Part 1

UGC-NET STUDY MATERIAL
PART-1
(SECOND EDITION)
ECONOMICS
HARBOUR
We Teach How to Reach Success!!!
CONTENTS
1. Micro-Economics
2. Macro-Economics
3. Development Economics
4. International Economics
5. Econometrics
6. Statistics
7. Mathematical Economics
8. Game Theory
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www.economicsharbour.com; admin@economicsharbour.com
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MICRO-ECONOMICS
Part 1- a Notes by Economics Harbour
Notes by Economics Harbour www.economicsharbour.com
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Micro-Economics
Micro-Economics
NOTES BY ECONOMICS HARBOUR
CONCEPT OF DEMAND
The concept of demand was given by Alfred Marshall in 1890s in his book “Principles of Economics”.
According to him, the demand can be represented by following words:
1. Desire
2. Willingness
3. Ability to pay for the commodity
4. Price of the commodity
5. Time
Demand is a flow concept.
Difference between “Demand Changes” and “Quantity Demanded Changes”
Demand Quantity
Changes Demanded
Changes
Due to any other factor

like income, tastes and
preferences, prices of Due to change in price.
substitutes or
complements, etc.
Law of Demand
The law of demand was given by Alfred Marshall. It is a partial equilibrium analysis and states that there
is an inverse relationship between price of the commodity and the quantity demanded of it.
Demand Curve: It is the graphical presentation of the law of demand
Demand Schedule: It is the tabular presentation of the law of demand.
Demand curve and demand schedule do not tell us what the price is, it only tells us how much quantity of
the good would be purchased by the consumer at various possible prices.
Notes by Economics Harbour (2nd Edition) www.economicsharbour.com
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Micro-Economics
Market Demand: It is the horizontal summation of individual demands. It is affected by the population
levels. Market demand curve is flatter as compared to the individual demand.
Reasons for downward sloping demand curve

1. Law of Diminishing Marginal Utility: The law was given by Alfred Marshall and it states that
“as the consumer consumes more and more of a good, the marginal utility derived from each
successive unit keeps on decreasing.
2. Income effect:
Decrease Increase in Increase in Increase in

in price Real Purchasing demand
Income power
3. Substitution effect: Marshall explained the downward sloping demand curve with the aid of
substitution effect alone; he ignored the income effect on price change.
Good becomes Consumption
Decrease in cheaper as and demand
price compared to increases
others
4. Different uses of a commodity
Decrease in Commodity Demand

price put to increases
different uses
5. Size of the market
Decrease in More Demand

price people will increases
be attracted
Exceptions to the Law of Demand
1. Veblen Effect: Goods having prestige value. Veblen propounded the doctrine of conspicuous
consumption. Under this case, the prestige value of a commodity is associated with its price. This
implies, higher the price of the commodity, more will be the prestige derived from it.
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Micro-Economics
2. Giffen goods: The concept was given by Robert

Giffen. According to him, for giffen goods there is a
positive relationship between price and quantity
demanded, that is, as price decreases, quantity
demanded of it also decreases.
Inferior Goods
The demand curve for a giffen goods is an upward

sloping curve. Giffen goods
Giffen goods
15
10
Price
0
0 2 4 6
Units
3. Ignorance
4. Expectations
5. War
Bandwagon Effect: It arises because individuals demand commodities because others are doing so, or in
simple words, it is in fashion.
Snob Effect: It arises due to the desire to purchase a commodity having prestige
value so as to look different or exclusive than others.
Factors Determining Demand
Factor Relation with the Demand
1. Tastes and Preferences of Demand +
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Micro-Economics
2. Income of the people +
3. Change in the price of Related Goods Substitutes (+)
Complements (-)
4. Advertising Expenditure +
5. Number of customers in the market +
6. Future Expectations about the price +
Increase or Decrease in Demand
 Leads to shift in the demand curve.

 Caused by Shift Factors of Demand (Factors other than price)
Expansion or Contraction of Demand
 Leads to movement in the demand curve.

 Caused due to price.
Demand for Durable goods
 Durable goods can be stored, hence the prices are not volatile.
 Consumption can be postponed.
Derived Demand
It is the demand for goods which are used to produce other goods. Example Labour.
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Micro-Economics
ELASTICITY OF DEMAND
The concept of elasticity of demand was given by Marshall. Elasticity of demand measures the
responsiveness or change in demand due to factors like price, income, price of related goods, etc.
The differences between quantity demanded and elasticity of demand are:
Demand Elasticity of demand
It is qualitative in nature. It is quantitative in nature.
It gives directions to where the demand will It tells about the extent of change in demand
go with the change in price. due to change in price.
Kinds of Elasticity
1. Elasticity of Substitution (Es) :
𝑸𝒙 𝑸𝒙
∆( )/( )
𝑸𝒚 𝑸𝒚
Es = ∆𝑴𝑹𝑺𝒙𝒚/𝑴𝑹𝑺𝒙𝒚
Where: x = Good 1, y = Good 2, MRSxy = Marginal Substitution of good x for good y
Good MRSxy Es
Perfect Substitutes Constant Infinity
Perfect Complements Zero Zero
In case of high elasticity of substitution, it is easy to change the proportion and there is not much
change in marginal rate of substitution.
2. Price elasticity
(∆𝑸/𝑸)
Price elasticity = (-) (∆𝑷/𝑷)
Price elasticity is the proportionate change in quantity demanded divided by the proportionate
change in price.
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Micro-Economics
Degrees of Price Elasticity:

Ep < 1 Ep = 1
15
25
20
10
Price
15
Price
10 5
0 0
0 5 10 15 0 2 4 6
Quantity Quantity
EP = 
Ep > 1
11 21.0
10
20.5
9
Price
Price
8 20.0
7
19.5
6
5 19.0
0 5 10 15 20 25 0 2 4 6
Quantity Quantity
EP = 0
50
40
30
Price
20
10
0
19.0 19.5 20.0 20.5 21.0
Quantity
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Micro-Economics
Measurement of Price Elasticity of Demand
∆𝑸
( )
𝑸
a. Proportionate or Percentage Method: (-) ∆𝑷
( )
𝑷
𝑳𝒐𝒘𝒆𝒓 𝑺𝒆𝒈𝒎𝒆𝒏𝒕
b. Point Elasticity Method = 𝑼𝒑𝒑𝒆𝒓 𝑺𝒆𝒈𝒎𝒆𝒏𝒕
∆𝑸𝟏
( ))
𝒒𝟏+𝒒𝟐
c. Arc Elasticity Method = ∆𝑷/(𝑷𝟏+𝑷𝟐)
It is used when price and quantity changes are somewhat large.

𝑨𝑹
d. Revenue Method (e) = (𝑨𝑹−𝑴𝑹)
e. Total Expenditure Method: Evolved by Marshall
Situation  in Price  in Qty  in Elasticity of

Expenditure demand
A   Constant Ed = 1 (Unitary
elastic)
B Increases Ed>1 (Greater
 
than unity)
C   Decreases Ed < 1 (Less than

unity)
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Micro-Economics
3. Income Elasticity: It is the

responsiveness of change in quantity Income
demanded due to change in income elasticity
levels.
∆𝐐/𝐐
Income elasticity = Normal Good Inferior goods
∆𝐘/𝐘
(ey) > 0 (ey) < 0
Luxuries Necessities
(ey) > 1 0 < ey < 1
Engel curve: Engel curve is the graphical presentation of relationship between income and
quantity demanded.
a. Necessities
Necessities
40
30
Income
20
10
0
0 2 4 6 8
Quantity
b. Luxuries:
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Micro-Economics
Luxuries
20
15
Income
10
0
0 2 4 6
Quantity
c. Inferior goods
Inferior Goods
20
15
Income 10
0
0 2 4 6
Quantity
4. Cross Elasticity of Demand measures the degree of responsiveness of change in the demand for
one good in response to the change in price of another good.
𝐏𝐫𝐨𝐩𝐨𝐫𝐭𝐢𝐨𝐧𝐚𝐭𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐭𝐡𝐞 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐝𝐞𝐦𝐚𝐧𝐝𝐞𝐝 𝐨𝐟 𝐗

Ec = 𝐏𝐫𝐨𝐩𝐨𝐫𝐭𝐢𝐨𝐧𝐚𝐭𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐭𝐡𝐞 𝐩𝐫𝐢𝐜𝐞 𝐨𝐟 𝐠𝐨𝐨𝐝 𝐘
𝚫𝐐𝐱 𝐏𝐲
Ec = 𝚫𝐏𝐲 * 𝐐𝐱
Qx = Quantity Demanded of Good X
Py = Price of Good Y
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Micro-Economics
Goods Cross Elasticity
Substitutes Positive
Complements Negative
Unrelated Zero
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Micro-Economics
THEORIES OF DEMAND
1. Cardinal or Marshallian Analysis
Cardinal school is the oldest school in case of
theories of demand. According to them, the
characteristics of utility are:
a. Subjective
b. Reflects the satisfaction level derived from a
commodity.
c. It is based on introspection
d. Measured in relative terms
e. It is ethically neutral, that is, cannot associate
features of good or bad.
Concept of Utility was originally given by
Bentham, however, it was formally introduced by
Jevons. He defined utility as the power of a
commodity or service to satisfy human wants.
Assumptions of cardinal analysis are as follows:
a. Utility can be measured.

b. Consumer is rational
c. Money is a measuring mode of utility.
d. Marginal utility of money is constant: The concept of Marginal Utility of money was given by
Daniel Bernoulli.
e. Utilities are additive in nature.
f. Utilities are independent.
g. It is based on introspection.
Theories under Marshallian Analysis
a. Law of Diminishing Marginal Utility: It is also known as Gossen’s First law. Law of
Diminishing Marginal Utility states that as the consumer consumes more and more of a
commodity, the marginal utility derived on consuming each additional unit keeps on declining.
Before going into details, we should know some important concepts:
 Total Utility (TU): Total utility is the total satisfaction achieved after consuming all the units of a
particular commodity. In other words, it is the sum of marginal utilities of each successive unit of
consumption.
o TU = ⅀MUX
 Marginal Utility (MU): Marginal Utility is the additional or incremental utility achieved after
consuming additional unit of a commodity. Therefore, it can be formulated as:
∆𝐓𝐔
o MUx = ∆𝐐
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Micro-Economics
 Marginal Utility curve is simply the slope of the total utility curve.
Diminishing Marginal Utility

40
TU
Point of Statiation
30 MU
TU, MU
20
10
Point of satiation
0
2 4 6 8 10
-10 Quantity
This law operates to:

 Achieve maximum satisfaction
 Goods are not perfect substitutes.
The law of diminishing marginal utility depends on the following factors:
 Total wants of a human are unlimited but it is possible to satisfy each single want.
 Different goods are not perfect substitutes for each other.
 Marginal utility of the money is constant.
In this law, marginal utility of money and tastes and preferences are generally taken to be stable.
However, if they change, then marginal utility curve will shift accordingly.
Significance of Law of Diminishing Marginal Utility
 It explains the relationship between demand and price.

 It explains the paradox of value. Marginal utility determines the price of a commodity and
not the total utility.
More
availability of Less durability Low Price
the commodity
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Micro-Economics
b. Law of Equi-Marginal Utility: It is also known as Gossen’s Second Law. The law states that
the marginal utility derived should be equal to that derived from the last rupee spent.
𝐌𝐔𝐱 𝐌𝐔𝐲 𝐌𝐔𝐤
MUm = = = …….. =
𝐏𝐱 𝐏𝐲 𝐏𝐤
The law is more associated with the consumer’s equilibrium. Consumer will reach the
equilibrium point when:
 In case of single good: MUx = Px
 In case of several goods: MUm = (MUx/Px) = MUy/Py = ……
Criticisms of Marshallian Analysis
a. Not practical
b. Utilities cannot be measured
c. Marginal utility of money cannot be constant.
d. Marshall ignored the income effect. Therefore, he was
unable to decompose price effect into income effect and
substitution effect.
e. He was unable to explain giffen paradox.
2. Ordinal or Hicksian Analysis

Utilities cannot be measured.
Assumptions of the theory:
a. Utilities can be ranked.
b. Consumer is rational.
c. Indifference curve is based on weak ordering, that is, it considers both preferences and
indifference.
d. The consumption follows a transitive pattern.
e. Completeness: If we have two goods, there would be some kind of relationship between them
(either preferred to or indifference).
f. Continuity: The consumption follows a smooth continuous curve which can be drawn.
g. Diminishing Marginal Rate of Substitution:
MRSXY = ∆Y/∆X = MUx / MUY
Note: MRSXY is also the slope of Indifference curves.
h. Dominance/Non-satiety/monotonicity: More will always be preferred to less.
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Micro-Economics
Indifference curves
The convex shape of IC shows diminishing MRS.
Indifference Map: Set of ICs
Why the MRS is decreasing?
 Want of the good is satiable.

 Goods are imperfect substitutes of each other.
Properties of Indifference curve
a. Downward sloping curve

b. Convex to the origin.
c. Two indifference curves never intersect.
d. Higher indifference curve means higher satisfaction.
Shapes of Indifference Curves are:
a. Substitutes:
Perfect Substitutes
6
4
Good Y
0
0 2 4 6
Good X
b. Perfect Complements:
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Micro-Economics
Perfect Complements
15
10
Good Y
5
0
0 1 2 3 4 5
Good X
c. When one commodity is a good and other is a bad: Bad is a good which gives disutility after
consumption.
40
30
Good
20
10
0
0 2 4 6 8
Bad
d. Circular Indifference Curve: Circular Indifference curve is when the consumer tries to reach
an optimal point between two goods. Closer is the consumer to the point of bliss, more will be
the satisfaction.
Budget Constraint
PxQx + PyQy = Money Income
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Micro-Economics
Budget Constraint
6
Good Y
2
0
0 2 4 6
Good X
When there is a change in income levels, it leads to shift in the budget line. When there is a change in
prices, it will lead to the movement in the budget line.
Consumer Equilibrium
Assumptions:
1. Given indifference map
2. Fixed income
3. Prices are given and constant
4. Goods are homogenous and divisible.
10
Indifference Curve
8 Budget Line
Good Y
0
0 2 4 6 8
Good X
At the point of equilibrium,
Second Order Condition: At the point of tangency, indifference curve should be convex to the origin.
MRSXY = MUX / MUY = (-) PX / PY

Conditions for consumer equilibrium
First Order Condition: MRSXY = MUX / MUY = (-) PX / PY
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Micro-Economics
Engel Curves
Engel Curves show the relationship between income of the consumer and the quantity demanded of a good
by him. The shape of the indifference curves are as follows:
Necessities
Luxuries
60
50
40
40
Income
Income
30
20 20
10
0 0
0 2 4 6 8 0 2 4 6 8
Quantity Quantity
Inferior Goods
When X is a Neutral Good
40
40
30
30
Income
Income
20
20
10 10
0 0
0 2 4 6 8 1.90 1.95 2.00 2.05 2.10 2.15
Quantity Quantity
Income Effect
To trace the income effect, we have an Income Consumption curve which shows the changes in
consumer equilibrium with changes in income.
We had classified the goods into normal good and inferior goods on
the basis of changes in consumption due to changes in income.
Normal goods are those whose consumption increases with increase
in income, while inferior goods are those whose consumption
decreases due to increase in income.
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Micro-Economics
In this case, both the commodities are normal goods.
However, it is possible that one good be inferior and the other may be inferior. Then in that case our
income consumption curve will be a backward bending curve. In the diagram below, the commodity X is
an inferior good.
Substitution Effect
Substitution effect traces the changes in consumption of commodities when the relative prices change.
In case of tracing the substitution effect, we keep the real income as constant so that we can know the
relative change in the prices.
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Micro-Economics
Substitution effect is always negative. This implies that a fall in the relative price, increases the demand
for the commodity.
Substitution effect is given by:
1. Hicks Substitution Effect: Under this method, the price changes are in tune with the changes in
money income so that the consumer is neither worse off nor better off, that is, he remains on the
same indifference curve. The amount by which money income changes is known as the
compensating variation in income.
2. Slutsky Substitution Effect: It is also known as the cost-difference method. It is a better method
as compared to hicks’ because it was built on the available data and is more mathematical. Under
this method, the consumer moves on a higher indifference curve, that is, the consumer is over
compensated. The consumer has the opportunity to buy the original bundle or go on the higher
indifference curve.
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Micro-Economics
Price Fall Price Rise
S.E.Slutsky > S.E.Hicks S.E.Slutsky < S.E.Hicks
I.E.Slutsky < I.E.Hicks I.E.Slutsky > I.E.Hicks
Price Effect
Price effect is the change in demand due to
change in the price of the commodity, other
things remaining the same. To trace the changes
in price effect, we have price consumption
curve.
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Micro-Economics
PCC Curve Price Elasticity (ep) Whether the goods are

related or not
PCC Ep < 1 Cross Elasticity < 0

40
Goods are complementary
30
Good Y
20
10
0
0 2 4 6 8
Good X
PCC Ep > 1 Cross Elasticity > 0

30
Goods are subsitutes
20
Good Y
10
0
0 2 4 6 8
Good X
PCC Ep = 1 Cross Elasticity = 0

10.6
10.4
10.2
Good Y
10.0
9.8
9.6
9.4
0 2 4 6 8
Good X
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Micro-Economics
Goods are unrelated
Goods Price Effect Income Effect Substitution Effect
Normal Goods Negative Positive Negative
Inferior Goods Negative (I.E.<S.E.) Negative Negative
Giffen Goods Positive (I.E. > S.E.) Negative Negative
Benefits of Ordinal Theory of Demand

1. It decomposes price effect into substitution effect and income effect.
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Micro-Economics
2. Explains the positive relationship between quantity demanded and price in case of giffen goods.
Compensated Demand Curve:
 Considers only substitution effect.

 Real income remains constant.
 While studying consumer surplus, compensated demand curve is better.
3. Revealed Preference Theory: The theory was given by Samuelson in 1938. It is a form of ordinal
ranking and is based on the concept of strong ordering. The theory is behaviour based and the
choice of the consumer reveals the preference.
Assumptions of the theory are:

a. Consistency: If A is chosen over B, then B won’t ever be chosen if A is still available.
b. Transitivity d. Income will be fully spent.
c. Choice is always made e. More is preferred to less.
Direct Revealed Preference
Direct Revealed Preference

10
IC1
8 IC2
A
Good Y
4
B
0
0 2 4 6
Good X
A will always be preferred to B hence revealing the property of consistency.
Indirect Revealed Preference
In this case more than two goods are involved. For example, if A is preferred to B, and B is preferred
to C, then A is indirectly preferred to C.
Weak Axiom of Revealed Preference (WARP)
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Micro-Economics
WARP
10
P1
8 P2
A
Good Y
6
2 B
0
0 2 4 6
Good X
B will be chosen on P1 set of prices because A becomes unaffordable.
On the other hand, the strong axiom of revealed preference (SARP) is just the generalisation of weak
axiom.
Criticisms
1. Samuelson ignores the possibility of indifference in consumer’s behaviour.

2. Considers only single act of choice.
3. The theory does not account for Giffen’s paradox.
Difference beween Indifference Curve and Revealed Preference
Indifference Curve Revealed Preference
Uses real income for estimating the level of Uses real income for estimating the purchasing
satisfaction. power.
Fundamental Theorem of Consumption
The theorem was given by Samuelson. It states that price and quantity will be negatively related if we
have positive income effect of demand.
In case of indifference curve analysis, real income is used in the sense of level of satisfaction. In case of
revealed preference, real income is used in the sense of purchasing power.
4. Hicks’ Logical Ordering

This theory is the revised version of Hicks’ own theory in his work “A Revision of Demand
Theory” in 1956. He was influenced by Samuelson’s work and hence used econometrics in his
theory, keeping the original assumption that utility is ordinal in nature.
The changes from his past theory were:
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Micro-Economics
a. He gave up indifference curve because it is limited to only two goods.

b. He gave up the assumption of continuity.
c. The difference between weak ordering and strong ordering was very clearly done in this theory.
d. He also considered money.
5. Consumer Behavior Under Uncertainty

The theory was propounded by Neumann and Morgenstein and is commonly known as N-M
Utility Index. They have considered the role of both risk and uncertainty.
Assumptions:
a. Axiom of complete ordering: If we have two lotteries, either there should be a relationship of
preference or indifference between them.
b. Transitiveness
c. Continuity
d. Reflexivity: A good is indifferent between the two events having same outcome.
e. Axiom of Independence: Suppose there are two lotteries,
L1 = P1 (A,B) and L2 = P2 (C,B)
If A is preferred to C, then L1 will be preferred to L2.
f. Axiom of unequal probabilities: if in the above example, P1 > P2, then L1 will be preferred to
L2.
g. Axiom of Compound lotteries: A lottery can also be the combination of two lotteries, for
example,
L1 = P1 (A,B) and L2 = P2 (L3, L4)
h. Axiom of dominance or monotonicity: It implies that more is preferred to less.
i. Local non-satiation: If there is even a minute difference between the two lotteries, consumer
will be able to make out that difference.
Expected value of a lottery
The expected value of a lottery can be calculated

using the weighted sum of the lotteries with
probabilities acting as weights.
E(L) = P1(A) + (1-P1)(B)
Expected Utility of a lottery

Expected utility of a lottery can be calculated
using the weighted sum of the utilities associated
with the outcomes with probabilities acting as
weights.
E(U(L)) = P1 (U(A)) + (1-P1)(U(B))
It reflects the uncertain income.
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Micro-Economics
However,
U(E(L)) = U[P1 (A) + (1-P1)(B)] shows certain income.
Risk Averse
20
Total Utility
15 Marginal Utility
Total Utility
10
0
2 4 6 8
-5 Income
For a risk averse person, U[E(L)] is greater than E[U(L)] and marginal utility of money is falling.
Risk Lover
30
Total Utility
Marginal Utility
20
TU, MU
10
0
0 2 4 6
Income
For a risk lover, U[E(L)] is less than E[U(L)] and marginal utility of money is rising.
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Micro-Economics
Risk Neutral
6
Total Utility
Marginal Utility
4
TU, MU
2
0
0 2 4 6
Income
For a risk neutral person, U[E(L)] is equal to E[U(L)] and marginal utility for money is constant
through all income levels.
Risk premium is to protect the risk averse person to avoid risk.
Measures of risk aversion:

Two measures of risk aversion were given by Arrow and Pratt.
a. Absolute measure: It is measured using the formula:

[-U’’(W)/U’(W)] where W is a measure of wealth
[-U’’(W)/U’(W)] is positive Risk Averse
[-U’’(W)/U’(W)] is negative Risk Lover
[-U’’(W)/U’(W)] is zero Risk Neutral
b. Relative measure: It helps in comparing the attitude of workers towards risk and is measured
using the formula
W*RA
Where RA is the relative attitude towards risk.
Some other theories related to Consumer’s behaviour towards risk
a. Bernoulli’s hypothesis: The theory assumes that majority of the population is risk averse and
hence marginal utility of money is declining. For the risk averse person, the effect of gain received
from the lottery will be less than the effect of loss incurred and hence he will never choose a 50-
50 probability.
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Micro-Economics
b. Friedman-Savage Hypothesis: According to this theory, the marginal utility will not be constant
over the entire range, that is, it will both increase and decrease. The attitude of the consumer would
depend on whether the marginal utility of money is increasing or decreasing.
Friedman-Savage Hypothese
40
(-)
Total Utility of Money

30
(+)
20
(-)
10
0
0 5 10 15 20
Income
c. Markowitz Theory: According to his theory, there can be both risk lovers as well as risk averse
individuals. The marginal utility of money will not be constant over the entire range. However, in
his theory, small increases or decreases in income will increase the marginal utility of money but
large changes in income will always lead to decrease in marginal utility of money.
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Micro-Economics
Markowitz Hypothesis
25
Marginal Utility of Money
20
15
10
0
0 5 10 15 20
Income
d. St. Petersburg Lottery/Paradox: The paradox states that when

the number of participants are less, then this might lead to
infinite expected value. In the case, an individual will always
accept the lottery.
Investor Choice Problem
Budget constraint will be an upward

sloping line because there is a
positive trade-off between risk and
return.
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Micro-Economics
PRODUCTION THEORY
A production function shows the technical relationship between the inputs and outputs.
Q=f(L,K)
Assumptions of production function are:
1. State of technology is assumed to be constant.

2. Production function is with reference to a particular period of time.
Production function
1 factor variable,
others fixed All factors variable
(Law of variable prop. (Returns to scale of
because proportion inputs, LR Law)
varies, SR law)
TP = Total output produced

AP= TP/L
MP= TP/L
Shifts in TP curve  in level of fixed TP increases

input fixed input
Output Elasticity of an Input

𝑶𝒖𝒕𝒑𝒖𝒕 𝑬𝒍𝒂𝒔𝒕𝒊𝒄𝒊𝒕𝒚 𝒐𝒇 𝒍𝒂𝒃𝒐𝒖𝒓
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒐𝒖𝒕𝒑𝒖𝒕 𝑴𝑷𝑳
= =
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒍𝒂𝒃𝒐𝒖𝒓 𝑨𝑷𝑳
Law of Variable Proportions/Returns to a Factor

It is a short run theory in which there is atleast one factor which
is fixed, that is, it cannot change. Thus, this law deals with the
changes in the factor proportions.
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Micro-Economics
Beyond a certain point, the MP of the factor would diminish.

