. Ends refer to human wants, which are unlimited. Resources or
means, on the other hand, are limited or scarce in supply. The scarce
means are capable of having alternative uses. Hence, anyone will choose
the resource that will satisfy his particular want. Thus, economics,
according to Robbins, is a science of choice.
d. Growth Definition - Professor Paul Samuelson defined economics as

“the study of how men and society choose, with or without the use of
money, to employ scarce productive resources, which could have
alternative uses, to produce various commodities over time, and
distribute them for consumption, now and in the future among various
people and groups of society”.
Based on all these definitions, Economics can be defined as: “Economics

is the social science that examines how people choose to use limited or
scarce resources by attempting to satisfy their unlimited wants.”

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Economics not only covers the decision making behaviour of individuals

but also the macro variables of economies like national income, public
finance, international trade and so on.
B. Nature of Economics - In discussing the nature of economics, we have to

indicate whether it is a science or an art and a positive science or a
normative science.
a. Economics - A Science and an Art
(i) Economics as science: It is science in the sense, it is a systematic

knowledge derived from scientific study, observation and experiments
based on scientific methods. In economics, one has to study social
behavior, i.e., behaviour of men in groups. So, it is social science.
(ii) Economics as art: Economics is an art too because an art is a system

of rules for the attainment of given end. There are several branches of
economics which provide practical guidance in the solution of
economic problem.
Science and art are complementary to each other and economics is both a
science and an art. It is science in its methodology and an art in its
application.
b. Economics - Positive and normative science

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(i) Economics as positive science: It only describes what it is and

normative science prescribes what it ought to be and does not indicate
what is good or what is bad to the society. It will simply provide
results of economic analysis of a problem.
(ii) Normative science: It makes distinction between good and bad. It

prescribes what should be done to promote human welfare. A positive
statement is based on facts. A normative statement involves ethical
values.
C. Methodology
Methodology of Economic Laws - Economics adopts two methods for the

discovery of its laws and principles, viz., deductive method and inductive
method.
a. Deductive method: Here, we descend from the general to particular, i.e.,

we start from certain principles that are self-evident or based on strict
observations. Then, we carry them down as a process of pure reasoning
to the consequences that they implicitly contain. The deductive method is
useful in analyzing complex economic phenomenon where cause and
effect are inextricably mixed up.
b. Inductive method: This method mounts up from particular to general,

i.e., we begin with the observation of particular facts and then proceed

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with the help of reasoning founded on experience so as to formulate laws

and theorems on the basis of observed facts. In deductive method, we
start from certain principles that are either indisputable or based on strict
observations and draw inferences about individual cases. In inductive
method, a particular case is examined to establish a general or universal
fact.
Both deductive and inductive methods are useful in economic analysis.
Methodology of Economic Theory – Economic theory involves

generalizations which are statements of general tendencies or uniformities of
relationships among various elements of economic phenomena. It provides
logical basis of the law. The various steps required to construct a theory of
economics are:
(1) Selecting the Problem,
(2) Collection of Data
(3) Classification of Data,
(4) Formulation of Hypothesis,
(5) Verification of Theory,
(6) Formulation of Solutions.
D. Scope of Economics
a. Micro Economics: It may be defined as that branch of economic

analysis which studies the economic behavior of the individual unit, may

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be a person, a particular household, or a particular firm. It is a study of

one particular unit rather than all the units combined together.
Importance of Microeconomics: Microeconomics occupies a very

important place in the study of economic theory. It is microeconomics
that tells us how a free market economy with its millions of consumers
and producers work to decide about the allocation of productive
resources among the thousands of goods and services. Microeconomics
has both theoretical and practical importance which may be summarized
as follows:
(1) Helpful in the Efficient Employment of Resources,
(2) Understanding Free Enterprise Economy,
(3) Helpful in the Development of International Trade,
(4) Helpful in Understanding the Implications of Taxation,
(5) Basis for Welfare Economics,
(6) Provides Tools for Evaluating Economic Policies,
(7) Construction and Use of Models
b. Macro Economics: It may be defined as that branch of economic

analysis which studies the behavior of not one particular unit, but of all

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the units combined together. It is a study in cumulative. Hence it is often

called Aggregative Economics.
Importance of Macroeconomics: It helps to understand the functioning

of a complicated modern economic system. It describes how the
economy as a whole functions and how the level of national income and
employment is determined on the basis of aggregate demand and
aggregate supply. The theoretical and practical importance of
Macroeconomics are:
(1) Functioning of an Economy,
(2) Formulation of Economic Policies,
(3) Understanding Macroeconomics,
(4) Understanding and Controlling Economic Fluctuations,
(5) Theory of inflation and Deflation,
(6) Study of National Income,
(7) Study of Economic Development,
(8) Performance of an Economy, and
(9) Nature of Material Welfare.

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1.2 Basic Concepts and Precepts: Economic Problems, Economic Agents,

Economic Organizations, Marginalism, Time Value of Money,
Opportunity Cost
Economic is concept based and technique oriented. The use of concepts and
techniques help us in developing the analytical rigour of the subject.
A. Economic Problems: All societies face the economic problem, which is

the problem of how to make the best use of limited or scarce resources. The
economic problem exists because, although the needs and wants of people
are endless, the resources available to satisfy needs and wants are limited.
Three basic economic problems of society are:
(a) What to produce? (Problem of Allocation of Resources) - Each and every

economy must determine what products and services, and what volume
of each, to produce.
(b) How to produce? (Problem of Choice of Techniques) - This basic

economic problem is with regards to the mix of resources to use to create
each good and service.
(c) For whom to produce? (Problem of Distribution) - This basic economic

question is focused on who receives what share of the products and
services which the economy produces.

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B. Economic Agents and Organisations: Economic Agent is an actor and

more specifically a decision maker in a model of some aspect of the
economy. Typically, every agent makes decisions by solving a well or ill-
defined optimization or choice problem.– An economic decision maker who
can recognize that different factors influence and motivate different
economic groups. There are four factors of production, namely land, labour,
capital, and entrepreneur, which receive rewards in the form of rent, wages,
interest and profit respectively.
C. Marginalism – Marginalism is a theory of economics that attempts to

explain the discrepancy in the value of goods and services by reference to
their secondary, or marginal utility. The marginal concept measures the
change in the dependent variable (cost, revenue or profits) with respect to a
unit change in the independent variable. The incremental concept is more
general and here, more than one independent variable is considered.
Marginal and incremental concepts are useful in taking optimal business
decision in view of limited resources. Incremental benefits must be higher
than incremental costs for profitable decision. All marginal concepts are
incremental concepts but not vice-versa.
D. Time Value of Money – The time value of money (TVM) is the concept
that money available at the present time is worth more than the identical
sum in the future due to its potential earning capacity. This core principle of
finance holds that, provided money can earn interest, any amount of money
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is worth more the sooner it is received. The concepts of compounding and

discounting have relevance in view of the time dimension involved in the
decision making process and planning. If “i” is the rate of interest, future
compound value (A) of a sum is P(1+i)n. Thus, P(present or discounted
value) is = A/(1+i)n.
E. Opportunity Cost – All decisions involving choices have opportunity cost

for optimal allocation of resources. A business firm must consider the
opportunity cost of using human and non-human resources. Opportunity
cost is the cost associated with the next best alternative sacrificed. As by
choosing one course of action, the other alternative course is sacrificed, the
chosen course of action can be evaluated in terms of sacrificed one.
1.3 . Forms of Economic Analysis
Economic analysis is a systematic approach to examining the allocation of

limited resources to achieve a certain objective. Businesses, government
agencies and nonprofit organizations use economic analysis techniques for a
variety of purposes.
Following are the various forms of economic analysis:
A. Micro versus Macro Economics – Micro economics (the theory of resource

allocation) and mcaro economics (the theory of money, income, and price
level) are the core of economics. Micro and macro economics are
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interdependent. Neither of the two is complete without the other. Prosperity

and well being of individual economic units can be ensured only if the
performance of the whole economy is excellent. Thus, every micro
economic problem involves macro economic analysis. Similarly, the
working of an economic system can be appreciated by studying the behavior
of individuals, firms, industries, and so on. The micro economic behavior
cannot be simply added up to derive the macro economic behavior. Thus, the
application of micro approach to generalize about the behavior of the
economy as a whole or vice versa is incorrect and misleading. There is a
need for an independent and separate analyses of the two.
B. Partial versus General Equilibrium – An equilibrium is a state of rest, a

position from where there is no tendency for change. Here, the market forces
of demand and supply balance each other. Partial equilibrium focuses
attention on a few economic variables to find the equilibrium, while general
equilibrium models capture a larger interaction. The main difference
between partial and general equilibrium models is that partial equilibrium
models assume that what happens on the market one wants to analyze has no
effect on other markets. Therefore in partial equilibrium models one only
considers a market for one good and assumes that the price of every other
good or the wealth one has does not change. In general equilibrium models
every market has an effect on every other market and therefore a change in
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one market may have changes in another market and therefore one has to
model every market simultaneously.
C. Static versus Dynamic – In the economic theory methodology, techniques

of economic static and economic dynamic occupy an important place. In
static, the behaviour of a system is studied at a particular time. Here, we
establish static functional relationship between the relevant variables.
Economic dynamic has become popular in modern economics. Under
dynamic, we study the behaviour of a system over time. Another difference
between static economics and dynamic economics is that static analysis does
not show the path of change. It only tells about the conditions of
equilibrium. On the contrary, dynamic economic analysis also shows the
path of change. Static economics is called a ‘still picture’ whereas the
dynamic economics is called a ‘movie’ of the market. In a nutshell, static
and dynamic are complementary to each other in the progress and
development of economics.
D. Positive versus Normative – In economics, one can take recourse to

positive approach or normative approach or both. Positive economics
explains the actual behaviour of economic agents, while normative
economics describes ideal situation by assisgning value judgements. Positive
economics is objective and fact based, while normative economics is
subjective and value based. Positive economic statements must be able to be
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tested and proved or disproved. Normative economic statements are opinion

based, so they cannot be proved or disproved.
E. Short run versus Long run – Economists analyse their probem with
reference to objectives and constraints. If some constraints or factors are
fixed, while others are variable, it is considered as a short-run analysis. On
the other hand, if all the constraints are variable or adjustable, it is called as
long-run analysis. The economists have to analyze the implications of short
run as well as long run changes on the demand, production and cost
decisions.
1.4 Relations betweeen Economics and Law: Economic Offences and

