Economic Cost : It is the sum total of explicit and implicit cost.

Explicit Cost : Actual money expenditure incurred by a firm on the purchase and hiring the
factor inputs for the production is called explicit cost. These are entered into books of
accounts. For example-payment of wages, rent, interest, purchases of raw materials etc.

Implicit cost is the cost of self owned resources of the production used in production process.
Or estimated value of inputs supplied by owner itself. These are not entered into books of
accounts.

Normal Profit : It is the minimum amount required to keep the producers into business. In
other words, it is the minimum supply price of the entrepreneur. It is also called the wage off
an entrepreneur.

Total cost refers to total amount of money which is incurred by a firm on production of a
given amount of a commodity. Total cost is the sum of total fixed cost and total variable
cost.TC = TFC + TVC or TC = AC × Q

Total fixed cost:- It is also called supplementary cost. It is the total expenditure incurred by
the producer for employing fixed inputs. Ex- Rent of land and building, interest on
capital,license fee etc.TFC = TC – TVC or TFC = AFC × Q

Features of Total Fixed Cost:- (a) It remains constant at all levels of output. It is not zero
even at zero output level. Therefore, TFC curve is parallel to X-axis. (b) Total cost at zero
level of output is equal to total fixed cost.
Total variable cost is the cost which vary with the quantity of output produced. It is zero at
zero level of output. TVC curve is parallel to TC curve.Ex-cost of raw material,expenses on
power etc.TVC = TC – TFC or TVC = AVC × Q

Features of Total variable cost:- (a) It is zero when output is zero. (b) It increases with
increase in output. (c) Initially TVC increases at diminishing rate due to increasing returns
and later it increases at an increasing rate due to diminishing return.

Average cost is per unit cost of production of a commodity. It is the sum of average fixed
cost and average variable cost.

Average fixed cost is per unit fixed cost of production of a commodity.

Features of AFC:- (a) AFC diminishes with increase in output. (b) AFC curve is a
rectangular hyperbola.(c) It can not intersect X-axis or Y-axis.
Average variable cost is per unit variable cost of production of a commodity. AVC is
U-shaped due to law of variable proportion.

Relation Between Short-Term Costs

1. Total cost curve and total variable cost curve remains parallel to each other. The
vertical distance between these two curve is equal to total fixed cost.
2. TFC curve remains parallel to X-axis and TVC curve remains parallel to TC curve.
 3. With increase in level of output, the vertical distance between AFC curve and AC
curve goes on increasing. On contrary the vertical distance between AC curve and
AVC curve goes on decreasing but these two curves never intersect because average
fixed cost is never zero.

Money received from the sale of product is called revenue.

Total revenue is the total amount of money received by a firm from the sale of given units of
a commodity.
 1. Per unit revenue received from the sale of given units of a commodity is called
average revenue. Average revenue is equal to price. Per unit price of a commodity it
also called AR.

Relation between TR, AR when more quantity by sold at the lower price or there is
monopoly or monopolistic competition in the market.
(a) Average revenue and marginal revenue curves have negative slope. MR curve lies below
AR curve. AR > MR
(b) Marginal revenue falls, twice the rate of average revenue.

(c) So long as marginal revenue decreases and positive, total revenue increases at diminishing
rate. When marginal revenue is zero, total revenue is maximum and when marginal revenue
becomes negative, TR starts falling.
 2. Relation b/w AR and MR (General relationship)When MR = AR, AR is maximum
and constant. MR can be negative, but not AR.When MR < AR, AR falls. When TR
increases at an increasing rate, MR and AR also increases.

Major Objectives of Firm

Survival:
Profit earning is regarded as a main objective of every business unit. But it is essential for the
survival and growth of every business enterprise. ‘To survive’ means, “to live longer”.
Survival is the primary and fundamental objective of every business firm. The business
cannot grow until and unless it survives in a competitive business world. Due to intense
global competition, survival has become extremely difficult for the organisation.

Growth:
Growth comes after survival. It is the second major business objective after survival. Growth
refers to an increase in the number of activities of an organisation. It is an important organic
objective of an organisation. Business takes place through expansion and diversification.
Business growth benefits promoters, shareholders, consumers and the national economy.
Profit:
The primary objective of every business is to earn profit. Profit is the lifeblood of business,
without which no business can survive in a competitive-market. Profit is the financial gain or
excess of return over investment.

It is the reward for bearing risk and uncertainty in the business. It is a lubricant, which keeps
the wheels of business moving. Profit is essential for the survival, growth and expansion of
the business.

Social Objectives:
Social objective means objective relating to the society. This objective helps to shape the
character of the company in the minds of the society. The obligation of any business to
protect and serve public interest is known as social responsibility of business.

Society comprises of the consumers, employees, shareholders, creditors, financial

institutions, government, etc. Business has some responsibility towards the society.
Businessmen engage themselves in research for improving the quality of products; some
provide housing, transport, education and health care to their employees and their families. In
some places businessmen provide free medical facility to poor patients. Sometimes they also
sponsor games and sports at national as well as international level etc.

Economic development

Economic development is the process of improving economic welfare in an economy.

Economic development can involve a stronger economy enabling a greater range of social
services that improve a nation’s welfare. For example, an undeveloped economy will be
primarily based on agriculture and very limited social services such as health care and
education. Economic development involves an increase in real incomes, higher life
expectancy, lower poverty and a greater provision of basic amenities.

Indicators of economic development

To know the level of economic development of a country there are a different indicators
which are used. These indicators help in understanding the level of development,
comparisons with other countries, or different time periods. These indicators help in better
planning towards achieving economic development. The indicators of economic development
are:
Growth rate of National Income:
● In this indicator real income is calculated on constant prices
● If there is rise in national income, this indicates economic development.
● When there is high rate of national income, development rate is high and vice versa

Per Capita Income (PCI):

● The average income of the people living in the country is the per capita income.
● A rise in PCI is an important indicator of economic development
● The rise in PCI indicates economic welfare of the country

Per Capita Consumption (PCC):

● The increase in consumption of goods and services by the people is measured in PCC.
● Example clothing, food, education, health etc
● An increase in PCC shows better quality of life of people and higher economic
development of the country.

Industrial progress:
Industrial progress is an important indicator of the economic development of a country. It
helps to increase per capita income and the national output of the country.

Capital formation:
It means investing in transport, irrigation, roads, electricity, technology etc. higher capital
formation will lead to higher economic development.
● The indicators under economic development are more towards the qualitative
improvement of people in the country.
● A higher rate of these indicators shows a higher level of economic development.
● Real GDP per capita – gross domestic product. The nation’s total economic output
which is the same as a nation’s income.
● GDP at purchasing power parity (PPP) takes into account the local purchasing
power of the currency and is a better guide to actual living standards.
● Levels of absolute poverty, e.g % of population with income less than minimum
necessary to meet basic necessities of life.

● Malnutrition levels. Percentage of population with insufficient food – levels of

malnutrition.

● Access to safe water. Percentage of population with access to safe water supply
and sanitation

● Literacy rate – The percentage of a population that can read and write. Also
consider gender discrepancy.
 ● Mean years of education – Length of education gives indication on deeper
education standards.

● Number of doctors per 1,000 of population.

● Average life expectancy. Life expectancy generally rises with economic

development.

● Openness of economy to international trade. Also, levels of foreign direct

investment.

● Quality of nation’s infrastructure – quantity and quality of roads, railways and

airports.

● Share of agriculture in economy. Over 90% indicates an undeveloped economy.

Less than 10% of economy in agriculture suggests more developed economy.

● Political stability and security.

● Wildlife Diversity

Human Development Index (HDI)

● The Human Development Index (HDI) is a statistic composite index of life

expectancy, education (mean years of schooling completed and expected years of
schooling upon entering the education system), and per capita income indicators,
which is used to rank countries into four tiers of human development.

● A country scores a higher level of HDI when the lifespan is higher, the education
level is higher, and the gross national income GNI (PPP) per capita is higher. It
was developed by Pakistani economist Mahbub ul Haq and was further used to
measure a country's development by the United Nations Development Programme
(UNDP)'s Human Development Report Office.

Economic Recession Definition

Economic recession is a period of general economic decline and is typically accompanied by
a drop in the stock market, an increase in unemployment, and a decline in the housing
market. Generally, a recession is less severe than a depression. The blame for a recession
generally falls on the federal leadership, often either the president himself, the head of the
Federal Reserve, or the entire administration.

Causes of a Recession

1. Real factors

A sudden change in external economic conditions and structural shifts can trigger a recession.
This fact is explained by the Real Business Cycle Theory, which says a recession is how a
rational participant in the market responds to unanticipated or negative shocks.

For example, a sudden rise in oil prices due to growing geopolitical tensions can harm crude
oil-importing economies. A revolutionary technology that causes automation in factories can
disproportionately impact economies with a huge pool of unskilled labor.

2. Financial/Nominal factors

According to a school of economics called monetarism, a recession is a direct consequence of

over-expansion of credit during expansion periods. It gets exacerbated by insufficient money
supply and credit availability during the initial stages of a slowdown.

There is a significant correlation between monetary and real factors, such as interest rates and
relationships between certain goods. The relationship is not explicit because monetary policy
instruments such as interest rates also encompass institutional responses to anticipated
slowdowns.

Financial indicators of an upcoming recession are often tied to benchmark interest rates. For
example, the Treasury yield curve inverted in the 18 months preceding the last seven
financial crises in the U.S. Also, a sustained fall in equity values shows lower expectations
for the future.

3. Psychological factors

Psychological factors include excessive euphoria and overexposure to risky capital during an
economic expansion period. The 2008 Global Financial Crisis was, at least in part, a result of
irresponsible speculation that led to the formation of a bubble in the housing market in the
US. Psychological factors can also manifest as a curtailed investment resulting from
widespread market pessimism, which lacks grounds in the real economy.

Effects of a Recession
 ● Recessions cause standard monetary and fiscal effects – credit availability
tightens, and short-term interest rates tend to fall. As businesses seek to cut costs,
unemployment rates increase.
● That, in turn, reduces consumption rates, which causes inflation rates to go down.
Lower prices reduce corporate profits, which triggers more job cuts and creates a
vicious cycle of an economic slowdown.
● National governments often intervene to bail out key businesses that face potential
failure or structurally important financial institutions such as large banks.
● Some companies with foresight and planning understand the implicit opportunity
created by the lower cost of capital as interest rates and prices fall and are actually
able to take advantage of a recessionary period.
● A larger pool of unemployed workers enables employers to recruit more qualified
candidates.

Policies for Economic Development

Macroeconomic Stability

Macroeconomic stability would involve a commitment to low inflation. Low inflation creates
a climate where foreign investors have more confidence to invest in that country. High
inflation can lead to devaluation of the currency and discourage foreign investment. To create
a low inflationary framework, it requires:
A potential problem of macroeconomic stability is that in the pursuit of low inflation, higher
interest rates can conflict with lower economic growth – at least in the short term.
Sometimes, countries have pursued low inflation with great vigour, but at a cost of recession
and higher unemployment. This creates a constraint to economic development. The ideal is to
pursue a combination of low inflation and sustainable economic growth.

It depends on the economic situation, some countries may be in a situation where there is a
fundamental lack of demand due to overvalued exchange rate and tight monetary policy.
Therefore, economic development may require demand-side policies which boost aggregate
demand.

Macroeconomic stabilisation may involve policies to reduce government budget deficits.

However, this may involve spending cuts on social welfare programs.