Assumptions :- (1) Tech is fixed and constant
(2) Some inputs should be ript constant
(3) Various factors can be combined to produce
a product.
Stages of Law of Variable Proportions

The stages of law of variable proportions can be defined as:
Law of Variable Proportions

30 Stage 1 Stage 2 Stage 3
Total Product
Average Product
20
Marginal Product
TP,MP,AP
10
0
5 10 15
Units
-10
Stage 1: Increasing returns to a factor

Under this stage the marginal product increases, reaches maximum and starts decreasing. The stage ends
where the average product reaches maximum.
In this stage MP of the fixed factor is negative.
Reasons for Stage 1 are:

1. Indivisibility of factors
2. Scope for specialisation and hence increase in efficiency. The fixed factor is efficiently utilised in
this stage.
Stage 2: Diminishing returns to a factor
Under this stage, the marginal product decreases, average product starts falling. The stage ends when
marginal product reaches zero.
Reasons for Stage 2 are:

1. Scarcity of fixed factor
2. Indivisibility of fixed factor
3. Imperfect substitutability of factors: This reason was given by Joan Robinson stating that
elasticity of substitution is not equal to infinity.
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Micro-Economics
Stage 3: Negative Returns to a Factor

Under this stage, the marginal product of the variable factor becomes negative as a result of which the
total product starts falling.
Reason for Stage 3:

1. Variable factor is in excess of fixed factor.
Therefore, the most optimal stage of production is stage 2.
A point to remember here is that in stage 1, the marginal product of fixed factor is negative because it is
in excess of the variable factor. On the other hand, in stage 3, the marginal product of a variable factor is
negative because it is in excess of the fixed factor.
Isoquants/Equal Product Curves/Iso-Product Curves

Isoquants is the locus of various combinations of input producing the same level of output.
Properties of Isoquants are:
a. Downward sloping curve

b. Convex to the origin.
c. Two isoquants never intersect.
d. Higher isoquants means higher level of production.
MRTS Slope of isoquants
 No of units of capital gives up to get me unit of labour, output to be the same.
 Diminishing is nature (Convexity)
If isoquant is concave linear, the optimum production would be at a corner solution
Elasticity of Substitution
1. Perfect substitutes: Marginal Rate of technical substitution is constant and elasticity of
substitution is equal to infinity.
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Micro-Economics
Perfect Substitutes
6
Input Y
2
0
0 2 4 6
Input X
2. Perfect Complements: Marginal rate of technical substitution is zero and elasticity of substitution
is also equal to zero.
Perfect Complements
15
10
Input Y
0
0 1 2 3 4 5
Input X
Technical Coefficient
It is the amount of factor required to produce a given level of output.
For example,
100 units – 25 labour
1Unit – 25/100
0.25-technical coefficient
Homogenous Production Function

Q=f(x,y)
Q=f,(mx, my)
Q=mf(x,y)
Homogenous of degree 1: linearly homogenous function
All factors increase in same prop, thus implying, Constant Returns to Scale
Types of Production Functions
1. Linearly Homogenous Production Function

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Micro-Economics
Q = f(L,K)
If we multiply the production function with a constant say m,
Q = f(mL, mK)
Taking m to be common, we get;
Q = m.f(L,K)
Q= m.Q
Anything raise to the power m, gives us the degree of homogeneity.
2. Cobb-Douglous Production Function

It was given in 1928 and is represented as follows:
Q = ALαKβ
Where:
Q = Output level, A = State of Technology, L = Labour, K = Capital, α = Share of Labour in
production, β = Share of capital in production
The features of C-D production function are:
 Linearly Homogenous Production Function
 Constant Returns to Scale
 Elasticity of Substitution is equal to one
 α tells the output or production elasticity of labour, β tells the output or production elasticity
of capital and they both are constant.
α+β=1 Constant Returns to Scale
α+β>1 Increasing Returns to Scale
α+β<1 Decreasing Returns to Scale
Euler’s Theorem: If the factors are paid on the basis of their marginal productivity, then ultimately the
total output will be exhausted. It holds true in linearly homogenous production function.
MPL * L + MPK * K = Q
3. CES Production Function

It was given in 1961 by Arrow, Minhas, Chenery and Solow
Q = Ɣ[ϨL-ϱ + (1-Ϩ)K-ϱ] -1/ ϱ

Where
Ɣ = Coefficient of technical efficiency; Ɣ > 0
Ϩ = Distribution Parameter; 0 < Ϩ < 1
ϱ = Substitution parameter
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Micro-Economics
𝟏
Elasticity of Substitution = (𝟏+𝛠)
Ridge Lines: Ridge lines are the locus of points where marginal productivity of atleast one factor is zero.
Isoclines: Isoclines is the locus of points in which marginal productivity of inputs is kept constant.
There are two ridge lines A and B. At A, the marginal productivity of capital is zero and points above
A show negative marginal productivity of capital.
At B, the marginal productivity of B is Zero and is negative at all points below it.
The optimum stage of production is the region between the two ridge lines and hence is called the
region of economic production.
Returns to Scale
It is a long run law in which all the factors are variable in nature and factor proportions do not change.
All inputs will be varied by the same proportion.
Technological Change
Technological
Change
Product Innovations Process Innovations

(New Product) (New technique of
production)
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Micro-Economics
Endogenous technological change

Brought about within the firms through R&D
Type of Technical Change

1. Neutral technical change
2. Labour saving technical change: capital bias.
3. Capital Saving technical change
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Micro-Economics
Stages of Returns to Scale

1. Constant Returns to Scale: Under this, the change in proportion of inputs is equal to the change
in proportion of outputs.
Isoquants are equi-distant.
2. Decreasing Returns to Scale: Under this, the change in proportion of inputs is greater than the
proportionate change in outputs. The distance between the isoquants keep increasing.
3. Increasing Returns to Scale: Under this, the change in proportion of inputs is less than the
change in proportion in outputs. The distance between the
isoquants would keep decreasing.
Reasons of Increasing, Decreasing or Constant Returns to

Scale are explained by the Economies of Scale.
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Micro-Economics
Economies of Scale
(Output
expansion's impact
on the costs)
Internal Economies External Economies

of Scale of Scale
(Firm Based) (Industry Based)
Real Economies: Real economies are experienced when we reduce the quantity purchased of our physical
inputs.
Pecuniary Economies: Pecuniary economies are experienced when we purchase large quantities of
physical inputs so that the overall price paid is less. For example, wholesale prices.
Diseconomies of Scale
Diseconomies of Scale
(Disadvantage due to
expansion of output)
Internal Diseconomies of External Diseconomies

Scale of Scale
Caused By: 1. Caused by: 1. Burden on
Management issues, 2. storage and
Co-ordination problem, 3. transportation
Technical Failures
Under Constant returns to scale, the economies and the diseconomies are equal to each other.
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Micro-Economics
Relationship between Returns to Scale and Returns to a factor
Returns to Scale When Capital is held constant
Constant Returns to scale Returns to a factor say MPL will diminish

when capital is held constant.
Decreasing Returns to scale Returns to a factor MPL will diminish at a

rapid pace.
Increasing Returns to scale There can be two possibilities:
1. If there are strong increasing returns

to scale then returns to a factor MP L
will increase.
2. If there is a slight increasing returns
to a scale then returns to a factor MPL
will decrease.
Multi-product Firm
Production Possibility Frontier: It is the combination of two goods which can be produced given the
technology or level of resources.
Iso-Revenue line: It is the locus of points of combination of two goods produced which generate equal
revenue.
Equilibrium
Producer's Equilibrium
25
20
Equilibrium
Good 2
15
10 PPC
5 Iso-Revenue Line
0
A
0 2 4 6 8
Good 1
Slope of PPC is the Marginal Rate of Product Transformation (MRPT) which is increasing because
different resources are suited to produce different goods.
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Micro-Economics
𝐌𝐂𝐱
MRPTXY = 𝐌𝐂𝐲
Equilibrium point will occur where

𝐌𝐂𝐱 𝐏𝐱
MRPTXY = 𝐌𝐂𝐲 = 𝐏𝐲
For a firm producing single output, equilibrium will occur at the point of tangency of isoquant and the iso-
revenue line
Producer's Equilibrium
20
15
Capital
10
Equilibrium
5
0
0 2 4 6 8
Labour
Expansion Path: It is the locus of point of revenue maximisation. It is also known as scale line
because it tells how firms change their scale of production.
Expansion Path
25
PPC 2
20 PPC 1
Good 2
15
Expansion Path
10
0
0 2 4 6 8
Good 1
Price Effect
In case of production theory, the price effect is the sum of output effect and substitution effect.
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Micro-Economics
In case when factors of production are substitutable, then substitution effect is greater than the output
effect implying that, if price of labor decreases, then labor would be used more as compared to the
other input.
In case the goods are complementary, then output effect is more than the substitution effect implying
that with decrease in price of labor, more of both factors will be used.
Important terms:
1. Technical Efficiency: It implies maximizing the output with given inputs.
2. Economic Efficiency: It implies minimizing the cost to produce a given level of input.
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Micro-Economics
COST THEORY
“In Economics, cost of production has a special meaning. It is all of the payments or expenditures
necessary to obtain the factors of land, labour, capital and management required to produce a commodity.
It represents money costs which we want to incur in order to acquire the factors of production.”
Gulhrie & Wallace
Cost = f (Output)
In short run, we assume one factor of production to be variable and rest all are fixed. In the long run, we
assume technology and prices to be constant.
Shift Factors: These are the factors shifting the cost function other than the output. In the long run,
technology and prices are the shift factors while in the short run, the fixed factors are considered to be the
shift factors.
Types of Cost
1. Explicit Cost: It is also known as the accounting cost, private opportunity cost. These costs are
out of the firm or cost of hiring a factor of production.
2. Implicit Cost: Also known as the imputed cost. These are the prices of owned services and are
included in the average cost.
3. Economic Cost: It is the sum of explicit and implicit cost.
4. Opportunity Cost: It is the cost of next best alternative and is a part of implicit cost. It is also
known as transfer earnings.
5. Historical Cost: It is the original price of the factor of production when bought in the past. It is
irrelevant in the production process.
6. Sunk Cost: It is a kind of historical cost which cannot be recovered. Even sunk costs are not
relevant to decision making.
Note: Economic Profits =

Total Revenue = Economic
Costs
Total Cost = Total Fixed Cost

+ Total Variable cost
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Micro-Economics
Average Cost = Average Fixed Cost + Average Variable Cost
Marginal cost is the change in Total cost represented as follows
MC = TCN – TCN-1 or
MC = TVCN – TVCN-1
Relationship between Average Cost and Marginal Cost
Average Cost and Marginal Cost

30
AC
MC
20
AC, MC
10
0
0 2 4 6 8
Units
When AC is falling, marginal cost is falling more than AC.
When AC is minimum, AC = MC
When AC is rising, MC rises more than AC
Long Run Costs

Long Run Costs are less than or equal to short run costs, and are hence flatter as compared to the short run
costs.
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Micro-Economics
Long Run Average cost curve is also known as the planning curve. Plants are used at less than full
capacity at point left to the minimum point and are used at more than full capacity at points right to the
minimum point. The optimum plant size is when it operates at minimum LAC.
Recent Developments in the Cost Theory
1. Saucer Shaped LAC

Saucer Shaped LAC
15
10
LAC
0
0 5 10 15
Units
The shape is such due to the reserve capacity.
2. L-Shaped or continuously falling LAC curve
Continuously Falling LAC curve

15
10
LAC
0
0 2 4 6 8
Units
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Micro-Economics
The reasons for continuously falling LAC curve are:

a. Economies of Scale
b. Technological Progress
3. Learning Curve: This was given by Kenneth Arrow.

It includes the concept of learning by doing. It states
that the increase in cumulative output leads to decline
in per unit cost due to learning by doing.
Economies of Scope: Joint production of a good is more

efficient than the separate production by two firms producing the same good.
Diseconomies of Scope: Joint production is less than the individual production.
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Micro-Economics
MARKET STRUCTURES
Market
Structure
Perfect Monopoly Monopolistic Oligopoly

Competition Competition
Collusive Non-
Oligopoly collusive
Essentials of a Market
1. Commodity
2. Existence of buyers and scales
3. Place
4. Communication b/w buyers and scales – 1 price
Form of No. of Nature of Price Price control Ease of entry

product elasticity
Market Firms
Perfect Large Homogenous Infinity Zero Free

Competition
Imperfect competition
a) Large Differentiated Large Some Free

Monopolistic (close
competition substitutes)
b) pure Few Homogenous Small Some Limited

oligopoly
(cout product
differentiation)
c) Few Differentiated Small Large Limited

Differentiated (close subsist.)
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Micro-Economics
(with product
diff.)
(3) Monopoly One Unique out Very small Very large Strong
close subst. barrows to
entry
1. Perfect Competition:
Features of perfect competition are:
a. Large number of buyers and sellers.
b. Free entry and exit.
c. Perfect information.
d. No transport cost.
e. Homogenous Product
It is important to understand the difference
between perfect and pure competition. Perfect
competition is a wider concept and is perfect in all
contexts. On the other hand, pure competition is a
narrower concept in which there is freedom from
monopoly errors and freedom from entry and exit.
Price Determination
Industry Demand and Supply analysis
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Micro-Economics
Time element
Marshall gave the concept and he divided time on the basis of response of supply
(1) Market period /very short time period – supply fixed and there are no adjustments
(2) Short period – Expand output with given equipment No change in plants or given capital.
(3) Long period – New entry and exit
New plants/abandon old ones
Full adjustment of all factors and all costs.
Demand curve of a Product facing a Perfectly Competitive Firm
1. No control over price

2. Raises price lose all customs
3. Sall any qty at that price
Under Perfect Competition,
MR = AR = Price
Short Run Equilibrium

Two conditions need to be satisfied for attaining the equilibrium level:
a. Marginal Cost (MC) = Marginal Revenue (MR)

b. MC should cut MR from below
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Micro-Economics
Short Run Equilibrium

15
AR=MR= Price
AR, MR, Price, MC

MC
10
5
Equilibrium
0
0 2 4 6 8 10
Quantity
a. Super Normal Profits:
Super normal profits occur when AR > AC
b. Normal Profits
Normal Profits occur when AR = AC
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Micro-Economics
c. Losses
Losses occur when AR < AC
Shut Down Point (P ≤ Average Variable Cost (AVC))
Long run
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Micro-Economics
In the long run, a perfectly competitive industry earns only normal profits, that is,
Price = AR = MR = LMC = LAC = SAC = SMC
Long Run Equilibrium (Industry):

Conditions for equilibrium are:
a. Every firm is at its equilibrium point, that is, price = MC.

b. No new firms enter or exit the industry.
Overall, Price = Marginal Cost = Long Run Marginal Cost.
When these conditions are satisfied with equality between demand and supply, then it is called full
equilibrium.
Supply Curve (Short Run): It is the upward sloping part of MC above the minimum point of
AVC.
Supply Curve (Long Run): It is the upward sloping part of MC above the minimum point of AC.
Industry curve can be upward/downward/horizontal sloping. It would be determined by net change

in Economies and Diseconomies of Scale.
Economic efficiency (Perfectly Competitive Market)

Resources efficiently used; maximum possible satisfaction.
Important points:
a. A perfectly competitive firm does not quit the industry even if it incurs losses in the short run
because they can’t alter the fixed capital equipment in the short run. As a result, they will have
to incur the losses equal to fixed cost even when they shut down. Thus, they continue
production in the short run even when they incur losses.
b. A perfectly competitive firm is in business even when economic profits are zero because
economic profits include the opportunity costs. So at zero economic profits, firms still earn a
return on capital invested. So at zero economic profits, the firms still earn a return on the capital
invested.
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Micro-Economics
Consumer surplus :- Price consumers are wailing to pay- what they actually pay
Producer’s surplus :- Mkt price at which sellers sell min price they are willing to sell.
Criticism
Maximising total economic surplus is not a good measure of equity. May not be fair/equitable Hence
social well being cannot be measured
2. Monopoly
Features:
a. Single seller
b. No close substitutes
c. Legal or natural barriers to prohibit the entry of
new firms.
d. Affects no other seller by its own action.
e. Firm and industry are one single entity.
f. The demand curve in case of a monopolist is a
downward sloping curve.
Sources/Causes of Monopoly
1. Patents or copy rights – especially in case of new products
2. Control over essential raw materials example in case of OPEC
3. Grant of franchise by the Government. example MTNL in Delhi
4. Natural Monopoly:- Such kind experiences significant economies of scale, that is, continuous falling
AC implying output large enough to meet the entire market demand.
5. Advertising and Brand loyalties of the Established firms.
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Micro-Economics
Types of Monopoly: The distinction was given by Chamberlin
Monopoly
Pure Monopoly
Ordinary Monopoly
(Single Seller, no substitutes,
cross elasticity = 0, price (Single Seller, the good
elasticity = 1. Thus Total produced has substitutes,
revenue remains constant. cross elasticity is low.)
Natural Monopoly: It experiences economies of scale and the average cost is diminishing in
nature. It is one big optimum sized firm.
Legal/Statutory Monopoly: The government provides the legal status through patents or
copyrights.
Price and Marginal Cost under Monopoly

Price difference from MC = f (Price elasticity at that point on AR curve)
Smaller the elasticity, greater the difference between price and MC.
Therefore,
Monopoly price = f (MC, Price elasticity)
Where, Monopoly price and MC are positively related, and Price elasticity and Monopoly price are
negatively related.
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Micro-Economics
Monopoly Equilibrium And price Elasticity of Demand

Monopolist will never be in when ep < 1
We know,
MR = AR [(e-1)/e]
So when e < 1, MR becomes negative, implying a fall in total revenue. So it will not be rational for the
monopolist to operate at a point where Marginal revenue is negative.
Monopoly Equilibrium in case of Zero Marginal cost.
Zero Marginal Cost
Monopolist has to decide the output where

total revenue will be maximum
At maximum total revenue, Marginal

revenue = 0, computing the elasticity = 1.
Therefore, when the marginal cost is zero, monopolist operates at the point where price
elasticity of demand is equal to one.
Average revenue is decreasing because more can be sold at lower price. MR is below AR because
its fall is twice the fall of AR. Therefore, Price is more than marginal cost.
Cost curves remain the same.
There is no supply curve in monopoly.
No unique price-quantity relationship.
Short Run:
Conditions of equilibrium
1. MR = MC
2. MC should cut MR curve from below
In short run, a monopolist can earn super-normal profits, normal profits or can even incur losses.
The diagrammatic representation would be as follows:
1. Super Normal Profits:
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Micro-Economics
2. Normal Profits:
3. Losses
Long Run: In the long run, a monopolist earns only super normal profits because there are no
barriers to entry.
Conditions for equilibrium:
a. Short run Average cost = Long run Average Cost (LAC)
b. Marginal Revenue = Long Run Marginal Cost = Short run Marginal Cost
c. Price > LAC
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Micro-Economics
Difference between Perfect Competition and monopoly

PC Monopoly
Price Longer Higher
Quantity Higher Longer
Monopolist does not have a unique supply curve because a shift in demand will lead to change in
output/price.
Monopoly, Resource Allocation & Social welfare
- No economic efficiency
- Dead weight loss.
Drawback of Monopolies
1. Restriction of output to charge higher prices
2. Management slack – due to absence of competition
3. Do not make adequate expenditure on R&D
Monopoly regulation
a. Price regulation
Price Regulation
MC Pricing AC Pricing
(Price is charged (Price is charged
equivalent to the equivalent to AC)
MC)
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Micro-Economics
According to the diagram above, a monopolist would charge Pm price. However, if government
regulations are imposed, then the price charged would be lower. According to the MC pricing, the price
charged would be Pg1 increasing the quantity to Qg1. While in case of AC pricing, the price charged
would be Pg2 and quantity further increasing to Qg2.
b. Taxes:
Taxes
Specific Tax
(It will affect both MC and AC. If Lump Sum Tax
specific tax increases, price
increases and entire burden falls (It only affects on AC. Only profits
on the consumers. would be reduced and there is no
change in quantity and price)
It is not a good way to regulate a
monopoly. )
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Micro-Economics
Price Discrimination: Price discrimination is an act of charging different prices from different
consumers for the same good. It can either be systematic or unsystematic.
Conditions necessary for price discrimination:
a. There is no interaction between the two markets.
b. Goods cannot be commuted between the two markets.
Degrees of price discrimination
a. First Degree of Price Discrimination:

Features:
 Extreme form of price discrimination.
 Extracts entire consumer surplus.
 Marginal Revenue curve also becomes the demand curve.
 Marginal Revenue = Price
 Each consumer is charged his respective reservation price.
 It is also the ‘Take it or leave it’ strategy.
Overall, 1. Extreme form because it extracts all consumer surplus, 2. MR = AR = P- Price charged is equal
to what each consumer can pay for an incremental output.
Second and third degree Price Discrimination are known as Imperfect Price Discrimination.
Imperfect Price Discrimination- Why?

a) Impractical to change each and every customer diff price
b) firm does not know the reservation price of each customers.
b. Second Degree of Price Discrimination:

Features:
 It is applicable to a particular section of goods.
 Goods can be divided into different parts.
 Goods included are either recorded or billed or metered.
c. Third Degree of Price Discrimination:
Features:
 Different prices are charged in different markets depending on the elasticities.
Example: Dumping.
 It is possible when the elasticities between the two markets are different.
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Micro-Economics
 In case of the diagram below, the elasticity of demand is low in case of market
segment 1 and thus price charged is higher. In case of the second market, the
demand is quite elastic, as a result, the price charged is lower.
When is price discrimination possible?

1. Nature of the commodity – in terms of transference like a
2. Long distance or tariff bankers – P.D. is possible
3. Legal sanction
4. Ignorance and laziness of burgers
Condition of Price Discrimination

1. No interaction between 2 markets. Consumers should not be able to interact
2. Goods cannot be commuted between two markets.
Under which market, price discrimination is possible?

1. Perfect competition- Not possible
2. Monopolistic competition- Some (Strong brand loyalty)
3. Monopoly – Yes
Equilibrium for a discriminating monopolist
Conditions are:
a. Aggregate MR = MC
b. MC = MRA = MRB
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Micro-Economics
Inter temporal price discrimination

Separating customers with different demand functions into different groups which leads to
charging diff. prices at different points of time.
Peak load pricing:- Charge high prices at peak times because capacity constrain to cause MC to
be high
Two part tariff:- Consumers are charged both entry of usage fees.
Degree of Monopoly Power: The monopoly power determines the extent to which a
monopolist has control over either prices or quantities.
Measures of Monopoly Power:
a. Performance based: It is an outcome of the use of the monopolists’ ability.

 Elasticity of Demand: Monopoly power is the inverse of elasticity of demand.
1
MP
E d
P  MC P  MR 1
 Lerner’s Measure: or or
P P Ed
Greater the difference between price and marginal cost, greater will be the lerner’s measure and
thus greater will be the monopoly power.
 Cross Elasticity of demand: The measure was given by R.Triffin and thus it is also known as
Triffin’s Measure. Monopoly power is determined by how many substitutes does the good has.
More the number of substitutes, less will be the monopoly power. Therefore, monopoly power
is measured by taking the inverse of cross elasticity of demand.
1
Monopoly Power =
e c
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Micro-Economics
P  LAC
 Bain’s rate of return:
P
Higher the difference between price and average cost; higher will be the monopoly power.
 Rothschild Measure: Under this, the proportionate demand curve is the objective demand
curve.
 Papandreou’s index
Emphasizes the effects of rivals to invades one another’s mkts.
Measures
Penetration Price cut –
Competitors Implies lower

enter the Able to Attract degree of
market customers monopoly
power.
Insulation- Degree of responses of the actual volume of sales of a firm to price cuts initiated by
its competitors.
Larger High degree of

Higher capacity of the monopoly
insulation firm to change power
its output
b. Structural Based Measures:

 Concentration Ratio (CR): It measures the extent to which the large firms control the
output.
 Hirfindahl-Hirschman Index (HHI) = ⅀xi2 where xi is the share of each firm.
xi = Xi / Total Industry size
 Gini Coefficient: It is a measure of inequality in a distribution and is measured with the
help of Lorenz curve.
Gini coefficient = 1 (In case of Monopoly)
= 0 (In case of Perfect Competition)
3. Monopolistic Competition:
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Micro-Economics
Imperfect Competition
(Concept given by Joan
Robinson. Work: "The
Economics of Imperfect
Competition"
Monopolistic Competition
(Concept by E.H.
Chamberlin. Work: "The Oligopoly
Theory of Monopolistic
Competition")
Difference between Perfect and Imperfect Competition
Perfect Competition: P = MR
Imperfect Competition: p>MR = f(elasticity of dd (-)). Also the difference between P and MR (P-
MR) determines the degree of monopoly power.
Features of monopolistic competition are:

a. Large number of buyers and sellers: This leads to a competition between firms due to
products being close substitutes.
b. Non-price competition: Slight difference between the products. Therefore, prices cannot be
very much different
c. Selling cost
d. Some influence over the price :-
Influence of Makes demand
Close change in price curve
Substitutes by one firm on downward
another sloping
There is an influence of price change & firms are not price takers.
e. Non-price competition :- competition is not on the basis of price but in terms of
advertisement & other selling costs. As a result, there is an effect on the price and cost.
f. Product variation :-
Firm tries to vary the product as per the wishes of the buyers.
g. Freedom of entry & exist :-
Not as easy as in case of Perfect Competition.
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Micro-Economics
Group: - Collection of firms producing close substitutes.