Economic Legislations
A. Relevance of Economics to Law - Law consists of rules made by the

authority for proper regulation of the community or society. It refers to those
rules which are laid by the status for determining the relationship of men in
the organized society. The purpose of law is to regulate and control human
actions in the society.
B. Role of Government in Controlling Economics Activities
a. Government steps in to protect the consumer and see that producer does
not exploit the consumer. Further, there is an increasing production of
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luxury items, which could be detrimental to the production of consumer

items.
b. The private enterprises close their eyes on social cost of their production.
They are only concerned with the private cost of production. Government
is required to pass legislation related to controlling the social cost.
c. The State lays down the economic framework, laws and rules for
controlling the economic activities. It helps to tackle the problems of
unemployment, inflation, etc. and stabilize the pace of economic growth.
C. Interaction between Law and Economics - The relationship between law

and economics is a mutual one. Both influence each other. It has been shown
by Dais that the mode of economy determines the nature of laws and the
status of the adjudicating bodies and legal professional. This shows as to
how the economy can influence law. On the other hand, various legislations
passed by the government bring new dimensions in economy. For instance,
social cost, etc.
A good law always encourages economic development and a bad law

inhibits it. Law imparts trust in actual government procedure and provides
security to the society. This is done through an appropriate system of
property right, contracts and extra contractual liability, which can generate
efficient use of resources.
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D. Economic Laws
a. Economic laws depict the activities of economic units in response to

various causes or forces. These laws explain generalizations about human
behaviour, which express relationship between a cause and effect. Like
other natural sciences, causes may be laid down in the form of imaginary
conditions or they may be drawn from observed facts or a mixture of the
two. Since they deal with the behaviour of the human beings as members
of the society, they are a part of social laws.
b. Economic laws are supposed to govern or explain economic activities,

i.e., activities which correspond to that part of human behaviour, where
the main motive is economic.
c. Economic laws are less accurate and lack preciseness and universal
applicability.
d. The aim of economics, like all other sciences, should be to develop laws
or generalizations or principles to understand the past and offer
trustworthy guidance for the future.
E. Government Laws - The government laws are the laws passed by the
parliament. These are based on social norms and customs. They involve a
lengthy procedure of framing having legal implications. These are associated
with maintaining law and order in the society. They are binding on all
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individuals. Any person violating these laws is liable to be punished by the

government.
F. Comparison between Economic and Government Laws - The comparison

between economic and government laws can be illustrated on various
criteria like origin/basis, universality, predictions, implications, precision,
change, formulating agency, impact on individual, transgression/sanction.
G. Economic Offences and Legislations - Economic offences form a separate

category of crimes under criminal offences. These are often referred as
White/Blue Collar crimes. Indulgences by technocarts, highly qualified
persons, well to do businessman, corporate persons, etc. in various scams
and frauds facilitated by the technological advancements, is often seen. In
economic offences, not only individuals get victimised with pecuniary loss.
Such offences often damage the national economy and defense.
UNIT II: DEMAND, SUPPLY, PRODUCTION ANALYSIS AND COST
2.1. Theory of Demand and Supply, Price Determination of a Commodity,

Shift of Demand and Supply, Concept of Elasticity
A. Theory of Demand – Meaning of demand– Demand in economics is the

consumer's desire and ability to purchase a good or service. It's the
underlying force that drives economic growth and expansion. Without
demand, no business would ever bother producing anything.
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Demand Schedule – The demand schedule is a table or formula that tells

you how many units of a good or service will be demanded at the various
prices, ceteris paribus.
Demand Curve - If you were to plot out how many units you would buy at
different prices, then you've created a demand curve. It graphically portrays
the data in a demand schedule.
Determinants of Demand - There are five main determinants of demand.

The most important is the price of the good or service itself. The second is
the price of related products, whether they are substitutes or complementary.
Circumstances drive the next three determinants. These are consumers'
incomes, their tastes, and their expectations. Some other determinants
include size and regional distribution of population, demographic
composition of population, economic distribution of income, etc.
Law of Demand – The law of demand governs the relationship between the
quantity demanded and the price. This economic principle describes
something you already intuitively know. If the price increases, people buy
less. The reverse is also true. If the price drops, people buy more. But, price
is not the only determining factor. The law of demand is only true if all other
determinants don't change. In economics, this is called ceteris paribus. The
law of demand formally states that, ceteris paribus, the quantity demanded
for a good or service is inversely related to the price.
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Movement along Demand Curve – Change in quantity demanded

consequent upon the change in price of the commodity holding other
demand determinants constant results in a movement along the same
demand curve. Increase in quantity demanded due to a fall in the price of the
commodity is referred to as extension in demand and vice versa. It explains
the law of demand.
Shift in Demand Curve – Change in factors other than price of the

commodity results in increase or decrease in demand. Accordingly, the
demand curve shifts to the right or left in the two cases respectively. It does
not explain the law of demand.
B. Theory of Supply
Meaning of supply – Supply refers to various quantities of a commodity
which a producer will actually offer for sale at a particular time at various
corresponding prices.
Supply Schedule – A supply schedule is a table which shows how much

one or more firms will be willing to supply at particular prices under the
existing circumstances.
Supply Curve – A supply curve is the graphic representation of the

relationship between product price and quantity of product that a seller is
willing and able to supply.
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Determinants of Supply – Supply is determined by:
1. Price: Producers will try to obtain the highest possible price whereas the
buyers will try to pay the lowest possible price both settling at the
equilibrium price where supply equals demand.
2. Cost of inputs: The lower the input price the higher the profit at a price
level and more product will be offered at that price.
3. Price of other goods: Lower prices of competing goods will reduce the
price and the supplier may switch to switch to more profitable products
thus reducing the supply.
4. Other factors: Other factors such as state of technology, goal of

producer, natural factors, means of transportation, communication,
banking and insurance, length of time, etc.
Law of Supply – The law of supply states that, keeping other factors
constant, an increase in price results in an increase in quantity supplied. In
other words, there is a direct relationship between price and quantity:
quantities respond in the same direction as price changes.
Movement along Supply Curve – Movement along the supply curve will
occur when the price of the good changes and the quantity supplied changes
in accordance to the original supply relationship. In other words, a
movement occurs when a change in quantity supplied is caused only by a
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change in price, and vice versa. This results in a movement along the same
demand curve. Increase in quantity demanded due to a fall in the price of the
commodity is referred to as extension in demand and vice versa. It explains
the law of demand.
Shift in Supply Curve – When the quantity of the commodity supplied

changes due to change in non-price factors, the supply curve does not extend
or contract but shifts entirely. The shift in supply curve can also be of two
types – rightward shift and leftward shift. The rightward shift occurs in
supply curve when the quantity of supplied commodity increases at same
price due to favorable changes in non-price factors of production of the
commodity. Similarly, a leftward shift occurs when the quantity of supplied
commodity decreases at the same price.
C. Price Determination of a Commodity - The price of a commodity is

determined as a function of its market as a whole – by the interaction of
market demand and market supply. In fact, the market price of a commodity
is determined (or reaches its competitive equilibrium) where the demand
curve and the supply curve intersect — where the forces of demand and
supply are just in balance.
Concept of Equilibrium – The price which will come to prevail in the

market is one at which quantity demanded is equal to quantity supplied or
the price at which market for the commodity is cleared. This price is usually
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called equilibrium price, and the quantity demanded and supplied at this
price is called the equilibrium quantity. So long as demand and supply
remain unchanged, equilibrium price or quantity will not change.
D. Shift of Demand and Supply
a. If demand and supply increase in the same proportion – The equilibrium

price remains the same but the quantity increases.
b. If demand and supply decrease in the same proportion – The equilibrium

price remains the same but the quantity decreases.
c. If the increase in demand is more than the increase in supply – The

equilibrium price will increase and the increase in quantity is more than
the increase in price.
d. If the increase in demand is lesser than the increase in supply – The

equilibrium price will decrease and the increase in quantity is more than
the fall in price.
e. If the decrease in demand is more than the decrease in supply – The

equilibrium price will decrease and the decrease in quantity is more than
the decrease in price.
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f. If the decrease in demand is lesser than the decrease in supply – The

equilibrium price will increase and the increase in quantity is lesser than
the rise in price.
E. Concept of Elasticity
a. Elasticity of Demand
Meaning - It refers to how sensitive the demand for a good is to changes

in other economic variables, such as prices and consumer income.
Demand elasticity is calculated as the percent change in the quantity
demanded divided by a percent change in another economic variable. A
higher demand elasticity for an economic variable means that consumers
are more responsive to changes in this variable.
Measurement of Elasticity of Demand - The top four methods used for

measuring elasticity of demand are:-
1. The Percentage Method
2. The Point Method
EP = Δq/Δp x p/q
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3. The Arc Method
4. Total Outlay Method
Factors affecting elasticity of demand:

(1) Nature of commodity,
(2) Availability of substitutes,
(3) Income Level,
(4) Level of price,
(5) Postponement of Consumption,
(5) Number of Uses,
(6) Share in Total Expenditure,
(7) Time Period.
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Slope and Elasticity - Slope refers to the steepness of the demand curve.
On the other hand, elasticity of demand measures the relative change in
price and quantity. Elasticity of demand is inversely proportional to the
slope of the demand curve.
Different types of Elasticity of Demand
1. Price Elasticity of Demand – It is the proportional change in the

quantity demanded, relative to the proportional change in the price of
the good.
2. Cross Elasticity of Demand – It is the proportional change in the

quantity demanded, relative to the proportional change in the price of
another good.
3. Income Elasticity of Demand – It is the proportional change in the
quantity demanded, relative to the proportional change in the income.
4. Advertisement Elasticity of Demand – It is the proportional change
in the quantity demanded, relative to the proportional change in the
price of another good.
5. Expectation Elasticity – It refers to the responses of the observed
current price to future price expectations.
c. Elasticity of Supply
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Meaning – Elasticity of supply is a measure used in economics to show

the responsiveness, or elasticity, of the quantity supplied of a good or
service to a change in its price.
Types of Elasticity of Supply
(i) Perfectly Elastic Supply: It refers to a situation when the quantity

supplied completely increases or decreases with respect to
proportionate change in the price of a product. the numerical value of
elasticity of supply ranges from zero to infinity (e S = ∞).
(ii) Relatively Elastic Supply: It refers to a condition when the

proportionate change in the quantity supplied is more than
proportionate change in the price of a product. The numerical value of
elasticity of supply is greater than one (eS>1).
(iii) Relatively Inelastic Supply: It refers to a condition when the

proportionate change in the quantity supplied is less than
proportionate change in the price of a product. The numerical value of
elasticity of supply is less than one (eS<1).
(iv) Unit Elastic Supply: Refers to a situation when the proportionate

change in the quantity supplied is equal to the proportionate change in
the price of a product. The numerical value of unit elastic supply is
equal to one (eS=1).
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(v) Perfectly Inelastic Supply: Refers to a situation when the quantity

supplied does not change with respect to proportionate change in price
of a product. The numerical value of elasticity of supply is equal to
zero.
Factors affecting Elasticity of Supply
There are several factors that affect the supply elasticity of a good or
service, such as nature of commodity, behavior of costs as output varies,
period of production, techniques of production, future price expectations,
number of products produced by an industrial unit, availability of
resources, etc.
2.2. Concepts of Production: Total Product, Average Product, Marginal

Product, Returns to Factor, Returns to Scale
A. Total Product - Total product is the overall quantity of output that a firm
produces, usually specified in relation to a variable input. Total product is
the starting point for the analysis of short-run production. It indicates how
much output a firm can produce according to the law of diminishing
marginal returns.
B. Average Product - The quantity of total output produced per unit of a

variable input, holding all other inputs fixed. Average product, usually
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abbreviated AP, is found by dividing total product by the quantity of the

variable input.
C. Marginal Product - The marginal product or marginal physical product of

an input (factor of production) is the change in output resulting from
employing one more unit of a particular input (for instance, the change in
output when a firm's labor is increased from five to six units).
D. Returns to Factor – Law of Variable Proportions - Returns to a factor relate

to the short period production function when one factor is varied keeping the
other factor fixed in order to have more output, the marginal returns of the
Variable factor diminish. This law, also known as law of variable
proportions, states that as more and more units of a variable factor are
applied to a given quantity of fixed factor, total product may increase at an
increasing rate initially but eventually it increases at a diminishing rate.
There are three Stages of the Law of Variable Proportions:
Stage 1. Stage of Increasing Returns: In this stage, total product increases

at an increasing rate up to a point. Corresponding vertically to this point of
inflection marginal product of labour is maximum, after which it diminishes.
This stage is called the stage of increasing returns because the average
product of the variable factor increases throughout this stage. This stage
ends at the point where the average product curve reaches its highest point.
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Stage 2. Stage of Diminishing Returns: In this stage, total product

continues to increase but at a diminishing rate At the end of the second
stage, i.e., at point M marginal product of labour is zero which corresponds
to the maximum point H of the total product curve TP. This stage is
important because the firm will seek to produce in this range.
Stage 3. Stage of Negative Returns: In stage 3, total product declines and

therefore the TP curve slopes downward. As a result, marginal product of
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labour is negative and the MP curve falls below the X-axis. In this stage the
variable factor (labour) is too much relative to the fixed factor.
E. Returns to Scale - It explains the behavior of the rate of increase in output

(production) relative to the associated increase in the inputs (the factors of
production) in the long run. The degree of change in output varies with
change in the amount of inputs. On the basis of these possibilities, law of
returns can be classified into three categories:
(i) Increasing returns to scale - If the proportional change in the output of

an organization is greater than the proportional change in inputs, the
production is said to reflect increasing returns to scale.
(ii) Constant returns to scale - The production is said to generate constant

returns to scale when the proportionate change in input is equal to the
proportionate change in output.
(iii) Diminishing returns to scale - Diminishing returns to scale refers to a

situation when the proportionate change in output is less than the
proportionate change in input.
F. Economies of scale – As the production increases, efficiency of production

also increases. . The advantages of large scale production that result in lower
unit (average) costs (cost per unit) is the reason for the economies of scale is
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that the total costs are shared over the increased output. There are two types
of economies of scale:
1. Internal economies of scale – It refers to the advantages that arise as a

result of the growth of the firm. Hence, a company reduces costs and
increases production, internal economies of scale have been achieved.
2. External economies of scale - External economies of scale refers to the

advantages firms can gain as a result of the growth of the industry. It is
normally associated with a particular area. External economies of scale
occur outside of a firm, within an industry.
G. Diseconomies of scale
These are the problems faced by businesses if they become too large - Lose
touch with the customers, Managers lose touch with the workers,
communication problems because the business is so large.
2.3 . Cost and Revenue Concepts
Cost Concepts - It refers to the total outlays of money expenditure, both

explicit and implicit, on the resources used to produce a given level of
output. It includes both fixed and variable costs. The total cost for a given
output is given by the cost function. The various concepts of cost are
discussed below:
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1. Nominal Cost and Real Cost: Nominal cost is the money cost of
production. The real costs of production are the pain and sacrifices of labour
involved in the process of production.
2. Explicit and Implicit costs: Explicit costs are the accounting costs or
contractual cash payments which the firm makes to other factor owners for
purchasing or hiring the various factors. Implicit costs are the costs of self-
owned factors which are employed by the entrepreneur in his own business.
These implicit costs are the opportunity costs of the self-owned and self-
employed factors of the entrepreneur, that is, the money incomes which
these self-owned factors would have earned in their next best alternative
uses.
3. Opportunity Cost and Actual Cost: The opportunity cost (or transfer
earnings) of any good is the expected return from the next best alternative
good that is forgone or sacrificed. For example, if a farmer who is producing
wheat can also produce potatoes with the same factors. Then, the
opportunity cost of a quintal of wheat is the amount of output of potatoes
given up. Actual cost refers to the expenditure on producing a given quantity
of a good. It consists of monetary payments made for the hired inputs plus
the imputed value of the inputs and services provided by the firm itself.
Thus, actual cost is the cost of all resources used in producing a particular
good.
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4. Direct Cost and Indirect Cost: A cost that is easily attributable to a cost
object is known as Direct Cost. Indirect Cost is defined as the cost that
cannot be allocated to a particular cost object.
5. Private costs and Social Costs: Private costs are the economic costs which
are actually incurred or provided for by an individual or a firm. It includes
both explicit and implicit costs. Social cost, on the other hand, implies the
cost which a society bears as a result of production of a commodity. Social
cost includes both private cost and the external cost. External cost includes
(a) the cost of free goods or resources for which the firm is not required to
pay for its used, e.g., atmosphere, rivers, lakes etc. (b) the cost in the form of
‘disutility’ caused by air, water, and noise pollution, etc.
6. Total, Average and Marginal Costs: Total cost refers to the total outlays of
money expenditure, both explicit and implicit on the resources used to
produced a given output. Average cost is the cost per unit of output which is
obtained by dividing the total cost (TC) by the total output (Q), i.e., TC/Q =
average cost. Marginal cost is the addition made to the total cost as a result
of producing one additional unit of the product.
7. Fixed Costs and Variable Costs: Fixed costs are the expenditure incurred
on the factors such as capital, equipment, plant, factory building which
remain fixed in the short run and cannot be changed. Therefore, fixed costs
are independent of output in the short run i.e., they do not vary with output
in the short run. Even if no output is produced in the short run, these costs
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will have to be incurred. Variable costs are costs incurred by the firms on the
employment of variable factors such as labour, raw materials, etc., whose
amount can be easily increased or decreased in the short run. Variable costs
vary with the level of output in the short run. If the firm decided not to
produce any output, variable costs will not be incurred.
9. Short-run and Long-run Cost: Short-run costs are the costs which vary
with the change in output, the size of the firm remaining the same. Short-run
costs are the same as variable costs. On the other hand, long-run costs are
incurred on the fixed assets, like plant, building, machinery, land etc. Long-
run cost are the same as fixed-costs. However, in the long-run even the fixed
costs become variable costs as the size of the firm or scale or production is
increased.
Relation Between Marginal Cost(MC) and Average Cost(AC): The