Privatisation and De-regulation

An important aspect of China’s rapid economic development was the decision to move from a
Communist economy to a mixed economy. Several state-owned industries were privatised.
This gives firms a profit incentive to cut costs and aim for greater efficiency. De-regulation
involves making state-owned monopolies face competition. This greater competitive pressure
can help to create incentives to cut costs. Greater competitive pressures may also be gained
through liberalising trade and opening markets to international competition.

A potential problem of privatisation is that it can exacerbate inequality in society. In Russia,

privatisation enabled a small number of oligarchs to gain control of key industries at low cost.
Arguably, this does little for economic development because the nation’s resources become
owned by a small number of very rich individuals, and there is little ‘trickle down’ to poorer
members of society.

Effective Tax Structure and Tax Collection

One of the challenges developing economies often face is to effectively tax and collect what
they are supposed to. If the government is unable to collect sufficient tax from the richest
aspect of the economy (e.g. production of natural resources) there will be little funds to
finance necessary public sector investment in services with a high social benefit. For
example, the average tax rate in Sub-Saharan Africa is only 15% of GDP – compared to an
average of 40% of GDP in the developed world.

But average revenue collection rates in Sub-Saharan African countries stood at only 13.3
percent of GDP during 1990 to 1994. They increased very slightly to 15.6 percent during
2000 to 2006… And the researchers found that – and this is even more alarming – most of
this slight increase came from sources such as value added taxes, which tend to burden the
poor more heavily than the wealthy.

Investment in Public Services

In areas such as education, healthcare and transport, there is often market failure – the free
market doesn’t provide sufficient levels of education. A key factor in improving economic
development is to increase levels of literacy and numeracy. Without basic levels of education
and training, it is very difficult for the economy to develop into higher value-added
industries.

Evidence on returns from investing in education are mixed. Often investment takes a long
time to feed through into directly higher rates of economic growth.

Diversification away from agriculture

A constraint developing economies may face is that their current comparative advantage is in
the production of primary products. However, these limit economic development due to
volatile prices, a low-income elasticity of demand and finite nature. Therefore, economic
development may require government encouragement of new industries in different sectors,
such as manufacturing. This may require a temporary commitment to tariffs

Attempts to diversify away from agriculture can have mixed results. Sometimes, countries
with a poor basic level of infrastructure struggle to make effective use of capital investment
in manufacturing. Some argue government attempts to encourage manufacturing industry is
misplaced because they tend to have poor information about best kinds of industries to
promote. It is better to allow the free market to decide to which industries to invest in.

Role of IMF in Economic Development

The IMF can play a role in dealing with economic crisis. The IMF can give a country a loan
to meet a temporary fiscal or balance of payments problem. This loan can be vital for helping
the economy to deal with an unexpected crisis. Without the loan, the economy may have to
experience a bigger fall in living standards to meet the creditors.

However, the role of the IMF is often criticised. In return for a loan, the IMF has often
insisted on certain free-market reforms in return for the loan. This has included

Privatisation

Tax reform

Cuts in government spending (often on welfare payments)

These free market supply-side policies have arguably often harmed economic development,
e.g. reducing access to basic necessities and lower government spending on the poor.

However, the IMF often point out that they are usually asked to help only in crisis so there is
often a difficult choice to make
World Bank and Economic Development

The World Bank is a financial body committed to the reduction of poverty in developing
countries. It offers long-term loans for capital programs.

The World Bank is committed to achieving its aims through the promotion of international
trade, capital investment and foreign investment.

The World Bank has often been criticised for its promotion of structural adjustment policies.
These free market-oriented policies have often caused, at least temporary, upheaval in the
economy.

Other Issues in economic development

Role of foreign aid Foreign aid can help boost capital investment in schemes which improve
economic development. However, it depends on the type of foreign aid.

Competitive Markets / Perfect Competition

❖ In a perfectly competitive market, there will be many sellers and many buyers –
a lot of different firms compete to supply an identical product.
❖ As there is fierce competition, neither producers nor consumers can influence
market price – they are all price takers. If any firm did try to sell at a high
price, it would lose customers to competitors. If the price is too low, they may
incur a loss. There will also be a huge amount of output in the market.

Features of Perfectly Competitive Market

1) A large number of buyers and sellers

There exist a large number of buyers and sellers in a perfectly competitive market. The
number of sellers is so large that no individual firm owns the control over the market price of
a commodity.

Due to the large number of sellers in the market, there exists a perfect and free competition.
A firm acts as a price taker while the price is determined by the ‘invisible hands of market’,
i.e. by ‘demand for’ and ‘supply of’ goods. Thus, we can conclude that under perfectly
competitive market, an individual firm is a price taker and not a price maker.

2) Homogenous products
All the firms in a perfectly competitive market produce homogeneous products. This implies
that the output of each firm is perfect substitute to others’ output in terms of quantity, quality,
colour, size, features, etc. This indicates that the buyers are indifferent to the output of
different firms. Due to the homogenous nature of products, existence of uniform price is
guaranteed.

3) Free exit and entry of firms

In the long run there is free entry and exit of firms. However, in the short run some fixed
factors obstruct the free entry and exit of firms. This ensures that all the firms in the long-run
earn normal profit or zero economic profit that measures the opportunity cost of the firms
either to continue production or to shut down. If there are abnormal profits, new firms will
enter the market and if there are abnormal losses, a few existing firms will exit the market.

4) Perfect knowledge among buyers and sellers

Both buyers and sellers are fully aware of the market conditions, such as price of a product at
different places. The sellers are also aware of the prices at which the buyers are willing to buy
the product. The implication of this feature is that if any individual firm is charging higher (or
lower) price for a homogeneous product, the buyers will shift their purchase to other firms (or
shift their purchase from the firm to other firms selling at lower price).

5) No transport costs

This feature means that all the firms have equal access to the market. The goods are produced
and sold locally. Therefore, there is no cost of transporting the product from one part of the
market to other.

6) Perfect mobility of factors of production

There exists geographically and occupationally perfect mobility of factors of production. This
implies that the factors of production can move from one place to other and can move from
one job to another.

7) No promotional and selling costs

There are no advertisements and promotional costs incurred by the firms. The selling costs
under perfectly competitive market are zero.

Advantages:

● High consumer sovereignty: consumers will have a wide variety of goods and services
to choose from, as many producers sell similar products. Products are also likely to be of
high quality, in order to attract consumers.
● Low prices: as competition is fierce, producers will try and keep prices low to attract
customers and increase sales.

● Efficiency: to keep profits high and lower costs, firms will be very efficient. If they aren’t
efficient, they would become less profitable. This will cause them to raise prices which
would discourage consumers from buying their product. Inefficiency could also lead to
poor quality products.

Disadvantages:

● Wasteful competition: in order to keep up with other firms, producers will duplicate
items; this is considered a waste of resources.

● Mislead customers: to gain more customers and sales, firms might give false and
exaggerated claims about their product, which would disadvantage both customers and
competitors.

Monopoly

❖ Dominant firms who have market power to restrict competition in the

market are called monopolies.
❖ In a monopoly, there is only a single seller who supplies a good or service.
Example: Railways.
❖ Since customers have no other firms to buy from, monopolies can raise prices –
that is they are able to influence prices as it will not affect their profitability.
❖ These high prices result in monopolies generating excessive or abnormal profits.
❖ Monopolies don’t face competition because the market faces high barriers to
entry – obstacles preventing new firms from entering the market.
❖ That is, there might be high start-up costs (sunk costs), expensive paperwork,
regulations etc. If the monopoly has a very high brand loyalty or pricing structures
that other firm couldn’t possibly compete with, those also act as barriers to entry.

Features

1. Single Seller of the Product

In a monopoly market, usually, there is a single firm which produces and/or supplies a
particular product/ commodity. It is fair to say that such a firm constitutes the entire industry.
Also, there is no distinction between the firm and the industry.

2. Entry Restrictions

Another feature of a monopoly market is restrictions of entry. These restrictions can be of any
form like economical, legal, institutional, artificial, etc.
3. No Close Substitutes

Usually, a monopolist sells a product which does not have any close substitutes. Therefore,
the cross elasticity of demand for such a product is either zero or very small. Also, the price
elasticity of demand for the monopolist’s product is less than one. Hence, in the monopoly
market, the monopolist faces a downward sloping demand curve.

4. Price Maker

Since there is only one firm selling the product, it becomes the price maker for the whole
industry. The consumers have to accept the price set by the firm as there are no other sellers
or close substitutes.

Disadvantages:
● There is less consumer sovereignty: as there are no (or very little) other firms selling the
product, output is low and thus there is little consumer choice.
● Monopolies may not respond quickly to customer demands.
● Higher prices.
● Lower quality: as there is little or no competition, monopolies have no incentive to raise
quality, as consumers will have to buy from them anyway. (But since they make a lot of
profit, they may invest a lot in research and development and increase quality).
● Inefficiency: With high prices, they may create high enough profits that, costs due to
inefficiency won’t create a significant problem in their profitability and so they can
continue being inefficient.
Why monopolies are not always bad?
● As only a single producer exists, it will produce more output than what individual firms
in a competition do, and thus benefit from economies of scale.
● They can still face competition from overseas firms.
● They could sell products at lower price and high quality if they fear new firms may enter
the market in the future.

The macroeconomic aims of government

Economic growth, the process by which a nation’s wealth increases over time. , full
employment/low unemployment, stable prices/low inflation, balance of payments stability,
redistribution of income.

Full Employment/ Low Unemployment

● Full employment is an economic situation in which all available labor resources

are being used in the most efficient way possible.
● True full employment is an ideal—and probably unachievable—situation in which
anyone who is willing and able to work can find a job, and unemployment is zero.
 ● It is a theoretical goal for economic policymakers to aim for rather than an
actually observed state of the economy.
● In practical terms, economists can define various levels of full employment that
are associated with low but non-zero rates of unemployment.

Stable Prices/ Low Inflation

● By stable prices, we mean that prices should not go up (inflation) significantly,

and an ongoing period of falling prices (deflation) should also be avoided.
● Long periods of excessive inflation or deflation have negative effects on the
economy

Balance of Payment Stability

● Balance Of Payment (BOP) is a statement that records all the monetary

transactions made between residents of a country and the rest of the world during
any given period.
● This statement includes all the transactions made by/to individuals, corporates and
the government and helps in monitoring the flow of funds to develop the
economy.
● The BOP of a country reveals its financial and economic status.
● A BOP statement can be used to determine whether the country’s currency value
is appreciating or depreciating.
● The BOP statement helps the government to decide on fiscal and trade policies.
● It provides important information to analyse and understand the economic
dealings with other countries.

Redistribution of income

● Redistribution of income and wealth is the transfer of income and wealth

(including physical property) from some individuals to others through a social
mechanism such as taxation, welfare, public services, land reform, monetary
policies,Reasons behind the choice of aims and the criteria that governments set
for each aim Objectives Priority Challenge Area Immidiate Concern possible
conflicts between macroeconomic aims

Possible conflicts between macroeconomic aims

Economic growth vs. Price stability
 ● Higher economic growth results in higher inflation rates. It could work through
aggregate demand.
● Say, the central bank lowers interest rates to stimulate economic growth. As a
result, borrowing costs become cheaper and encourage households to increase
consumption and businesses to invest. As a result, aggregate demand rises.
● Since the interest rate is not explained in the aggregate demand model, its
decrease will shift the aggregate demand curve to the right. As a result, aggregate
demand increases and causes aggregate output to rise, but that will be
accompanied by an increase in aggregate prices (inflation rises).