Perceived demand curve: It is subjective in nature. If one firm is changing prices, other firms
keep their price constant; it would cause a relative change in prices making the perceived demand
curve slide down.
Proportionate demand curve: If number of firms increase, the curve shifts leftwards implying
that the proportionate quantity demanded of that firm’s output decreases.
Group: A group is a collection of the firms producing closely differentiated goods.
Price Variation: It refers to change in prices.
Product Variation: It refers to the change in the product itself.
In case of monopolistic competition, a firm can earn super normal profits or normal profits or even
losses in the short run; while in the long run it earns only normal profits.
Equilibrium:
Equilibrium = Function of:
 Price
 Nature of its product
 Advertising Outlay
The conditions of equilibrium are:
a. MC = MR
b. MC should be rising
Short Run Equilibrium: In the short run, a monopolistic firm can earn super normal profits,
normal profits or even losses. Diagrammatically we can represent them as follows:
a. Super Normal Profits:
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Micro-Economics
b. Normal profits:
c. Losses:
Note: In the long run, a firm under monopolistic competition earns only normal profits.
Group Equilibrium
Assumptions under group equilibrium are:
a. Uniformity: cost and demand for firms is the same.

b. Symmetry: In long run, no firm reacts to the changes in price and quantity by other firms.
Chamberlin explained the concept of Excess capacity in terms of perceived and
proportionate demand curve.
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Micro-Economics
In the long run, the perceived demand curve shifts down due to active price competition.
Excess Capacity: Extent to which the long run output is falling short of ideal output is called
excess capacity. It must be noted that excess capacity is a long run concept and is not applicable
in the short run.
There is always an excess capacity in case of monopolistic competition due to downward sloping
demand curve. Greater the elasticity of demand curve, lesser will be the excess capacity.
Causes of excess capacity

1) Downward sloping dd curve.
2) Product differentiation  Some degree of monopoly power.
3) Entry of a very large no. of firms

Small demand left to each firm, as a result of which firms are made to produce less than the
optimum capacity.
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Different views on excess capacity

a. Cassel’s View: According to him, excess capacity can be divided into two parts: Firstly,
Individual optimum, Secondly, Social Optimum.
XM is the individual optimum and the excess capacity is XM – XE.

X1 is the social optimum and the excess capacity is X1 – XE.
b. Chamberlin’s View: Diagram. According to him, excess capacity will arise when firstly, there
is free entry and secondly, when there is no price competition.
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Micro-Economics
Price Output Equilibrium under Monopolistic Competition and Perfect Competition

1) Price is greater than MC under Monopolistic Competition.
2) Long run equilibrium under Monopolistic Competition is established at less than technically
efficient scale.
No profits or normal profits by both Monopolistic Competition and Perfect Competition.
Moreover, output is less in monopolistic competition as compared to perfect competition.
3) Price under Monopolistic Competition is greater than competitive price.
Monopolistic Competition & Economic Efficiency.

Economic inefficiency is caused by two factors:
1. P > MC: Value to > MC of \ producing customers

2. Excess capacity
Is Monopolistic Competition socially undesirable?
No. Reasons:
1. Monopoly power is very small (due to large no of furms producing close surst). This makes the Dead
weight loss very small. Moreover, Demand curve is elastic (highly)  Excess capacity will be small.
2. Product Diversity

Better for Consumers (Variety of Choices)
4. Oligopoly:
Competition among the few.
Simplest case  Duopoly  2 Sellers
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Micro-Economics
Oligopoly
Pure oligopoly Differentiated

Oligopoly
(Without product (With product
differentiation; differentiation; close
Homogenous) substitutes)
Features of Oligopoly are:

a. Few Sellers
b. Same good/different goods
c. Interdependence
d. Selling costs
e. Group behavior
Interdependence Group Profit

Behaviour maximisation
f. Indeterminate demand curve

Causes for existence of oligopolies.
1. Economies of scale :- When economies of scale are strong, Market may be too small to support
large no. of firms.
Economies of scale
Few firms can fulfil the demand by

producing large output
Small firms may not be able to compete.
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Micro-Economics
Economies of scale may exist due to large out of fixed cost (developing & designing product)
2) Barriers to entry
Barriers to
entry
Technological Legal
3) Product Differentiation: This gives the firms some kind of Market Power
4) Firm-created causes of oligopolies
a) Merging
b) Predatory Pricing :- Lowering the price so much to drive the rivals out of the market.
Collusive Oligopoly: Firms recognised that they can help each other in the form of:
a. Cartel: Group of firms mutually decide price and quantity and get rid of the uncertainty.
Types of cartel:
Cartel
Perfect Cartel
(Members cannot cheat. One firm out of Market sharing cartel
the group decides the price and output
for all. The cartel acts as a multi-plant (These are loose cartels whch share
monopolist. It is a tight cartel because the market)
one firm has all the control. The
objective is joint profit maximisation.
Quota Geographical
Non-price basis (Under this output to be produced (Under this, an
by each firm is decided. area is decided
(Same price but
freedom in the way a
Moreover, in case there are where the
identical costs, market will be product can be
firm wants to sell its shared equally; otherwise it
output. sold. However,
depends on the bargaining power the product can
of the firms. )
vary.
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Micro-Economics
Instability of a Cartel
Low cost firm has Collapse of

Cost Difference The tendency to collusive
decrease price to agreements
maxi profits
If entry in free
New firms may not join cartel

Fix a lower price to sell a large 9ty

Price wars
b. Price leadership: Under this, one firm will set

its price which will be followed by other
firms.
The basis on which the firms decide the price
leader are as follows:
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Price Leadership
Exploitative or
Aggressive Price
Low cost firm Barometric Price Leadership
Dominant price leadership
(Set a low price leadership (Large or
which is to be (Firm which is dominant firm
(Firm with maximum oldest and most follows aggressive
followed by high market share leads)
cost firms) experienced) price policies,
threatens other
firms)
Non-collusive oligopoly
Nash Equilibrium, given by John Nash 1951. It implies a set of strategies or action in which each
firm does the best it can, given its competitors.
a. Cournot Model: The model was developed in 1838 by Augustin Cournot.
Assumptions are:
 There are two firms.
 Firms produce homogenous goods.
 Firm assumes that other firm will keep its output constant.
 Marginal cost of producing a good is zero.
 The firms simultaneously take the decision.
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Micro-Economics
The output produced by other firm is the ½ of the remainder. In the end, both firms produce 1/3rd
of the total output.
If there are more than two firms, then total output produced in the market would be n/(n+1) where
n is the number of firms in the market. Suppose there are 10 firms, then total output produced
would be 10/11 of the perfectly competitive output and each firm will produce 1/11 of the output.
 Cournot price is between monopoly price and competitive price.

Mp > Cp > P.C.p
 Cournot price is the 2/3rd of the most profitable price.
 Cournot output is the 2/3rd of the maximum output or perfectly competitive output.
b. Bertrand Model: The model was developed in 1883.

 It works on the assumption that other firm will keep the price constant.
 Firms have an unlimited productive capacity to meet the demand requirements.
 The model is based on the price cutting behaviour.
 By under-cutting the price, the firm can capture the entire output.
 Concluding result of the model is:
Price = Average cost
Say there are two firms A and B, so the total output produced will be a perfectly competitive output.
QA + QB = Perfectly competitive output.
c. Edgeworth Model: It is simply the modification of the Bertrand Model.

 Under this model, the firms do not have unlimited capacity.
 We do not get any determinate solution.
 Both firms share the market equally.
 The firms under cut the price and reach perfectly competive price (p’). Later the firms then start
increasing the price and reach monopoly price (p). As a result, the price keeps oscillating between
monopoly and perfectly competitive price.
Stackelberg Model
 It is also known as the First Mover Advantage Model.
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Micro-Economics
 It is a development over Cournot model.

 The firms move in a sequential way.
 Reaction Curves: It is the locus of maximum points of output of a firm given the reaction by other
firms.
 Iso-Profit Curve: Locus of points of same profits. Under this, price leadership as well.
 First entrant will know the reaction of other and will move accordingly. Same is the case with the
other.
Stackelberg Model
15
A's Reaction Curve
B's Reaction Curve
10
Nash Equilibrium
5
0
0 2 4 6
 Following situations can occur:
Situation 1 A: Leader Determinate Solution

B: Follower
Situation 2 A: Follower Determinate Solution
B: Leader
Situation 3 Both A and B want to It is known as nash
be leaders disequilibrium. So
either there will be
price wars or collusion
and hence is
determined by
Edgeworth Box
Diagram.
Situation 4 Both A and B want to Indeterminate

be the followers. Solution. Expectations
cannot be realised.
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Micro-Economics
If A enters the market, then output will be decided by the tangency between lowest iso-profit curve
and reaction curve of the other firm. This is so because closer the point is to the X-axis, more is the
tendency of the firm to move towards monopoly.
Kinked Demand Curve
The concept of kinked demand curve was given by Sweezy in 1939.
According to this, if a firm raises its price, then the price rise is not matched by other firms. If a
firm reduces its price, then other firms will also reduce its price.
The kink arises in the demand curve due to the difference in elasticities.
Concepts in Kinked Demand Curve are:
 Prices and Quantity are rigid at the kink.

 Decline in costs, keep the prices stable but the gap in elasticities increase. As a result, the
break in MR curve increases.
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Micro-Economics
 Decline in demand keeps the prices stable.

 Increase in costs and increase in demand leads to the rise in prices. Also the gap between
the elasticities reduce as a result of which the break in MR reduces leading to the rise in
prices.
Chamberlin Model
 There are two firms.

 The firms produce homogenous goods.
 One firm will recognise the interdependence and will predict the action of other firm and
set its output.
 The concluding result is that each firm acts as a monopoly and hence ½ of the output is
produced.
Hall And Hitch Average Cost Pricing
 Also known as Full Cost Pricing, Mark Up Rule.

 Price = Average Direct Cost + Average Indirect Cost + Margin for profit.
 They used kinked demand curve and stated that mark-up is inflexible making the prices
rigid.
 Average cost is used by the firms when; Firstly, Price > Average cost, which threatens the
position of firms due to possibility of more firms entering the marker. Secondly, If MR and
MC are unknown then average cost pricing is beneficial. Lastly, it is considered to be
morally correct because it charges the lowest possible price.
Andrew’s Version of Average Cost Pricing
 Price = Average Direct Cost + Cost Margin. Cost margin should cover indirect cost with
some level of profits.
 Cost Margin = (Indirect Cost + Normal Rate of Profit)/Q and remains constant due to
following two reasons: Firstly Andrew assumes a saucer shaped long run average cost
curve. Secondly, price set is relatively flexible due to changes in direct and indirect cost.
Limit Price
 The concept of Limit Price is given by Bains, Sylos, Labini.

Bains Limit Price: It considers the entry of potential firms. Limit price is the price set which
does not allow firms to enter the market.
E P P
L C
P C
Where:
E = Condition of Entry
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Micro-Economics
PL = Limit Price
PC = Competitive Price
Firms’ entry will depend upon Barriers to Entry.
Sylos Labini Limit Price: They gave Sylos Postulate which analysed the expected behaviour
of established firms and potential entry.
Assumptions:
 Market demand is given.

 Elasticity of demand is equal to one.
 There are three different sized firms.
 Low cost price leadership.
Already established firms will feel that new firms will not enter if price is less than average
cost for the latter. While new firms believe that when they enter the market, the price would
become greater than average cost.
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Micro-Economics
FACTOR PRICING
Personal Distribution: It is the income distribution amongst individuals
Functional Distribution: Factor prices depends on the services rendered by factors. Functional
distribution is a part of the personal distribution.
Also known as ‘Theory of distribution’.


How income is distributed between various factors of production.
Demand for factors of production is different from demand for goods :-
1) Joint demand
 labour & capital , not alone
2) Derived demand
 Factors don’t directly satisfy consumer wants; but indirectly by producing goods &
services.
Features of derived demand are:
- Indirect demand
- Produce goods & services
- Derived from demand of Goods & Services.
Some Basis Concepts

1) Productivity of the factors.
 contribution of the factor to the total output.
2) Marginal productivity :- ‘Additional product’ due to employment of an additional unit of a factor.
Marginal Productivity
Marginal Revenue
Marginal Physical Productivity Value of Marginal
Productivity or Marginal (Addition to total revenue) Productivity
Product
TRP/L (VMP = MPAR)
(TPn – TPn-1, TP)
MRP = MP  MR
Difference between Physical Product & Revenue Product

Physical Product: Expressed in Physical units
Revenue Product: expressed in terms of money value of output
Difference between MR & MRP

MR: Additional revenue on account of sale of just one additional unit.
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Micro-Economics
MRP: Additional revenue to the produces on account of sale of all additional units
Difference between MRP & VMP

VMP = MR  AR
MRP = MR  MP
Under Perfect Competition
MR = AR
VMP :- MR  MR = MR  MP :- MRP
VMP = MRP
Other than Perfect Competition;
AR > MR
VMP > MRP
(b) Average Productivity
Average
Productivity
Average Revenue
Average Physical Productively
Productivity
ARP = TRP/L or
AP= TP/L
ARP= AP  AR
Behaviour of APR and MRP Curves
Cost of the factor
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Micro-Economics
Cost of the factor
Marginal Factor Cost (MFC)

Average Factor cost (AFC)
Difference in total wage bill
AFC = TFC/units of factor used when additional labour is emp.
AFC = Total Wage Bill/no of MFC = TFCn – TFCn-1
labour emp.
Under Perfect Competition:-

AFC = MFC
Imperfect competition:-
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Micro-Economics
Theory of factor pricing  Marginal productivity theory

 Modern theory
Marginal Productivity Theory

Propounded by T.H. Von Thunen in 1826.
Later given by Ricardo, Clark, Marshall, Karl Menger, Bohn Baverk, Warlras, Wicksteed, Edgeworth.
Under Perfect Competition, price of the service of factors is equal to MP.
Assumptions of the theory
1. Perfect Competition in product mkt
2. Perfect Competition in factor mkt  All units of factors are homogenous
Fop are perfectly mobile
3. Variable proportion type production function :-
Output can be increased by changing the factor ratio.
4. Possibility of factor substitution.
5. Divisible factors :- For can be divided into small units.
6. Aim of producer  profit maxi
7. Full employment.
8. Technology remains constant
9. One variable input, other fixed
Demand for a factor  MRP curve (in a competition mkt)
Equilibrium: MRP = w
If MRP > w, hire more labour
If MRP < w; lay off labour
Supply of Labour
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Micro-Economics
Theory by Clark
Focused on supply Side & ignored the demand side.
Theory by Marshall
 Considered both supply and demand in determining the wages & labour.
Supply Curve of Labour
Backward bending:- At higher wages, workers prefer desire to work.
Substitution effect: Always positive in case of labour supply
Induce workers Substitute

 in wage to work more leisure hours
for work hours
Income effect
Rise in Prefer Discourages

wage Leisure Work
Till the point supply of labour curve is upward sloping, then S.E. > I.E.
When the supply of labour curve bends backward, I.E. > S.E.
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Micro-Economics
Equilibrium Conditions
Conditions of equilibrium :- (1) MFC = MRP
Marginal factor cost correct notes
(2) MRP should cut MFC from above
Case 1:- Perfect competition in product & factor market.
SR, factor market & product market may be earning losses/profits.

Long run:- MRPL/W = MRPL/r
This equation shows variability of factor
With MRPL curve

decrease shifts
in wages leftwards
(Case of substitution when S.E. > O.E.)
Complementary Factor
(-ve S.E.) < Shifts MRP

 in wages output curve
effect rightwards
Process of profit maximisation
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Micro-Economics
MC decreases (MC shifts to right)
More output will be produced
Rise in expenditure.
Shift of Iso-profit curve (due to fall in MC)
More of labour & can be bought (Using the

additions profit & to  output)
Case 2 Factor Market Perfect Competition & Product Market. Imperfect Competition/Monopoly
“Monopolistic exploitation” given by Joan Robinson
Under this, the exploitation will take place to the extent of RE. RE level of exploitation is known as
Monopolistic Exploitation.
Case 3 Monopsony  In Factor Market
Perfect Competition  In Product Market
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Micro-Economics
Under monopsony in the factor market, the labour faces monopsonistic exploitation. If the factor market
would have been perfectly competitive, then the labour would have got wages to the extent of Wpc.
However, in this case he gets wages Wm.
Case 4 Monopsony in the factors Market.
Monopoly Product Market
There is double exploitation. The exploitation doubles in the sense that labour generates marginal revenue
to the extent of WU but receives wages Wm. Hence he faces monopolistic as well as monopsonistic
exploitation in this case.
Labour is doubly exploited because:-

1) Excess of MRP over price of factor  Monopsonist Exploitation
2) Due to excess of VMP over MRP  Monopolistic Exploitation.
ROLE OF TRADE UNION

1) Can help attain higher wages at the cost of lower employment.
Whether result is beneficial depends on :-
a) Elasticity of demand for labour (ed):-
If ed is high  Higher wages means higher supply of labour higher unemployment.
b) Distribution policies of the union
Adding up Problem :- Product Exhaustion Theorem

Each factor paid according to its M.P. As a result, total output would be exhausted without out any surplus
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Micro-Economics
Wicksteed’s solution of product exhaustion problem Phillip Wicksteed.

Used Euler’s Theorem
X = MPL .L + MPk.K
Homogenous for of 1st degree (CRS)

 in Labour & Capital by N    by N
Criticism
There is increasing Returns to Scale or Decreasing Returns to Scale.
In case of ing RTS  If factor rewards are paid according to MP then total factor rewards would be more
than TP.
In case of ling RTS :- MP = W

Total factor rewards < TP

Surplus Left.
Economic Rent :
Amount that firms are willing to pay for an input less the minimum amount necessary to buy it.
When the Supply is inelastic;
Entire value of land = Economic rent.
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Micro-Economics
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Micro-Economics
THEORIES OF MACRO-DISTRIBUTION (SHARE OF WAGES IN NATIONAL

INCOME)
Theories in Chronological Order
1. Ricardian Theory
2. Marxian Theory
3. Kalecki Degree of Monopoly power
4. Keynesian-Kaldor Theory
5. Neo-Classical Approach
1. Ricardian Theory:
Ricardo uses a marginal principle and surplus principle. The land gets rent, labour gets wages and
entrepreneur gets profit. According to him, land is the most important factor of production and as
a result rent should be paid first. The remainder of the income would then be divided into wages
and profits.
2. Marxian Theory: He considered two classes:

a. Capitalists: Who exploited labour on the basis of surplus value.
b. Workers
Capital accumulation reduces the rate of profit because capitalists’ source of profit is labour. So if
labour is equipped with capital, then less profit would be left for capitalists.
Constant capital (C)+ Variable Capital (V) + Surplus Value (S)
Degree of exploitation = S/V
Organic Composition of Capital = C/V
Rate of Profit = S/(C+V) or (S/V) ÷ 1+(C/V)

If rate of profit is to be increased, then following measures should be taken;
a. Prolonged working hours of labour.

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Micro-Economics
b. Reduce the time of labour used by him to produce for his own subsistence.
c. Capital Accumulation: According to Marx, capitalists will opt for capital accumulation.
3. Kalecki’s Degree of Monopoly: According to him, there are two classes:

a. One who gets economic profit
b. One who earns wages
Kalecki used Lerner’s Measure to identify the monopoly power, that is;
Monopoly Power = (P-MC)/P
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Micro-Economics
GENERAL EQUILIBRIUM AND WELFARE ECONOMICS

Partial Equilibrium: It doesn’t consider the interdependence between the two markets, that is, factor
market and product market.
General Equilibrium: Under general equilibrium, interdependence is considered.
General Equilibrium involves following conditions:
General Equilibrium involves following conditions :-

1) Efficiency in exchange
Exchange economy:- Market in which two or more consumers trade two goods among themselves.
Efficient Allocation (Pareto Efficient) :- Allocation of goods in which no one can be made better off unless
someone else is made worse off.
Efficiency in exchange is attained when
MRSxyA = MRSxyB
Edgeworth Box Diagram :-

Shows all efficient contract curve allocation of goods between consumers or of 2 inputs between 2
production function.
2) Efficiency in Production
Technical efficiency:- when firms combine to produce a given output as inexpensively as possible.
Production contract curve :- Shows all technically efficient combination of inputs.
Efficiency in production is attained when :-
MRTSLXM = MRTLKN
3) Efficiency in Product - Output Mix

Production Possibility Frontier (PPF) or (PPC): Shows combination of 2 goods that can be produced using
fixed quantities of inputs.
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Micro-Economics
Slope of PPF  Marginal rate of transformation (MRT)

Amount of one good that must be given up to produce one additional unit of the second good.
MRT = MCA/MCB
MRT is increasing; because as we shift resources from B to A, their MP increases in case of inputs producing
B where MP decreases in case of inputs producing A.
Output efficiency will be attained when :-
MRTxy = MRSxyA = MRSxyB
Welfare Economics
Concerned with the evaluation of economic situation from the point of view of society’s well being.
Positive Economics  Concerned with ‘what is’
Normative Economics  ‘What should be’ or ‘what ought to be’.
1. Old Welfare Economics: It was given by Classicals (Pigou, Bentham, Marshall).
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Micro-Economics
Pigou's Analysis
Meaning of Welfare Pigouwian Welfare

(Social Welfare = conditions
Sum of individual (Maximisation of
welfare) welfare)
For maximisation of welfare :-

1) National Income :- if National Income increases  welfare increases
Given that tastes remain constant
2) Distribution of National Income :-
Income transferred from rich to poor  welfare increases
Assumptions:
a. Marginal Utility of Money is diminishing.
b. Full employment
c. Perfect competition
d. Involves inter-personal and intra-personal comparison.
e. Involves comparison of utility.
Features of Old Welfare Economics:

 Analysis was cardinal.
 Welfare is subjective, depending on the state of mind.
 Welfare is measured in terms of individual’s level of satisfaction measured in terms of
money. Social welfare is the sum total of individual welfare.
 National Income was used as a measure of social welfare.
Concluding results:
If national income increases then it implies welfare increases. Also if share of poor people in
national income increases, then welfare increases.
Overall : 1) Analysis is cardinal (welfare can be measured)

2) Welfare is subjective (depending on state of mind).
2. Pareto Optimality:
Assumptions:
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Micro-Economics
a. Factor prices are known.

b. Technology is given.
c. Prices are given.
d. Consumers and producers are rational.
Important points:
 Pareto optimality is a point where someone can only be made better off by making someone
worse off.
 It is an ordinal measure of utility.
 It is free from value judgement.
 Concept of pareto optimality is free from comparison.
Pareto Optimality: It is the point where someone can only be made better-off by making
someone worse off.
The locus of point of tangency of the indifference curve is known as contract curve. At
this curve,
MRSXYA = MRSXYB
 Pareto Optimality will always lie on the contract curve, which implies that there are no
leftovers. However, there is no unique solution on the contract curve.
 Efficiency in Production-Exchange: Efficiency is achieved when the slope of iso-revenue
curve becomes equal to the slope of the budget like.
 In case of production possibilities, pareto optimality is achieved when
Slope of Indifference curve (MRS) = Slope of PPC (MRTSLK)
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Micro-Economics
First Order Conditions in Pareto Optimality

a. MRSxyA = MRSxyB
b. MRTSLKM = MRTSLKN
c. MRTXY = MRSXYA = MRSXYB
d. Optimum degree of specialisation which implies MRTXYA = MRTXYB
e. Optimum relationship between factor of production: MPLA = MPLB
f. Optimum allocation of factors: Marginal rate of substitution between work and leisure should
be equal to Marginal rate of transformation of labour time and output.
g. Optimum allocation of money essence: Interest at which money is lent is equal to the marginal
product of the borrower.
Second Order Conditions: These are related to the slope.
a. Indifference curve is downward sloping and convex to the origin.

b. Product possibility curve is concave to the origin.
3. New Welfare Economics (Kaldor-Hicks)

Under this, someone is made better off and someone is made worse-off. Welfare is dependent on
production and the distribution side is ignored.
Assumptions:
a. Technology is given.
b. No externalities.
c. Satisfaction derived by different persons are independent of each other.
d. Ordinal utility.
Compensation Criteria:
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Micro-Economics
a. Kaldor’s view: Kaldor gave his view from the gainer’s point of view. If gainers can
compensate losers and still they are better off, then social welfare increases.
b. Hicks’ view: Hicks gave his view from the loser’s point of view. If losers cannot convince the
gainers to make the change, then the optimality is achieved.
Utility Possibility Frontier: It was given by Samuelson.
Utility Possibility Frontier

25
20 A
B
B's Utility
15
C
10
D
5 Q
0
0 2 4 6 8
A's Utility
.
Initially say the consumers A and B are at Q. Point A is not according to the Kaldor-Hick’s criteria
because A is made worse off while making B better off. Therefore, at point A, the compensation
criteria is not satisfied.
At point B, consumer B is made better off while there is no change in the utility of A. Similarly
for D, A is made better off while there is no change in B’s utility.
Lastly at point C, there is a rise in utility of both the consumers, hence satisfying our utility criteria.
Scivotsky Criteria
Scivotsky Criteria
60
UF1
C UF2
40
B's Utility
D
A
20
B
0
0 2 4 6 8 10
A's Utility
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If movement is from A to B, then consumer A is made better off and consumer B is made worse
off. Therefore, point C is an optimum point, where only consumer B is made better off.
However, if the movement is from B to A, then in that case consumer A is a loser and consumer B
is the gainer. Therefore, in that case, D is the optimum point.
This conclusion leads to inconsistent results.
So Scivotsky gave a double criteria of welfare which includes two tests which should be satisfied
to get consistent results:
a. Kaldor-Hicks: If movement is from point a to c, then Kaldor-Hicks criteria is satisfied.

b. Reversal tests: Movement from c to a should not possible.
Grand Utility Possibility Frontier (GUPF) and point of constrained bliss
GUPF shows the pareto optimal points. In other words, it is the locus of all pareto optimal points.
Assumptions:
a. Two goods
b. Two individuals
c. Two factors of production which are homogenous in nature and are perfectly divisible.
d. Production function is given.
e. State of technology is given.
f. Every consumer has a unique preference.
g. Endowment of factors of production is given.
Above point shows us the locus of pareto optimal points, that is, the grand utility possibility
frontier. At all points on this curve,
MRSXYA = MRSXYB = MRT

Social Welfare Function is the ordinal index of society’s welfare. Abram Bergson introduced
the concept of social welfare function in 1938.
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Point of Constrained Bliss: It shows maximum welfare. In the below diagram, when we super
imposed the social welfare functions on the grand utility possibility curve, we get a point of
tangency between the two, that is, point P. Point P is hence, known as the point of constrained
bliss.
The point of constrained bliss shows us efficiency in exchange, efficiency in production and both
together.
Types of Social Welfare function
a. Classical’s Social Welfare Function:

 Cardinal in nature
 Societal welfare is dependent upon all individuals in the society.
 Equality in distribution of income which leads to the formation of social welfare
function.
b. Rawlsian’s Social Welfare Function: According to this, the social welfare sees the degree of
inequality. For welfare to take place, the worst off person should be made better-off.
c. Bergson-Samuelson Social Welfare function:

 It considers ordinal utilities
 Society welfare is dependent upon ordinal utility.
 Inter-personal comparison.
 Value judgements should be consistent.
Arrow’s Impossibility Theorem/Arrow’s Theory of Social Choices
The theory states that it is impossible to construct a social welfare function that will reflect individual’s
preferences. Social choices made will not be able to reflect individual choices.
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Social choices must satisfy the following criteria:
1. Consistency/Transitivity in social choices, that is, if A is preffered to B and B is preferred to C then

A is preferred to C.
2. Responsibilities to individual preferences: If individual preferences change then social preferences
should reflect those changes.
3. Non-imposition: Social choice should not be imposed on people without considering their personal
choices.
4. Non-dictatorship: No single person should act as a dictator. Democratic society should be
encouraged.
5. Independence of irrelevant alternative
In case of two commodities, if social choices are to be considered then atleast one of the above criterion
will be violated. If we take three choices, consistency and transitivity will be violated.
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BAUMOL’S SALES MAXIMISATION MODEL

The main aim of the model is to maximise the sales or maximising revenue from sales, subject to some
minimum level of profits.
L is the minimum profit line which should be earned to satisfy the shareholders.
The managers aim to maximise revenues instead of maximising the profits. As a result, the firm does not
operate at A level of output. Rather it works at B output level, so as to maximise the sales and hence
revenue. If the firm produced more than B, then profits would become less than the minimum profit level,
hence causing disequilibrium to the shareholders. Therefore, the management prefers to produce output
till B.
It should be noted that profit maximisation leads to lesser output as compared to revenue maximisation.
The reasons behind managers working towards maximising sales instead of profits are as follows:
1. Sales is considered to be the main criteria for the index of performance of the firm by various
financial institutions.
2. The managers are more satisfied by maximising revenue instead of maximising profits in which
they get no share.
3. Salaries and perks of the managers are dependent on the sales earning.
4. The day to day problems can more easily be solved by growing the sales of the firm, hence
increasing revenue.
5. Increasing sales implies more share of the firm in the market and hence increasing the bargaining
power of the firm.
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MARRIS MODEL OF MAXIMISATION OF GROWTH RATE

According to R. Marris, the managers do not aim to maximise profits. Rather they aim to maximise the
balanced growth rate of the firm. It can be expressed as
Maximise: G = Gd = Gc
Where: Gd is the growth of product market, Gc is the growth of supply of capital.
It should be noted that utility of managers is a function of,
Umanagers = F ( Gd, Job Security)

And Utility of owners is a function of
Uowner = F( Gc)
Marris also talked about two types of constraints
1. Managerial constraints: These are related to the skills of manager and research & Development.
2. Financial constraints: He talked about a few ratios:
𝑫𝒆𝒃𝒕
a. Debt Ratio/Leverage ratio = 𝑮𝒓𝒐𝒔𝒔 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒂𝒔𝒔𝒆𝒕𝒔
Higher the ratio, lesser the security.
𝑳𝒊𝒒𝒖𝒊𝒅 𝒂𝒔𝒔𝒆𝒕𝒔
b. Liquidity Ratio = 𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔
Higher the ratio, higher is the security.
𝒓𝒆𝒕𝒂𝒊𝒏𝒆𝒅 𝒑𝒓𝒐𝒇𝒊𝒕𝒔
c. Retention Ratio = 𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔
Higher the ratio, higher the security.
Financial Constraint is a combination of debt ratio, liquidity ratio and retention ratio.
Rationale for Maximizing Growth Rate

Managers do not maximize the absolute size of the firm but the rate of growth.
Utility function of managers :-
Um = f (Gd, S)
Where Gd = Growth rate of product market or demand (+), S = Measure of job security (+)
Utility of owners:
Uowner = F( Gc)
Where: GC = Growth rate of capital supply
GC depends on debt ratio, liquidity ratio, retention ratio
Equilibrium:
Um = Uowners
Gd = GC
Gd = f(d, k)
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Where d = rate of diversification (+), k = proportion of successful new products (+)

K = function(
1. Rate of diversification (+)
2. Price of the product (-)
3. Exp. On advertising (+)
4. R & D (-)
Capital supply = f (a)
Where a further determines retained profits

Average Rate of profit (m) = P – C – A – (R & D)
Where P = Price, C = Cost, A = Advertising
Price & cost are assumed constant
M is negatively related with A and (R & D)
Profits are a function of ‘d’
Profit = f (m, d)
gD = Gc maximisation
Instrument variables in Marris model are

1. Financial security coefficient
Policies adopted by managers.
3 ratios
2. Rate of diversification
3. Average profit margin  Higher the expenditure on (A) & (R & D), Lower the profit.
According to Marris, the managers try to maximise their own utility function because owners get highly
satisfied with the size of the firm and growth rate of the firm. Thus, managers try to maximise a steady
growth rate.
Criticisms of the theory

1. The theory ignores oligopolistic interdependence.
2. It ignores the price determination which is one of the concern of price maximisation hypothesis.
3. The theory does not challenge the profit maximisation hypothesis seriously.
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WILLIAMSON’S MANAGERIAL THEORY

The theory was given by O.E. Williamson. He stated that the managers are motivated towards their own
self-interest and they try to maximise their own utility function. The utility function of managers is as
follows:
Umanagers = F( Monetary expenses, number of staff under the manager, management slack,
discretionary investment)
Managerial utility function :-

1) Salaries & other forms of monetary compensation (+)
(2) No of staff under the control of a manager. (+)
More the More the Greater

staff power the utility
3) Management Slack  Lavishly Furnished offices, cars, etc.
4) Magnitude of discretionary investment exp. Made by managers.
Amount of resources which managers can spend according to their discretion
Managers want to maximise their utility function subject to minimum constraint.
Actual profits = Revenue (R) – Cost (C) – staff expenditure (S)
Reported profits = R – C – S – management slack
Criticisms of the theory

1. The theory fails to explain the pricing and output in the cases of strong rivalry.
2. The theory does not consider the interdependence of firms in the oligopoly.
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THEORIES OF DISTRIBUTION
Factors of production :- Capital, Labour, Land, Entrepreneur
Factor Rewards :- Interest, wages, rent, profit
Theories of Rent
1) Ricardian theory of rent.
Book “Principle of Political Economy & Taxation”
- Rent arises due to operation of law of diminishing returns
A 50 50-35 =
B 40 40-35 = 5
C 35 No rent land
Criticism
a) No original & indestructible power of land  soil can become infertile
b) Wrong assumption of no rent land

Land can be put to several uses, hence rent is paid.
c) Neglect of scarcity principle
Modern Theory of Rent
- Given by Pareto, Joan Robinson, Boulding
- Rent is determined by forces of Supply & demand.
Acc. To modern theory

Rent = difference between actual earning of a factor over its transfer earnings.
Rent depends on elasticity of supply of factors of production:-
1. Perfectly elastic supply :- no economic rent.
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2. Totally inelastic supply :- entire income is economic rent no transfer earning.
3. Less than perfectly elastic supply:
Wages
1. Subsistence theory of wages/Brazen Law of wages/ Iron law of wages.
In Long Run,
wages = Min. level of subsistence sufficient enough to meet the basic necessities of life
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Wages > subsistence level

Labour will marry early
More children
Rise in workforce
Moneys wages will fall
2. Wage Fund Theory

Introduced by Adam Smith; developed by J.S. Mill
Wage Rate = Wage fund/No of Workers  Part of Floating capital
Increase in wage rate can be achieved in 2 ways :-
a) Increase in floating capital
b) Decrease in number of workers
3. Residual Claimant Theory
Given by Walker
Wages = TP – Rent- Interest- Profit
Leftover is distributed as wages
4. Marginal Productivity theory of wages
Under Perfect Competition:
Wages = MP
If MP > wages; firm will employ more labour
If MP < wages; firm will lay off workers
Prof Taussing :- wages are not equal to MP but
W = Discounted Marginal net product
Which accounts for risks like fall in price of product in future
5. Modern theory of wages
(Theory of factor pricing)
Case I: Perfect Competition in the Product and Factor Market
In short run, demand for labour is given by VMP curve when we are holding other factors as constant.
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Case II: Imperfect Competition in The Product Market and Perfect Competition in the Factor
market
Imperfect competition in product market implies that AR > MR and hence VMP > MRP.
Under this, the exploitation will take place to the extent of RE. RE level of exploitation is known as
Monopolistic Exploitation.
Case III Monopsony in the Factor market
Supply of labour curve is upward sloping and MFC curve is also upward sloping. So a monopsonist could
exist only when
1. Labour is unorganised.
2. Labour is geographically immobile.
Monopsony in the Factor Market and Perfect Competition in the product market.
Under monopsony in the factor market, the labour faces monopsonistic exploitation.
Monopsony in Factor Market and Imperfect Competition in the Product Market
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There is double exploitation. The exploitation doubles in the sense that labour generates marginal revenue
to the extent of WU but receives wages Wm. Hence he faces monopolistic as well as monopsonistic
exploitation in this case.
THEORIES OF INTEREST
1. Productivity theory of interest (Turgot)
Interest = Reward for the use of capital in production.
2. Abstinence/waiting theory if interest
Given by Senior
Interest is the reward for waiting
Saving in present  Sacrificing consumption at present
This implies, Interest is rewarded for this sacrifice
3. Austrian/Agio theory of Interest
Initially given by John Rao in 1834
Later developed by John-Bawerk
Interest = Premium which present goods command over future
Why? A) future consumption involves risk
B) Present wants, if fulfilled, give more utility
4. Loanable and theory of interest or (Neo-Classical Theory of Interest)
Initially given by Wicksell. Later developed by Ohlin, Robertson, etc.
Demand for loanable funds depends on: Households (Consumption purposes) and Entrepreneurs
(Productive purposes)
Enterpreneur’s demand depends on :-

a) Expected net return on newly invested funds
b) Interest paid to the lender
MEC > I; Continue Borrowing
With more borrowing, MEC decreases (Law of diminishing returns)
Supply of Loanable funds:
Individuals (savings)
Business (idle cash)
Bank credit
Disinvestment
All are positively related with interest rate.
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5. Keynesian theory of Interest/Liquidity preference

Interest is the reward for surrendering liquidity
Demand for money
a) Transaction motive Mt = f (Y) (+)
b) Precautionary motive Mp = f (Y) (+)
c) Speculative motive Ms = f (i) (-)
Supply of money = depends on central bank
In Short Run :- Suppy of money is constant

Keynes theory is Short Run theory :-
6. Modern theory of interest/IS-LM Model
Equilibrium product market:- by IS curve
IS curve :- Assumptions :- 1) S = f (r (+), y(+))
2) I = f (r (-))
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Equilibrium in money market = by LM curve

1) Dm M = f (Y (+))
2) Supply of money is fixed & exogenously determined
Equilibrium Interest Rate:
IV. THEORIES OF PROFIT

1) Hawley’s Risk bearing theory of Interest (F.B. Hawley)
Profit :- Reward for taking risks; higher the risk, higher should be the profit.
2) Uncertainty theory of profit
By Knight
Profit :- Reward for uncertainty bearing & not risk taking.
Risk is anticipated and be insured, and uncertainty is Unforeseen & are non-is insurable uncertainty.
2) Rent Theory of profit
By Francis A Walker
Features of profit :
a) Profit is rental in character;
b) profit of superior businessman is calculated from less efficient ones.
4. Marginal productivity theory of profit
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Profit depends on MP of the employer

Higher the MP of the employer, higher will be the profit.
5. Dynamic theory of profit.
Profit arises in a dynamic economy like any change in society (pop., technology etc)
Static society :- Only monopoly profits
Dynamic society :- profits get diluted
Perfect Competition society :- profits are eliminated
6) Monopoly theory of profits.
Profits arise due to presence of monopoly power higher the monopoly power.
Higher the monopoly power; Higher the Price over & above AC; Higher the Profits
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ELASTICITY OF SUPPLY
Factors determining Elasticity of supply.
1) Change in MC :-  IN prodn   in MC  elasticity of supply (Short Run)
Law of diminishing returns
Long Run :- Supply curve is relatively more elastic, due to entry of new firms.
Increasing cost industry :- Long Run supply curve more elastic than in Short Run.
Constant cost Industry :- Long Run supply curve is perfectly elastic coz  in industrial output
can be obtained at same cost of production.
Decreasing cost industry :- Long Run supply curve is downward sloping & has a negative
elasticity of supply.
(large increase in industry output plus low cost of production leads to additional output can be
produced at lower supply price.
2) Response of the produces :-
Profit maximisation producer would increase supply at higher price.
3) Availability of input for expanding output :-
Inputs easily available :- elasticity of supply is large
Inputs limited:- inelastic supply.
4) Possibilities of substitution of one product for the others :-
Greater the extent of possibilities of shifting resources from other products to the
production of given product; greater will be the elasticity of supply.
5) Length of Time :- Longer the time; more elastic will be the supply.
Market Period: Inelastic supply
Short period :- Less Elastic supply
Long period :- More Elastic supply.
FACTOR INTENSITY
- K/L ratio
Measured by the slope of line through the origin representing the particular process.
Upper part of isoquant  More Capital intensive

Lower part of isoquant  More Labour intensive.
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COST ELASTICITY (K)= (DC/C)/(DQ/Q) = MC/AC

MC>AC ; K>1
MC = AC ; K =1
MC < AC; K<1
Elasticity of Average cost = K – 1
Elasticity of MC = d/dQ (C.K./Q) Q2 /C.K.
TYPES OF EQUILIBRIUM
1. Stable Equilibrium:- Any disturbance takes place; forces bring it back to original equilibrium
position.
2. Neutral Equilibrium:- Any disturbance takes place; no forces operate; system remains at rest.
3. Unable Equilibrium:- Small Disturbances :- Forces take it away from equilibrium position.
Stability conditions of Equilibrium

1. Marshallian Approach :- Price dependent approach’ depends on Quantity movements.
2. Walras Approach :- Quantity dependent approach depends on price movement.
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Shape of Dd Shape of ss Particular Walras Marshall

curve
Curve Feature Stability Stability
Downward Upward Intersecting Stable Stable

Upward Downward Intersecting Unstable Unstable
Downward Downward Supply curve cuts demand Stable Unstable
curve from above
Downward Downward Supply curve cuts demand Unstable Stable
curve from below
Upward Upward Supply curve cuts demand Stable Unstable
curve from above
Upward Upward Supply curve cuts demand Unstable Stable
curve from below
Quasi Rent :- - Given by Alfred Marshall; short run phenomenon

- Arises from the barriers to entry that potential competitors face
COWEB THROREM
Possibilities :- (1) Perpetual oscillations
(2) damped oscillations
(3) Explosive Ocillations
1. Perpetual Oscillations:-
Slope of demand curve = slope of supply curve
2. Explosive Oscillations:
Slope of demand curve > slope of supply curve
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3. Damped Oscillations :-
Slope of Demand curve < slope of supply curve
Finished
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MACROECONOMICS
Part – 1- (b) Notes by Economics Harbour
Macroeconomics is the branch of economics that studies the behavior

and performance of an economy as a whole.
Macroeconomics
Macroeconomics
DETERMINATION OF OUTPUT AND EMPLOYMENT

1. Classicals: The terms ‘Classicals’ was
coined by Karl Marx. According to them,
the economy will always be in a state of full
employment, and any deviations from the
equilibrium would be restored automatically
through market mechanism.
Main assumptions of the classical theory :-

1. Full Employment – All resources (L,K) are
fully employed.
No Government interference.
Any deviation from full employment, Market forces act accordingly, and bring the economy back to
its original situation.
Note: Classicals stated that there can be frictional and voluntary unemployment in the state of full
employment situation.
2. Economy is always, in the state of equilibrium
Value of Goods & Services = Income
Income earners spend their entire Income
No overproduction & under production
In Long Run, AD= AS and economy is in the state of stable equilibrium
3. Laissez - faire system (Necessary Condition)
Laissez faire economy – 1) Absence of Government Control

2) Absence of Monopolies and restrictive trade practices
3) Freedom of Choice – Consumers and Producers
4) Market forces of demand & supply operate
4. Money does not matter / Money is neutral
According to classicals: Money acts as a Medium of exchange
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Macroeconomics
Level of output & employment = f (real resources in the economy, i.e., L,K)
Other Assumption taken by Classicals:

1) Perfect Competition (No monopolies)
2) Closed economy (no trade)
3) Workers don’t suffer from money illusion, that is, workers easily determine price levels in the economy
and hence demand real wages.
4) Existence of 2 sectors - Real and Monetary (Classical Dichotomy)
5) Prices, wages are flexible in both upward and downward duration.
6) Rate of interest = f ( Savings(+), Investment(-))
7) Quantity Theory is used to determine price
8) Demand & Supply of labour = f (w/P) where w – nominal wages; P Price Level). This implies there
is No money illusion
Say’s law was the basis of Classical Theory saying that supply creates its own demand.
Assumed a barter economy initially
Goods produced by people
Some of it used for own consumption
other part / surplus is used to purchase other

goods
No overproduction
In the exchange economy
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Macroeconomics
Prodn of Goods and services
employment of factors of production
Generates Income in the form of factor prices
spending the Income means generating

demand for Goods and services
Therefore,
AD=AS, and S = I, implying No surplus / deficit
Equality is maintained between aggregate demand (AD) and Aggregate supply (AS), that is,
AD=AS; and Saving (S) and Investment (I) [S=I].
According to Classicals,
̅, 𝐓
𝐐 = 𝐟(𝐋, 𝐊 ̅)
Where: Q = Output, L = Labour, K = Capital (constant), T = Technology (constant).
Supply of labor curve (SL) is upward sloping because substitution effect is greater than
income effect.
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Macroeconomics
According to the Classicals,
SL = f (W/P), that is. Supply of labour is a function of real wages.
DL = f (W/P . MRPL), demand for labour is a function of real wages and marginal revenue
productivity of labour.
Potential GDP is the amount of goods and services produced, given the resources and state of
technology when the labour market is in equilibrium.
However, according to classicals, there might be frictional and voluntary unemployment when we
talk about full employment.
Savings & Investment

Savings = Investment is a necessary condition to achieve
AD = AS.
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Macroeconomics
Classical Dichotomy
By the term classical dichotomy we mean that there exists two

independent sectors in the economy- real sector and monetary
sector. There is a complete independence of real variables from
nominal variables. This implies that the money is neutral in
nature. It acts as a medium of exchange only.
Money impacts prices and hence only affects the nominal

variables, keeping the real variables unchanged.
Real factors are determined by variables totally
different from nominal variables.
Long Run Aggregate Supply
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Macroeconomics
According to the classicals, in the long run aggregate supply is fixed. So any change in the
aggregate demand would only lead to a rise in price level and there won’t be any change in income.
Classical Theory faced the following criticisms:

Keynes criticised the theory by introducing the following process:
Wages Income Aggregate Under-

Decrease Decrease demand employment
decreases
Therefore, according to Keynes, an economy will not be at full employment level. There will
always be underemployment.
2. Keynesian Theory
According to Keynesian theory, full employment is not possible. There will always be
underemployment equilibrium in the economy.
Moreover, the workers suffer from money illusion because;
DL = f (W/P); demand for labour is a function of real wages
SL = f (W); supply of labour is a function of nominal wages, because workers cannot estimate
perfectly the effect of price levels on their monetary income.
Difference between Classicals and Keynesians with respect to money

According to Classicals, Money is neutral and acts as a Medium of exchange.
Keynesians: Money is not neutral and acts as a Medium of exchange and store of value.
According to Keynes,
Wages are flexible upwards & rigid downwards :-
1) Wage contracts
2) Trade Unions
3) Min. wage laws
4) Efficiency on the part of labour.
Positive relationship between wages & working hours.
* Classicals focused on the supply side

Keynesians focused on the demand side.
Aggregate supply Function

Total supply of goods and services in an economy.
Y= f (K,N) - SR Production function where N = labour
N = f (effective demand)
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Macroeconomics
Aggregate Demand function – 2 sector model.

AD = C+ I, where I is exogenously determined.
C=f (Y) = “Fundamental Psychological law” when income increases, consumption increases but not as
much as the increase in income.
Nonlinear consumption function
MPC = C/Y  decreases with increase in income
(As income increases, people consume a decreasing proportion of the marginal income)
C= a+by where b = MPC APC = c/y
Income Determination
Assumptions
(1) 2 sectors (Households & business firms)
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Macroeconomics
(2) Households own all factors of production & sell factor services to the business
Business hire factor services & sell entire Produce to Households.
(3) No Government expenditure.
(4) Closed Economy
(5) No corporate savings / retained earnings
(6) Prices Remain constant
(7) Supply of Capital & Technology are given.
Equilibrium income or output:-

AD = AS
C+I = C+S
Savings = f (Income) while Investment = f (MEC, r) where MEC is the marginal efficiency of capital
(negative relationship) and r is the rate of interest (negative relationship).
There is no division of economy into real and monetary sectors.
Wages and prices are flexible upwards and rigid downwards due to:
a. Wage contracts
b. Trade unions
c. Minimum wage laws
d. Efficiency on the part of labour, that is, lower wages leads to lower efficiency.
Where Classicals focussed on the supply side, Keynes focussed on the demand side, that is, AD.
According to him,
Y = f (N) where Y = Output/Income, N = labour
N = f(effective demand)
AS Price: it is the minimum price given to the labour. The AS Price curve shows a relationship between
receipts and full employment.
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Macroeconomics
AD Price: These are the expected earnings which an employer can get out of sale of output.
Point where ADP is equal to ASP, is known as effective demand.
Savings-Investment Model
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Macroeconomics
Under Keynesian model, investment is exogenously determined and is considered to be fixed in

the short run.
Inflationary gap: The amount by which income is more than the full employment level. In other
words, it is defined as the planned expenditure in excess of output available at full employment.
Increase in government expenditure
Full employment of resources; resources will

not increase (DemandFactor > SupplyFactor)
Increase in factor prices
Inflationary pressures
Inflationary gap only generates money income without creating matching real output because economy is
in full employment equilibrium.
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Macroeconomics
Increase in income
Create multiplier effect
Prices increase till extra money income & excess

demand is Absorbed
Deflationary Gap: It is the amount by which income is less than the full employment level.
A point to note here is that Keynes didn’t take into consideration the expectations on the part of
the buyer.
3. New Classicals: Adaptive Expectations/ Regressive Expectations: The theory was given by
Cagan and Nerlove in 1956-57. Other New Classicals were Lucas, Sargeant, Wallace, etc.
 Adaptive expectations: Under

this, people believe that future is in
continuation of the past. As a result,
changes due to government policies
do not take place rapidly. It is a
backward working approach.
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Macroeconomics
 Rational Expectations: The theory was

given by John Muth in 1961. It is a
forward looking approach and people
are considered to be rational. Any errors
in forecasting is random in nature.
Rational Expectations
Weak Hypothesis Strong Hypothesis

(People use all (Subjective value
possible information becomes equal to
and consider it before objective value)
taking any decision)
Assumptions:
a. Full employment
b. Wages and prices are flexible.
c. People will be utility maximisers.
d. Relevant information is available.
e. Imperfect information which can alter the decision making.
f. Inter-temporal utility maximisers, that is, people will maximise utility over a period.
According to the theory, any new policy will be ineffective because it would be anticipated
before it is being introduced. This was known as policy ineffectiveness/irrelevant impotency
theory which was given by Lucas.
Equilibrium will be established at the point where equality is reached between long run
supplies, short run supply and demand.
Long run supply curve will shift if there is a change in the labor, capital or technology.
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Macroeconomics
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Macroeconomics
Even when there is an increase in aggregate demand, the price increases, monetary wages then
decreases, and supply of labour then decreases. As a result, aggregate supply curve shifts and reaches
the full employment level in the long run. Thus, money is super neutral. Any change would only
increase the price level, keeping the output same.
Lucas Critique (1976): Lucas criticized the

macro- econometric models because due to any
policy changes, the models remained invariant. He
believed that the relations in the models should
change with any kind of policy change. He also
stated that econometric models are inconsistent or
unsuitable in explaining the economic relationships
when the policies are changing. The policy should
rather be a surprise to bring some effect in output.
4. Supply Side Economics: Given by Arthur

Laffer
The focus of the theory was on:
a. Increase in Aggregate supply
b. Tax cuts
c. Reducing government spending, that is, reduce budget deficit.
Assumptions of the theory :-
1. Perfect Competition.
2. Wage & Price flexibility Based on classical assumptions
3. Upward sloping supply curve Full employment.
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Macroeconomics
Postulates of Supply side economics

1) Labour supply has a positive slope
2) I = f (r)
3) Interest rate is determined by the supply of savings & demand for Investment funds.
4) Advocate free –enterprise capitalist system with minimum Government intervention.
Central theme of supply side Economics

1) Factor supply & technology determine medium – term Growth Rate of output.
2) Factor supply is determined by post tax return on saving, Investment & work effort.
3) Excessively high rate of taxation reduces tax – revenue, factor supply & prevents growth.
4) Tax cut is the most effective incentives for saving, I & work effort.
5) Excessive control & regulation of business discourages I & efficiency.
Factors responsible for the emergence of this school are:
a. Gulf war crisis in 1973: This was one of the major supply shocks. In gulf war crisis,
Supply Oil price Cost Prices

decreased increased increased increased
overall
b. U.S. was an exporter of agricultural products.

c. Depreciation of dollars, which made imports expensive, increasing the cost of production and
hence supply decreased.
d. Vietnam War: Government funded more on war.
Policy prescription
a. Reduce taxes: The benefits of reduction in tax
cuts are:
 Will give an incentive to work.
 Will give an incentive to save and invest.
 Decrease in underground/ parallel/ black money
economy. People will not evade taxes and this
money can be transferred to productive shelters.
b. Reduce budget deficit: Government spending
should be reduced equal to or more than the tax
cuts.
c. Supply side economists were in favour of
privatisation and deregulation.
d. They were also in favour of free trade.
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Macroeconomics
e. They favoured investment allowances, that is,

increase the investment activities.
f. They were against unemployment allowances given to labour.
g. They were against the trade union activities.
The major drawbacks of this school were:
a. They didn’t consider the negative impact of tax

cuts. Tax cuts would increase the aggregate
demand and hence increase the price level.
b. They didn’t consider the negative impact of
budget deficit. Any kind of tax cuts, would
reduce the public revenue and hence increase
the budget deficit.
c. Following the supply side economics may
increase inequalities.
5. New Keynesians: The term “New Keynesians” was coined by Parkin and Bade in 1982. The
main aim of this school of thought was to improve upon the Keynesian theory. Keynes theory did
not provide any rationale for the wage-price rigidity. Therefore, their main aim was:
a. Provide a rationale behind wage-price rigidity.
b. Provide micro-foundations to macro theories.
Assumptions taken by New Keynesians were:
a. Involuntary unemployment is possible.
b. Imperfectly competitive market structures.
c. Considered both supply and demand shocks.
d. Considered asymmetric information and incomplete labour markets.
e. The New Keynesians have talked about nominal and real wage-price rigidity.
𝐏𝐢
𝐲𝐢 = ( )−𝐞 𝐲
𝐏
Where: (Pi/P)-e is the relative price, yi is the demand, e is the elasticity.
Price would be set with a mark up.