relationship between MC and AC may be explained as follows:
1. When MC falls, AC also falls but at lower rate than that of MC. So long
as MC curve lies below the AC curve, the AC curve is falling.
2. When MC rises, AC also rises but at lower rate than that of MC. That is,
when MC curve lies above AC curve, the AC curve is rising.
3. MC intersects AC at its minimum. That is, MC = AC at its minimum.
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Revenue Concepts- The term revenue refers to the income obtained by a

firm through the sale of goods at different prices. In the words of Dooley,
'the revenue of a firm is its sales, receipts or income'. The revenue concepts
are concerned with Total Revenue, Average Revenue and Marginal
Revenue.
1. Total Revenue - The income earned by a seller or producer after selling

the output is called the total revenue. In fact, total revenue is the multiple
of price and output.
2. Average Revenue - Average revenue refers to the revenue obtained by

the seller by selling the per unit commodity. It is obtained by dividing the
total revenue by total output.
3. Marginal Revenue - Marginal revenue is the net revenue obtained by

selling an additional unit of the commodity. In algebraic terms, marginal
revenue is the net addition to the total revenue by selling n units of a
commodity instead of n – 1.
Relationship among TR, MR and AR - The relation of TR, AR and MR

can be explained with the help of fig.
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When AR falls, MR also falls more than that of AR: TR increases initially at
a diminishing rate, it reaches maximum and then starts falling. Moreover, it
is also clear that when both AR and MR are falling, MR is less than AR. MR
can be zero, positive or negative but AR is always positive.
UNIT III: MARKET STRUCTURE, THEORY OF DETERMINATION OF

FACTOR PRICES
3.1. Classification of Markets: Pure and Perfect Competitions, Monopolistic

and Imperfect Competition, Monopoly, Duopoly and Oligopoly, Cartels
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In simple terms, market refers to a physical place where goods and services
are exchanged between buyers and sellers at a particular price. However, in
economic sense, market is defined as a set of buyers and sellers who are
geographically separated from each other, but are still able to communicate
to finalize the transaction of a product. The market for a product can be
local, regional, national, or international. Depending on the degree and type
of competition, market structures can be grouped into following categories:
A. Pure and Perfect competition
a. Features - In a perfect market, there are no checks either on the buyers or

sellers, cheap and efficient transport and communication, large number of
firms, large number of buyers, homogeneous product, free entry and exit,
and perfect knowledge:
b. Pure versus Perfect Competition: Like under perfect competition,

under pure competition also the competitive firm is price taker (while
competitive industry is price maker). However, under pure competition,
three features of perfect competition are absent, namely
(1) Perfect mobility of factors of production,
(2) Perfect knowledge, and
(3) Absence of selling and transportation costs.
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c. Equilibrium of Perfectly Competitive Firm: A firm is in equilibrium

when it has no tendency to change its level of output. It needs neither
expansion nor contraction. It wants to earn maximum profits in by
equating its marginal cost with its marginal revenue, i.e. MC = MR.
Conditions for Short-Run Equilibrium:
(1) The MC curve must equal the MR curve.
SMC = MR = AR = SAC.
(2) The MC curve must cut the MR curve from below and after the
point of equilibrium, it must be above the MR. This is the
second order condition.
In the short- run, some firms may be earning supernormal profits and
some incurring losses. This is illustrated in following diagram:
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Conditions for Long-Run Equilibrium:
(1) SMC = LMC = MR = AR = P = SAC = LAC at its minimum

point, and
(2) LMC curve must cut MR curve from below.
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In the long run, if some firms are earning supernormal profits, new
firms will enter the industry and supernormal profits will be competed
away. If some firms are incurring losses, some of the firms will leave
the industry till all earn normal profits.
B. Monopolistic and Imperfect Competition
a. Meaning: Monopolistic competition is a type of imperfect competition

such that many producers sell products that are differentiated from one
another (e.g. by branding or quality) and hence are not perfect substitutes.
b. Features: Many sellers, Product differentiation, Sales Promotion,

Identical demand and cost curves, and free entry and exit.
c. Equilibrium:
Short-run equilibrium: The firm maximizes its profits and produces a

quantity where the firm's marginal revenue (MR) is equal to its marginal
cost (MC). The firm is able to collect a price based on the average
revenue (AR) curve. The difference between the firm's average revenue
and average cost, multiplied by the quantity sold (Qs), gives the total
profit.
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Long-run equilibrium: Long-run equilibrium of the firm under

monopolistic competition. The firm still produces where marginal cost
and marginal revenue are equal; however, the demand curve (and AR)
has shifted as other firms entered the market and increased competition.
The firm no longer sells its goods above average cost and can no longer
claim an economic profit.
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C. Monopoly
a. Meaning: A market structure characterized by a single seller, selling a

unique product in the market. In a monopoly market, the seller faces no
competition, as he is the sole seller of goods with no close substitute.
b. Features:
(1) One seller and large number of buyers.
(2) No close substitutes.
(3) Difficulty of entry of new firms
(4) Monopoly is also an industry, price maker.
(5) Price Discrimination.
c. Equilibrium:
Short-run equilibrium: The monopolist maximizes his short-run profits

if the following two conditions are fulfilled. Firstly, the MC is equal to
the MR. Secondly, the slope of MC is greater than the slope of the MR at
the point of intersection.
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Long-run Equilibrium: In the long run, the monopolist has the time to
expand his plant, or to use his existing plant at any level which will
maximize his profit. The barriers to entry allow the profit of monopolist
to continue even in the long-run. However, monopolist need not reach for
an optimal scale of plant at an optimal capacity, even when he earns
normal profits in the extreme possibility. However, no firm can stay in
the business in the long run with losses.
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D. Duopoly - A duopoly is a situation where two companies own all or nearly

all of the market for a given product or service. A duopoly is the most basic
form of oligopoly, a market dominated by a small number of companies. A
duopoly can have the same impact on the market as a monopoly if the two
players collude on prices or output. Collusion results in consumers paying
higher prices than they would in a truly competitive market, and it is illegal
under U.S. antitrust law. In a duopoly, two competing businesses control the
majority of the market sector for a particular product or service they provide.
A business can be part of a duopoly even if it provides other services that do
not fall into the market sector in question. For example, Amazon is a part of
the duopoly in the e-book market but is not associated with a duopoly in its
other product sectors, such as computer hardware.\
E. Oligopoly
a. Meaning: Oligopoly is a market structure with a small number of firms,

none of which can keep the others from having significant influence. The
concentration ratio measures the market share of the largest firms. A
monopoly is one firm, duopoly is two firms and oligopoly is two or more
firms. Oligopolies are typically composed of a few large firms. Each firm
is so large that its actions affect market conditions. Therefore, the
competing firms will be aware of a firm's market actions and will respond
appropriately.
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b. Features: Interdependence, Advertising, Group Behaviour,

Competition, Barriers to Entry of Firms, Lack of Uniformity, Existence
of Price Rigidity, No Unique Pattern of Pricing Behaviour.
c. Emergence of Oligopoly: Oligopoly emerges due to huge capital

investment, absolute cost advantage, product differentiation, mergers,
and informal collusion.
d. Kinds of Oligopoly: Oligopoly market can be classified on the basis of:
(1) Product differentiation (pure and differentiated)
(2) Entry of firms (open and closed)
(3) Leadership (partial and full)
(4) Agreement (collusive and non-collusive)
(5) Coordination (organized and unorganized).
e. Oligopoly Models: Oligopoly models maybe non-collusive or collusive.