Full employment vs. Price stability

● When the unemployment rate is at its natural level, it cannot fall again without
causing the inflation rate to rise. Thus, pursuing lower unemployment will
sacrifice price stability.
● During full employment, people who are willing and actively looking for work
have found it. The labor market is tight, and companies find it difficult to attract
skilled workers.
● A further decline in unemployment will cause the labor market to become tighter
and push wages up. As a result, companies must pay more to recruit new workers.
And they will pass wage increases to selling prices to maintain profit margins. So,
recruiting workers – lowering unemployment – will only cause inflation to rise.

Economic growth vs. Balance of payments equilibrium

● Encouraging higher economic growth will result in a balance of payments

disequilibrium. For example, during economic growth, households are more
prosperous. They see their job and income prospects improving. Finally, they
spend more on goods and services, causing aggregate demand to rise.
● An increase in aggregate demand causes the price level to rise, prompting
businesses to increase their output. And further demand increases could lead the
economy to operate above its potential output. But not all aggregate demand can
be met by domestic production, which ultimately increases imports.

Full employment vs. Balance of payments equilibrium

● Full employment occurs when the unemployment rate is at its natural rate. And
the real output is equal to the potential output. And the economy operates at full
capacity.
● Full employment is the lowest point in the unemployment rate. In other words,
during this period, the economy was prosperous. However, a further decline in the
unemployment rate will result in a balance of payments disequilibrium.
Market failure

● Market failure occurs when there is a state of disequilibrium in the market due to
market distortion.
● It takes place when the quantity of goods or services supplied is not equal to the
quantity of goods or services demanded. Some of the distortions that may affect
the free market may include monopoly power, price limits, minimum wage
requirements, and government regulations.
● Market failure refers to the inefficient distribution of goods and services in the
free market.
● In a typical free market, the prices of goods and services are determined by the
forces of supply and demand, and any change in one of the forces results in a price
change and a corresponding change in the other force.

Causes of Market Failures

1. Externality

● An externality refers to a cost or benefit resulting from a transaction that affects a

third party that did not decide to be associated with the benefit or cost. It can be
positive or negative. A positive externality provides a positive effect on the third
party. For example, providing good public education mainly benefits the students,
but the benefits of this public good will spill over to the whole society.
● On the other hand, a negative externality is a negative effect resulting from the
consumption of a product, and that results in a negative impact on a third party.
For example, even though cigarette smoking is primarily harmful to a smoker, it
also causes a negative health impact on people around the smoker.

2. Public goods

● Public goods are goods that are consumed by a large number of the population,
and their cost does not increase with the increase in the number of consumers.
Public goods are both non-rivalrous as well as non-excludable. Non-rivalrous
consumption means that the goods are allocated efficiently to the whole
population if provided at zero cost, while non-excludable consumption means that
the public goods cannot exclude non-payers from its consumption.
● Public goods create market failures if a section of the population that consumes
the goods fails to pay but continues using the good as actual payers. For example,
 police service is a public good that every citizen is entitled to enjoy, regardless of
whether or not they pay taxes to the government.

3. Market control

● Market control occurs when either the buyer or the seller possesses the power to
determine the price of goods or services in a market. The power prevents the
natural forces of demand and supply from setting the prices of goods in the
market.
● On the supply side, the sellers may control the prices of goods and services if
there are only a few large sellers (oligopoly) or a single large seller (monopoly).
The sellers may collude to set higher prices to maximize their returns. The sellers
may also control the quantity of goods produced in the market and may collude to
create scarcity and increase the prices of commodities.
● On the demand side, the buyers possess the power to control the prices of goods if
the market only comprises a single large buyer (monopsony) or a few large buyers
(oligopsony). If there is only a single or a handful of large buyers, the buyers may
exercise their dominance by colluding to set the price at which they are willing to
buy the products from the producers. The practice prevents the market from
equating the supply of goods and services to their demand.

4. Imperfect information in the market

● Market failure may also result from the lack of appropriate information among the
buyers or sellers. This means that the price of demand or supply does not reflect
all the benefits or opportunity cost of a good. The lack of information on the
buyer’s side may mean that the buyer may be willing to pay a higher or lower
price for the product because they don’t know its actual benefits.
● On the other hand, inadequate information on the seller’s side may mean that they
may be willing to accept a higher or lower price for the product than the actual
opportunity cost of producing it.

Solutions to Market Failures

1. Use of legislation

One of the ways that governments can manage market failures is by implementing legislation
that changes behavior. For example, the government can ban cars from operating in city
centers, or impose high penalties to businesses that sell alcohol to underage children, since
the measures control unwanted behaviors.

2. Price mechanism
Price mechanisms are designed to change the behavior of both the consumers and producers.
For products that cause harm to consumers, the government can discourage their
consumption by increasing taxes. For example, taxes on cigarettes and alcohol are
periodically increased to discourage their consumption and reduce their harmful effects on
unrelated third parties.

Basic Terms

1. Merit goods - Merit goods are commodities that the public sector provides free or
cheaply because the government wishes to encourage their consumption.
Examples of merit goods include education, health care, welfare services, housing,
fire protection, refuse collection and public parks

2. Demerit Goods - Tobacco, alcoholic drinks, addictive substances, betting,

unhealthy snacks, pornography, and prostitution are examples of demerit goods.
Due to the obvious nature of these items, governments frequently impose taxes on
them (particularly, sin taxes), as well as limiting or prohibiting their usage or
advertisement.

3. Public good - Public good refers to a commodity or service that is made available
to all members of a society by governments and paid for collectively through
taxation. Examples of public goods national defence, infrastructure, education,
security, and fire and environmental protection almost everywhere.

4. Social benefits - Social benefits means benefits to society that contribute to the
public's general well-being beyond an economic benefit, such as educational,
environmental, cultural, or community-oriented benefits.

5. External Benefits - Taking a bus reduces congestion on a road, enabling other

road users to travel more quickly. Buying a burglar alarm may deter possible
burglars from a street or an area, which provides a benefit to other home

6. Private benefits - Private benefits are experienced by either the producer or consumer
of a specific good or service. For example, after purchasing a car, the consumer
will pay solely for the car and not for the pollution caused by driving the car.

7. Private Cost - The private cost is any cost that a person or firm pays in order to
buy or produce goods and services.

8. External costs - External costs are borne by someone not involved in the
transaction. For example, when people buy fuel for a car, they pay for the production
 of that fuel (an internal cost), but not for the costs of burning that fuel, such as air
pollution, health-related problems, Noise pollution.

9. Social cost Social cost is the total cost to society. It includes private costs plus any
external costs.

Money and Banking

Money: Money may be defined as anything which is generally acceptable as a medium of
exchange and at the same time acts as a measure, store of value and standard of deferred
payment.

Supply of Money: Total stock of money (currency notes, coins and demand deposit of
banks) in circulation are held by the public at a given point of time.
Supply of money does not include cash balance held by central and state govt. and stock of
money held by banking system of country as they are not in actual circulation of the country.

Measures of Money Supply = Currency held by Public + Net Demand Deposits held by
commercial banks
M1 = C + DD
C = Currency and coins with the public
DD = Demand deposits of the public with the banks

Functions of Money

Money performs four main functions in today’s society. It mainly serves as:

1. A medium of exchange
2. A standard of deferred payment
3. A store of wealth
4. A measure of value

Money as a Medium of Exchange

A medium of exchange is an asset that can be used in a transaction to exchange goods and
services. Gold and other precious metals have been used as a medium of exchange before
money itself, or alongside it.

Money as a Standard of Deferred Payment

The above function is somehow related to the first, as it creates credit and allows transactions
to be settled in the future. To be a standard of deferred payment, money must be an accepted
way to value and settle a debt in the future.
Money as a Store of Wealth
As services can’t be stored and a lot of goods are perishable, society requires more effective
ways of storing wealth. Money can be easily stored, retrieved, and used at a later time, and, at
least in times of low inflation, it’s able to maintain most of its value.

Money as a Measure of Value

Money can be used as a universal unit of account to measure the value of all the goods and
services exchanged in an economy.

In a money-based economy, prices can be indicated using only one measure of value,
simplifying transactions and people’s understanding of how much a good or service is worth.

Conversely, in a barter economy, the prices for a good or service should be established based
on all the other goods or services produced and exchanged.

Central Bank - The central bank is the apex institution of a country’s monetary system.
The design and the control of the country’s monetary policy is its main responsibility.
Indonesia’s central bank is the Bank Indonesia

Functions of Central Bank.

1. Currency Authority: The central bank has the sole monopoly to issue currency
notes. Commercial banks cannot issue currency notes. Currency notes issued by the
central bank are the legal tender money. Legal tender money is one, which every
individual is bound to accept by law in exchange for goods and services and in the
discharge of debts. However, the monopoly of central bank to issue the currency notes
may be partial in certain countries.
2. Banker, Agent and Advisor to the Government: Central bank everywhere in the
world acts as banker, fiscal agent and adviser to their respective government. It
receives deposits from the government and collects cheques and drafts deposited in
the government account. As Fiscal Agent: As a fiscal agent, it performs the following
functions :
• It manages the public debt.
• It collects taxes and other payments on behalf of the government.
• It represents the government in the international financial institutions (such as World
Bank, International Monetary Fund, etc.) and conferences.
As Adviser
• The central bank also acts as the financial adviser to the government.
 • It gives advice to the government on all financial and economic matters such as
deficit financing, devaluation of currency, trade policy, foreign exchange policy, etc.
3. Banker’s Bank: Central bank acts as the banker to the banks in three ways: (i)
custodian of the cash reserves of the commercial banks; (ii) as the lender of the last
resort; and (iii) asclearing agent. As a custodian of the cash reserves of the
commercial banks, the central bank maintains the cash reserves of the commercial
banks. Every commercial bank has to keep a certain percent of its cash reserves with
the central bank by law. As Lender of the As banker to the banks, the central bank
acts as the lender of the last resort. In other words, in case the commercial banks fail
to meet their financial requirements from other sources, they can, as a last resort,
approach to the central bank for loans and advances.
4. Clearing Agent - Since it is the custodian of the cash reserves of the commercial
banks, the central bank can act as the clearinghouse for these banks. Since all banks
have their accounts with the central bank, the central bank can easily settle the claims
of various banks against each other simply by book entries of transfers from and to
their accounts. This method of settling accounts is called Clearing House Function of
the central bank.
(b) Supervisor
(i) The Central Bank supervises, regulate and control the commercial banks.
(ii) The regulation of banks may be related to their licensing, branch expansion,
liquidity of assets, management, amalgamation (merging of banks) and liquidation
(the winding of banks).
5. (iii) The control is exercised by periodic inspection of banks and the returns filed by
them.
4. Controller of Money Supply and Credit: Principal instruments of Monetary
Policy or credit control of the Central Bank of a country are broadly classified as:
(a) Quantitative Instruments or General Tools; and
(b) Qualitative Instruments or Selective Tools.
(a) Quantitative Instruments or General Tools of Monetary Policy: These are the
instruments of monetary policy that affect overall supply of money/credit in the
economy. These instruments do not direct or restrict the flow of credit to some
specific sectors of the economy. They are as under:

Fiscal Policy

Government Budget - A government budget is a document prepared by the government

and/or other political entity presenting its anticipated tax revenues (Inheritance tax, income
tax, corporation tax, import taxes) and proposed spending/expenditure (Healthcare,
Education, Defence, Roads, State Benefit) for the coming financial year.
Reasons for Government Spending

1. Improve Public Services

Higher government spending can lead to improved public services like health,
education and transport. These are important for increasing the quality of life and
economic well being

2. Increase Productive Capacity of Economy.

Some types of government spending, can help to overcome market failure. For
example, education can help increase labour productivity and reduce structural
unemployment; if the education spending is well targeted it can help to increase the
long run trend rate of growth.