𝐞
𝐏𝐢 = ( ) 𝐌𝐂
𝐞−𝟏
Aggregate output will depend upon real money supply (M/P).
According to New Keynesians,
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Macroeconomics
𝐏̅𝐢
𝐲𝐢 = ( )−𝐞 . 𝐲
𝐏
In other words, relative prices remain constant. So with increase in income, the profits reduce.
Answer:-
a. Prevalence of menu costs, that is, costs of
making the price adjustment.
b. Aggregate price externality: If one price
Why prices are decreases price, the income share of other firms
assumed to be will also increase due to income externalities.
constant? But firms never consider such externalities and
hence do not decrease the price.
c. Price Wars
d. Co-ordination failures: The firms do not co-
ordinate with each other and hence they reach a
recessionary situation.
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Macroeconomics
CONSUMPTION HYPOTHESIS
1. Absolute Income Hypothesis: The theory was given by Keynes in 1936. Also known as
“Fundamental Psychological Law”. He considered a short run consumption function which is
linear in nature.
C = f (Y)
Where: C = consumption, Y = Income
C = a + bY
Where a = autonomous consumption, b = Marginal Propensity to consume (MPC)
Average Propensity to Consume (APC) = C/Y

Marginal Propensity to Consume (MPC) = ∆C/∆Y
According to Keynes, when income increases, consumption also increases but not in the same
proportion. Thus, he assumed that the relationship between consumption and income are non-
proportional and is reversible over time.
Main Features of his theory;

 Short Run Theory
 MPC is constant.
 In short run, APC > MPC. Similarly,
average propensity to save (APS) is less
Let us assume…
than marginal propensity to save (MPS).
 When income increases, APC decreases.
 APC + APS = 1
 MPC + MPS = 1
 0 < MPC < 1
 APC becomes equal to infinity when
income is zero.
 Current level of consumption is a function
of current and absolute level of income.
 MPC declines with increase in income.
 APC declines with increase in income.
 Factors on which consumption function
depends are:
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Macroeconomics
Factors
Subjective Objective
1. Individual motives (which (Factors which shift the
influence consumption). consumption function like
2. Business motives (which rate of interest, windfall
influences liquidity, financial gains or losses, credit
soundness of a firm). policies, etc.
 Long run consumption function was given by Kuznets. It focuses on the proportionality
between consumption and income. The consumption function is expressed as:
C = bY
Empirical evidence suggest that in the long run, the MPC becomes equal to APC and their value
is 0.9.
Criticisms:
1) Based more on introspection than on facts.
2) Properties 0< MPC <1 and MPC decreases with increase in income; failed empirical testing.
3) Kuznets stated that MPC = APC (Based on U.S. Data)
Keynesian consumption function Based on Pre – War data.
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Macroeconomics
2. Relative Income Hypothesis: The theory was given by Duessenberry in 1949. It is different from
absolute income hypothesis in two respects:
a. In relative income hypothesis, the consumption also depends on relative income besides
absolute income.
b. According to relative income hypothesis, the relationship between consumption and
income are irreversible, unlike the case in absolute income.
Duessenberry gave the concept of Demonstration effect:

Households with relatively lower income & living in the community of higher incomes; spend
more proportion of income than the households with high incomes.
The theory was based on imitations, that is, consumption habits of the people will ve influenced
by people around them.
𝒚
Relative Income (Ry) = ̅𝒚̅̅̅ where ̅̅̅
𝒚𝒙 is the mean income.
𝒙
Relative income can also be expressed as:

𝐲𝐭
𝐑𝐲 =
𝐲𝐭−𝟏
Points to note:
̅̅̅𝒙
If y = 𝒚 Ry = 1 APC constant
̅̅̅𝒙
If y > 𝒚 Ry > 1 APC decreases
̅̅̅𝒙
If y < 𝒚 Ry < 1 APC increases
Duessenberry, in his theory, gave the concept of demonstration effect which means that if income
increases then consumption also increases with respect to the consumption pattern of others.
He gave four rules:
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Macroeconomics
1. If income of all households increases, then consumption level

of all households will also increase at the same rate.
• 2. If a household remains at the same scale of relative income and its absolute
income increases, then the absolute consumption and savings will also increase
but MPC and MPS will remain constant.
3. If a household is on the same scale of relative income and

income of other households increases, then MPC will increase,
keeping the income to be constant.
• 4. If a household moves up from a lower income group to a higher income group,

then its MPC decreases.
Duesenberry also introduced the concept “Ratchet Effect”. According to Ratchet Effect,
a. If income increases, consumption increases keeping APC constant.
b. If income decreases, consumption remains constant because of firstly, the demonstration
effect and secondly, a consumer or household gets accustomed to the consumption
standards.
Short run aggregate consumption function of the community is linear because (C/Y) ratio does not
change much due to demonstration effect even when income increases in the short run. Also with
the fall in income, the (C/Y) ratio will not decline that much.
Criticisms:-
1) Not applicable to large changes in income. Change in consumption not proportional to large
changes in income.
2) Consumption in Long run is reversible. People cannot go on dis saving
In recession of 1948-49 in U.S., relationship between consumption & income was negative.
Consumption expenditure increased with decrease in income.
3. Permanent Income Hypothesis: The theory of permanent income hypothesis was given by
Milton Friedman in 1957 in his work “A Theory of Consumption Function”. According to the
theory, the consumption is dependent upon permanent income. Let’s discuss a few terms in brief
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Macroeconomics
Measured
Income (Ym)
Ym = Yp + Yt
Permanent Transitory
Income (Yp) Income (Yt)
Measured
Consumption (Cm)
C m = Cp + Ct
Permanent Transitory
Consumption (Cp) Consumption (Ct)
Assumptions of Permanent income hypothesis:

a. Consumer is rational
b. No covariance between permanent income and transitory income, that is, Cov (Yt , Yp ) = 0
c. No covariance between permanent consumption and transitory consumption, that is, Cov (Ct ,
Cp) = 0.
d. No covariance between transitory income and transitory consumption, that is, Cov (Yt , Ct ) = 0
We mentioned above that permanent consumption is a function of permanent income.
Cp = k. Yp
Where: k = APC
However, k is not a function of Yp. Rather,
k = f (r, H, T, U)
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Macroeconomics
Where: r= rate of interest; H = Proportion of human to non-human wealth, T = Tastes and preferences,
U = variability (or changes in income).
Permanent income is a function of transitory income in period n and in period n-1.
If Yt = Yt-1 Then Yp = Yt = Yt-1
If Yt > Yt-1 Then Yp < Yt
If Yt < Yt-1 Then Yp > Yt
According to permanent income hypothesis, in long run APC is constant. However, in short run, APC
decreases with increase in income.
Short Run MPC < Long Run MPC
APCrich < APCpoor
Criticisms
1. Friend and Kravis stated that MPC decreases when permanent income increases.
2. Some relation exists between Yt and Ct, like in cases of lotteries.
3. Not appropriate according to econometric analysis.
4. Life Cycle Income Hypothesis: The theory was given by Ando, Modigliani in 1957 in their
work “The Life Cycle Hypothesis of Saving: Aggregate Implications and Tests”. According to
the theory, an individual will base his consumption on the lifetime income.
C = f (Ylt, YLTe , w)
Where, Ylt = lifetime income, w = wealth
Assumptions under the theory:
a. Person knows when he will die and when he will enter the labour market.
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Macroeconomics
b. No changes in prices.
c. Consumption level is constant over the lifetime.
d. Little relationship between current income and current consumption.
Consumption depends upon:
a. Resources available to the person.
b. Rate of return on capital
c. Spending age
d. Age at which the plan will be made.
According to the theory, in long run, APC = MPC and it supports Kuznet’s curve and cross-
sectional non-proportional relationships.
In short run, APCrich < APCpoor
Criticisms:
1. Wrong assumptions about death age, etc.
2. There can be uncertainty in assumptions.
3. Unrealistic assumptions of perfect information.
4. Does not assume a higher relationship between current consumption and current income.
5. Not according to empirical evidences.
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Macroeconomics
DEMAND FOR MONEY THEORIES

1. Classical Theory: Classical quantity theory of money was conceived by Jean Bodin in 1568.
A. Fisher’s Quantity Theory of Money: Given by Fisher in 1911 in his book “Purchasing Power of
Money”. According to the theory:
MV = PT
Where: M = Quantity of Money/ supply of money, V =

Velocity of money, P = Price Level, T = Transactions
MV represents the supply of money and PT represents

the demand for money.
Demand for money will be dependent upon the value of
transactions to be undertaken.
Transaction demand, is a constant proportion of income
and is a function of full employment.
Assumptions of Fisher’s Quantity theory of money:

 T is constant because the amount of resourcs and
technology is given.
 V is constant because it is determined by institutional factors.
 Full employment of resources.
 Money is exogenously determined.
 V is independent of changes in M, P, T.
 Money supply is autonomous of changes in price level, that is, money supply is not affected by
price level. Also, changes in money supply precede price changes.
 Considers both final and intermediate goods.
Fisher expanded the equation:

Included money supply created by banks in their credit creation process.
MV + M1 V1 = PT
M1 = Total Bank deposits subject to transfer by cheques.
V1 = average Velocity of circulation of bank deposits.
Conclusion: - P = MV/T, keeping V and T as constant

Any increase in money supply  increase in Price level.
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Macroeconomics
B. Income Version of Quantity Theory of Money

The theory emerged because there is a difficulty in measuring the price level (P) and number of
transactions (T) in the case of Fisher’s quantity theory of money.
This theory states that;
MV = PY
Where: M = Quantity of Money/ supply of money, V = Velocity of money, P = Price Level, Y =
Income
The theory replaced velocity of circulation with income velocity, that is, number of time a unit of
money is used for making payments involving the final goods.
Income version only considers final goods. Also demand for money is dependent on real income
or real output.
According To the theory;  in money  Proportionate rise in prices.
AD , no
Supply of  cash balance  spending on change in AS
Goods & (Production Increase in price
money with the people Services
Cannot  in SR)
C. Cambridge Version/Neo-Classical/Cash Balance Approach:
The approach was initially given by Alfred Marshall and later modified by Pigou, Robertson,
Keynes. According to them, price level is affected only by that part of the money which people hold
in the form of cash for transaction purpose, and not by total money supply, that is, MV which was
suggested by Classical theory.
According to the theory,
Md = kPy
Where: Md is the demand for money, k = proportion of income held for transaction purposes, P =
Price level, y = Real income.
Besides the medium of exchange function of money, the Cambridge approach also considered the
store of value function. Moreover, they also recognised the role of rate of interest and wealth but
didn’t include it in the model.
ROBERTSON’S EQUATION FOR DEMAND FOR MONEY

M = Pk T
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Macroeconomics
Where: M = Quantity of money, P = Price level, k = proportion of total amount of goods and services
which people wish to hold in the form of cash balance, T = Total Volume of G & S Purchased during a
year.
PIGOU’S EQUATION
P = KR/M
Where P = Value of money, K = Prop. of total real resources or income (R) which people wish to hold in
the form of titles to legal tender units of legal tender, M = Number of actual units of legal tender.
Difference between Pigou Equation & Robertson Equation
Total Real Resources Volume of Total
k = 1/V, that is, k is the inverse of velocity of

circulation of money.
Money and prices are directly related to each other.
 Income elasticity (ey) and price elasticity (ep)
is equal to one.
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Macroeconomics
Difference between Fisher’s Approach and Cambridge Version of Quantity theory of

money
Fisher’s Approach Cambridge Version
It considers only medium of exchange It consider both medium of exchange and

function of money. store of value function of money.
In this, ‘V’ was based more on the In this, ‘k’ was based more on the behaviour
institutional factors. depending upon the individual’s action.
2. Keynesian Theory of Demand for Money

It is simply an extension of the Cambridge Version. Keynes introduced three motives for Demand
for Money
Transactionary motive
Money is demanded for day to
day transactions.
(Demand for money is a function
of Income)
MT = f (Y)
Precautionary motive
Money is demanded for some
Motives of Demand for unforeseen events
Money (Demand for money is a function
of Income)
Mp = f (Y)
Speculative Purpose
Money is demanded for
investment purposes
(Demand for money is a function
of rate of interest)
MS = f (r)
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Macroeconomics
There is a negative relationship between demand for money and rate of interest because of the following
process:
Rate of Bond Demand

interest prices for money
increase decrease is low
Note: If the bond prices are high, a consumer would want to sell it. If bond prices are low, consumer would
want to buy the bonds.
Liquidity Trap
Under the state of liquidity trap, the interest rate is so low that the demand for money becomes infinitely
elastic. Moreover, the supply of money will not affect the rate of interest and income.
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Macroeconomics
Criticism
1. Unrealistic division of demand for money
2. Unrealistic assumption that people hold money either in the form of cash or bonds.
In reality, people hold a combination of the two.
3. Baumol’s Inventory Theoretic Approach: The theory was given in Baumol’s famous work “The
Transaction Demand for Cash and Inventory Theoretic Approach” in 1952.
Different from Keynes theory:-
1. Keynes  Mt,Mp, Msp Separately
Baumol  Together as Real cash Balance
2. Keynes  Demand for money = f (Y, i)
Baumol: Demand for money = f (Y, I, cost of transforming real cash balance into interest bearing
bonds)
3. Keynes = Mt is not a f (i) while in case of Baumol, Mt = f (i).
Following are the assumptions in the approach:

a. Individuals receive the income only once per unit of time, like monthly, annually, etc.
b. An individual spreads his/her expenditure in a uniform manner over the period of time.
c. Individual makes a combination of both cash and bond so as to minimise his cost.
d. Individual lives in a certain environment where he is perfectly aware about the
consequences.
In short, in the theory given by Baumol, individuals hold money as a form of inventory optimum
cash holding. Opportunity cost of holding money is the interest income foregone. If interest rate
on assets increase, then people readjust their portfolio by transferring money towards those assets.
Overall, individuals would hold money in the form in which their cost is minimum.
Cost is defined as:
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Macroeconomics
Cost
Interest Brokerage
income fee
foregone
Abbreviations:
y = Individual’s salary
C = Average cash withdrawal/Average money holding
t = number of times the individual visits the bank
b = brokerage fee paid per visit
r = rate of interest
𝐶
Opportunity cost = 2 ∗ 𝑟
Brokerage fee = bT
Where T = y/2
𝑪 𝒃.𝒚
Total cost = ∗ 𝒓 +
𝟐 𝟐
The demand for money formula is:
𝟐𝒃𝒚
DDm = √ which is also known as the Square Root Formula
𝒓
If b is very high, then the individual demands more money.
If r is high, then individual’s demand for money is less.
4. Friedman’s Restatement of Quantity Theory of Money: The theory is based on the Cambridge’s
quantity theory of money. It is also known as the ‘Modern Theory of Demand’ or ‘Capital
Theoretic Approach’.
According to Friedman, demand for money is the most stable function, contrary to Keynes’
thoughts who said that demand for money is unstable.
Friedman treats money as a capital good, and expresses demand for money as follows:
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Macroeconomics
Md = kPy
Where: Md is the demand for money, k = people’s desire to hold money in the form of cash and is
taken in the ex-ante form, P = Price level, Y = Income
Further, he stated that k is a function of:

a. rm (Rate of interest on income)
b. rb (Rate of interest on bonds)
c. re (Rate of interest on equities)
Therefore; OK?????
Demand for Relation with the
money is a demand for
function of money
Rm Negative
Rb Negative
Re Negative
Py Positive
According to Friedman, Real Demand for Money ( Md/P) is a function of:
Factor Relationship with the real demand for

money
Wealth (W) Positive
Proportion of Human to Non-Human Positive

Wealth (H)
Price Level (P) Positive
Rate of Inflation Negative
Rate of interest Negative
Emperically, Friedman found that Income elasticity for demand for money is greater than one
while interest elasticity is negligible.
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Macroeconomics
5. Tobin’s Theory of Interest Elasticity of Transaction Demand for cash: The theory was given
in 1956. It is based on the Liquidity Preference Behaviour towards risk. The theory, unlike the
previous ones, considers both risk and return.
Assumptions taken under this theory:

a. People want to maximise utility which
is function of wealth and risk.
b. Individuals can hold both cash and
bonds.
c. People are diversifiers, that is, they hold
mixture of different securities.
d. Individuals treat risk to be bad and
return to be good.
e. Return from money holding is zero.
f. Prices are constant.
6. Baumol-Tobin Theory: Baumol and Tobin together gave a theory for demand for money to prove
that income elasticity for demand for money is less than one; and change in demand for money is
less than the change in income.
According to them,
Bond Holding = f (Income, number of bond transactions)
𝒏−𝟏
Average Bond Holding (ABH) = ∗𝒚
𝟐𝒏
𝒚 (𝒏−𝟏)
Average Cash Holding (ACH) = 𝟐 − ∗𝒚
𝟐𝒏
Cost = n*a
Where n = number of bond transactions, a = cost of transactions
Revenue = rate of interest * ABH
When r increases, cash holdings decreases and people prefer to keep money in the banks, and thus
demand for money decreases.
When Income increases, both bond holdings and cash holdings increase. However, increase in cash
holding is less than the increase in bond holdings. This implies that income elasticity of demand
for money is less than one.
Empirically they calculated the values as:
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Macroeconomics
Income elasticity for demand for money 0.5
Interest elasticity 0.5
I understand
now 
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Macroeconomics
INVESTMENT THEORIES
1. Keynes Theory of Investment: Investment can be of two types:
Investment
Financial
(Shares and bonds, Real
etc. There is no (It implies addition in
addition or creation of capital stock)
capital)
Fixed Residential Inventory

(Example Machinery) (Example: Housing) (Adding stock of
capital)
Keynes in his theory talks only about Real Investment.
Also, investment can either be autonomous (independent of level of income) or induced (function
of income). Therefore, Keynes gave the Investment function as follows:
I = f (MEC, r, business expectations)
Where:
I = Investment
MEC = Marginal Efficiency of Capital (negative relationship with investment)
r = rate of interest
There were two views about MEC. First view was given by Fischer who in 1963 stated that MEC is
dependent on the profit generated. Second view was given by Keynes who said that MEC is
dependent on the expected return. It is the rate of discount which would make prospective yield
equal to its supply price, that is, which makes return = cost.
MEC curve shows us the optimal capital stock corresponding to different rate of interest.
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Macroeconomics
According to Keynes, while considering MEC, rate of interest is relatively sticky. Moreover, MEC
declines with increase in investment because of two reasons:
a. Prospective yield with time decreases.
b. Supply price increases.
Keynes stated that business expectations can either be short run or long run (expectations regarding
consumer demand, uncertainty).
If expectations change, curve shifts, that is,
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Macroeconomics
Factors affecting business expectations are:

a. Price level
b. Government policy
Investment decisions would be taken up considering three factors: MEC, r, business expectations
If MEC > r Investors will invest
If MEC < r Investors will not invest
So equilibrium is attained when MEC = r
Marginal Efficiency of Investment (MEI): It reveals investments at different rates, given the
optimal stock.
MEI curve shows the investment demand for the entire community at different rates of interest.
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Macroeconomics
2. Accelerator Theory
Clark gave the accelerator principle and this theory was propounded way before Keynes.
Before studying the accelerator theory, we need to understand the idea behind multiplier and
accelerator
Multiplier Change in investment leads to a

change in income
Accelerator Change in income leads to a change in
investment.
Therefore,
I = f (y)
Kt = v (yt)
Where v = accelerator
Taking the first difference, we get;
Kt – Kt-1 = v (yt – yt-1)
It = v (∆y)
(Change in capital stock is equal to investment.Therefore, Kt – Kt-1 = I)
It/∆y = v = Accelerator
Acceleration theory of Investment describes a technological relationship between the change in
capital stock & the change in level of output.
Assumptions:
1. C-D production function
2. Factors of production are homogenous & perfectly divisible
3. Factor market is competitive & factor prices are given
4. Firms produce with least cost combination of inputs
5. No excess production capacity
6. Firms’ calculation about the future demand is fairly accurate
7. No financial constraint & funds are easily available
a. Fixed Accelerator Model: Assumptions of the model are:

 Accelerator (v) will be fixed
 No time lags in Investment decisions
 Instantaneous adjustment
 Excess capacity in Investment sector, that is, unutilised capital stock.
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Macroeconomics
b. Flexible Accelerator Model:

It considers both optimal (desired) capital
stock and Actual capital stock and there is a
gap between them.
Kt+1 – Kt = λ (K* - Kt)
Where: λ = speed of adjustment, K* is the
optimal capital stock
However, there is just partial fulfilment in the
gap.
Moreover, λ is negatively affected by the rate
of interest.
Investment are less volatile.
c. Capital Stock Adjustment:

 There are lags present.
 Gap between optimal and actual is to be filled.
 Immediate adjustment would be more costly.
 Per period addition is made.
3. Neo-Classical or Jorgenson’s theory of Investment:

The theory helps determine the desired level of capital that any firm would want to hold. The
theory used a Cobb-Douglous Production function.
Assumptions of the model:

a. Full employment in the economy.
b. Perfect Competition, which implies perfection in the financial market.
c. Capital units are homogenous.
d. No uncertainties.
e. No adjustment costs.
f. Investment decisions are flexible before and after the decisions are taken.
g. Marginal productivity of labour and capital are positive.
The model uses the following production function:
y = AKαL1-α
𝐀𝐲 𝐫
𝐌𝐏𝐊 = =
𝐊 𝐏
Where r = rental, P = Price level, r/P = user cost
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Macroeconomics
𝐏
𝐃𝐞𝐬𝐢𝐫𝐞𝐝 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐬𝐭𝐨𝐜𝐤 = 𝐊 = 𝐀𝐲.
𝐫
Equilibrium would be attained were MPK = r/P
If MPK > r/P Invest

If MPK < r/P Not invest
4. Tobin’s Q Theory: The theory was given in 1969.
𝐌𝐚𝐫𝐤𝐞𝐭 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐢𝐧𝐬𝐭𝐚𝐥𝐥𝐞𝐝 𝐜𝐚𝐩𝐢𝐭𝐚𝐥

𝐓𝐨𝐛𝐢𝐧 𝐐 =
𝐑𝐞𝐩𝐥𝐚𝐜𝐞𝐦𝐞𝐧𝐭 𝐯𝐚𝐥𝐮𝐞 (𝐜𝐨𝐬𝐭)
If Q > 1 Invest because market valuation is

higher
If Q < 1 Disinvest because cost is higher
5. Cash Flow Theory: Given by Duessenberry
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Macroeconomics
MULTIPLIER
The first concept of multiplier was given by R.F. Kahn in 1931, namely Employment Multiplier.
Employment multiplier shows the impact on total employment with increase in primary employment.
Investment Multiplier
The concept was given by Keynes and is also known as ‘Closed Economy Multiplier’. The investment
multiplier shows the change in income due to change in investment.
∆𝐲 𝟏 𝟏 𝟏
= = =
∆𝐈 𝟏−𝐛 𝟏 − 𝐌𝐏𝐂 𝐌𝐏𝐒
According to Keynes, repeated investment needs to be done.
Assumptions taken by Keynes were:

1. MPC constant
2. Closed economy
3. Ignored induced investment and accelerator effect.
4. Excess capacity in consumer goods industry.
5. No excess capacity in production sector.
Main features of investment multiplier are:
1. Higher MPC implies higher value of multiplier.

2. Multiplier can reduce due to leakages like savings,
government taxes, imports, etc.
3. Value of the multiplier lies between 1 and infinity.
Foreign Trade Multiplier
The foreign trade multiplier implies that with increase in exports, what is the impact on income, that is by
how much does the income increase.
Assumptions under Foreign Trade Multiplier
1. Open Economy
2. Works in both forward and backward directions.
3. Exports are autonomously determined.
4. Imports are a positive function of income.
5. Consumption is directly related with income.
6. No accelerator
7. No government taxes
8. Fixed exchange rates.
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Macroeconomics
∆𝐘 𝟏
𝐅𝐨𝐫𝐞𝐢𝐠𝐧 𝐓𝐫𝐚𝐝𝐞 𝐌𝐮𝐥𝐭𝐢𝐩𝐥𝐢𝐞𝐫 = =
∆𝐗 𝐌𝐏𝐌 + 𝐌𝐏𝐒
Where MPM = Marginal Propensity to Import, MPS = Marginal Propensity to Save.
Point to Note:
Keynes Multiplier > Foreign Trade Multiplier
Super Multiplier
The concept of Super Multiplier was given by Hicks. He considered both induced and autonomous
investment.
Change in Change in Change in

autonomous income induced
investment investment
I = A + iy
Where i = propensity to invest, A is the Autonomous investment, y = income.