Non-collusive (non-cooperative) oligopoly implies absence of explicit or
implicit agreement or understanding among the firms regarding price
fixation or market sharing. It results in independent action by firms
affecting one another. Cournot and Sweezy models are some popular
examples. Collusive (cooperative) oligopoly implies some sort of
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understanding among the firms regarding price fixation, leadership or

market. Cartel (perfect collusion), price leadership (imperfect collusion –
dominant or barometric) and market sharing model are some common
examples.
3.2. Dumping: Meaning, Types, Importance and Impact of Dumping
A. Meaning: Dumping is an international price discrimination in which an

exporter firm sells a portion of its output in a foreign market at a very low
price and the remaining output at a high price in the home market.
B. Types of Dumping:
a. Persistent Dumping: When a monopolist continuously sells a portion of

his commodity at a high price in the domestic market and the remaining
output at a low price in the foreign market, it is called persistent
dumping.
b. Predatory Dumping: The predatory dumping is one in which a

monopolist firm sells its commodity at a very low price or at a loss in the
foreign market in order to drive out some competitors. But when the
competition ends, it raises the price of the commodity in the foreign
market. Thus, the firm covers loss and if the demand in the foreign
market is less elastic, its profit may be more.
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c. Sporadic Dumping: It is adopted under exceptional or unforeseen

circumstances when the domestic production of the commodity is more
than the target or there are unsold stocks of the commodity even after
sales. In such a situation, the producer sells the unsold stocks at a low
price in the foreign market without reducing the domestic price.
d. Reciprocal Dumping: The sale by firms from two countries into each
others' markets for prices below they charge at home. So called because
both firms' exports meet the price-discrimination definition of dumping.
3.3 Importance and Impact of Dumping: Dumping affects both the importer
and exporter countries in the following ways:
A. Effects on Importing Country:
1. If a producer dumps his commodity abroad for a short period, then the
industry of the importing country is affected for a short while. Due to the
low price of the dumped commodity, the industry of that country has to
incur a loss for some time because less quantity of its commodity is sold.
2. Dumping is harmful for the importing country if it continues for a long

period. This is because it takes time for changing production in the
importing country and its domestic industry is not able to bear
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competition. But when cheap imports stop or dumping does not exist, it
becomes difficult to change the production again.
3. If the dumped commodity is a consumer good, the demand of the people

in the importing country will change for the cheap goods. When dumping
stops, this demand will reverse, thereby changing the tastes of the people
which will be harmful for the economy.
4. If the dumped commodities are cheap capital goods, they will lead to the
setting up of a now industry. But when the imports of such commodities
stop, this industry will also be shut down. Thus ultimately, the importing
country will incur a loss.
5. If the monopolist dumps the commodity for removing his competitors

from the foreign market, the importing country gets the benefit of cheap
commodity in the beginning. But after competition ends and he sells the
same commodity at a high monopoly price, the importing country incurs
a loss because now it has to pay a high price.
6. If a tariff duty is imposed to force the dumper to equalise prices of the

domestic and imported commodity, it will not benefit the importing
country.
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7. But a lower fixed tariff duty benefits the importing country if the dumper
delivers the commodity at a lower price.
B. Effects on Exporting Country:

1. When domestic consumers have to buy the monopolistic commodity at a
high price through dumping, there is loss in their consumers’ surplus. But
if a monopolist produces more commodities in order to dump it in
another country, consumers benefit. This is because with more
production of the commodity, the marginal cost falls. As a result, the
price of the commodity will be less than the monopoly price without
dumping.
2. The exporting country also benefits from dumping when the monopolist
produces more commodity. Consequently, the demand for the required
inputs such as raw materials, etc. for the production of that commodity
increases, thereby expanding the means of employment in the country.
3. The exporting country earns foreign currency by selling its commodity in

large quantity in the foreign market through dumping. As a result, its
balance of trade improves.
3.4. Wage Determination, Rent, Interest, and Profits
Theory of Distribution: The theory of distribution is concerned with the

principles guiding the distribution of income among the various factors
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which help in the production process, namely land, labor, capital and
enterprise.
Marginal Productivity Theory of Distribution: According to this theory,

the price (or the earnings) of a factor tends to equal the value of its marginal
product. Thus, rent is equal to the value of the marginal product (VMP) of
land; wages are equal to the VMP of labour and so on. The neo-classical
economists have applied the same principle of profit maximisation (MC =
MR) to determine the factor price. Just as an entrepreneur maximises his
total profits by equating MC and MR, he also maximises profits by equating
the marginal product of each factor with its marginal cost.
A. Wage Determination: Classical economists argue that wages - the price of

labor - are determined (like all prices) by supply and demand. They call this
the market theory of wage determination. When workers sell their labor, the
price they can charge is influenced by several factors on the supply side and
several factors on the demand side. The most basic of these is the number of
workers available (supply) and the number of workers needed (demand). In
addition, wage levels are shaped by the skill sets workers bring and
employers need, as well as the location of the jobs being offered. The
interplay between all of these factors will eventually cause wages to settle -
that is, the number of workers, the number of jobs, the skills involved, and
the location of the jobs will eventually lead workers and employers to reach
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a series of wage agreements. If employers (demand) cannot find enough

workers to meet their needs, they will keep raising their wage offers until
more workers are attracted. If workers are in abundance (supply), wages will
fall until the surplus labor decides to go elsewhere in search of jobs. When
supply and demand meet, the equilibrium wage rate is established.
B. Economic Rent: In economics, economic rent is any payment to an owner

or factor of production in excess of the costs needed to bring that factor into
production. In classical economics, economic rent is any payment made
(including imputed value) or benefit received for non-produced inputs such
as location (land) and for assets formed by creating official privilege over
natural opportunities (e.g., patents). It is the positive difference between the
actual payment received for the work you have done or the money a piece of
land or machinery has made for you and the payment amount that was
expected in the first place. Economic rent should not be mistaken for the
more commonly used 'rent' term, which simply refers to payments made for
using an asset or property. Economic rent can be thought of as more of a
surplus amount. Economic Rent does arise when the Supply of a Factor is
Less than perfectly elastic. If the supply is not perfectly elastic, some factor
units will be available at a price lower than the price they will actually
receive, the difference between the actual price and the one necessary to
make them available is surplus or economic rent. If the supply curve is
perfectly elastic, there is no economic rent but only transfer earnings.
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C. Interest Rate Determination
a. Classical Approach: According to this theory rate of interest is

determined by the intersection of demand and supply of savings. It is
called the real theory of interest in the sense that it explains the
determination of interest by analyzing the real factors like savings and
investment. Therefore, classical economists maintained that interest is a
price paid for the supply of savings.
b. Loanable Fund Theory: Further, Loanable Funds Theory like the

Classical Theory is indeterminate. According to this theory, the rate of
interest is determined by the intersection of the demand curve for
loanable funds with the supply curve. But since the ‘savings’ part of the
supply curve varies with the level of income, it follows that the total
supply curve of loanable funds will also vary with income.
c. Keynesian Theory: Keynes’ analysis concentrates on the demand for

and supply of money as the determinants of interest rate. According to
Keynes, the rate of interest is purely “a monetary phenomenon.” Interest
is the price paid for borrowed funds. People like to keep cash with them
rather than investing cash in assets. Thus, there is a preference for liquid
cash.
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D. Profits – Profit is the difference between total revenue (value of output) and
total cost (value of inputs). The two are determined by demand and supply
conditions respectively.
Gross Profit or Accounting Profit is an accounting concept and represents

the residual sales revenue to the owners of the firm after making payments to
all other factors or resources the firm uses. It refers to the sales revenue of
the firm minus its explicit costs. Thus
Gross Profit (Accounting Profit) = Total sales revenue – Explicit costs
Net profit or economic profit is the revenue received from the sale of an
output in excess of the opportunity cost of the inputs used. In calculating
economic profit, opportunity costs are deducted from revenues earned. It
represents the sales revenue of the firm in excess of both explicit and
implicit costs.
Economic profits = Sales revenue – Explicit costs – implicit costs.
Normal Profit is the minimum price that must be paid to an entrepreneur for
retaining his services.
Abnormal Profit is an excess over normal profit.
Break-even point and profit maximization
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1. Break-even point is the point at which the total revenue of the firm is
equal to total cost. As total cost includes normal profit, the break-even
point does not imply zero profit.
2. Profit maximization implies maximum positive gap between total

revenue and total cost. Here, two conditions are satisfied:
(i) MR = MC
(ii) Slope of MR < Slope of MC
UNIT IV: THEORY OF MONEY, BANKING AND FINANCIAL

INSTITUTIONS
4.1. Concept of Money: Functions of Money, Impact of Money; Inflation

and Deflation
A. Limitations of Barter System: The barter system, that is direct exchange of

one good for another without the mediation of money, had a number of
difficulties associated with it. These are:
1. Lack of Double Coincidence of Wants.
2. Lack of a Common Measure of Value.
3. Indivisibility of Certain Goods.
4. Difficulty in Storing Value.
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5. Difficulty in Making Deferred Payments.
6. Lack of Specialization.
B. Money: Money is the circulating medium of exchange as defined by a

government. Money is often synonymous with cash and includes various
instruments such as checks. Each country has its own money that it and its
residents exchange for goods within its borders.
C. Origin and Development of Money: Money developed in response to the

urgent and inevitable needs of the various stages of growth of the economic
system took the following forms: Commodity money, Metallic money,
Paper money, and Credit money.
D. Functions of Money: Money has many important functions to perform.