However, not all government spending is guaranteed to actually increase government

spending, it may be subject to government failure and inefficiency.

3. Expansionary Fiscal Policy

Increased government Spending without higher taxes is likely to increase AD. It will
cause a budget deficit, however, the increased Government spending is an injection of
spending to the economy and could help to increase the rate of economic growth.
Note, some monetarists argue increased government spending will just cause
crowding out, and therefore it will not increase AD.

4. Reduce Inequality.

A significant % of government spending is spent on social security. This includes

benefits, such as; unemployment benefit, income support, child benefit and housing
benefit. The majority of these benefits are means tested; this means they are targeted
to those on low incomes. The aim is to reduce relative poverty and inequality

Reasons for Taxation

• The purpose of taxes is to provide the government with funds for spending
without inflation. Taxes are used by the government for a variety of purposes,
some of which are:

• Funding of public infrastructure

• Development and welfare projects

• Defense expenditure

• Scientific research
 • Public insurance

• Public utilities such as water, energy, and waste management systems

• Salaries of state and government employees

• Operation of the government

• Public transportation

• Unemployment benefits

• Pension schemes

• Law enforcement

• Public health

• Public education

Classification of Taxes

1. A progressive tax is a tax in which the tax rate increases as the taxable amount
increases. The term progressive refers to the way the tax rate progresses from low to
high, with the result that a taxpayer's average tax rate is less than the person's
marginal tax rate.
2. A regressive tax is a tax imposed in such a manner that the tax rate decreases as the
amount subject to taxation increases. "Regressive" describes a distribution effect on
income or expenditure, referring to the way the rate progresses from high to low, so
that the average tax rate exceeds the marginal tax rate.

3. A Proportional tax is a tax imposed so that the tax rate is fixed, with no change as
the taxable base amount increases or decreases. The amount of the tax is in proportion
to the amount subject to taxation.

4. Direct Tax - Although the actual definitions vary between jurisdictions, in general, a
direct tax or income tax is a tax imposed upon a person or property as distinct from a
tax imposed upon a transaction, which is described as an indirect tax. An indirect tax
is a tax that is levied upon goods and services before they reach the customer who
ultimately pays the indirect tax as a part of market price of the good or service
purchased.

Principles of Taxation

1. Equity - This means fairness in the sense that the amount of tax people and firms has
to pay, should be based on their ability to pay. A rich person has a greater ability to
pay tax than a poor person.
 2. Certainty: - A tax should be easy to understand and households and firms should be
able to calculate the amount of tax required to be paid by them
3. Convenience: A tax should be easy to pay.
4. Economy: - The cost of collecting a tax should be considerably less than the revenue
it generates.
5. Flexibility: It should be possible to change the tax if economic activity changes or
government aims change. The revenue from some taxes changes automatically to
offset economic booms and slumps. For instance, tax revenue rises from income tax
and sales tax, without any change in the rates, when there is an economic boom. This
is because more people will be employed, incomes will rise and people will spend
more. Such a rise in tax revenue may slow down the rise in aggregate demand and
prevent inflationary pressure building up.
6. Efficiency: A tax should improve the performance of markets or at least, not
significantly reduce the efficiency of markets. For instance, an extra one-off tax,
sometimes called a windfall tax, imposed on high supernormal profits of banks may
encourage banks to reduce the charges they impose on customers.

The factors of production

In economics, factors of production, resources, or inputs are what is used in the production
process to produce output—that is, finished goods and services. The utilized amounts of the
various inputs determine the quantity of output according to the relationship called the
production function.

The 4 Factors of Production

There are four factors of production—land, labor, capital, and entrepreneurship

Land As a Factor

Land has a broad definition as a factor of production and can take on various forms, from
agricultural land to commercial real estate to the resources available from a particular piece
of land. Natural resources, such as oil and gold, can be extracted and refined for human
consumption from the land.

Labor As a Factor

Labor refers to the effort expended by an individual to bring a product or service to the
market. Again, it can take on various forms. For example, the construction worker at a hotel
site is part of labor, as is the waiter who serves guests or the receptionist who enrolls them
into the hotel.
Capital As a Factor

In economics, capital typically refers to money. However, money is not a factor of production
because it is not directly involved in producing a good or service. Instead, it facilitates the
processes used in production by enabling entrepreneurs and company owners to purchase
capital goods or land or to pay wages. For modern mainstream (neoclassical) economists,
capital is the primary driver of value.

Entrepreneurship As a Factor

Entrepreneurs use land, labor, and capital in order to produce a good or service for
consumers. Entrepreneurship is involved with establishing innovative ideas and putting that
into action by planning and organizing production.

Rewards for Factors of Production

Economists say the rewards for factors of production are:

1. Rent
2. Wages
3. Interest
4. Profit

Rent

Rent is a reward for land. Landlords can lease their land to producers throughout the
economy.

Wages

Compensation to workers takes many forms. It can be wages, salaries, and benefits such as
insurance and pensions. Wages usually refer to compensation to manual workers, for which
they are paid hourly. Meanwhile, salary refers to compensation in a fixed amount, usually
paid per month. If the wages received by workers depend on their total hours worked, it is not
on salary. But, in economics, we specifically refer to them all as wages, i.e., compensation for
workers’ mental and physical effort used in the production process.

Interest
Interest is compensation for capital. Capital represents a man-made tool to help process
inputs into outputs. They include machinery, buildings, equipment, and vehicles. Sometimes,
we also refer to them as capital goods.

Profit

Profit is the reward for entrepreneurship. Entrepreneurs earn it for their willingness to take
risks to commercialize a business idea, start and run a business. Profit is the revenue
remaining after all production costs have been paid, including payments to suppliers of the
other three resources.

Mobility of factors of Production

• The mobility of factors of production refers to the extent to which resources can
be changed for one another in the production process.

• Among all the factors of production, Labour is largely pronounced with mobility
not denying that other factors of production can become mobile.

• Factor mobility can be seen when land used for growing vegetables can be used
for building a complex for departmental stores,

• Capital equipment that are used to produce shoes can also be used to produce
bags,

• Enterprise can also delve into production of other commodities, Dangote that
produces cement is also involved in the production of Pasta.

Labor mobility can be broken down into two categories:

• Geographical Mobility: This refers to the willingness and ability of a person to

relocate from one area to another for employment purposes.

• Occupational Mobility: This refers to the ease with which a person is able to
change between jobs. The degree of occupational mobility depends on the cost
and length of training required to change profession.

Causes of changes in quantity & quality of factors of production

• The quantity and quality of factors of production will change if there is a change
in demand for and supply of land, labour, capital & enterprise. Possible changes
include the following:

• Changes in cost of production

• Government policies

• New technologies
 • net migration

• Improvements in Education & Healthcare

Monetary Policy

Money Supply - The money supply is all the currency and other liquid instruments in a
country's economy on the date measured. The money supply roughly includes both cash and
deposits that can be used almost as easily as cash. Governments issue paper currency and
coin through some combination of their central banks and treasuries.

Monetary Policy - Monetary policy is the policy adopted by the monetary authority of a
nation to control either the interest rate payable for very short-term borrowing (borrowing by
banks from each other to meet their short-term needs) or the money supply, often as an
attempt to reduce inflation or the interest rate, to ensure price stability and general trust of the
value and stability of the nation's currency.

Central bank - The central bank is the apex institution of a country’s monetary system. The
design and the control of the country’s monetary policy is its main responsibility. Indonesia’s
central bank is the Bank Indonesia.

Types of Monetary Policy

Contractionary

A contractionary policy increases interest rates and limits the outstanding money supply to
slow growth and decrease inflation, where the prices of goods and services in an economy
rise and reduce the purchasing power of money.

Expansionary

During times of slowdown or a recession, an expansionary policy grows economic activity.

By lowering interest rates, saving becomes less attractive, and consumer spending and
borrowing increase.

Goals of Monetary Policy

Inflation

Contractionary monetary policy is used to target a high level of inflation and reduce the level
of money circulating in the economy.
Unemployment

An expansionary monetary policy decreases unemployment as a higher money supply and

attractive interest rates stimulate business activities and expansion of the job market.

Exchange Rates

The exchange rates between domestic and foreign currencies can be affected by monetary
policy. With an increase in the money supply, the domestic currency becomes cheaper than its
foreign exchange.

Tools of Monetary Policy

Open Market Operations

In open market operations (OMO), the Federal Reserve Bank buys bonds from investors or
sells additional bonds to investors to change the number of outstanding government securities
and money available to the economy as a whole.

The objective of OMOs is to adjust the level of reserve balances to manipulate the short-term
interest rates and that affect other interest rates.

Interest Rates

The central bank may change the interest rates or the required collateral that it demands.
Banks will loan more or less freely depending on this interest rate.

The Federal Reserve commonly uses three strategies for monetary policy including reserve
requirements, the discount rate, and open market operations.

Reserve Requirements

Authorities can manipulate the reserve requirements, the funds that banks must retain as a
proportion of the deposits made by their customers to ensure that they can meet their
liabilities.

Lowering this reserve requirement releases more capital for the banks to offer loans or buy
other assets. Increasing the requirement curtails bank lending and slows growth.

Monetary Policy vs. Fiscal Policy

Monetary policy is enacted by a central bank to sustain a level economy and keep
unemployment low, protect the value of the currency, and maintain economic growth. By
manipulating interest rates or reserve requirements, or through open market operations, a
central bank affects borrowing, spending, and savings rates.

Fiscal policy is an additional tool used by governments and not central banks. While the
Federal Reserve can influence the supply of money in the economy, The Central Bank can
create new money and implement new tax policies. It sends money, directly or indirectly, into
the economy to increase spending and spur growth.

Both monetary and fiscal tools were coordinated efforts in a series of government and Federal
Reserve programs launched in response to the COVID-19 pandemic.

How Has Monetary Policy Been Used to Curb Inflation

A contractionary policy can slow economic growth and even increase unemployment but is
often seen as necessary to level the economy and keep prices in check.

Why Is the Federal Reserve Called a Lender of Last Resort?

The Fed also serves the role of lender of last resort, providing banks with liquidity and
regulatory scrutiny to prevent them from failing and creating financial panic in the economy.4

Conclusion

Monetary policy employs tools used by central bankers to keep a nation's economy stable
while limiting inflation and unemployment. Expansionary monetary policy stimulates a
receding economy and contractionary monetary policy slows down an inflationary economy.
A nation's monetary policy is often coordinated with its fiscal policy.

Fiscal Policy
Fiscal policy is the use of government spending and taxation to influence the economy.
Governments typically use fiscal policy to promote strong and sustainable growth and reduce
poverty. The role and objectives of fiscal policy gained prominence during the recent global
economic crisis, when governments stepped in to support financial systems, jump-start
growth, and mitigate the impact of the crisis on vulnerable groups.

Structure of the Budget Or Components of the Budget

Structure of the budget refers to the components of budget.It has two broad components:

(a)Revenue Budget and (b)Captial budget.