𝟏
𝐌𝐮𝐥𝐭𝐢𝐩𝐥𝐢𝐞𝐫 =
𝐌𝐏𝐒 − 𝐌𝐏𝐈
Where: MPI = Marginal Propensity to Invest
Point to note:
Super Multiplier > Investment Multiplier
Balanced Budget Multiplier
Assumptions:
 Taxes are only autonomous and lump sum.

 Government purchases of goods and
services are included and not the transfer
payments.
 Government expenditure and tax do not
affect the investment activity.
1. Government Purchases Multiplier: It reflects the

change in income due to change in government expenditure.
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Macroeconomics
∆𝐘 𝟏
=
∆𝐆 𝟏−𝐛
Where b = MPC
2. Tax Multiplier: It reflects the change in income due to change in taxes.

∆𝐘 −𝐛
=
∆𝐓 𝟏−𝐛
Taxes imposed will reduce the consumption partially.
Point to Note:
Tax Multiplier < Government Multiplier
3. Balanced Budget Multiplier

𝐁𝐚𝐥𝐚𝐧𝐜𝐞𝐝 𝐁𝐮𝐝𝐠𝐞𝐭 𝐦𝐮𝐥𝐭𝐢𝐩𝐥𝐢𝐞𝐫 = 𝐆𝐨𝐯𝐞𝐫𝐧𝐦𝐞𝐧𝐭 𝐦𝐮𝐥𝐭𝐢𝐩𝐥𝐢𝐞𝐫 + 𝐓𝐚𝐱 𝐌𝐮𝐥𝐭𝐢𝐩𝐥𝐢𝐞𝐫
𝟏 −𝐛
𝐁𝐚𝐥𝐚𝐧𝐜𝐞𝐝 𝐁𝐮𝐝𝐠𝐞𝐭 𝐌𝐮𝐥𝐭𝐢𝐩𝐥𝐢𝐞𝐫 = + =𝟏
𝟏−𝐛 𝟏−𝐛
Some important formula:
Tax Multiplier with induced

−𝒃
taxation/Proportional tax =
𝟏−𝒃−𝒃𝒕
Where t= tax rate
Balanced Budget multiplier with induced
𝟏−𝒃
taxation = 𝟏−𝒃−𝒃𝒕
𝒃
Transfer Payments Multiplier = 𝟏−𝒃
An important point to note here is that

balanced budget multiplier is equal to one
only in case of lump sum taxes. In case of
proportional tax, the balanced budget
multiplier is less than 1.
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Macroeconomics
4. Static and Dynamic Multiplier

Static Multiplier is also known as simultaneous multiplier or logical multiplier. It reflects how
income responds immediately to the change in investment. Example: Keynes multiplier is a static
multiplier.
Dynamic Multiplier: It is also known as sequence/period multiplier.

∆I = ∆y (1+b+b2 + b3 + ….. + nn-1)
Ultimately,
∆I/ ∆y = 1/(1-b)
Dynamic multiplier tells us that over the time consumption decreases.
Econometrics……Ind
ian Economy…..
Developmental….
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Macroeconomics
TRADE CYCLES
Trade Cycles are the alternate phases of business activity. They are universal, periodic and synchronous
in nature. Profits are majorly affected by Trade cycles.
Trade cycles can be graphically presented as:
Phase 1: Recovery Phase (Lower turning point)
Phase 2: Prosperity/Upswing/Expansion Phase. It is the cumulative effect of recovery.
Phase 3: Boom: It is the peak level, that is, the topmost level of expansionary phase. The economy
experiences this phase when it has crossed the full employment level. At one side, when the economy
shows signs of prosperity, on the other hand, boom is a symptom of downswing.
Phase 4: Recession (Upper turning point): The stage lies between prosperity and depression. The
process followed under this is:
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Macroeconomics
Increase in Decrease Decrease Shut down

interest in in Income the
rate Investment production
Phase 5: Depression: It is the extreme case of recession.
Phase 6: Trough: It is the lowest point of economic activity.
Theories of Trade Cycle
1. Samuelson’s Theory of Trade Cycle: The theory was given in 1939. Samuelson used the concepts
of both multiplier and accelerator. According to him,
Increase in Increase in income Increae in induced

autonomous (due to effect of investment (due to
investment multiplier) the effect of
accelerator)
According to Samuelson, cycles can be explosive in nature. He assumed different values of

multiplier and accelerator and considered a one period lag. Also he treated MPC to be constant.
Samuelson talked about 5 situations:

a. Cycleless Growth Path: MPC = 0.5 Accelerator = 0
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Macroeconomics
b. Damped Fluctuations/ Oscillations: Magnitude is decreasing. It is not consistent with real

situations.
MPC = 0.5 and Accelerator = 1
c. Constant Amplitude Cycle: It is not realistic.

d. Anti-damped/ Explosive Cycles: It assumes no buffers could control the cycles.

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Macroeconomics
e. Cycleless Growth Path: It goes away from the equilibrium path, either in increasing
direction or decreasing direction. Cycles are not generated.
2. Hicks’ Theory of Trade Cycle: The theory was given in 1950 in Hicks work namely “A
Contribution to the Theory of Trade Cycles”. His theory is also known as “Constrained Cycles
Theory”. He used buffers in his theory and stated that both the multiplier and the accelerator will
lead to the generation of cycles. However, according to him, the explosive cycles can be controlled,
which was not given in the theory by Samuelson.
Following are the concepts used in his

theory:
a. Multiplier-Accelerator
b. Induced Investment
c. Warranted rate of growth
Assumptions taken in the theory are:
a. Autonomous investment grows at a

constant rate.
b. Economy remains in the state of moving
equilibrium.
c. There is a maximum level or ceiling to
the output expansion.
d. Hicks uses the concept of warranted rate
of growth (output ceiling).
e. There is a restraint on the downward movement of investment and income (Lower ceiling).
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Macroeconomics
f. Multiplier-accelerator values are constant.

g. Investment level will be positive. Some investment will be there in the economy.
Where:
Max Y = Full employment ceiling level
Y* = Equilibrium growth path
Min Y = Floor ceiling/ slump equilibrium
I0ent = Autonomous Investment: It is determined by capital stock. It determined the quantum of

labour with the help of multiplier.
Growth path would be determined by multiplier and accelerator.
In the diagram, movement from:
1 to 2 : Expansion
2 to 3: Boom (Investment lag): Investment lag occurs because investment does not increase with
that pace as compared to the Growth path
3 to 4: Recession
5 to 6: Depression (represents excess capacity)
6 to 7: Recovery
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Macroeconomics
3. Kaldor’s Theory “A model of Trade Cycle”: The theory was given in 1940. Kaldor uses the
concepts of savings and investment in the ex-ante form. He assumes a non-linear saving and
investment curve because they cannot be treated as constant. Moreover, with linear functions, the
trade cycles won’t be reflected.
Kaldor also stated that trade cycles are self-generating.
Points b, c are the points of stable equilibrium and a is the point of unstable equilibrium.
Expansion process will generate when a and c are in the process of co-incidence and will stop when
these points coincide.
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Macroeconomics
PHILLIPS CURVE
The concept of Phillips Curve was given by A.W. Phillips in 1958. Originally the relationship was
estimated between wages and unemployment. It was stated that there is a negative relationship between
the two.
If workers can push the wages beyond their productivity, then it will lead to the change in price level.
∆𝐖 ∆𝐲 ∆𝐏
> 𝐢𝐦𝐩𝐥𝐢𝐞𝐬
𝐖 𝐲 𝐏
Later on, Phillips curve was established showing a negative relationship between rate of inflation and rate
of unemployment.
Following assumptions were taken into consideration:

1. Phillips curve is a short run curve and static in nature.
2. No expectations
3. It is downward sloping and takes the shape of a rectangular hyperbola.
4. Non-linear relationship.
5. Stable in nature.
6. There is a constant trade-off.
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Macroeconomics
Expansionary Policy Decrease in unemployment rate
Increase in rate of inflation
Contractionary Policy Increase in unemployment rate.
Decrease in rate of inflation.
Theoretical Explanations for trade-off between Rate of price level (∆P/P) and Rate of
unemployment (∆U/U)
1. Lipsey (1960): According to Lipsey, wages are directly related with excess demand.
Unemployment and excess demand are inversely related.
W = f (Nd – Ns)
Where: Nd = Demand for labour, Ns = Supply of labour, Nd – Ns = Excess demand for labour, W
= Wages.
2. Phelps: Phelps gave a theory named “Theory of Collective bargaining/ Trade Unionisation”.
According to him, monetary settlements are through collective bargaining. Wages are indirectly
related to unemployment.
High Less power Decrease in

unemployment with the trade wages
rate union
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Macroeconomics
3. Keynes Dynamic analysis of price-output determination: According to Keynes, if there is an

increase in aggregate demand, it will be distributed between price level and unemployment. In
other words, with increase in aggregate demand, the price level will increase, while unemployment
rate will decrease.
4. Aggregative nature of data: According to this, the settlements are made through demand-supply
interaction.
If DL > SL Wages Increase

Unemployment decrease
If DL < SL Wages are kept constant

Unemployment increase
Policy Implications
There can be two types of policies which can be followed:
Increase in
Inflation
Expansionary
Policy
Decrease in
Unemployment
Policy
Decrease in
Inflation
Contractionary
Policy
Increase in
Unemployment
Long Run Phillips Curve
The Long-Run Phillips Curve was given by Milton Friedman. It is also known as Augmented Phillips
Curve or Adaptive Expectations Phillips Curve.
It is expressed as:
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Macroeconomics
W = U + λPte
Where: W = Wages, U = Unemployment, λ = Speed of adjustment, Pte = Price expectations.
It should be noted that:
λ = 1 would imply perfect expectations
λ = 0 in the short run
λ < 1, according to Tobin.
In the long run, there are factors which shift the curve Pe – P.
Natural Rate of Unemployment (NRU): The concept of NRU was given by Milton Friedman while it
was given a new name by Tobin which is “Non-Accelerating Inflation Rate of Unemployment (NAIRU)”.
It is the rate at which there is no gap between actual and expected inflation. In other words, inflation is
stable at that point.
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Macroeconomics
Suppose if we adopt expansionary policy. The unemployment would reduce to U2 level and inflation is
3.5%. So labour will demand wages according to 3.5% because they haven’t realised the inflation. But
when they do, they demand higher wages and Phillips curve would then shift to SRPC 2. Long run Phillips
curve will show that there is no trade off between inflation rate and unemployment rate. Any change in
the policy would only lead to increase in the inflation rate.
PHILIPS CURVE (LR)

1. Tobin’s
2. Solow’s
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Macroeconomics
Curve vertical at positive rates of inflation & horizontal at negative rates.
Ekstein-Brinner’s Phillips Curve: According to this, there is no trade-off till NAU but beyond that there
is a trade-off.
Decrease in unemployment rate below the natural rate is possible only if there is a time lag between money
wages and price levels.
Stagflation is a situation in which prices increase without increase in employment and output levels.
Policy implication of Long run Philips curve

1. Minimum level of unemployment which the economy will have to tolerate.
Can be reduced but for a short while at the cost of inflation.
2. Contain unemployment below its natural rate
&
Corresponding inflation rate

Highly Unproductive
IS-LM MODEL
The IS-LM Model was given by Hicks and Hansen in 1937. It reflects on the simultaneous integration of
the two sectors.
Product Market
IS curve shows equilibrium in the product market.
All the points on the IS curve show Saving = Investment and Aggregate Demand = Aggregate Supply.
Also there is a negative relationship between rate of interest and income.
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Macroeconomics
Fall in rate Increase in Increase in Increase in

of interest Investment Aggregate income
Demand
Conditions of IS:
y = Aggregate Demand (AD)
AD = C + I + G + (X – M)
Where C = consumption, I = investment, G = government expenditure, X = Exports, M = Imports
C = a + by
I = IA – id
Substituting the above equations in AD,
̅ + ̅̅̅̅̅̅̅̅̅̅̅
𝐲 = 𝐚̅ + 𝐛𝐲 + 𝐈̅𝐚 − 𝐢𝐝 + 𝐆 (𝐗 − 𝐌)
Considering all the autonomous terms together to be A, we get
y – by = A – id
y (1-b) = A – id
𝐀 − 𝐢𝐝
𝐲=
𝟏−𝐛
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Macroeconomics
Slope of IS Curve depends upon:
1. Interest elasticity of Investment Demand: Small changes in interest rates, lead to larger changes
in Investment. Higher the interest elasticity of demand, flatter will be the IS curve and vice versa.
2. Size of the multiplier: More the size of the multiplier, flatter will be the IS curve and vice-versa.
IS curve shifts when the autonomous elements changes.
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Macroeconomics
Money market
Money market equilibrium is represented by LM
Curve. At all points on the LM curve, demand for
money is equal to the supply of money. We assume
that the supply of money is exogenously
determined by the bank or Central authority.
We know that,
Md = f (y, i)
(Money demand is a function of income and rate

of interest)
𝐌𝐝
= 𝐤𝐲 − 𝐢𝐡
𝐏
𝐌𝐝
𝐢𝐡 = 𝐤𝐲 −
𝐏
From the above equation, it is evident that i and y are positively related. The process can be explained as
follows:
Sell bonds, which Because demand

Increase in Demand for reduces the price for bonds is now
income money increases of bonds less, the interest
rate increases
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Macroeconomics
Slope of LM curve depends upon:

1. Income elasticity of demand for money: More the income elasticity of demand for money,
steeper will be the LM curve and vice-versa.
2. Interest elasticity of demand for money: Lesser the interest elasticity of demand for money,
steeper the LM curve and vice versa.
Effectiveness of policy using IS-LM Curve
1. Monetary Policy
a. Monetary policy is more effective when LM Curve is steeper.
Reason: Money supply is more powerful in bringing a greater fall in rate of interest.
Monetary policy is more effective when IS curve is flatter.
Reason: Investment expenditure is highly interest elastic and due to this increase in money
supply decreases the rate of interest and ultimately increases the investment by a larger amount
and so does brings a rise in income.
b. Monetary policy is less effective when LM curve is flatter.

Reason: Rates are changing less times.
Monetary policy is less effective when IS curve is steeper.
Reason: Low interest elasticity of investment. As a result, investment will not rise much with
the change in rate of interest.
c. Monetary policy is totally effective when LM curve is a vertical line.

Reason: Rates will fall drastically and demand for money is perfectly interest inelastic.
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Macroeconomics
Monetary policy is totally effective when IS curve is horizontal.

Reason: Perfectly interest elasticity of investment.
d. Monetary policy is totally ineffective when LM curve is horizontal.

Reason: Liquidity trap; Increase in money supply has no impact on the rates or income.
Monetary policy is totally ineffective when IS curve is vertical.
Reason: Perfect inelasticity of investment.
Effectiveness of Monetary Policy
Shape of LM curve Shape of IS curve Effectiveness
Steeper Flatter More
Flatter Steeper Less
Vertical Horizontal Highly effective
Horizontal Vertical Totally ineffective
2. Fiscal Policy
a. Fiscal policy is more effective when IS curve is steeper.
Reason: Investment demand is less interest elastic. So with fiscal
expansion, rates won’t fall much.
Fiscal policy is more effective when LM curve is flatter.
Reason: Demand for money is more interest elastic. So rate of interest do
not rise that much.
b. Fiscal policy is less effective when IS curve is flatter.

Reason: Investment demand is more interest elastic. So with fiscal
expansion, rate of interest will rise more and Investment and income would
decrease.
Fiscal policy is less effective when LM curve is steeper.
Reason: Demand for money is interest inelastic and there is crowding out.
c. Fiscal policy is totally effective when IS curve is vertical.

Reason: Perfectly interest inelastic investment demand.
Fiscal policy is totally effective when LM curve is horizontal.
Reason: Perfectly interest elastic demand for money. So income rises by full multiplier of the
increase in government expenditure and interest rates are not impacted.
d. Fiscal policy is totally ineffective when IS curve is horizontal.
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Macroeconomics
Reason: Perfectly interest elastic investment demand. If there is an increase in

government expenditure, income will not be affected.
Fiscal policy is totally ineffective when LM curve is vertical.
Reason: Demand for money is interest inelastic.
Effectiveness of Fiscal Policy
Shape of IS Shape of LM Effectiveness
Steeper Flatter More
Flatter Steeper Less
Vertical Horizontal Highly effective
Horizontal Vertical Totally ineffective
Monetary Policy
In the Keynesian range, monetary policy is completely ineffective and will not change the rate of interest.
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Macroeconomics
In the intermediate range, policy is less effective than the classical range and more effective than the
Keynesian range.
In the Classical Range, monetary policy is highly effective because income’s magnifying impact is very
high.
Fiscal Policy
In the Keynesian range, fiscal policy is highly
effective.
In the Intermediate range, fiscal policy is less

effective as compared to the Keynesian range
and more effective as compared to the
Classical Range.
In the Classical range, fiscal policy is totally

ineffective. Entire impact is on the rate of
interest and no change in income.
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Macroeconomics
MONEY
Functional definition of money Currency (C) + Demand
Deposits (DD)
(narrow definition)
Broader definition C + DD + Time Deposits

(TD)
Definitions of Money
Classical/ Conventional definition Money = C + DD
Given by Marshall
Chicago School Money = C + DD + TD
Given by Milton Friedman
Gurley-Shaw Approach Money = weighted average of all the assets
(According to them, TD and savings (Weights are given according to their

deposit can be substituted) liquidity)
Liquidity Approach/ Central Bank Money = state of liquidity in the economy.

Approach
(Given by Radcliff)
High powered money  Currency issued by Central Bank and is supported by Reserves
India Adopted Minimum Reserve System in Oct. 1956

Presently 200 crores

115 crore in Gold other in rupee securities
Measure of High Power Money ss in India
H = C + R + OD
Currency Approx 1% of total money Supply

Held by public
And R is the cash reserves of commercial banks
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Macroeconomics
Commercial Banks and Money Creation
Money supplied by
banks in credit money
Primary Deposits
1. HH savings
2. Payment received from central
bank for Sale of Govt. Bonds
3. Payment received from abroad & Secondary/Derivative
deposited c bank
4. Money deposited for convenience in
transaction
DETERMINANTS OF MONEY SUPPLY

1. Required Reserve Ratio = Sum of currency in the hands of public (c)
+
Cash Holdings & deposits at the Central Bank (R)
2. Level of Bank Reserves = reserve ratio Commercial Banks /Deposit Liabilities
3. Public’s Desire to hold currency & deposits
Measures of Money Supply
These measures were adopted by our economy in 1977.
M1 = C + DD + Other deposits
M2 = M1 + Savings with the post office
M3 = M1 + TD
M4 = M3 + Post office savings (excluding NSC)
Revised Monetary Measures

M1 = Currency + DD + OD
M2 = M1 + Time liabilities position of savings deposit with banks + certificate of deposits (CDS) +
Term Deposits, maturity within a yr.
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Macroeconomics
M3 = M2 + Term deposits with banks with maturity of over ones year + call/term borrowing of the
banking system.
Liquid Resources
L1 = New M3 + All deposits of Post Office savings Banks excluding NSCs.
L2 = L1 + Term deposits c term lending inst. & refinancing inst. + term borrowing by FIs.
L3 = L2 + Public deposits of non-banking financial inst.
Money Multiplier
Formula:
M = mH
Where: M = money supply, m = money multiplier, H = High
Powered money
M = C + DD
H = C + Reserves (R)
R = Required reserves + excess reserves
Money multiplier ‘m’ tell us that with change in H, how much will the money supply in the economy
change.
Determinants of Money multiplier

𝐌 𝐂+𝐃
=
𝐇 𝐂+𝐑
Dividing the numerator and denominator by D, we get
𝐶
𝑀 𝐷+1
=
𝐻 𝐶 +𝑅
𝐷 𝐷
Factors determining the money supply:
1. C/D is the currency deposit ratio which has a negative relationship with the money supply.
2. R/D is the reserve deposit ratio and has a negative relation with the money supply.
3. Proximate/Ultimate factors: like CRR, SLR, affect C/D, R/D
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Macroeconomics
Systems of Money
1. Barter System: Exchange in terms of goods which was known as commodity money. Problems
under this system was:
 No durability
 No portability
 Not homogenous
2. Metallic Coins: It is a full bodied money. Money value is equal to the intrinsic value or commodity
money.
3. Credit Money: Commodity value is nil. Money value if much greater than commodity value.
INFLATION
Concepts of Inflation
Type of Inflation Inflation rate
Creeping Inflation Around 3%
Trotting 3-7 percent or less than 10%

inflation/Crawling/
walking
Running Inflation 10-20%
Hyperinflation/Runaway Above 20%

inflation
Inflation rate in India: 5.01% (as in May 2015)
Causes of Inflation
1. Excess demand: According to monetarists, with the increase in money supply, there would be a
rise in the price level. On the other hand, Keynesians stated that price would rise only after demand
reaches income.
2. Cost push inflation: Cost of production increases. Studies with respect to trade union activities.
3. Profit-push inflation: It is also known as Administered pricing inflation or pricing power
inflation. It is studied from the employer’s side who increase the price above the cost of production
to increase their own profits.
4. Structural inflation: It is caused due to rigidities in the economy.
5. Mark-up inflation: It was given by Professor Ackley. Wages of workers are administered by
labour and employers together. Employers keep price above the cost. On the other hand, labour
keeps a mark up of its wages above their minimum living requirements.
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Macroeconomics
6. Sectoral Inflation/Demand shift rigidities: It was given by Charles Schultz. Such kind of an
inflation is caused due to downward rigidities in wages. If there is excess demand, prices increase
and in case of deficient demand, prices decrease. Overall, the net result is the increase in price.
Inflation on the basis of Government’s role
1. Open Inflation: In this, the government doesn’t interfere. Activities are left on the market forces.
2. Suppress Inflation: It is the case in which open inflation is controlled by the government by
imposing monetary or fiscal limits.
Concepts related to inflation
Concept Meaning
Deflation Negative inflation
Reflation Occurs at times of recession/depression.
Government adopts the policies to increase

the prices.
Core inflation Also known as underlying inflation. It is the

inflation not accounting for volatile price
movements, particularly food and energy
prices.
Headline inflation/topline inflation Includes all the volatile inflation. It accounts

for everything which affects the cost of
living.
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Macroeconomics
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Macroeconomics
AGGREGATE DEMAND AND AGGREGATE SUPPLY

Aggregate Demand
The curve slopes downwards because:

1. Real Balance Effect: If there is a decrease in price, people become better off and hence demand
more quantity.
2. Rate of interest effect:
Decrease in demand for rate of Investment Aggregate

price money interest increases demand
decreases decreases increases
3. Net export effect: Decline in price, leads to increase in exports and hence the aggregate demand
increases.
Page 70
Macroeconomics
Aggregate supply
On combining both the concept, we get an upward sloping aggregate supply curve.
Page 71
Macroeconomics
Aggregate supply curve is upward sloping because of nominal wage rigidities in the short run.
AD curve shifts due to changes in government expenditure, investment and net exports. On the other hand,
AS curve shifts due to change in technology, input prices, taxes or subsidies.
Sticky Wage Model: By Lucas
𝐲 = 𝐲̅ + 𝛂(𝐏 − 𝐏 𝐞 )
y = aggregate output
𝑦̅ = Potential GDP (Labour market equilibrium, that is, NRU achieved)
α = Rate at which output is changing with change in prices
P = Price level
Pe = Expected Price level
Page 72
Macroeconomics
The aggregate supply curve is a vertical curve in the long run because the money wages are not sticky
then. They are rather flexible so they keep the real quantity constant. If money wages increase, prices also
increase and hence relative quantities remain stable.
Only due to changes in labor, capital and technology, does there arise a shift in the aggregate supply curve.
In the long run, macro-economic equilibrium will be established where equality is achieved between
aggregate demand, short run aggregate supply and long run aggregate supply.
Page 73
Macroeconomics
It is the point where:
1. Real GDP = Potential GDP

2. P = Pe
3. Actual unemployment rate = Natural rate of Unemployment (NRU)
Decrease in Output Real GDP > Rate of

P > Pe real wages increases Potential GDP unemployment
< NRU
In long run, money wages help in establishing equilibrium because they are flexible.
A point to note is that
NRU = Structural unemployment + Frictional Unemployment
Page 74
Macroeconomics
EFFECTIVE DEMAND
Point where AD curve intersects AS
Effective demand determines the level of income & employment.
Lack of effective demand  unemployment.
Total effective demand includes :- 1. demand for consumption goods or consumption demand. 2.
Demand for capital goods or Investment demand
 in consumption demand >  in total income  unemployment.
CIRCULAR FLOW OF INCOME
NATIONAL INCOME AGGREGATES

1. GDP  Total Production
2. GDPMP = GNPMP - NFIA
3. GDPfc = GDPMP – Net Indirect Taxes
Net Indirect Tax = Indirect Taxes – subsidies
4. NNPMP = GDP – Depreciation
5. NDP = GDP - Depreciation
Real Y = Current year NNP/Current year index  100
National Income = NNPFC
Private Income= National income – Income of Govt. Cos. Savings of Non- Deptt. Enterprises +
Interest on National debt + Net Current transfers from Govt. + Net current transfers
from abroad.
Page 75
Macroeconomics
Personal Income = Private Y- Undistributed profitss of enterprises – Corp. Tax – retained earnings of
foreign Cos.
Personal Disposable Y = Personal income – Personal Income Taxes – Misc. Receipt of the Govt.
Admin. Depts.
Page 76
Macroeconomics
PATINKIN’S INTEGRATION OF MONETARY AND VALUE THEORY THE REAL