These functions may be classified as follows:
1. Primary Functions –
(a) Medium of exchange
(b) Measure of Value.
2. Secondary Functions –
(a) Store of Value.
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(b) Standard of deferred payments.
(c) Transfer of Money.
3. Contingent Functions –
(a) Measurement and distribution of national income.
(b) Money equalizes marginal utilities/productivities.
(c) Basis of credit.
(d) Liquidity
E. Impact of Money - Money is important for every economic system –

capitalist, mixed, mixed capitalist and socialist. Money helps in the circular
flow of goods and services in a socialist economy. The role of money in a
socialist economy may be less important as compared to a capitalist
economy due to state regulation and control. Nevertheless, it helps in fixing
prices, wages, incomes and profits.
F. Inflation
Meaning: Inflation is the rate at which the general level of prices for goods
and services is rising and, consequently, the purchasing power of currency is
falling.
Types of Inflation:
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1. On the basis of intensity of price rise, inflation can be classified into

three types, creeping inflation, running inflation, and hyper inflation.
2. On the basis of degree of control, inflation can be classified into two

types, open inflation, and suppressed inflation.
3. On the basis of degree of control, inflation can be classified into five

types, credit inflation, currency inflation, deficit induced inflation,
demand pull inflation, and cost push inflation.
Causes of Inflation:
Causes working on the demand side are:
(i) Rise in money supply,
(ii) Rise in public expenditure,
(iii) Deficit financing, and
(iv) Rise in population.
Causes working on the supply side are:
(i) Inadequate agricultural growth,
(ii) Slow industrial growth,
(iii) Rise in administered prices,
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(iv) Taxation, and
(v) Rise in import prices.
Impact of Inflation – Inflation can be both beneficial to economic recovery

and, in some cases, negative. If inflation becomes too high the economy can
suffer; conversely, if inflation is controlled and at reasonable levels, the
economy may prosper. With controlled, lower inflation, employment
increases, consumers have more money to buy goods and services, and the
economy benefits and grows. Inflation impacts the cost of living, the cost of
doing business, borrowing money, mortgages, corporate and government
bond yields, and every other facet of the economy. However, the impact of
inflation on economic recovery cannot be assessed with complete accuracy.
Remedies for Inflation: There are three main ways by which inflation can
be controlled by:
a. Monetary Policy; controlled by central bank of the country, through
(i) Open market operation
(ii) Interest rate
b. Fiscal Policy; controlled by government via instruments of taxes and

government expenditure.
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c. Direct or physical control
(i) Price pegging
(ii) Encourage saving
(iii)Price tagging.
G. Deflation
Meaning: The concept of deflation is opposite to inflation. It is defined as a

situation when the general income level and price level are falling. It is also
known as negative inflation. During deflation the income level falls against
the available supply of goods and services.
Causes of Deflation: There are two main potential causes of deflation:
1. A fall in aggregate demand (AD)

2. A shift to the right of aggregate supply (AS) – i.e. lower costs of
production through improved technology.
Deflation usually occurs during a deep recession, when there is a sustained

fall in demand and output. This deflation may occur in the aftermath of
credit boom and bust or severe tightening of monetary policy/fiscal policy.
Monetarists emphasize the role of the money supply – falling money supply
and/or falling velocity of circulation causing a fall in the price level.
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Effects of Deflation:
1. Holding back on spending: Consumers may postpone demand if they

expect prices to fall in the future.
2. Debts increase: The real value of debt rises with deflation and higher real
debts can be a big drag on consumer confidence.
3. The real cost of borrowing increases: Real interest rates will rise if
nominal rates of interest do not fall in line with prices.
4. Lower profit margins: Lower prices can mean reduced revenues & profits
for businesses - this can then lead to higher unemployment as firms seek
to reduce costs by shedding labour.
5. Confidence and saving: Falling asset prices such as price deflation in the
housing market hits personal sector wealth and confidence.
6. Income distribution: Deflation leads to a redistribution of income from

debtors to creditors – but debtors may then default on loans.
7. Deflation can make exporters more competitive eventually – but this

often comes at a cost i.e. higher unemployment in short term.
4.2. Supply of and demand for Money
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A. Demand for Money - The demand for money is the desired holding of
financial assets in the form of money: that is, cash or bank deposits rather
than investments. The demand for money is affected by several factors,
including the level of income, interest rates, and inflation as well as
uncertainty about the future. The way in which these factors affect money
demand is usually explained in terms of the three motives for demanding
money: the transactions, the precautionary, and the speculative motives.
a. Transaction motive - The transaction motive for demanding money

arises from the fact that most transactions involve an exchange of money.
Because it is necessary to have money available for transactions, money
will be demanded. The total number of transactions made in an economy
tends to increase over time as income rises. Hence, as income or GDP
rises, the transactions demand for money also rises.
b. Precautionary motive - People often demand money as a precaution

against an uncertain future. Unexpected expenses, such as medical or car
repair bills, often require immediate payment. The need to have money
available in such situations is referred to as the precautionary motive for
demanding money.
c. Speculative motive - Money, like other stores of value, is an asset. The

demand for an asset depends on both its rate of return and its opportunity
cost. Typically, money holdings provide no rate of return and often
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depreciate in value due to inflation. The opportunity cost of holding

money is the interest rate that can be earned by lending or investing one's
money holdings. The speculative motive for demanding money arises in
situations where holding money is perceived to be less risky than the
alternative of lending the money or investing it in some other asset.
B. Supply of Money
Meaning - The money supply is the total value of monetary assets available
in an economy at a specific time. There are several ways to define "money",
but standard measures usually include currency in circulation and demand
deposits.
Measures of Money Supply - There are four measures of money supply in

India which are denoted by M1, M2, M3 and M4.
M1 = Currency with the public which includes notes and coins of all
denominations in circulation excluding cash on hand with banks + Demand
deposits with commercial and cooperative banks, excluding inter-bank
deposits + Other deposits held with the RBI.
M2 = M1 + post office savings bank deposits.

M3 = M1 + time deposits with commercial and cooperative banks,
excluding interbank time deposits.
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M4 = M3 + Total post office deposits comprising time deposits and demand

deposits.
Determinants of Money Supply - There are two theories of the

determination of the money supply. According to the first view, the money
supply is determined exogenously by the central bank. The second view
holds that the money supply is determined endogenously by changes in the
economic activity which affects people’s desire to hold currency relative to
deposits, the rate of interest, etc. Thus, the determinants of money supply are
both exogenous and endogenous which can be described broadly as: the
minimum cash reserve ratio, the level of bank reserves, and the desire of the
people to hold currency relative to deposits. The last two determinants
together are called the monetary base or the high powered money.
C. Monetary Equilibrium - Monetary equilibrium is a situation where the

supply of money equals the demand, given a particular constellation of
prices. The supply of money includes both the monetary base and various
forms of credit. An excess supply of money induces people to make some
trades that market participants will later judge not to have been beneficial. A
deficient supply of money hinders people from making some beneficial
trades.
4.3. Central Banking: Functions, Credit Control through Monetary Policy
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A. Meaning: A central bank, reserve bank, or monetary authority is an

institution that manages a state's currency, money supply, and interest rates.
Central banks also usually oversee the commercial banking system of their
respective countries. The critical feature of a central bank distinguishing it
from other banks is its legal monopoly status, which gives it the privilege to
issue bank notes and cash. Privately owned commercial banks are only
permitted to issue demand liabilities, such as checking deposits.
B. Functions: The major functions of a central bank in an economy are:
(1) Bank of Issue,
(2) Banker, Agent and Advisor to Government,
(3) Custodian of Cash Reserves,
(4) Custodian of Foreign Balances,
(5) Lender of Last Resort,
(6) Clearing House,
(7) Controller of Credit, and
(8) Protection of Depositor’s Interest.
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C. Credit Control through Monetary Policy - Credit control is an important

tool used by Central Bank, a major weapon of the monetary policy used to
control the demand and supply of money (liquidity) in the economy. Central
Bank administers control over the credit that the commercial banks grant.
There are two methods to control the money supply in the economy-
quantitative method and qualitative method
Quantitative Method - By quantitative credit control we mean the control

of the total quantity of credit. Different tools used under this method are-
1. Bank rate - Bank rate also known as the discount rate is the official
minimum rate at which the central bank of the country is ready to
rediscount approved bills of exchange or lend on approved securities.
2. Open Market Operations – It means purchase or sale by a Central Bank

of any kind of paper in which it deals, like government securities or any
other public securities or trade bills etc.
3. Varying Reserve Requirements -When it is sought to restrict credit, the

Central Bank may raise the reserve ratio. The Reserve Bank has also the
power to vary the cash reserve ratio (CRR) which the banks have to
maintain with it from the minimum requirement. Variations of reserve
requirements affect the liquidity position of the banks and hence their
ability to lend.
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4. Credit Rationing - Credit rationing means restrictions placed by the

Central Bank on demands for accommodation made upon it during times
of monetary stringency and declining gold reserves. The credit is rationed
by limiting the amount available to each applicant. Further, the Central
Bank restricts its discounts to bills maturing after short periods.
Qualitative Method - Qualitative method controls the manner of

channelizing of cash and credit in the economy. It is a 'selective method' of
control as it restricts credit for certain section where as expands for the other
known as the 'priority sector' depending on the situation. Tools used under
this method are-
1. Marginal requirement -The marginal requirement of a loan is the

current value of security offered for a loan or the value in totality of the
loans granted. The marginal requirement is increased for those business
activities, whose flow of credit is to be restricted in the economy.
2. Rationing of credit - Under this method there is a maximum limit to

loans and advances that can be made, which the commercial banks
cannot exceed.
3. Publicity - RBI uses media for the publicity of its views on the current
market condition and its directions that will be required to be
implemented by the commercial banks to control the unrest.
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4. Direct Action - Under the banking regulation Act, the central bank has
the authority to take strict action against any of the commercial banks
that refuses to obey the directions given by Central bank. There can be a
restriction on advancing of loans imposed by Reserve Bank of India.
5. Moral Suasion – Central bank persuades the commercial bank to follow

their policies. RBI puts a pressure on the commercial banks to put a
ceiling on credit flow during inflation and be liberal in lending during
deflation
4.4. Commercial Banking: Functions, Organization and Operations (Credit