1. Revenue budget includes revenue receipts and revenue expenditure of the govt.
2. Captial budget includes captial receipts and Captial expenditure.of the govt.

Budget Receipts - Budget receipts refer to estimated money receipts of the govt. from all
sources during the fiscal year. Budget receipts are classified as (a) Revenue Receipts
(B)Capital Receipts
Revenue Receipts - Those money receipts of the govt. are known as revenue receipts which
satisfies two related features. These receipts do not create any corresponding liability for the
govt.The receipts do not cause any reduction in assets of the govt.

Capital Receipts - Capital receipts of the govt. are those monetary receipts which satisfies
he following two features. These receipts create a liability for the govt. These receipts cause
reduction in assets of the govt.Capital Receipts of the govt. are further classified

1.Recovery of loans

2.Borrowing and other liabilities.

3.Other receipts.

Budget Expenditure - It refers to estimated expenditure of the govt.on its Development and
Non Development Programmes;or on its Plan and Non Plan programmes during the fiscal
year. Like budget receipts; budget expenditure of the govt. is broadly classified as

(A)Revenue Expenditure and (B)Capital Expenditure

Revenue Expenditure of the govt. are those expenditures which have the following features
:-

These expenditures do not create assets for the govt. These expenditures do not cause any
reduction in liability of the govt.

Captial Expenditure - Those expenditures of the govt.are captial expenditures which

1.Create assets for the govt.

2.Cause reduction in liabilities of the govt.

Other types of public expenditure

1.Development expenditure:This relates to growth and development activities of the govt.

2.Non development expenditure; Non development expenditure of the govt relates to non
development activities of the govt.

3. Plan expenditure:It refers to that expenditure which is incurred by the govt,to fulfill its
planned development programmes.

4. Non plan expenditure: This refers to all such govt. expenditures which are beyond the
scope of its planned development programmes.

Significance or importance of Public Expenditure.

Following observations highlights the significance of public expenditure.

1. It increase economic growth

2. Increase economic welfare.
 3. Corrects depression and checks unemployment.
4. Reduction of inequality.

Budget Deficit:

Meaning Budget deficit refers to a situation when budget expenditure of the govt are
greater than the budget receipts.

Thus,

B D =B E or T E(R E+C E )-B R or T R (R R +C R )

When T E>T R

Here

BD=Budget Deficit BE=Budget Expenditure

BR=Budget Receipts RE= revenue Receipts

CE=Capital Expenditure RR= Revenue Receipts

CR=Capital Receipts TE= total Expenditure

TR Total Receipts

Types and Measurement:

Three important types of budget deficit are:

1.Revenue Deficit

2.Fiscal deficit

3.Primary Deficit

1.Revenue Deficit It is the excess of revenue expenditure over revenue receipts.

2. Fiscal Deficit Fiscal Deficit is the excess of total expenditure over total receipts.

FD=BE-BR other than borrowings,when BE>BR other than

borrowings.

3.Primary Deficit It is the difference between fiscal deficit and interest payment.

Primary Deficit=Fiscal Deficit-Interest Payment

PD=FD-IP

Balanced and Unbalanced Budget:

 1. A comparison Balanced Budget is a budget in which govt.receipts are equal to
govt. expenditure.
2. UnBalanced Budget is that budget in which receipts and expenditures of the govt
are not equal.This may be.

Surplus Budget:Estimated govt.receipts>Estimated govt expenditure

Deficit Budget: Estimated govt expenditure > Estimated govt receipts.

Market System

A market system is the network of buyers, sellers and other actors that come together to
trade in a given product or service. The participants in a market system include: Direct
market players such as producers, buyers, and consumers who drive economic activity in the
market. Suppliers of supporting goods and services such as finance, equipment and
business consulting. Entities that influence the business environment such as regulatory
agencies, infrastructure providers and business associations.

Market Equilibrium
Market equilibrium is a market state where the supply in the market is equal to the demand
in the market. The equilibrium price is the price of a good or service when the supply of it is
equal to the demand for it in the market. If a market is at equilibrium, the price will not
change unless an external factor changes the supply or demand, which results in a disruption
of the equilibrium.

Market disequilibrium

Market disequilibrium is an imbalance between supply and demand - such that supply
exceeds the level of demand or demand exceeds the available supply.
Key Resources Allocation Decisions

Production, Distribution, and Exchange of goods and services are among the basic economic
activities of life. During the period of these economic activities, every society has to suffer
from scarcity of resources and it is the scarcity of resources that arises the problem of choice.
The scarce resource of an economy has several usages. In other words, every society decides
how to use scarce resources optimally?

The problems of an economy are often summarized in the following three ways:

1. What to produce and in what quantity? - This problem refers to the decisions
regarding the selection of different commodities and the quantities that need to be
produced. Labour, land, machines, capital, equipment, tools and natural resources are
limited. So, it is not possible to fulfil society’s every demand. Therefore, it is
important to decide what goods and services are required to be produced and in what
quantity?

2. How to produce? - This problem is about the choice of techniques that need to be
adopted and used in the production of goods and services. The two majorly-used
techniques are- Labour Intensive and Capital Intensive. In Labour Intensive
technique more units of labor in proportion to capital are used in the production
process. The Capital Intensive Technique involves more capital and less utilization of
labor. A producer will use that particular technology which is available at minimum
cost.
 3. For whom to produce? - One of the most crucial problems of the economy is to
decide which commodities shall be produced for which sections of society. For
instance, essential goods and services are in demand from all sections of society, but
only certain sections of society have a demand for luxury commodities. Hence,
considerations regarding the socio-economic conditions of a country or market are
highly pertinent to this problem.

Price Mechanism

Price mechanism refers to the system where the forces of demand and supply determine
the prices of commodities and the changes therein. It is the buyers and sellers who actually
determine the price of a commodity.

Disposable income is the income of a person after all income-related taxes and charges have
been deducted.
Spending (Consumption)

The buying of goods and services is called consumption. The money spent on consumption
is called consumer expenditure.
People consume in order to satisfy their needs and wants and give them satisfaction.

Factors affecting consumption:

● Disposable income: the more the disposable income, the more people consume.
● Wealth: the more wealthy (having assets such as property, jewels, company shares) a
person is, the more he spends.
● Consumer confidence: if consumers are confident of keeping their jobs and their future
incomes, then they might be encouraged to spend more now, without worries.
● Interest rates: if interest rates provided by banks on saving are high, consumers might
save more so they can earn interest and thus consumer expenditure will fall.
Saving

Saving is income not spent (or delaying consumption until some later date). People can save
money by depositing in banks, and withdraw it a later date with the interest.

Factors affecting saving:

● Saving for consumption: people save so that they can consume later. They save money
so that they can make bigger purchases in the future (a house, a car etc). Thus, saving can
depend on the consumers’ future plans.
● Disposable income: if the amount of disposable income people have is high, the more
likely that they will save. Thus, rich people save a higher proportion of their incomes than
poor people.
● Interest rates: people also save so that their savings may increase overtime with the
interest added. Interest is the return on saving; the longer you save an amount and the
higher the amount, the higher the interest received.
● Consumer confidence: if the consumer is not confident about his job security and
incomes in the future, he may save more now.
● Availability of saving schemes: banks now offer a variety of saving schemes. When
there are more attractive schemes that can benefit consumers, they might resort to saving
rather than spending.
Borrowing

Borrowing, as the word suggests, is simply the borrowing of money from a person/institution.
The lender gives the borrower money. The lender is usually the bank which gives out loans to
customers.

Factors affecting borrowing:

● Interest rates: interest is also the cost of borrowing. When a person takes a loan, he must
repay the entire amount at the end of a fixed period while also paying an amount of
interest periodically. When the interest rates rise, people will be reluctant to borrow and
vice versa.
● Wealth/Income: banks will be more willing to lend to wealthy and high-income earning
people, because they are more likely to be able to repay the loan, rather than the poor. So
even if they would like to borrow, the poor end up being able to borrow much lesser than
the rich.
● Consumer confidence: how confident people feel about their financial situation in the
future may affect borrowing too. For example, if they think that prices will rise (inflation)
in the future, they might borrow now, to make big purchases now.
● Ways of borrowing: the no. of ways to borrow can influence borrowing. Nowadays there
are many borrowing facilities such as overdrafts, bank loans etc. and there are more credit
(future payment) options such as hire purchases (payment is done in installments
overtime), credit cards etc.

Expenditure patterns between income groups

1. The richer people spend, save and borrow more amounts than the poor
2. The poor spend higher proportions of their disposable income, especially on
necessities, than the rich.
3. The poor save lesser proportions of their disposable income in comparison with the
rich.
 Price Elasticity of Supply: Refers to the degree of responsiveness of supply of a
commodity with reference to a change in price of the commodity. It is always positive
due to direct relationship between price and quantity supplied.

Methods for measuring price elasticity of supply:

1. Percentage Method:

Degrees or Types of Price Elasticity of Supply

Relatively elastic supply

When percentage change in quantity supplied is greater than percentage change in price, the
condition is known as relatively elastic supply. This situation when plotted in graph makes an
upward slope which intersects positive Y-axis.
In figure i, we can see that ratio of change in quantity supplied is greater than the ratio of
change in price. As a result, when we put their values in the above mathematical expression,
we get PES>1.

Elasticity tends to be greater than 1 in case of products which are not necessary to sustain our
lives. Luxury goods such as expensive smart phone, gold, etc. show this kind of price
elasticity.

Relatively inelastic supply

When the percentage change in quantity supplied is lesser than percentage change in price,
the condition is known as relatively inelastic supply. This situation when plotted in graph
makes highly inclined upward slope which intersects positive X-axis.
In the above figure, it is clearly shown that ratio of change in price is greater than ratio of
change in quantity, whose value when substituted in the given expression, we get PES<1.

Such kind of price elasticity can be observed in goods which are necessary in our day to day
lives. Clothes, foods, etc. are good examples of these kinds of goods.

Unitary elastic supply

When percentage change in quantity supplied is exactly equal to percentage change in price,
the situation is known as unitary elastic supply. This situation is graph is represented by an
upward slope which intersects the origin.
In the above figure, the ratio of change in quantity supplied is equal to the ratio of change in
price. Consequently, when the value of these variables are substituted in the given expression,
we get PES=1. This behavior between price and quantity supplied of commodity is also
known as lock-step movement.

Infinite/perfectly elastic supply

When a slight or minimal change in price causes infinite change in quantity supplied, it is
said to be infinite or perfectly elastic supply. In a graph, such situation is represented by a
straight line which is parallel to X-axis.

In the above figure, we can see that quantity supplied has varied significantly even at the
same price level. This kind of price elasticity is expected to occur in highly luxurious goods.
However, perfectness of anything, including perfectly inelastic supply is considered to be rare
or impractical in economy.
Zero /perfectly inelastic supply

When quantity supplied remains unchanged with change in price, it is said to be zero or
perfectly inelastic supply. Such situation in graph is represented by a straight line which is
parallel to Y-axis.

In figure v, we can see that the amount of commodity supplied has remained unchanged even
when the price has greatly changed. This type of price elasticity is expected to be observed in
highly essential goods such as medicines. However, as mentioned earlier, perfectness of
anything in economy is rare or impractical.