BALANCE EFFECT
Work “Money, Interest & Prices”
Acc. To the theory; Demand & supply of goods are affected only by relative prices

Money prices have no effect on demand & supply of goods implying Demand & supply functions
for goods are homogenous of degree zero
When prices level changes  change in purchasing power of cash holdings

Affects demand & supply of goods
This process is known as the REAL BALANCE EFFECT.
Demand = f (Real balance, relative prices)
Decrease
 price in real Demand
level balance
Basic Conclusion :- People don’t suffer from Money Illusion
Page 77
Macroeconomics
PARADOX OF THRIFT
People save   Consumption   Standard of living. This leads to  in eco g growth
Deposit multiplier = (1/r)*(D) , where D = Deposits of the Bank and r = Required cash reserve ratio
FUNCTIONS OF MONEY
Primary functions Secondary functions Contingent functions
1. Medium of exchange Std. of deferred payment Distribution of NY
2. Medium of exchange Store of value Equating of MU
3. Measure of value Store of value Basis of credit
Store of value Basis of credit
Transfer of value Liquidity to Wealth
Finished!!!!!
Page 78
DEVELOPMENTAL ECONOMICS
Part – 1 – (c) Notes by Economics Harbour
A branch of economics that focuses on improving the

economies of developing countries.
Developmental Economics
ECONOMIC GROWTH AND DEVELOPMENT

Economic Growth implies the change in per capita income, while economic development means
economic growth plus change. Change here may be welfare changes or distributional changes.
Modern Economic Growth
Features of Modern Economic Growth; given by Kuznets:
1. High rates of growth per capita product (10 times) and population (5 times).
2. Rise in productivity:
Increase in rate of per capita product
Improvement in quality of inputs
Creates efficiency and productivity

3. High Rate of Structural Transformation: Shift away from agriculture to non-agricultural
sectors.
4. Increased urbanisation
Economic development :- features

1. Process: Social (Control of population), technological (new technology) or economic forces
(efficient use of resources).
Dynamic Changes => Increase in Real National income of the country

Economic Development is a dynamic Process
2. Real National Income :-
Positive relationship between Real National Income and Economic development
Stability of price is an essential condition for promoting development.
3. Long Period
Real National Income should continue to rise in Long run.
Accelerates development
Page 1
According to G.M. Meier, Development is of two types:
Development
Initiating Development Sustaining

Development
(Increase in real (Increase in real
national income for national income for
short run) long run)
Amartya Sen’s Concept of Development: He gave the concept in 1980s in his work “Development
as Freedom”. According to him, development would mean if
there is:
1. Capabilities to function: Entitlements give a right in the

society, which further decides their capabilities to function.
2. Included freedom: Principal means of achieving
development/ Removing un-freedoms like lack of political
freedom, famine and under-nourishment)
Dudley Seers, in his work “The Meaning of Development”
(1969), took three indicators which would reflect whether
development has occurred or not. The indicators are: Amartya Sen
1. Unemployment
2. Poverty
3. Inequality
Page 2
Decline in any of them would lead to development
Denis Goulet introduced three core values of development in his

work “The Cruel Choice: A New Concept in the Theory of
Development” which are:
1. Life sustenance: Ability of a person to meet his basic

needs, which can be in the form of reduction in absolute poverty,
hunger, etc.
2. Self-Esteem: Ability to be a person, that is, kind of things
a person enjoys like self-esteem, dignity, etc. In other words, there
should not be a feeling of inferiority complex.
3. Freedom: Freedom from servitude, person should be free
from miseries, exploitation, etc.
Denis Goulet
Characteristics of an Under-Developed Economy

1. General Poverty
2. Agriculture: Main occupation
3. Dualistic economy
4. Under-developed natural resources
5. Demographic features
6. Unemployment and disguised unemployment
7. Economic backwardness
8. Lack of enterprise and initiative
9. Insufficient capital equipment
10. Technological backwardness
11. Foreign trade orientation
Page 3
SUSTAINABLE DEVELOPMENT
Amartya Sen was the major contributor in the concept of Sustainable Development. The concept
appeared in 1987 in “Our Common Future: The Brundtland Report”.
Sustainable development means meeting the needs of present generation without compromising
the needs of future generation.
Environmental Accounting
It was given by David Pearce and Jeremy Warfard.
Environmental accounting is done using the formula:
Total capital = Human capital + manufacturing capital + Environment Capital
NNP = GNP – Dm - Dn
Where: NNP = Net National Product; GNP = Gross National Product; Dm = Depreciation of
manufacturing capital; Dn = Depreciation of environment capital
NNP = GNP – Dm – Dn – A – R
Where: A = Averting expenditure; R = Restoring Expenditure
Indian Scenario:
To promote the concept of sustainable development, Ministry of Environment and Forests (MOEF)
was set up in 1985.
Page 4
INDEX OF DEVELOPMENT
Features of a good index:
1. It should not assume a single pattern of development

2. Any index should not be specific to cultural values.
3. It should lend itself to comparisons.
4. It should be able to reflect results and not inputs.
5. It should be easy to construct and comprehend.
The types of Index are:
1. Gross National Product: Initially the change in gross

national product was considered to be an indicator of
development. However, it had its own flaws:
a. It was an index of production only.
b. It didn’t tell about the quality of life of people.
2. Physical Quality of Life Index (PQLI): The PQLI index was given by Morris D. Morris in
1979. He used three indicators:
a. Life Expectancy at age 1: The best till date was for Sweden in 1973 (77 years) and worst
Gunnia Bissau in 1950 (28 years).
b. Infant Mortality: It is the number of deaths per 1000 live births. The best value was 9
(Sweden in 1973) and worst 229 (Taiwan in 1950).
c. Literacy: It only considered general ability to read and write. The best was 100 and worst 0.
As a result, the value of the index ranges from 0 to 100 with 0 to be the worst scenario and 100
to be the best.
PQLI = (Life Expectancy at age 1 + Infant Mortality + Literacy)/3
Demerits of the index:
a. It has been considered to be a limited measure.

b. Arbitrary weights are taken in the index.
c. This index does not tell us about how social structure is changing.
d. It does not reflect the quality of life results in terms of justice, freedom.
Page 5
Relationships
Variables Relationship
Life Expectancy and Infant Mortality Negative Relationship

Rate
Life Expectancy and Literacy Positive Relationship
Literacy and Infant Mortality Negative Relationship
3. Human Development Index (HDI): It was given by Amartya Sen and Mehboob-Ul-Haq in
1990 and was published by UNDP.
Indicators in HDI are:
a. Income or Standard of living: the proxy variable for this is real per capita income.
b. Education/Knowledge Indicator: Two variables are used:
 Adult Literacy: Weight attached to it is 2/3.
 Gross Enrolment Ratio (Number of years of schooling): Weight attached to it is
1/3.
c. Longevity/Health Index: The proxy variable used is life expectancy at age zero.
HDI = 1/3 (Income + Education + Longevity)
HDI value ranges between zero and one where zero is considered to be the worst while one is
considered to be the best.
HDI value Overall 182 nations are ranked

and India ranks 135 with HDI
0 to 0.499 Low Level of human development
value 0.612.
0.5 to 0.799 Medium level of human development Rank 1: Norway
Rank 2: Australia
0.8 to 1.0 High level of human development Rank 3: U.S.A.
Merits:
a. It is better than PQLI Index because it is more sensitive to
quality of life, education and health.
b. It shows disaggregated picture for men and women.
Demerits:
a. It overstates the years of schooling.

b. We cannot judge the quality of schooling.
Page 6
THEORY OF BIG PUSH

The theory of big push was given by Rodenstein Rodan in 1943 in his work “Problems of
Industrialization of East and South-East Europe”
Assumptions of this model are:
1. Oligopolistic structure.
2. Economies of scale.
Points to note
 A firm will be influenced by what other firms are doing.

 Probability of one firm will depend on how the firms are operating.
 Co-ordination amongst firms is important.
 The theory talks about indivisibilities: External economies which
will result from wide scale production and hence cheap raw
materials and wide extent of markets.
There are four areas of indivisibilities:
1. Production indivisibilities: The theory

states that initial capital requirements should be high.
Greater level of output would result in decreased cost
and thus capital-output ratio decreases.
2. Demand indivisibilities: It suggests that
investment in a number of ventures at the same time
would be profitable. The concept was widely
publicised in Nurkse’s book namely “Problems of
capital formation in Underdeveloped countries”.
3. Supply indivisibilities: Usage of savings
should be in profitable ventures.
4. Psychological indivisibilities: The
environment in which development takes place
should be created so that people can adapt to that
environment.
The theory also talks about complementarities, that is, interdependence. It implies that investment in
one firm are dependent upon investments of other firms.
The theory of big push gives importance to government’s role.
In short, the main elements of the theory are:
1. Government’s role
2. Savings
3. Foreign capital
4. Foreign trade
Page 7
Need for Big Push

1. Urbanisation effects
2. Infrastructure effects
3. Training effects
4. Inter-temporal effects : Avoid co-ordination failure
Demerits:
1. The theory didn’t consider the role of small
capital.
2. Problems of shortage in capital, dynamic
entrepreneurs, skilled labour, etc. are ignored.
3. The theory might not be suitable for under-
developed countries.
4. The theory suggests measures to increase
employment and hence expansion of effective
demand, which could lead to high inflation levels
in the economy.
5. The theory neglected the agriculture sector and its role completely.
6. According to Jacob Viner, the economies are cost reducing and not output expanding.
Page 8
CRITICAL MINIMUM EFFORT THESIS

The theory is given by Harvey Leibenstein in his work “Economic Backwardness and Economic
Growth” in 1957 and provides a strategy for development.
 The theory suggests that to break the vicious circle of poverty, the economy should move to
critical level in terms of investment.
 It is based on Malthusian theory of population which states that with increase in income,
population will initially increase but will decrease at a later stage because of cost of bringing up
the family.
 The theory talks about shocks (Income depressing factors) and stimulants (Income increasing
factors). In case of under-developed economies, shocks is greater than stimulants. In case of
developed economies, shocks are less than the stimulants.
 Initially in the process of development, shocks is greater than stimulants but after some time, due
to institutional factors, the stimulants become greater than shocks.
 Stimulants in an economy depends upon:
1. Attitude of people and the motivation aspect.
2. Activities of the growth agents (innovators)
3. Creation of positive sum incentive (factors which change the attitudes of people and will help
in increasing income) and discourage zero sum incentives (factors which have no effect on
income and only leads to transferring income).
 Leibenstein talks about two types of incentives in the under-developed countries:
Incentives
Positive sum incentives

Zero-sum incentives (these promote and induce
(these have zero effect on the economic growth. These are
economic growth. These important for development
incentives have a distributive process because they bring a
effect) change in attitudes and
aspirations of the people. )
Page 9
 According to Leibenstein, the income depressing factors are as follows:

1. Entrepreneurial activities focussing
on maintaining the economic status.
2. Conservative attitude of the labour
class.
3. Reluctance to accept new ideas and
innovations
4. Expenditure influenced by
conspicuous consumption and
demonstration effect.
5. Population and unlimited supply of
labour.
6. High capital-output ratio.
 To promote growth, following are the important factors:
1. Expansion of growth agents
2. Creation of economic opportunities
3. Expansion of secondary and tertiary sectors
4. Creation of social environment
5. Internal peace and international co-operation.
6. Break vicious circle of poverty
 Leibenstein gives an important role to the entrepreneur as a growth agent. According to him,
“growth agents are those individuals who have the capacities to carry out growth contributing
activities.”
 Need for Critical Minimum Effort are:
1. To overcome internal diseconomies: Producing on a large scale to neutralize
diseconomies. Therefore, investments should be made in leading sectors.
2. For achieving balanced growth: Each industry should be of minimum size to achieve
balanced growth. This is due to the interdependence between the industries.
3. To overcome depressants like high death rate, etc. Therefore, investments should be
made in public health services.
4. To generate growth momentum
 Difficulties in achieving Critical Minimum Effort are
1. Lack of entrepreneurs
2. Limited investment opportunities: Under-developed countries have limited investment
opportunities due to structural rigidities.
3. Deficiency of capital
4. Scarcity of resources like skilled labour, technical expertise, etc.
Demerits of the theory are:
1. It didn’t consider government’s role into consideration.
2. It didn’t consider the time element.
3. Relation between per capita income and population growth is not a simple affair.
Page 10
THEORIES OF DEVELOPMENT
1. Classical Theory of Development
The theory is given by Adam Smith who is known
as the Father of Political Economy and is the
Founder of Classical School of Economics.
Smith’s work is “An Enquiry into the Nature and
Causes of the Wealth of Nations”.
He gave the following views on development:
a. Classicals were in favor of free trade.
b. Capital accumulation is the central point of
this theory around which the entire theory of
development revolves. Thus, capital
accumulation should be encouraged, that is,
economic agents should be encouraged to save
more and spend less.
c. Promoted the concept of division of labor and
specialization which would increase the
productivity of workers.
d. In favor of Laissez-Faire policy, that is, no
government intervention.
e. Natural law: The classicals supported
freedom of action for the society which would
take care of individual’s welfare.
f. The classicals promoted the concept of
invisible hand.
According to Adam Smith, the development is not sudden and abrupt, rather it is a cumulative
and slow process.
2. Ricardian Theory of Development
Ricardo gave the theory of development in his book “Principles of Political Economy and
Taxation” (1817). He gave the main role to the capitalists who accumulate capital from the
profits which is the primary source of capital accumulation.
It is also considered to be the theory of distribution which determines the shares of different
factors- land, labour and entrepreneur.
Assumptions of the theory:
a. Perfect competition
b. Full employment
c. Supply of land is fixed.
d. Only purpose of land is production of corn.
e. Demand for corn is perfectly inelastic.
f. Subsistence wages are being paid to the labour.
g. State of technology is given.
Page 11
Ricardo uses marginal principle and surplus principle, according to which first rent is
determined. The remaining earning is divided into wages and profits.
Factor Income Dependent upon
Profits Wages
Wages Price of Corn
Price of corn Productivity of land
According to Ricardo, it is the productivity of land which determines the level of agricultural
profit and it occupies the central place in the Ricardian system of development.
Stationary State: Features of a stationary state are:
a. Profits tend to decline.

b. It is the state in which the rent increases and profits and wages decrease.
c. Profits become equal to zero and there is no capital accumulation.
d. Wages become equal to the subsistence level.
e. Stationary state arises due to increase in population and fixed supply of products.
According to the theory, international trade provides opportunities for fresh investments and
thus should be free from government interference.
Classical Criticism
Operation of the law of diminishing returns is criticized. In case of a new technology, the law
fails to operate.
3. Marxian Theory of Development

The theory of development was given in his
book ‘Das Capital’ in 1867.
The basis of this theory was that we move
from a classless society to that with class.
Marx’ main ideas of development are:
a. The materialistic interpretation of
history.
b. Theory of class struggle
c. Theory of surplus value
d. The concept of reserve army
e. Economic development under
capitalism
Page 12
Historical Materialism: Marx introduced the concept of historical materialism stating that any
change in the society will have its base in economic causes or policies.
Movements in the society will be in the following stages:
a. Primitive/Asiatic Society: Classless society.
b. Slavery society
c. Feudal society: There is a relationship
between haves and have nots.
d. Capitalists society
Theory of class struggle: Clash of interest of two groups, that is, capitalist and working class.
Commodities: “Congealed Labour”
Value of Commodities: “Crystallised Labour”
According to this theory,
Total Capital = Constant Capital (C) + Variable Capital (V) + Surplus Value (S)
Rate of Exploitation = S/V
Organic Composition of Capital (K): It is the amount of labour equipped with capital.
K = C/V or C/C+V
𝑺
𝑽
Rate of Profit = 𝑪
+𝟏
𝑽
Rate of profit can increase with the help of following factors:
a. Increase in technology
b. Reduce the working hours of labour for subsistence.
Increase in Decrease Industrial Doom of

Technology in Labour Reserve capitalism Socialism
Army
Reproduction Schema
a. Simple Reproduction Schema: Under this, production is equal to consumption. There is no
scope for accumulation for investment.
Department 1: Produces Capital goods; production of department 1 is the consumption of
department 2.
Dept 1: C1 + V1 + S1 = C1 + C2
This implies, V1 + S1 = C2
Dept 2: V1 + S1 + V2 + S2 = V2 + S2 + C2
Page 13
This implies, V1 + S1 = C2
b. Expanded Reproduction Schema: Under this, the production in department 1 is greater than
the demand by department 2.
V1 + S1 + C1 > C1 + C2
V1 + S1 > C2
Theory of Crisis: The theory of crisis is due to over production.

The theory of crisis is characterized by:
a. Falling rate of profit
b. Unbalanced growth of different sectors
Under consumption
The process is as follows:
Over Labour Wages Reduced

Production Unemployment decrease purchasing
power
Capitalists believe in capital accumulation which leads to under consumption and hence a glut
in the economy.
4. Schumpeter Theory of Development

Schumpeter’s ideas about economic development first appeared in his book “The Theory of
Economic Development” in 1911. According to him, the development is a spontaneous and
discontinuous change in the flow channels which causes a disturbance in equilibrium and
hence alters and displaces the equilibrium state forever. In simple words, development is a process
of creative destruction because development is the spontaneous change in something which is
already existing.
Schumpeter gave the concept of circular

flow which had the following features:
a. It is the existing situation of
equilibrium.
b. Demand = Supply
c. Perfect Competition
d. Full employment
e. Static State
f. No profits, that is, average cost is equal
to the price.
Page 14
According to Schumpeter, development will happen only when circular flow is disturbed. The
circular flow can only be disturbed through innovations or any new discoveries.
There can be five kinds of innovations:
a. New product
b. New method of production
c. New source of raw material
d. New industrial organisation
e. New market
Source of Innovations/Role of inventors or innovators
 Schumpeter gave a very important role to the innovators.

 He believed that an environment for development should be
created.
 Innovators will be willing to take the risk.
 Innovators’ main task is to manage funds.
The qualities must for an innovator are:
 He should have a technical know-how.

 Services of other factors.
People will prefer to work as innovators because:
 For their own joy.

 For superiority
 For wealth purposes
Crisis
 It is the process of creative destructions.

 Through process of development, old things
are replaced by new things.
 Primary wave of expansions (upswings) will be
followed by secondary wave (downswings).
 Creative destruction will start when the
gestation period will get over.
 Innovations are copied by others in the form of
swarm like clusters.
Demerit is that it might not be applicable to under-developed economies.
 Role of innovator is over-emphasized

 Role of real savings is ignored.
 The theory is not applicable to under-developed economies.
Page 15
MODELS OF GROWTH
1. Harrod Domar Model: Harrod gave his model in 1939 and Domar in 1946-47. The main
variables in their theory were Investment (I) and Savings (S). Besides this, they explored the
dual nature (demand and supply) of Investment. Investment will create income and hence
generate demand (demand effect). On the other hand, investment will add to the productive
capacity of the economy and hence create supply of productive capital (supply effect). Also
according to them, the net investment should continue in the economy. However, income should
be able to incorporate the increased investment. Therefore, the theory talks about growth rate of
investment and growth rate of income/output.
Harrod: “Deepening Aspect of Investment” (Each worker has more tools to work with.)
Domar: “Widening Aspect of Investment” (Each worker has more pieces of equipment of the
same type.)
General Assumptions of the theory:

a. Full employment
b. No government interference
c. Closed economy
d. No lags in adjustment
e. Average propensity to save (APS) =
Marginal Propensity to Save (MPS)
f. Propensity to save and capita coefficient are
constant, that is, they follow constant returns
to scale.
g. Income, Investment and Savings are taken to
be in the net sense.
h. Savings and Investment are equal in ex-ante
and ex-post sense.
Harrod Model:
According to the Harrod Model, neutral technical progress was labour augmenting.
Assumptions of Harrod Model:
a. (Saving(s)/Income(y)) is assumed to be constant.

b. Neutral technical progress is labour augmenting.
c. (Capital/Income) and (Labour/Income) are constant.
d. Constant returns to scale.
Harrod gave three concepts of growth:
a. Actual Growth Rate (G): It implies growth rate of output in a period of time.
∆𝐲 𝐒𝐚𝐯𝐢𝐧𝐠 𝐈𝐧𝐜𝐨𝐦𝐞 (𝐒)
G= or G = 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐈𝐧𝐜𝐨𝐦𝐞 (𝐂)
𝐲
Page 16
b. Warranted Growth Rate (GW): It is the full capacity or potential growth rate which tells us
the entrepreneurial equilibrium.
GWCr = S
Where: Cr is the required capital to maintain warranted growth rate.
c. Natural Growth Rate (GN): It is the maximum growth rate or full employment that can be
achieved. In other words, it is the maximum growth rate that can be supported by labour
growth and technical progress.
In case of Harrod Model, if G = GW which implies C = Cr. It is known as Knife Edge
Equilibrium.
However, if there is an inequality between G and GW, then;

Case 1:
Supply > Demand;
G < GW
Deficiency of Problem of Over Stagnation or
demand because
they are not fully Production Depression
absorbed
C > Cr Actual Amount of

Capital > Required
Amount
MEC decreases in
long run
Depression and
Unemployment
Case 2:
Growth rate of
G > GW income >
Growth rate of
Demand >
Supply Inflation
output
Actual Amount Deficiency of

C < Cr of capital <
required
amount
capital leading
to fall in
production
Secular Inflation
Page 17
Equilibrium is reached when G = GW = GN which is known as knife edge equilibrium when labour
growth is considered. At this point, the equality is maintained between Growth Rate of Investment,
Growth Rate of Income and Growth Rate of Labour.
Domar Model
Main assumptions of the theory are:
a. Income generation will take place through increase in investment through the multiplier
process.
b. Investment is also induced by output growth and entrepreneur confidence.
c. Productive capacity will be created by Investment and will depend upon potential average
productivity of Investment.
d. Employment is a function of labour utilisation rate.
e. Junking (Depression): If junking, then capital is wasted and hence level of investment will
fall.
Domar used Kurihara’s equations. At full employment level,
yd = I/s
where I = Investment and s = marginal propensity to save
ys = k.σ
where: k = real capital stock and σ = productivity of capital
yd = ys
I/s = k. σ
I = k. σ.s (Condition for steady growth)

If we take the change concept,
∆I = ∆k. σ.s
∆I/∆k = σ.s
∆I/I = σ.s (Razor Edge Equilibrium and the condition to maintain steady growth)
∆I/I > σ.s Leads to increase in purchasing power

and hence Inflation
∆I/I < σ.s Leads to over-production and thus

Depression
Page 18
Main points of the theory:

1. Investment is the central theme.
2. Increased capacity leads to increased output and increase in employment.
3. Concepts of growth rate.
4. Business cycles are taken as deviations from the path of steady growth.
Similarities in the theory
1. Similar assumptions
2. Keynesian Saving = Investment; a condition for steady growth
3. Model is addressed to advanced economies and not backward economies.
4. Introduced dynamic elements
5. Assume fixed K/O and L/O
6. Exponential equilibrium path.
7. Knife edge equilibrium inherent
Differences in the theories:
Basis Harrod’s Model Domar’s Model
Long run Labour shortage deflecting “Under-Investment” sapping

difficulty growth. growth.
Position of Determinant of natural growth Shortage of labour may lead to fall

labour input rate, key element. in investment; optional.
Equilibrium Unstable Undermines investment incentives.
Reason for Fixed interest rate, low For convenience

fixed K/O sustainability.
State of Labour unemployment Idle capacity exists.

economy
Page 19
2. Meade Model: It is also known as Steady Growth rate model. Given in his work “A Neo-
Classical Theory of Economic Growth” in 1961.
Assumptions:
a. There are two kinds of goods: Consumption goods and Capital Goods.
b. Two factors of production: Land and Labour.
c. No government interference.
d. Closed Economy
e. Full employment
f. Machinery is the only form of capital.
g. Perfect substitution between consumption and capital goods.
h. Prices are not changing.
i. Considered depreciation of capital because of which capital will be replaced.
j. Perfect Competition
Q = F (K, L, N, t)
Where: Q = Output; K = Capital; L = Labour; N = Land (constant); t = technology (constant
technical progress)
∆y = v∆K + w∆L + ∆y’
Where: v = Capital productivity; w = Labour productivity; ∆y’ = rate of change in output because
of technical progress.
Similarity in Harrod-Domar Model is that the baselines are the same for both the models.
While Harrod-Domar Models are different in the sense that both have used the concept of
accelerator but Harrod’s accelerator concept is more technical.
Dividing the above equation with y, we get;

∆𝐲 𝒗. 𝑲. ∆𝐊 𝒘. 𝑳. ∆𝐋 ∆𝐲′
= + +
𝒚 𝒚. 𝑲 𝒚. 𝑳 𝒚
Simplifying it,
y = uk + Ql + r
Per capita changes would be depicted by y-l; where
l is the labour growth.
y-l = uk + Ql-l + r
Page 20
y-l = uk – l (1-Q) + r
where y – l is the per capita output growth

Oh my God!!!
Steady growth conditions: So many
equations!!!!!
a. Elasticity of substitution between all factors is unity.
Not again…..
b. Population growth is constant.
c. Proportion of wages, rents and profits saved are the same.
d. Neutral technical progress for all factors.
∆𝒚 ∆𝑲
Steady State = =
𝒚 𝒌
u, Q are constant; r = constant and l = constant
Critical rate of capital accumulation which will help in

∆𝑦 ∆𝐾
achieving the equality between and .
𝑦 𝑘
y=k=a
a = ua + Ql + r
a – ua = Ql + r
a(1-u) = Ql + r
𝑸𝒍+𝒓
a= (Critical rate of Capital accumulation)
𝟏−𝒖
If Capital (K) Income growth Savings Capital

is more than a < capital decrease decreases
growth
Income growth Savings Capital

If K < a > Capital increase increases
growth
Growth of income depends on:
 Productivity of capital
 Limit of savings
 Development of technology
Page 21
Conditions of steady growth:
 The elasticity of substitution between various factors is unity.