Creation)
A. Meaning - A commercial bank is a type of financial institution that accepts

deposits, offers checking account services, makes business, personal and
mortgage loans, and offers basic financial products like certificates of
deposit (CDs) and savings accounts to individuals and small businesses.
B. Functions: The functions of commercial banks are broadly classified into

primary functions and secondary functions.
a. Primary Functions: These refer to the basic functions of commercial

banks that include the following:
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(i) Accepting Deposits - Implies that commercial banks are mainly

dependent on public deposits. There are two types of deposits,
demand deposits that can be easily withdrawn by individuals without
any prior notice to the bank and time deposits that are for certain
period of time. Banks pay higher interest on time deposits. These
deposits can be withdrawn only after a specific time period is
completed by providing a written notice to the bank.
(ii) Advancing Loans - Refers to one of the important functions of

commercial banks. The public deposits are used by commercial banks
for the purpose of granting loans to individuals and businesses.
Commercial banks grant loans in the form of overdraft, cash credit,
and discounting bills of exchange.
b. Secondary Functions: These refer to crucial functions of commercial

banks. The secondary functions can be classified under three heads,
namely, agency functions, general utility functions, and other functions.
(i) Agency Functions -Implies that commercial banks act as agents of

customers by performing various functions, which are as follows:
(1) Transfer of Funds -Banks provide the facility of economical and

easy remittance of funds from place-to-place with the help of
instruments like demand drafts, mail transfers, etc.
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(2) Collection and Payment of Various Items - Commercial banks

collect cheques, bills,’ interest, dividends, subscriptions, rents and
other periodical receipts on behalf of their customers and also
make payments of taxes, insurance premium, etc. on standing
instructions of their clients.
(3) Purchase and Sale of Foreign Exchange - Some commercial
banks are authorized by the central bank to deal in foreign
exchange. They buy and sell foreign exchange on behalf of their
customers and help in promoting international trade.
(4) Purchase and Sale of Securities - Commercial banks buy and sell
stocks and shares of private companies as well as government
securities on behalf of their customers.
(5) Income Tax Consultancy- They also give advice to their
customers on matters relating to income tax and even prepare their
income tax returns.
(6) Trustee and Executor - Commercial banks preserve the wills of
their customers as trustees and execute them after their death as
executors.
(7) Letters of Reference - They give information about the economic
position of their customers to traders and provide the similar
information about other traders to their customers.
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(ii) General Utility Functions - Commercial banks render some general

utility services like:
(1) Locker Facility -Commercial banks provide facility of safety
vaults or lockers to keep valuable articles of customers in safe
custody.
(2) Traveller’s Cheques - Commercial banks issue traveler’s cheques

to their customers to avoid risk of taking cash during their journey.
(3) Letter of Credit - They also issue letters of credit to their

customers to certify their creditworthiness.
(4) Underwriting Securities - Commercial banks also undertake the

task of underwriting securities. As public has full faith in the
creditworthiness of banks, public do not hesitate in buying the
securities underwritten by banks.
(5) Collection of Statistics - Banks collect and publish statistics

relating to trade, commerce and industry. Hence, they advice
customers on financial matters.
(iii) Other Functions - Include the following:
(1) Creating Money - Refers to one of the important functions of

commercial banks that help in increasing money supply.
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(2) Transfer of Funds - Refers to transferring of funds from one bank

to another. Funds are transferred by means of draft, telephonic
transfer, and electronic transfer.
C. Balance Sheet of a commercial Bank - The balance sheet of a commercial

bank provides a picture of its functioning. It is a statement which shows its
assets and liabilities on a particular date at the end of one year. The assets
are shown on the right- hand side and the liabilities on the left-hand side of
the balance sheet.
The major components of liabilities of a bank are capital, reserve fund,

deposits, borrowings from other sources, bills payable, bills for collection,
acceptances, endorsements, contingent liabilities, profit or loss, etc.
The major components of assets of a bank are cash, money at call and short
notice, bills discounted, loan and advances, investments, bills receivable,
acceptance, endorsements, premises, furniture and other assets, non-banking
assets, etc.
By studying the balance sheets of the major commercial banks of a country,

one can also know the trend of the monetary market.
D. Credit Creation
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A central bank is the primary source of money supply in an economy

through circulation of currency. It ensures the availability of currency for
meeting the transaction needs of an economy and facilitating various
economic activities, such as production, distribution, and consumption.
However, for this purpose, the central bank needs to depend upon the
reserves of commercial banks. These reserves of commercial banks are the
secondary source of money supply in an economy.
The most important function of a commercial bank is the creation of credit.

Therefore, money supplied by commercial banks is called credit money.
Commercial banks create credit by advancing loans and purchasing
securities. They lend money to individuals and businesses out of deposits
accepted from the public. Since every bank loan creates an equivalent
deposit, credit creation by bank implies a multiplication of bank deposits.
In a single bank economy model as well as in a multiple bank economy

model, whole of the system is treated as a single unit. In the single bank
economy case, we consider the one banking system. In single bank
economy, the question of inter-bank transactions does not arise at all, as
there is just one bank in the economy. In multiple bank economy, we
observe inter-bank transactions. But, cash reserves do not flow out of the
system.
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The deposit multiplier (K) bears an inverse relationship with the cash reserve
ratio (r). As the value of (r) rises, the value of ‘K” falls and vice-versa.
Credit Contraction – Bank credit can be destroyed through a reduction in

bank’s loans and advances. The extent of destruction depends upon the
prevailing cash reserves ration. A reduction of cash required to support
demand deposits leads to a multiple contraction of bank credit throughout
the banking system. As a result, the total supply of money will fall
drastically.
Significance of Credit Creation and Contraction: Expansion of bank

deposits or credit means an expansion of money supply, while contraction of
bank deposits implies contraction of money supply. The fluctuations in the
money supply influence the level of economic activity, prices and wages.
The following factors limit the power of banks to create credit:
(1) Total cash reserves in the country,
(2) Cash Reserves Ratio,
(3) People’s desire to hold cash,
(4) Business conditions,
(5) Monetary Policy,
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(6) Nature of securities offered.
4.5 Non-banking financial institutions: Meaning and Role
Meaning: A non-bank financial institution (NBFI) is a financial institution

that does not have a full banking license or is not supervised by a national or
international banking regulatory agency. NBFI facilitate bank-related
financial services, such as investment, risk pooling, contractual savings, and
market brokering. NBFIs such as insurance companies, housing finance
providers, pension funds, and investment funds mobilize savings, provide
market-based safety nets, and fund long-term investments to support growth
and job creation.
Types of NBFIs: There are five financial institutions under the full-fledged
regulation and supervision of the Reserve Bank, viz.
Export Import Bank of India (EXIM) – EXIM is the premier export

finance institution in India, established in 1982 under Export-Import Bank of
India Act 1981. Since its inception, EXIM Bank of India has been both a
catalyst and a key player in the promotion of cross border trade and
investment. EXIM Bank India has, over the period, evolved into an
institution that plays a major role in partnering Indian industries, particularly
the Small and Medium Enterprises, in their globalization efforts, through a
wide range of products and services offered at all stages of the business
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cycle, starting from import of technology and export product development to

export production, export marketing, pre-shipment and post-shipment and
overseas investment.
NABARD - National Bank for Agriculture and Rural Development

(NABARD) is an apex development financial institution in India,
headquartered at Mumbai with regional offices all over India. The Bank has
been entrusted with "matters concerning policy, planning and operations in
the field of credit for agriculture and other economic activities in rural areas
in India". NABARD is active in developing financial inclusion policy and is
a member of the Alliance for Financial Inclusion.
NHB - National Housing Bank (NHB), a wholly owned subsidiary of