Price Elasticity of Supply

1. A firm’s revenue rises from Rp 400 to Rp 500 when the price of its product rises from
? 20 to ? 25 per unit. Calculate the price elasticity of supply.
2. The Price Elasticity of Supply of a good is 0.8. Its price rises by 50%. Calculate the
percentage increase in its supply.
3. The Price Elasticity of Supply of a commodity is 2.0. A firm supplies 200 units of it at
a price of Rp 8 per unit. At what price will it supply 250 units.
4. A 15% rise in the price of a commodity raises its supply from 300 units to 345 units.
Calculate its Price Elasticity of Supply.
 5. When the price of a good rises from ? 20 per unit to ? 30 per unit, the revenue of the
firm producing this good rises from ? 100 to ? 300. Calculate Price Elasticity of
Supply.
6. A firm supplies 10 units of a good at a price of 15 per unit. Price Elasticity of Supply
is 1.25. What quantity will the firm supply at a price of Rp 7 per unit.
7. At a price of X 5 per unit of a commodity A, Total Revenue is Rp 800. When its price
rises by 20%, Total Revenue increases by Rp 400. Calculate its Price Elasticity of
Supply.
8. Price of commodity A is Rp 10 per unit and Total Revenue at this price is Rp 1600.
When its price rises by 20%, Total Revenue increases by 1 Calculate its Price.
9. Total Revenue at a price of Rp 4 per unit of a commodity is ?Rp 480. Total Revenue
increases by Rp 240 when its price rises by 25%. Calculate its Price Elasticity of
Supply
10. Total Revenue is Rp 400 when the price of the commodity is Rp 2 per unit. When
price rises to Rp 3 per unit, the quantity supplied is 300 units. Calculate the Price
Elasticity Of

Firms and Production

Demand for Factors of Production

1. The demand for the product: if more goods and services are demanded by consumers,
more factors of production will be demanded by firms to produce and satisfy the demand.
That is, the demand for factors of production is derived demand, as it is determined by the
demand for the goods and services (just like labour demand).

2. The availability of factors: firms will also demand factors that are easily available and
accessible to them. If the firm is located in a region where there is a large pool of skilled
labour, it will demand more labour as opposed to capital.

3. The price of factors: If labour is more expensive than capital, firms will demand more
capital (and vice versa), as they want to reduce costs and maximize profits.

4. The productivity of factors: If labour is more productive than capital, then more labour
is demanded, and vice versa.
Labour-intensive and Capital-intensive production

Labour-intensive production is where more labourers are employed than other factors, say
capital. Production is mainly dependent on labour. It is usually adopted in small-scale
industries, especially those that produce personalised, handmade products. Examples: hotels
and restaurants.

Advantages:

1. Flexibility: labour, unlike most machinery can be used flexibly to meet changing levels
of consumer demand, e.g., part-time workers.

2. Personal services: labour can provide a personal touch to customer needs and wants.

3. Personalised services: labourers can provide custom products for different customers.
Machinery is not flexible enough to provide tailored products for individual customers.

4. Gives feedback: labour can give feedback that provides ideas for continuous
improvements in the firm.

5. Essential: labour is essential in case of machine breakdowns. After all, machines are only
as good as the labour that builds, maintains and operates them..

Disadvantages:

1. Relatively expensive: in the long-term, when compared to machinery, labour has higher
per unit costs due to lower levels of productivity.

2. Inefficient and inconsistent: compared to machinery, labour is relatively less efficient

and tends to be inconsistent with their productivity, with various personal, psychological
and physical matters influencing their quantity and quality of work.

3. Labour relation problems: firms will have to put up with labour demands and
grievances. They could stage an overtime ban or strike if their demands are not met.

Capital-intensive production
Capital refers to the machinery, equipment, tools, buildings and vehicles used in production.
It also means the investment required to do production. Capital-intensive production is
where more capital is employed than other factors. It is a production which requires a
relatively high level of capital investment compared to the labour cost. Most capital-intensive
production is automated (example: car-manufacturing).

Advantages:

1. Less likely to make errors: Machines, since they’re mechanically or digitally

programmed to do tasks, won’t make the mistakes that labourers will.

2. More efficient: machinery doesn’t need breaks or holidays, has no demands and makes
no mistakes.

3. Consistent: since they won’t have human problems and are programmed to repeat tasks,
they are very consistent in the output produced.

4. Technical economies of scale: increased efficiency can reduce average costs

Disadvantages:

1. Expensive: the initial costs of investment is high, as well as possible training costs.

2. Lack of flexibility: machines need not be as flexible as labourers are to meet changes in
demand.
3. Machinery lacks initiative: machines don’t have the intuitive or creative power that
human labour can provide the business, and improve production.

Production and Productivity

A firm combines scarce resources of land, labour and capital (inputs) to make (produce)
goods and services (output). Production is thus, the transformation of raw materials
(input) to finished or semi-finished goods and services (output).
In other words, production is the adding of value to inputs to create outputs. It is the
production that gives the inputs value.

Some factors that influence production:

● Demand for product: the more the demand from consumers, the more the production.
● Price and availability of factors of production: if factors of production are cheap and
readily available, there will be more production.
● Capital: the more capital that is available to producers, the more the investment in
production.
● Profitability: the more profitable producing and selling a product is, the more the
production of the product will be.
● Government support: if governments give money in grants, subsidies, tax breaks and so
on, more production will take place in the economy.

Productivity measures the amount of output that can be produced from a given amount
of input over a period of time.
Productivity = Total output produced per period / Total input used per period

Productivity increases when:

● more output or revenue is produced from the same amount of resources

● the same output or revenue is produced using fewer resources.
(Labour productivity is the measure of the amount of output that can be produced by each
worker in a business).

Factors that influence productivity:

● Division of labour: division of labour is when tasks are divided among labourers. Each
labourer specializes in a particular task, and thus this will increase productivity.
● Skills and experience of labour force: a skilled and experienced workforce will be more
productive.
● Workers’ motivation: the more motivated the workforce is, the more productive they
will be. Better pay, working conditions, reasonable working hours etc. can improve
productivity.
● Technology: more technology introduced into the production process will increase
productivity.
● Quality of factors of production: replacing old machinery with new ones, preferably
with latest technologies, can increase efficiency and productivity. In the case of labour,
training the workforce will increase productivity.
● Investment: introducing new production processes which will reduce wastage, increase
speed, improve quality and raise output will raise productivity. This is known as lean
production.
 Government and the macro economy

The role of government Guidance Locally, nationally and internationally

Local government

Local government is responsible for a range of vital services for people and businesses in
defined areas. Among them are well known functions such as social care, schools, housing
and planning and waste collection, but also lesser known ones such as licensing, business
support, registrar services and pest control.

Nationally

Government is responsible for the conduct of national affairs. Its areas of responsibility
include defence and foreign affairs; trade, commerce and currency; immigration; postal
services, telecommunications and broadcasting; air travel; most social services and pensions.
It is also involved, mainly through funding, in many things largely carried out by the States,
such as health, education, environmental issues, industrial relations, etc.

Internationally

International business is conducted through the mobility of capital, formation of a

manufacturing and trading center, and the movement of technicians and manager borders that
require the role of government. The government provides capital to facilitate international
business activities to increase the national

Production Possibility Curve

Production Possibility Frontier

1. Production possibility frontier is a curve which depicts all possible combinations of

two goods which can be produced with given resources and technology in an
economy.
2. Production possibility frontier is also known as production possibility curve or
transformation curve.
3. The concept of PP curve is based on the following assumptions:

1. First, the amount of resources in the economy is fixed.

2. Second, the technology is given and unchanged.
3. Third, the resources are efficient and fully employed.
4. Fourth, all the resources are not equally efficient in production of all goods.
 Production Possibility Frontier Schedule and Curve

It helps us to understand and solve the problem of what to produce and in what quantity.

By plotting the data, we get the following PP Curve:

 1. In the given diagram, Tank is measured on vertical axis whereas Rice is measured on
horizontal axis. If the economy decides to use all its resources in the production of
Tanks, OA quantity of Tanks will be produced but Rice cannot be produced. On the
other hand, if resources are devoted exclusively to the production of Rice, OF amount
of Rice will be produced but no Tanks can be manufactured.
2. These two are extreme possibilities. In between, there are many other possibilities.
Another alternative is that the economy devotes a part of its resources to the
production of Tanks and a part to the production of Rice. In that case there can be
different possibilities of production as is indicated by the points B, C, D and E. By
joining points A, B, C, D, E and F of a curve, we get Production Possibility Curve.

Full Employment and Underemployment Under PP Curve

(i) Full Employment of Resources: It is represented along the PP-curve. The economy has
to decide that which combination of good X and good Y should be produced. It means that
the economy has to decide that how should resources be allocated in the production of good
X and good Y. The desired allocation of the two goods must lie somewhere on the PP curve.
For example, point A on the PP represents one such allocation.
(ii) Under Utilization of Resources: If resources are not fully and efficiently employed, may
there be a problem of under utilization of resources. Under utilization of resources arises
because of unemployment and inefficiency.

● The Problem of Unemployment: If the actual combination of two produced goods

lies below the PP curve, it means that the resources are not fully employed. If the
resources are fully employed, the combination must lie somewhere on the PP curve.
 For example, the combination ‘U’ below the PP curve represents unemployment, i.e.,
the resources are not fully utilized.
● The Problem of Inefficiency: Assuming that the resources are fully efficient, and if
the actual combinations, say I, produced still lies below the PP curve, it means that
resources are inefficiently employed. So, any combination that lies below the PP
curve also indicates the problem of inefficient utilization of resources.

Rightward and Leftward Shift of PP Curve

Rightward Shift (When both Intercept Changes)

● When Resources Increase: Production possibility curve shows the combination of

two pieces of goods which can be produced-by utilizing the resources efficiently.
But, every economy tries to increase its resources so that more and more goods can
be produced. PP curve is based on the assumption that the amount of resources in the
economy is fixed. When resources are fixed, one or more goods can be produced
only by sacrificing some quantity of the other good. We cannot produce more of both
the goods. However, when resources increase, we can produce more pieces of both
the goods.
For example, Discovery of oil reserves in the GULF countries has caused a
substantial shift to rightward in the PPC of these countries.
 ● When Technology Changes: Generally, the change in technology is for the better.
Better technology means that more quantities of both goods can be produced. In this
situation also PP frontier shifts upwards.

Rightward Shift (When One intercept Changes):

In the given figure the improvement in technology, takes place only in one good, good X.
There is no improvement in the technology’ of producing the good Y. Thus, more quantity of
good X can be produced. Production possibility curve PP’ expands to PP’ showing economic
growth. Similarly for good Y.
Leftward Shift:

● When Resources Decrease: Resources with the society may decrease due to unusual
happenings like earthquakes, war, natural calamities like floods etc. In such situations
the production capacity of the country decreases, and the PP frontier shifts
downwards.

The concept of opportunity

1. Modern economists have used the concept of opportunity cost in allocation of

resources besides other fields. Simply, opportunity cost means opportunity lost.
2. What is given up for getting something is called the opportunity cost of that thing. For
instance, theoretically if a consumer has to forego 2 cups of tea for getting one glass
of orange juice, opportunity cost of one glass of orange juice will be 2 cups of tea.
3. Thus opportunity cost of any commodity is the amount of other goods which has been
given up in order to produce that commodity. Alternatively opportunity cost of a
given activity is the value of the next best activity.
Marginal opportunity cost is an addition to a cost in terms of a number of units of a
commodity sacrificed to produce one additional unit of another commodity.

Marginal rate of transformation is the ratio of number of units of a good sacrificed to

produce one additional unit of another commodity.

PPC is concave to the point of origin because of increasing marginal opportunity cost
(MOC). This behavior of the MOC is based on the assumption that all resources are not
equally efficient in production of all goods. Rise in opportunity cost occurs when factors
(resources) which are specialized or more adopted for production
of a particular good (say, guns), is transferred to the production of another good (say, rice) for
which they are less productive or less specialized. Thus, transfer of resources from more
productive to less productive uses indirectly means fall in their productivity, with the result
more of such resources are needed to produce an additional unit of the other commodity.
Thus marginal opportunity cost goes on increasing making the PP curve concave in shape.
 Opportunity Cost
Opportunity Cost

● The scarcity of resources means that there are not sufficient goods and services to
satisfy all our needs and wants; we are forced to choose some over the others.
● Choice is necessary because these resources have alternative uses- they can be
used to produce many things. But since there are only a finite number of
resources, we have to choose.
● When we choose something over the other, the choice that was given up is called
the opportunity cost. Opportunity cost, by definition, is the next best alternative
that is sacrificed/forgone in order to satisfy the other.

Influence of Opportunity Cost on Decision Making:

1. Opportunity Cost and Consumes :

⮚ We all are consumers and most of us cannot buy everything we like
⮚ We have to make a choice based on the priorities.
2. Opportunity Cost and Producer:
⮚ Producers have to decide what to make for example Agricultural field -
Rice or Sugarcane
⮚ Manufacturing -Factory – Model A Car or Model B Car
⮚ Profits plays an key role in choosing an option.
⮚ Demand for different Product and the cost of production also play a role.
3. Opportunity Cost and Workers:
⮚ Taking up one job means giving up another job for example -Teacher job
VS civil servant job
⮚ The choice will be based on the remuneration, chance of promotion and
the job satisfaction
⮚ If the pay and the working condition in civil servant job are higher, the
opportunity cost of being a teacher
4. Opportunity Cost and Government
⮚ Government has to decide how to spend the tax revenue for example
Military or health care.
⮚ It could raise Tax revenue but the burden will fall on tax payers.
⮚ In order to pay high tax, people may give opportunity to purchase goods
and services.
Unemployment

The term unemployment refers to a situation where a person actively searches for
employment but is unable to find work. Unemployment is considered to be a key measure
of the health of the economy. The most frequently used measure of unemployment is the
unemployment rate.

Measurements

In order to find the rate of unemployment, four methods are used:

● Labor Force Sample Surveys: provide the most comprehensive results.

Calculates unemployment by different categories such as race and gender. This
method is the most internationally comparable.
● Official Estimates: combines information from the three other methods. The
method is not the preferred method to use when calculating the rate of
unemployment.
● Social Insurance Statistics: these statistics are calculated based on the number of
individuals receiving unemployment benefits. The method is criticized because
unemployment benefits can expire before an individual finds employment which
makes the calculations inaccurate.
● Employment Office Statistics: only include a monthly total of unemployed
individuals who enter unemployment offices. This method is the least effective for
measuring unemployment.

Measurement Shortcomings

1. The measurement of unemployment is not an absolute calculation and is prone to

errors. For example, the unemployment rate does not take into account individuals
who are not actively seeking employment, such as individuals attending college or
even individuals who are in U.S. prisons.
2. Individuals who are self-employed, those who were forced to take early retirement,
those with disability pensions who would like to work, and those who work part-time
and seek full-time employment are not factored in to the unemployment rate.
3. Some individuals also choose not to enter the labor force and these statistics are also
not considered. By not including all underemployed or unemployed individuals in the
 measurement of the unemployment rate, the calculation does not provide an accurate
assessment of how unemployment truly impacts society. Errors and biases are also
present due to data assembly and reporting inconsistencies.

Types of Unemployment

There are diverse types of unemployment. Below is the explanation of these types of
unemployment.

● Frictional Unemployment: Frictional unemployment occurs due to temporary

transitions within the employees' lives. For example, the workers move to a new
town and have to search for a new job. Also, this form of unemployment includes
individuals who are freshly entering the workforce, such as graduates from
colleges. Frictional unemployment is the leading cause of unemployment and
impacts the economy.
● Structural Unemployment: Structural unemployment occurs due to a mismatch
between the types of available employment and the workers' demographics. In this
case, there is the availability of employment opportunities, but the employees do
not have the required skills to handle the given job and vice versa.
● Cyclical Unemployment: Cyclical unemployment occurs due to reduced demand
for services and goods within the economy; thus, the business fails to offer
employment opportunities. This form of unemployment mainly happens during
recession periods when consumers decrease their spending and elevate their
savings due to fear that conditions might worsen. Hence, making the firms unable
to grant employment opportunities to the entire employable workers.
● Seasonal Unemployment: Seasonal unemployment occurs due to the operation of
different industries through seasons whereby the labor force is available at some
seasons and unavailable in others.
● Disguised Unemployment: Disguised unemployment is the type of
unemployment that does not affect the aggregate economic output. This form of
unemployment happens when there is low productivity and the existence of
affluent workers who are willing to fill the few jobs.
● Technological unemployment is the unemployment that results from the
introduction of new technology into the economy. It can be caused by the
replacement of workers by machines or the automation of tasks that were once
done by workers.

The consequences of unemployment

1. Loss of income and living standard - Employment is the major source of

income for most individuals, so being unemployed results in a fall in income, and
a loss of living standard. Of course, welfare payments provide some level of
support, but are unlikely to be generous as this can create a disincentive to seek
work.
2. Loss of skills and worsening employment prospects - As skills depreciate,
individuals may become trapped in an extended period of ‘long term’
unemployment. The loss of work-based skills reduces an individual’s
employability in the future. When applying for new jobs, periods of
unemployment will be revealed in an individual’s resume (CV). With imperfect
knowledge of the reason for unemployment potential employers may make certain
assumptions about the quality of the applicant, and rightly or wrongly, not call
them forward for interview.

3. The unemployment trap - Some unemployed individuals may become

dependent on welfare and increasingly trapped in unemployment. In this sense,
welfare payments could be said to create moral hazard where out-of-work benefits
are seen as an insurance against unemployment, but perversely increase the
likelihood of remaining unemployed.

4. Reduced health - The unemployed are more likely to suffer from poor physical
and mental health. This, in turn, increases the probability of remaining
unemployed.

5. Likelihood of poverty - An unemployed ‘breadwinner’ will mean that family

income falls, which could push individuals below the poverty line. Poverty is
clearly a major cost of unemployment, and once pushed into poverty individuals
can be trapped there – the so called ‘poverty trap’.

6. Opportunity cost - Every individual that is not employed creates an opportunity

cost to society. The opportunity cost is the lost output that could have been
produced if the unemployed had worked.

7. Waste of resources - An economy uses scarce resources to educate and train

individuals as they progress from childhood to adulthood and into the labour
market. If individuals become or remain unemployed then these resources have
been wasted – if only temporarily.
 8. Erosion of human capital - Human capital is the total stock of human resources
existing in an economy, including the quality and skills of labour. Given that many
important skills are gained while at work, unemployment can mean that new skills
may not be acquired, and existing ones eroded – hence a depreciation in human
capital.

9. Inefficiency - When an economy is fully using all its scarce resources it is said to
be operating on the edge of its production possibility frontier (curve, or boundary),
which indicates that the economy is operating at an efficient level.

10. Loss of government revenue - Given that the unemployed have reduced levels of
income, and are likely to spend less on a range of normal goods, less revenue will
go the government both in terms of lower income tax and indirect tax receipts.
This direct effect is accompanied with an indirect multiplier effect, where lower
spending causes less income for others, and falling tax receipts.

11. Additional public spending - However, at the same time, government is likely to
have to spend more on welfare support for the unemployed. If this cannot be
raised through taxation, then the public sector will have to increase its borrowing
– as happened in dramatic fashion because of the pandemic.

12. Loss of revenue and profits to firms - Like the government, some firms will also
experience a fall in potential revenue from falling sales, which is also likely to
lead to falling profits for producers. The downturn in profits is also likely to
feedback into a fall in demand for labour, and increase the probability of more
unemployment.

13. Unemployment may become embedded - Unlike episodes of inflation,

unemployment may not be temporary, and can become embedded in an economy
as workers displaced from the labour market become long-term unemployed. This
creates a ‘deadweight’ loss to the economy.

Unemployment rates can continue to rise even when the initial cause of unemployment has
ceased to exist. The tendency for unemployment to continue to rise is called ‘hysteresis’ – a
term first used by the 19th Century Scottish physicist, Sir James Erving.
Market Equilibrium

Market equilibrium is a market state where the supply in the market is equal to the demand
in the market. The equilibrium price is the price of a good or service when the supply of it is
equal to the demand for it in the market. If a market is at equilibrium, the price will not
change unless an external factor changes the supply or demand, which results in a disruption
of the equilibrium.

Market disequilibrium

Market disequilibrium is an imbalance between supply and demand - such that supply
exceeds the level of demand or demand exceeds the available supply.
Price Elasticity of Demand : Price Elasticity of Demand is a measurement of change in
quantity demanded in response to a change in price of the commodity.

Percentage Method:

Or
Degrees of price elasticity of Demand:
(a) Unitary elastic demand: If percentage change in the quantity demanded is equal to
percentage change in price of the commodity, then ED = 1 and the result is known as unitary
elastic demand.
Negative sign indicates the inverse relationship between price and the quantity demanded.
PED = 1 [Unitary elastic demand]
(b) More than unitary elastic demand or elastic demand: If percentage change in quantity
demanded is more than the percentage change in price of the commodity then, ED > 1 and
result is known as more than unit elastic demand.
(c) Less than unitary elastic demand or inelastic demand: If percentage change in quantity
demanded is less than the percentage change in price of the commodity, then ED < 1 and the
result is known as less than unit elastic demand.

(d) Perfectly elastic demand: If quantity demand changes and price remains constant, then
ED = α and the result is known as perfectly elastic demand.

(e) Perfectly Inelastic demand: If price is changed ,and quantity demanded constant,then
ED=0 and the result is known as Perfectly Inelastic demand.

Factors Determining Price Elasticity:

1. Nature of commodity: Elasticity of demand of a commodity is influenced by its nature.

(a) The demand for necessities of life (commodities satisfying minimum basic needs) is less
elastic. They are required for human survival and they have to be purchased

whatever may be the price. Therefore, demand for necessities of life does not fluctuate much
with price changes.

(b) Whereas, demand for luxury goods is more elastic than the demand for necessities. When
the price of luxuries falls, consumers buy more of them and when the prices rises, demand
contracts substantially. Please remember the term “luxury” is a relative term, as a luxury for a
low-income earning worker may be a necessity for rich employer.

2. Availability of substitutes/Substitute goods:

(a) If close substitutes for the commodity are available, the demand for the commodity will
be elastic. The reason is that even a small rise in its prices will induce the buyers to go for its
substitutes. For example, Pepsi and Coke are considered fairly close substitutes. If the price
of coke increases, Pepsi becomes relatively cheaper. Consumer will buy more of Pepsi and
less of relatively expensive Coke.

(b) However, the demand for a commodity (such as salt) having no close substitutes is
inelastic.

3. Income Level:

(a) Higher income level groups have less elasticity of demand for any commodity as
compared to the people with low incomes. It happens because rich people are not influenced
much by changes in the price of goods.