Reserve Bank of India (RBI), was set up on 9 July 1988 under the National
Housing Bank Act, 1987. NHB is an apex financial institution for housing.
NHB has been established with an objective to operate as a principal agency
to promote housing finance institutions both at local and regional levels and
to provide financial and other support incidental to such institutions and for
matters connected therewith.
SIDBI - Small Industries Development Bank of India (SIDBI) is a

development financial institution in India, headquartered at Lucknow and
having its offices all over the country. Its purpose is to provide refinance
facilities and short term lending to industries, and serves as the principal
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financial institution in the Micro, Small and Medium Enterprises (MSME)

sector. SIDBI also coordinates the functions of institutions engaged in
similar activities.
Non-banking financial companies: Meaning and Role
Meaning: A Non Banking Financial Company (NBFC) is a company

registered under the Companies Act, 1956 of India, engaged in the business
of loans and advances, acquisition of shares, stock, bonds, hire-purchase
insurance business or chit-fund business but does not include any institution
whose principal business includes agriculture, industrial activity or the sale,
purchase or construction of immovable property.
Types of Non-Banking Financial Companies (NFBC)
 Asset Finance Company(AFC) - The main business of these companies is

to finance the assets such as machines, automobiles, generators, material
equipments, industrial machines etc.
 Investment Company (IC) – The main business of these companies is to
deal in securities.
 Loan Companies (LC) – The main business of such companies is to make
loans and advances (not for assets but for other purposes such as working
capital finance etc.).
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 Infrastructure Finance Company (IFC) – A company which has net

owned funds of at least Rs. 300 crore and has deployed 75% of its total
assets in Infrastructure loans is called IFC provided it has credit rating of A
or above and has a CRAR of 15%.
 Systemically Important Core Investment Company (CIC-ND-SI) - A
systematically important NBFC (assets Rs. 100 crore and above) which has
deployed at least 90% of its assets in the form of investment in shares or
debt instruments or loans in group companies is called CIC-ND-SI. Out of
the 90%, 60% should be invested in equity shares or those instruments
which can be compulsorily converted into equity shares. Such companies do
accept public funds.
 Infrastructure Debt Fund (IDF-NBFC) - A debt fund means an
investment pool in which core holdings are fixed income investments. The
Infrastructure Debt Funds are meant to infuse funds into the infrastructure
sector. The importance of these funds lies in the fact that the infrastructure
funding is not only different but also difficult in comparison to other types of
funding because of its huge requirement, long gestation period and long term
requirements.
 Non-Banking Financial Company – Micro Finance Institution (NBFC-
MFI) - NBFC-MFI is a non-deposit taking NBFC which has at least 85% of
its assets in the form of microfinance. Such microfinance should be in the
form of loan given to those who have annual income of Rs. 60,000 in rural
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areas and Rs. 120,000 in urban areas. Such loans should not exceed Rs.
50000 and its tenure should not be less than 24 months. Further, the loan has
to be given without collateral. Loan repayment is done on weekly,
fortnightly or monthly installments at the choice of the borrower.
 Non-Banking Financial Company – Factors (NBFC-Factors) - Factoring
business refers to the acquisition of receivables by way of assignment of
such receivables or financing, there against either by way of loans or
advances or by creation of security interest over such receivables but does
not include normal lending by a bank against the security of receivables etc.
4.6 Money Market and Capital Market
A. Money Market
Definition - Money market basically refers to a section of the financial

market where financial instruments with high liquidity and short-term
maturities are traded. Money market has become a component of the
financial market for buying and selling of securities of short-term maturities,
of one year or less, such as treasury bills and commercial papers. Over-the-
counter trading is done in the money market and it is a wholesale process. It
is used by the participants as a way of borrowing and lending for the short
term.
Functions
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Money markets serve five functions—to finance trade, finance industry,

invest profitably, enhance commercial banks' self-sufficiency, and lubricate
central bank.
Instruments of Money Market
1. Treasury Bills: The Treasury bills are short-term money market

instrument that mature in a year or less than that. The purchase price is
less than the face value. At maturity the government pays the Treasury
Bill holder the full face value. The Treasury Bills are marketable,
affordable and risk free.
2. Certificate of Deposit: The certificates of deposit are basically time

deposits that are issued by the commercial banks with maturity periods
ranging from 3 months to five years. The return on the certificate of
deposit is higher than the Treasury Bills because it assumes a higher level
of risk.
3. Commercial Paper: Commercial Paper is short-term loan that is issued

by a corporation use for financing accounts receivable and inventories.
Commercial Papers have higher denominations as compared to the
Treasury Bills and the Certificate of Deposit. The maturity period of
Commercial Papers are a maximum of 9 months. They are very safe
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since the financial situation of the corporation can be anticipated over a

few months.
4. Banker's Acceptance: It is a short-term credit investment. It is

guaranteed by a bank to make payments. The Banker's Acceptance is
traded in the Secondary market. The banker's acceptance is mostly used
to finance exports, imports and other transactions in goods. The banker's
acceptance need not be held till the maturity date but the holder has the
option to sell it off in the secondary market whenever he finds it suitable.
5. Repos: The Repo or the repurchase agreement is used by the government

security holder when he sells the security to a lender and promises to
repurchase from him overnight. Hence the Repos have terms ranging
from 1 night to 30 days. They are very safe due government backing.
B. Capital Market
Definition: A capital market is a financial market in which long-term debt

(over a year) or equity-backed securities are bought and sold. Capital
markets channel the wealth of savers to those who can put it to long-term
productive use, such as companies or governments making long-term
investments.
Functions- Various functions and significance of capital market are:
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(1) Link between savers and investors,
(2) Encouragement to savings,
(3) Encouragement to investment,
(4) Promotes economic growth,
(5) Stability in security prices,
(6) Benefits to investors
Instruments of Capital Market:
1. Debt Instruments – A debt instrument is used by either companies or

governments to generate funds for capital-intensive projects. It can
obtained either through the primary or secondary market. The
relationship in this form of instrument ownership is that of a borrower –
creditor and thus, does not necessarily imply ownership in the business of
the borrower.
2. Equities (also called Common Stock) - This instrument is issued by

companies only and can also be obtained either in the primary market or
the secondary market. Investment in this form of business translates to
ownership of the business as the contract stands in perpetuity unless sold
to another investor in the secondary market.
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3. Preference Shares - This instrument is issued by corporate bodies and

the investors rank second (after bond holders) on the scale of preference
when a company goes under. The instrument possesses the characteristics
of equity in the sense that when the authorised share capital and paid up
capital are being calculated, they are added to equity capital to arrive at
the total.
4. Derivatives - These are instruments that derive from other securities,

which are referred to as underlying assets (as the derivative is derived
from them). The price, riskiness and function of the derivative depend on
the underlying assets since whatever affects the underlying asset must
affect the derivative. The derivative might be an asset, index or even
situation. Derivatives are mostly common in developed economies.
Money market versus Capital Market
1. The place where short-term marketable securities are traded is known as

Money Market. Unlike Capital Market, where long-term securities are
created and traded is known as Capital Market.
2. Capital Market is well organized which money market lacks.
3. The instruments traded in money market carry low risk, hence, they are
safer investments, but capital market instruments carry high risk.
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4. The liquidity is high in the money market, but in the case of the capital
market, liquidity is comparatively less.
5. The major institutions that work in money market are the central bank,
commercial bank, non-financial institutions and acceptance houses. On
the contrary, the major institutions which operate in the capital market
are a stock exchange, commercial bank, non-banking institutions etc.
6. Money market fulfils short-term credit requirements of the companies

such as providing working capital to them. As against this, the capital
market tends to fulfill long-term credit requirements of the companies,
like providing fixed capital to purchase land, building or machinery.
7. Capital Market Instruments give higher returns as compared to money

market instruments.
8. Redemption of money market instruments is done within a year, but

capital market instruments have a life of more than a year as well as some
of them are perpetual in nature.
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E-notes - Economics-I Ballb 207

LLB (Guru Gobind Singh Indraprastha University)

Studocu is not sponsored or endorsed by any college or university

Chanderprabhu Jain College of Higher Studies

Class : BA LLB – Third Semester

Paper Code : BALLB 207

UNIT I: INTRODUCTION TO ECONOMICS

1.1. Definition, Methodology, Scope of Economics

a. Wealth Definition - Adam Smith (1723-1790), Father of Economics, in

b. Welfare Definition - Alfred Marshall (1842-1924) wrote a book

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c. Scarcity Definition - Lionel Robbins published a book “An Essay on the

d. Growth Definition - Professor Paul Samuelson defined economics as

Based on all these definitions, Economics can be defined as: “Economics

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Economics not only covers the decision making behaviour of individuals

B. Nature of Economics - In discussing the nature of economics, we have to

a. Economics - A Science and an Art

(i) Economics as science: It is science in the sense, it is a systematic

(ii) Economics as art: Economics is an art too because an art is a system

b. Economics - Positive and normative science

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(i) Economics as positive science: It only describes what it is and

(ii) Normative science: It makes distinction between good and bad. It

Methodology of Economic Laws - Economics adopts two methods for the

a. Deductive method: Here, we descend from the general to particular, i.e.,

b. Inductive method: This method mounts up from particular to general,

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with the help of reasoning founded on experience so as to formulate laws

Both deductive and inductive methods are useful in economic analysis.

Methodology of Economic Theory – Economic theory involves

a. Micro Economics: It may be defined as that branch of economic

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be a person, a particular household, or a particular firm. It is a study of

Importance of Microeconomics: Microeconomics occupies a very

(1) Helpful in the Efficient Employment of Resources,

(2) Understanding Free Enterprise Economy,

(3) Helpful in the Development of International Trade,

(4) Helpful in Understanding the Implications of Taxation,

(5) Basis for Welfare Economics,

(6) Provides Tools for Evaluating Economic Policies,

(7) Construction and Use of Models

b. Macro Economics: It may be defined as that branch of economic

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the units combined together. It is a study in cumulative. Hence it is often

Importance of Macroeconomics: It helps to understand the functioning

(1) Functioning of an Economy,

(2) Formulation of Economic Policies,

(3) Understanding Macroeconomics,

(4) Understanding and Controlling Economic Fluctuations,

(5) Theory of inflation and Deflation,

(6) Study of National Income,

(7) Study of Economic Development,

(8) Performance of an Economy, and

(9) Nature of Material Welfare.

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