(b) But, poor people are highly affected by increase or decrease in the price of goods. As the
result of, demand for lower income group is highly elastic.
4. Level of price/Own price of a good:

(a) Higher own price of a good or Costly goods like car, gold etc. have highly elastic demand
as their demand is very sensitive to changes in their prices.

(b) However, demand for inexpensive goods like thread, needle etc. is inelastic as change in
prices of such goods do not change their demand by a considerable amount.

5. Postponement of Consumption:

(a) Commodities like ice cream, soft drinks, etc. whose demand is not urgent, have highly
elastic demand as their consumption can be postponed in case of an increase in their prices.

(b) However, commodities with urgent demand like life saving drugs, have inelastic demand
because of their immediate requirement.

6. Number of Uses:

(a) If the commodity under consideration has many alternative uses, its demand will be
highly elastic. For example, electricity.

(b) As against it, if commodity under consideration has only limited uses, its demand will be
highly Inelastic.

7. Share in Total Expenditure:

(a) If a smaller proportion of consumer’s income is spent on a particular commodity, its

elasticity is highly inelastic because lesser proportion of consumer income is spent on
consumption of these commodities. Demand for goods like salt, needle, etc. tends to be
inelastic as consum ers spend a small proportion of their income on such goods. When prices
of such goods change, consumers continue to purchase almost the same quantity of these
goods.

(b) As against it, if a larger proportion of consumer income is spent on the commodity,
elasticity of demand is highly elastic.

8. Time Period: Price elasticity of demand for a commodity also affected by time period.

(a) Demand is inelastic in the short period as consumers find it difficult to change

their habits during short period.

(b) As against it, demand is highly elastic during long period as their is availability of close
substitutes in long period.
9. Habits

(a) The demand for those goods that are habitually consumed is inelastic. The reason is that
such commodities become a necessity for the consumer, and even if prices change,
consumers continue to purchase and consume the commodity. Examples of habit-forming
commodities include alcoholic beverages, tobacco (in its various forms) consumption and
even tea and coffee.

(b) As against it, if a person is not habitual, demand is elastic.

Numerical Questions:
1. Due to a 10% fall in the price of a commodity, the demand rises
from 100 units to 120 units. How much percentage will its
demand fall, due to a 10% rise in its price?

2. 2. A consumer spends Rs 100 on a good priced at Rs 4/unit.

When its price falls by 50%, the consumer continues to spend Rs
100 on that good. Calculate the Price elasticity of demand.

3. 3. There is a 50% fall in the price of the commodity. But the

quantity demanded remains to be 150 units. Find elasticity of
demand.

4. 4. A certain quantity of the commodity is purchased when its

price is Rs. 10 per unit. Quantity demanded increases by 50% in
response to a fall in price by Rs. 2 per unit. Find elasticity of
demand.

5. 5. At a certain price of the commodity quantity purchased is 150

units. When the price falls by 25%, the quantity purchased
increases by 75 units. Find elasticity of demand.

6. 6. Price elasticity of demand is found to be (?)2. Price falls from

Rs. 10 per unit to Rs. 8 per unit. Find the percentage change in
quantity demanded.
 7. 7. For a commodity, ΔP/P = -0.2, and elasticity of demand = ?
0.3. Find the percentage change in quantity demanded.

8. For a commodity, ΔP/P = -0.2, and elasticity of demand is 0.5. Find

quantity demanded after a fall in price when initially it was 60 units. (66)

9. A commodity shows Ed = (-)2, Quantity demanded reduces from 300

units to 150 units. In response to an increase in price. Find the increased
price when initially it was Rs. 20 per unit. ( 25 )

10. Price elasticity of demand for a good is (?)1. At a given price the
consumer buys 60 units of the good. How many units will the consumer
buy if the price falls by 10 percent? ( 66)

11. The price elasticity of demand of a good is (?) 4. If the price increases
from Rs. 10 per unit to Rs. 12 per unit, what is the percentage change in
demand? (80%)

12. At a given market price of a good, a consumer buys 100 units. When
price increases by 40 percent he buys 80 units. Calculate the price
elasticity of demand. (0.5)

13. A consumer buys a certain quantity of a good at a price of Rs. 10 per

unit. When the price falls to Rs. 8 per unit, she buys 40 percent more
quantity. Calculate the price elasticity of demand by percentage method.
(2)

14. A consumer buys 80 units of a good at a price of Rs. 4 per unit. When
the price falls, he buys 100 units. If the price elasticity of demand is (-) 1,
find out the new price. (3)

15. A consumer buys 40 units of a commodity at a price of Rs. 5 per unit

and his price elasticity of demand is (-) 1.5. Calculate the amount he will
buy at the price of Rs. 4 per unit of the commodity. (52)
16. A household increases its demand for a commodity from 40 units to 50
units when its price falls by 10%. What is the price elasticity for the
commodity? (2.5)

17. A consumer spends Rs. 80 on a commodity when its price is Re. 1 per
unit and spends Rs. 96 when the price is Rs. 2 per unit. What is the price
elasticity of demand for the commodity? (0.4)

18. Price of good rises from Rs. 4 to Rs. 5 per unit. As a result, its demand
falls from 200 units to 100 units. Calculate Ep (2)

19. A consumer buys 50 units of a good at Rs. 10 per unit. At a price of

Rs. 8 per unit, he buys 100 units. Find out Ep. (5)

20. A 7% fall in the price of a good leads to a 49% increase in demand for
that good. Find out Ep. (7)

21. Ep of good is – 3. At a price of Rs. 8 per unit, a consumer buys 160

units of the good. How many units of the goodwill the did consumer buy
when the price falls to Rs. 6 per unit? (280)

22. Ep of good is – 5. At a price of Rs. 10 per unit, the consumer buys 200
units. At what price will he buy 100 units? (11)

23. Ep of good is – 4. When the price of this good rises from Rs. 5 to Rs. 6
per unit, a consumer buys 40 units less. How many units did he buy at Rs.
5? (50)

24. Given Ep = -1, complete the following table:

Price Demand (Rs. per unit) (Units)

4 60

– 90. Use percentage change method (2)

25. Draw a downward-sloping straight-line demand curve. Indicate the
points on this demand curve, where Ep =0, Ep =1 and Ep = infinity

26. The price elasticity of demand for a good is (-) 2. 40 units of this good
are bought at a price of Rs 10 per unit. How many units will be bought at a
price of Rs. 11 per unit? Calculate. (32)

27. At a price of Rs 50 per unit, the quantity demanded of a commodity is

1000 units. When its price falls by 10 percent, its quantity demanded rises
to 1080 units. Calculate its price elasticity of demand. Is its demand
inelastic? Give reasons for your answer. (0.8 and inelastic)

28. When the price of a good falls by 10 percent, its quantity demanded
rises from 40 units to 50 units. Calculate the price elasticity of demand by
the percentage method. (2.5)

29. The quantity demanded of a commodity rises from 800 units to 850
units when its price falls from Rs. 20 per unit to Rs. 19 per unit. Calculate
its elasticity of demand. (1.25)

30. The price elasticity of demand for a good is (-) 1. At a given price the
consumer buys 60 units of the good. How many units will the consumer
buy if the price falls by 10 percent? (66 units)

31. The price elasticity of demand for a good is (-) 2. The consumer buys a
certain quantity of this good at a price of Rs. 8 per unit. When the price
falls he buys 50 percent more quantity. What is the new Price? (6)

32. The market for pens has three consumers – A, B, and C. If the
individual demand for pens at a price of Rs 5/pen for A, B, and C is 3
pens, 7 pens, and 12 pens respectively, then what is the market demand for
pens at a price of Rs 5/pen? (22)

33. A consumer buys 2,000 units of a good at a price of Rs. 10/- per unit.
When the price falls he buys 2,500 units. If the price elasticity of demand
is -2, what is the new price? (8.75)
34. At a price of Rs. 20/- per unit the quantity demanded of a commodity
is 400 units. If the price falls by 10%, its quantity demanded rises by 90
units. Calculate its price elasticity of demand. (2.25)

35. A consumer buys 10 units of a good at a price of Rs. 4/- per unit.
When the price falls by Rs 1/- per unit, he buys 20 units. Calculate the
price elasticity of demand. (4)

36. A consumer spends Rs. 250/- on a good when its price is Rs. 10/- per
unit. When the price rises to Rs. 11/- per unit, he spends Rs. 240/-.
Calculate the price elasticity by the percentage method. (1.2)

37. As a result of a 10% fall in the price of a good, its demand rises from
200 to 240 units. Find out the price elasticity of demand. Is its demand
elastic? (2 and Elastic)

38. The price elasticity of demand for a good is (-)2. 100 units of this good
are bought at a price of Rs. 10/- a unit. How many units will be bought at a
price of Rs 11/- per unit? (80 units)

39. The slope of a demand curve is -0.4, calculated is the elasticity of

demand, if at an initial price of Rs. 5/- per unit, the initial quantity
demanded was 20 units of the commodity. (0.625)
 Demand

Quantity Demanded : It is that quantity which a consumer is able and is willing to buy at
particular price and in a given period of time.

Market Demand :It is the total quantity of the commodity demanded in the market by all
consumers at different prices at a point of time.

Demand Function :It is the functional relationship between the demand for a commodity
and factors affecting demand.

Law of demand :The law states that when all other thing remains constant then there is
inverse relationship between price of the commodity and quantity demanded of it. That is,
higher the price, lower the demand and lower the price,higher the demand.
Demand curve and demand schedule : The tabular presentation of price and quantity
demanded is called demand schedule and a demand curve is the graphical representation of
the demand schedule.

Demand curve and its slope :

Factors affecting personal (individual) demand:

1. Price of the commodity: Inverse relationship exists between price of the commodity
and demand of that commodity. It means with the rise in price of the commodity the
demand of that commodity falls and vice-versa.
2. Price of related goods: It may be of two types: Substitute goods and Complementary
goods

(i) Substitute Goods: Substitute goods are those goods which can be used in place of
another goods and give the same satisfaction to a consumer. There would always exist
a direct relationship between the price of substitute goods and demand for given
commodity. It means with an increase in price of substitute goods, the demand for
given commodity also rises and vice-versa. For example, Pepsi and Coke.

(ii) Complementary Goods: Complementary goods are those which are useless in
the absence of another goods and which are demanded jointly.There would always
exist an inverse relationship between price of complementary goods and demand for
 given commodity. It means, with a rise in price of complementary goods, the demand
for given commodity falls and vice-versa. For example pen and refill.

3. Income of a Consumer: There are three types of goods:

For Normal Commodity: For normal commodity, with a rise in income, the demand
of the commodity also rises and vice-versa. Shortly, direct relationship exists between
income of a consumer and demand of normal commodity.

For Inferior Goods: For inferior goods, with a rise in income, the demand of the
commodity falls and vice-versa. Shortly, inverse relationship exists between income
of a consumer and demand of inferior goods.

For Necessity Goods: For necessity goods, whether income increases or decreases,
quantity demanded remains constant.

4. Taste and Preferences of the Consumer: Tastes, preferences and habits of a

consumer also influence its demand for a commodity. For example, if Black and
White TV set goes out of fashion, its demand will fall. Similarly, a student may
demand more of books and pens than utensils of his preferences and taste.

Change in Demand: When demand changes due to change in any one of its determinants
other than the price.

Change in Quantity Demanded:When demand changes due to change in its own price
keeping all other factors constant.
Change of Demand:

1. Change in quantity Demanded or Movement along Demand curve

2. Change in Demand or Shift in Demand