 Technical progress is neutral at a constant rate for all factors.
 Proportions of wages, rents and profits saved are constant.
 Growth rate of population is constant.
Page 22
STRUCTURAL TRANSFORMATION MODELS

The structural transformation models focus on how the structure of the economy changes with the
development.
1. Lewis Theory of Development: The theory was given by Arthur Lewis in 1954. It is also known
as the “Model of Unlimited Supply of Labor”. The theory provides solution to the excess labor
supply in the developing nations. The theory states that with the movement of labor from rural to
urban sector, the traditional society transforms into the modern society.
The theory has following assumptions:

a. The theory assumes a dual economy, that is, co-existence of Agriculture/ Subsistence/ Traditional
sector and Industrial/Manufacturing/Modern sector.
b. Wages:
Wages
Agriculture Wages are a fixed

As MPL = 0, hence wages premium over and above
in this sector are the agricultural wages.
determined by APL. WM = WA + 30% of WA
c. Development in an economy takes place due to

transfer of labor from agriculture to industrial
sector. As a result of movement of labor from
traditional to modern sector, the capital in the
latter accumulates and output expands, thus
leading the economy towards development.
The speed with which labor moves depends on
the speed of investment in the industrial sector.
It is also assumed that the capitalists will
reinvest all the profits.
d. Supply curve of labor is perfectly elastic at
minimum wage rate till the point the entire
surplus labor is not fully absorbed in the
economy.
Page 23
e. The number of workers in rural sector are more as compared to that in the industrial sector.
So the transfer of labor would take place from rural to urban areas.
f. No capital accumulation in the agriculture sector.
g. Growth in industrial sector is self-sustaining because it absorbs the entire surplus labor.
h. There are diminishing returns to labor.
In the agriculture sector, the maximum labour which can be absorbed is equal to LA. At that point of
employment, the total product is maximum and corresponding to that the marginal product of labour
is equal to zero. The wages paid in the agriculture sector is equal to WA. The labour beyond LA point,
is the surplus labour which is then absorbed in the manufacturing sector.
In the manufacturing sector, the labour is paid a wage which is higher than the wages paid in the
agricultural sector (WM and is fixed). So when L1 labour produces TPM(KM1) output, wages paid are
WM and there is surplus left. That surplus is then re-invested which shifts the total product curve
upwards. The process continues till all the surplus labour is absorbed in the agricultural sector.
Page 24
2. Fei-Ranis Model: Given in 1964 in their work “Development of the Labour Surplus Economy”.
It is an improvement over Lewis Model. Even this model assumes co-existence of a dual
economy, that is, agriculture and industrial economies.
The assumptions of the model are:

a. Labor moves from rural to urban sector through the process of development.
b. The economy experiences diminishing returns to a factor.
c. Output in agriculture is a function of land and labor. On the other hand, output in
manufacturing sector is a function of labor and capital.
d. Surplus of agriculture sector finances the development of industrial sector.
e. Wages in agriculture sector are at a subsistence level, that is, they are at a constant institutional
wage rate.
f. Supply of labor is perfectly elastic.
g. Marginal product of excess labor is zero.
h. Returns to scale are constant.
i. Closed Economy
Profits and Hidden rural savings are

reinvested
Increase in Capital Accumulation
Profits increase
Wages increase
Labour supply increases till the point

surplus labour is absorbed.
Three ratios given by Fei-Ranis Model:

𝑳𝒂𝒃𝒐𝒖𝒓 𝒑𝒓𝒐𝒅𝒖𝒄𝒕𝒊𝒗𝒆𝒍𝒚 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅
a. Labour Utilisation Ratio (r) = 𝑮𝒊𝒗𝒆𝒏 𝒂𝒎𝒐𝒖𝒏𝒕 𝒐𝒇 𝒍𝒂𝒏𝒅 𝒐𝒓 𝒄𝒂𝒑𝒊𝒕𝒂𝒍
𝑻𝒐𝒕𝒂𝒍 𝒂𝒎𝒐𝒖𝒏𝒕 𝒐𝒇 𝒘𝒐𝒓𝒌𝒆𝒓𝒔
b. Labour Endowment Ratio (s) = 𝑳𝒂𝒏𝒅
𝑳𝒂𝒃𝒐𝒖𝒓 𝒑𝒓𝒐𝒅𝒖𝒄𝒕𝒊𝒗𝒆𝒍𝒚 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅
c. Non-redundancy coefficient (T) = 𝑻𝒐𝒕𝒂𝒍 𝒍𝒂𝒃𝒐𝒖𝒓 𝒇𝒐𝒓𝒄𝒆
Page 25
T = r/s
Criticism:
 Migration is not easy.

 Marginal Product is not equal to zero.
 Funds raising process is difficult.
 Assumption of closed economy not valid.
3. Harris-Todaro Model of Migration
Harris gave his model in 1970 and Todaro gave his model in 1969. The model came in reaction
to the Lewis Model. According to it, any labor migrated from rural sector may remain
unemployed even after going to urban sector. This view was completely against the Lewis Model.
The following assumptions were taken into

consideration:
a. Migration is entirely an economic phenomenon.
b. Migration to urban areas is in excess of urban jobs.
Growth rate is both likely and possible so that the
labor which has migrated may remain either
unemployed or underemployed in the informal
sector.
c. Migration decision is influenced by the expected
urban rural income differentials rather than the
actual differentials. Decision of migration is
financially and psychologically made.
d. Migrants want to maximize their expected gains
from migrations.
e. The possibility of getting an urban job varies
directly with employment rate in the urban areas.
Page 26
At the subsistence level of wages (WA* and WM*), all the labour is employed in both the sectors.
Manufacturing sector then sets an institutionally determined wage rate, that is, ̅̅̅̅̅
𝑊𝑀 . Therefore, the
labour employed in manufacturing sector now decreases and reached LM. At that point, if we assume
full employment, the wages in agricultural sector would reduce to WA** because labour supply has
increases in that sector and hence the wages have decreased.
The decision of migrating will depend upon:

𝑳
WA = 𝑳 𝑴 ∗ ̅̅̅̅̅
𝑾𝑴
𝑼𝑷
Where:
WA = Wages in agriculture
LM = Labour in manufacturing sector

̅̅̅̅̅
𝑊𝑀 = Institutional wages in manufacturing sector
LUP = Labour in urban pool with or without the employment

𝐿𝑀
If WA > ∗ ̅̅̅̅̅
𝑊𝑀 , Then migration would take place from urban to rural sector.
𝐿𝑈𝑃
𝐿
If WA < 𝐿 𝑀 ∗ ̅̅̅̅̅
𝑊𝑀 , then migration would take place from rural to urban sector.
𝑈𝑃
Page 27
Migration can be initiated when:
a. Wages in manufacturing sector are set at a higher level.
Agricultural productivity becomes

low
Marginal productivity decreases
Wages decrease
Incentive to migrate
The number of labor in

manufacturing sector can be
controlled by:
a. Increase the labour productivity in
agricultural sector.
b. Focus on labour intensive industries.
c. Education
d. Minimising the factor price
distortions.
4. Balanced Growth Theory:
The theory of balanced growth was promoted by Ragnar Nurkse, Lewis, Allen Young, Rodan.
According to the balanced growth theory, all sectors should grow together. The investments
should be made simultaneously in all the sectors. Moreover, the state intervention is required
and hence more requirement of capital. The theory focuses on creating social overhead capital
which would further generate economies of scale.
Following were the theories for balanced growth:
Page 28
Big Push Theory: By Rosenstein Rodan

(Planning industrialisation and balance in supply approach)
Vicious Circle of Poverty: By R. Nurkse

(Breaking of vicious cycle of poverty by application of capital to
wide range of industries)
Lewis Theory of Development

(Balance between agriculture and industries, material and human
capital, export and import, etc.)
The following are the requirements for any

economy to follow the path of balanced growth:
a. More Capital
b. State intervention
c. Formulation of plans
d. Co-ordination and co-operation between
different sectors of the economy.
Merits of Balanced Growth Theory:

a. Balanced growth would help in creating social overhead capital.
b. It creates economies of scale.
c. Balanced growth leads to specialisation and division of labour.
d. Wide extent of market.
Demerits of Balanced Growth Theory
a. The theory is not suitable for under-developed economy.

b. The theory ignores the effect of inflation on the economy.
c. Deficiency of capital and other resources in developing countries.
d. Ignored the existence of disproportionality in factors of production.
Page 29
5. Unbalanced Growth
The theory was first propounded by
Hirschman in his work “The
Strategy of Economic
Development” (1958). Other
proponents of the theory were H.W.
Singer, Paul Streeton, R. Rostow,
Kindleberger.
The theory focused upon
deliberately creating imbalance
between the sectors of an economy.
Investment should be made in
leading sectors which will further
create economies for other sectors.
Unbalanced growth theory focused on two types of series:

a. Convergent Series
Source of Investment is from private enterprises.
They appropriate more economies than they create.
It is not beneficial from the social point of view.
b. Divergent Series
They create more economies.
Source of investment is from the public domain.
It is beneficial from the social point of view.
Moreover the Unbalanced growth theory talked about two strategies which are as follows:
Page 30
Strategies
Social overhead Directly Productive

capital to Directly Activities to Social
Productive Overhead Capital
Activities
Let’s discuss them in detail:
a. Social Overhead Capital to Directly Productive Activities: Social Overhead activities

are the basic services given to primary, secondary and tertiary sectors. Therefore,
they are known as “Pressure Relieving Investment”.
Development takes place through excess capacity
It is a smooth process.
It is pressure relieving.
More preffered
b. Directly Productive Activities to Social Overhead Capital: These are “Pressure

Creating Investment”
Page 31
It is followed due to shortage of social overhead capital
It is pressure creating
The productive activities have an incentive to improve the

social overhead capital to generate economies of scale.
Merits of the theory:

a. It is a better strategy for under-developed economies, due to
shortage of capital in those nations.
b. It is useful for industrial development.
c. The theory involves a linkage effect as one sector generates
development process in other sectors.
d. It is a short term strategy.
e. Resources are not wasted.
f. Creation of economies and is thus known as “Powerhouse for generation of external
economies”.
g. Promotes self-reliance as it focuses on expansion of leading sectors.
h. Generation of economic surplus.
i. Skill formation: Creating better facilities.
Demerits of the theory:
a. The unbalanced growth strategy may lead to inequalities.

b. It focusses too much on industrial development.
c. The resources may not be used optimally.
d. Degree of imbalance not discussed.
e. Neglect of resistance.
f. Lack of basic facilities.
g. Disadvantage of localisation like slums, etc.
h. Danger of inflation as investment takes place in capital goods industries.
i. Neglect of agriculture.
Page 32
The difference between Balanced Growth and Unbalanced Growth Strategies are as
follows:
Balanced Growth Unbalanced Growth
The investment is simultaneous. The investment is done in one sector at a

time.
It is a long term strategy. It is a short term strategy.
Capital requirement is more in case of Capital requirement is less in case of

balanced growth. unbalanced growth.
6. Prebisch-Singer Thesis
The theory was given in 1950s and it highlights the
negative impact of trade. The theory divides the world
into two parts:
a. The centre: It is a group of developed nations.
b. The Periphery: It is a group of under-developed
nations.
As we know that,
𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐞𝐱𝐩𝐨𝐫𝐭𝐞𝐝 𝐠𝐨𝐨𝐝
𝐓𝐞𝐫𝐦𝐬 𝐨𝐟 𝐭𝐫𝐚𝐝𝐞 =
𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐢𝐦𝐩𝐨𝐫𝐭𝐞𝐝 𝐠𝐨𝐨𝐝
The developing countries do not benefit from trade because they produce primary goods. As a
result, the resources would be transferred from developing to developed nations through trade,
hence deteriorating the economic conditions of the periphery.
7. Cumulative Causation Theory

The theory was given by Myrdal on the basis of backwash effects and spread effects. Myrdal
assumes a type of multiplier-accelerator mechanism producing increasing returns in the favoured
region.
According to him, the economy experiences two kinds of effects:
Page 33
Effects
Spread Effects
Backwash Effect (These are positive
(Negative effects from externalities. The
development in one area development in one area
to another.) initiates development in
surrounding area.)
It is also stated that the developing nations do not develop because in case of them the backwash
effects are greater than spread effects.
8. Low Level Equilibrium Trap
The theory was given by R. Nelson in his work “Theory of Low Level Equilibrium Trap” in
1956. The theory is based on the Malthusian Theory of Population. According to this,
Per capita Income

increases more than Population increases
subsistence level
However, population and per capita income are positively related only till some point, beyond
which rise in per capita income won’t have much effect on the population levels.
According to the theory, the economies facing a low level equilibrium trap will also experience a
situation of ‘slack’. By slack it means that those economies will not be able to achieve maximum
possible rate of growth.
Income is a function of labour and capital, assuming technology to remain constant. Also, labour
is a constant proportion of the population.
Page 34
Growth rate of capital (dk/k) comes from:

a. Addition to capital stock
b. Land brought under cultivation.
dk/k = f(per capital income)
Land is positively related to population and

negatively related with land already under
cultivation.
Per capita income changes due to:
a. Rate of growth of population

(dP/P = f(Y/P)) where P is the
population.
b. Rate of growth of income (dY/Y
= f(Y/P)) where Y is the income.
With the increase in per capita income above the

minimum subsistence level, the population tends to increase. However, when the growth rate of
population reaches an upper physical limit, it starts declining with further increase in the per
capita income.
Lower the difference between the slopes of the two curves, weaker will be the trap.
Reasons for low level equilibrium trap are as follows:
a. Inefficient production processes.

b. Correlation between per capita income and population.
c. Slack
d. Social structure of the economy.
Policy options:
a. Increase the productivity and amounts of capital and labour.

b. Change the social system.
Demerits:
a. No rigid and simple functional relationship between per capita income and rate of population
growth.
b. No rigid and simple relationship between per capita income and growth rate of income.
c. Neglects time element.
Page 35
9. Vicious Circle of Poverty

The theory was propounded by Nurkse, Gunar
Myrdal. Nurkse gave the theory in his work
namely “Problem of Capital Formation in
Under developed countries” in 1953.
According to the theory, a country is poor
because it is poor. The theory focused on the
supply of capital, stating that the inducement to
invest is limited by capital.
Supply of Capital = f(Willingness to save,

ability to save)
Demand for Capital = f(Inducement to
invest)
The theory was explained from both the

demand as well as supply side.
From the supply side:
Low Low
Poducitvity Income
Low Low
Capital Saving
Formation
Low
Investment
From the demand side:

Page 36
Low Low Income

Productivity
Low
Low Capital demand,
hence Small
Market
Low
Inducement
to invest
Measures to Break Vicious Circles

a. Investment by both public and private investment.
b. Investment in production oriented policies will help curb inflation levels.
c. Growth of population should be checked.
10. Model of Capital Accumulation / Golden Age Model
The model was given by Mrs. Joan Robinson in 1963. She used the Marx’ concept of Expanded
Reproduction Schema; Keynes’ Income theory (Inflationary gap, effective demand, hoarding),
Harrod’s concept of Balanced Growth and Neutral technical progress. Besides this, she also used
Kalecki’s saving function that states capitalists save all and workers spend all.
The focus of this theory is on Capital accumulation and profit maximization.

Savings and income (ex-ante) equalise through changes in income levels.
Page 37
Following were the assumptions taken in the

theory:
a. Two factors of production: Labour and
Capital
b. Entire income is divided into wages and
profits.
c. Wage earners consume everything and do
not save. Profit earners will invest
everything and consume nothing.
d. Neutral technical progress.
e. Fixed technical coefficient
f. Laissez-faire
g. Closed economy
h. Prices are not changing
i. Elements of monopoly power encourage
saving through their influence on income
distributed.
Main idea of the theory was that rate of capital accumulation and rate of profits are to be brought in
equilibrium.
y = wL + ΠK
where y = income, w = wages, L = labour Π = rate of profit, K = capital
ΠK = y – wL
Π = (y – wL)/K
Dividing the numerator and denominator by L, we get;
Π = (y/L – w)/(K/L)
Where y/L = labour productivity and (y/L – w) give us the net return on capital
We know that savings and investment equalise through the changes in income levels, that is,
S = I …(1)
Capitalists save everything, therefore,
S = ΠK
Investment is nothing but the change in capital, and can be represented as,
I = ∆K
So, substituting the values in (1), we get;
Page 38
ΠK = ∆K
Rearranging the terms, we get;
∆K/K = Π
The above equation signifies the desired/warranted rate of capital accumulation, where ∆K/K is the
rate of growth of capital.
If ∆K/K > Π , then any further investment will not be profitable. The capital should be accumulated
till the point the equality is maintained.
Features of Golden Age

a. Smooth and steady state
b. Full employment
c. Production activities are being carried out smoothly.
d. Population is growing at a constant rate.
e. Capital accumulation is fast enough to equip all the labour.
f. Profits are also constant.
g. Wages will increase with output per person.
h. Potential growth rate is realised. Potential growth rate is the maximum rate of capital
accumulation which can be maintained and achieved at constant profit rate.
Golden Age: Robinson also gave the concept of golden age. Under the golden age, we
consider the labour growth rate, capital growth rate and rate of profits. The golden age is
achieved when the equality is maintained between all the three variables, that is,
∆K/K = ∆L/L = ∆Π
Static State
A static state is the state when the growth rate becomes zero and profits are also zero. Also, the net
return is absorbed in wages.
The state is also known as the state of economic bliss.
However,
If ∆N/N > ∆K/K Money wages decrease, keeping the

price constant, which implies, real
wages decrease and hence profits
decrease.
Page 39
If ∆N/N < ∆K/K Changes will take place in such a way

that will absorb all the excess capital.
Types of Golden Age

Golden age is parallel to the steady state. Following are the types of golden age:
a. Limping Golden Age: Rate of capital accumulation is well below full employment level,
which would lead to unemployment. In simple terms, capital accumulation is less than the
labour growth rate.
b. Leaden Golden Age: It is a situation of mass unemployment and there is a fall in the standard
of living.
c. Restrained Golden Age: Under this, the desired rate of accumulation is not achieved because
output per worker doesn’t support it.
d. Bastard Golden Age: According to this, the desired rate of accumulation is not achieved
because of rise in prices, that is, inflation.
Platinum Age
Under the platinum age, the initial rate of investment/consumption is not suitable for desired rate
of growth to take place.
The types of Platinum Age are:
a. Galloping: (Investment/Consumption)
is not suitable. So when there is an
increase in investment, wages decrease.
b. Creeping: (Investment/consumption) is too high

for possible growth to take place. Full employment is
already achieved, profits are high, but labour growth is not
high.
c. Bastard Platinum Age:

Investment/consumption) is not suitable, the
economy is free from the threat of inflation and
there is rise in wages.
Page 40
Similarity between Harrod Domar Model and

Joan Robinson Model are:
a. Both the theories postulate fixed capital

coefficient and technical neutrality.
b. According to both the theories, there is no
automatic mechanism by which adjustment
could be brought about between natural
growth rate and warranted growth rate.
c. Knife-edge equilibrium is inherent in both the
models.
Differences between Harrod Domar Model and Joan Robinson Model are:
Robinson’s Model Harrod-Domar Model
Growth rate is determined Growth rate is determined by

by profit-wage saving-income ratio and
relationship and productivity of capital.
productivity of labour.
Labour is the ultimate Capital is the prime source of

source of capital capital accumulation.
accumulation.
Page 41
SOLOW MODEL
The model was given by Solow in 1956 in his
work “A Contribution to the Theory of
Economic Growth” and is also known as
Exogenous Growth Model or Neo Classical
Growth Model.
Under this, the technical progress and

population growth rate are treated to be
exogenous in nature.
It is different from Harrod-Domar Model in

the following ways:
a. Harrod-Domar Model states fixed technical

coefficient and Solow Model assumes
variable technical coefficient.
b. Under Harrod-Domar Model, there is a
tendency of divergence from equilibrium
while in case of Solow Model, there is a tendency
of convergence towards the equilibrium.
Assumptions of the model:
a. Single good is being produced.

b. There are two factors of production: Labour and Capital
c. Full employment of resources.
d. Perfect competition
e. Labour and Capital are substitutable.
f. Labour is paid a wage as per their marginal product.
g. Variable technical coefficient
h. Flexible price, and follows an interest-wage system.
i. Assumes constant returns to scale.
j. Production function is homogenous of degree 1.
k. There is a dual economy, that is, agriculture sector and industrial sector.
According to the theory, any Capital- Labour Ratio (K/L) will move towards the equilibrium.
Important abbreviations in the theory:
yt = Real Income
S = Savings
S’ = Rate of savings = S.yt
Page 42
K = Capital stock
K’ = Change in capital stock = I
K’ = S(yt)
y = f(L,K)
This implies that;
K’ = S.f(L,K)
L here is exogenously determined and is equal to L0ent
K’ = S.f(L0ent, K)
Further,
r’ = S[F(r,1)] – nr
Where: F(r,1) implies with 1 unit of labor, r units are produced and nr= increment in labour
S[F(r,1)] means the increment in capital, r = K/L, r’ = ∆(K/L), n = Change in labour or (L’/L)
If r’ = r Equilibrium K/L
Rate of growth of capital = rate of growth of

labour
If r’ < r Labour is growing at a faster rate than capital
Equilibrium K/L is less than the actual K/L
If r’ > r Labour growth us slower than the capital

growth.
Equilibrium K/L is more than the actual K/L
A point to note is that rate of growth is steady and is maintainable.
Limitations of the theory:
1. Unrealistic assumptions of the theory.

2. The theory does not give any time frame to achieve the growth rate.
3. The theory doesn’t link the technical progress with capital accumulation.
4. No role has been given to business expectations.
Page 43
KALDOR’S MODEL
The model was given in 1957. It relates technical progress with capital accumulation. Kaldor gave
importance to non-economic factors also in the development process. He followed the Keynesian’s
theory and Harrod’s analysis.

1. In short run, supply will be inelastic.
2. He divided the society into two sections:
Labour and Capitalists. Entire income is
divided into wages and profits.
Wages include the income of the marginal
labour while profits include the income of the
capitalists, entrepreneurs and property
owners.
3. Total Savings = Savings out of wages +
Savings out of profits.
4. All macro concepts are shown at constant
prices.
5. Constant returns to scale
6. Marginal propensity to consume for workers
is more than the marginal propensity to
consume for capitalists.
Kaldor gave the theory in two respects: Firstly, when population remains constant. Secondly, when
population is expanding.
1. Constant Population
Under this,
Proportionate growth rate of income or output = Proportionate growth rate of output per head.
Savings = αPt + β(yt – Pt)
Where: αPt = Savings out of profits and β(yt – Pt) are savings out of wages
Investment:
𝑃
Kt = α’yt-1 + β’𝐾𝑡−1 *yt-1
𝑡−1
It = ∆Kt = Kt+1 - Kt
Growth Rate of Output/Real income:

𝐼
∆y = a’’ + b’’𝐾𝑡
𝑡
Where: a’’ = Coefficient of technical progress and b’’ = capital per head
Conditions to achieve stable equilibrium

a. Savings > Investment
Page 44
b. Pt ≤ yt – w
c. Pt > minimum profit margin for investment to continue
2. Expanding Population
Under this, the proportionate growth rate of income or output is the sum total of proportion of
output per head and proportionate change in the working population.
We assume that the population is an increasing function of increase in income upto a certain point
after which the population is stagnant.
ENDOGENOUS GROWTH MODELS

Endogenous growth models, also known as New Growth Theory, treat technical progress to be
endogenous in nature. They also assume that similar technical conditions are not available to all
countries.
Endogenous growth models focus on:
1. Human Capital
2. Knowledge
3. Innovations
4. Research and Development
5. Investment
These theories consider the spillover effects or externalities of investment in technology.
Moreover, they do not assume constant returns to scale to be a necessary condition. According to
them, increasing returns to scale is also possible.
1. Romer’s Model
The model is also known as Learning by Investment and was given in 1986.
According to Romer’s Model, creation of knowledge is a sub-product of Investment. Knowledge
is considered to be a non-rival good. The model also considers the possibility of externalities, that
is, returns to investment help in creating more knowledge. However, it is quite possible that
knowledge may show decreasing returns.
The focus of the theory was on Research & Development which helps in creating more
knowledge.
Features of knowledge:
a. Sub-product of Investment
b. Non-rival good
c. Knowledge may show decreasing returns.
a. Growth is derived from a firm/industry.

b. Industry produces under constant returns.
c. The model assumes a Cobb-Douglous type of production function.
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d. Assumes a steady state of growth, that is,
𝐝𝐲 𝐝𝐊
=
𝐝𝐭 𝐝𝐭
e. Labour is allocated for two purposes:
i) For current production
ii) For creation of knowledge
g= rate of growth of knowledge + rate of growth of labour
2. Lucas Model
The Lucas Model was given in 1948. The theory focused upon investment in human capital.
According to the theory, growth rate is defined as:

g= Growth rate of labour + Growth rate of per capital Investment in human capital
Features of Lucas model:
 Total output is divided into two parts, namely, investment in knowledge and current
production.
 Technological progress is endogenously determined.
 The model uses a cobb-douglas production function.
 The model assumes a constant returns to scale.
3. Arrow’s Learning by Doing
The theory focused upon how you gain by learning by doing which helps in decreasing the
average cost. In other words, a firm, over time, learns to produce more efficiently and increases
its stock of knowledge. Workers become more familiar with the work as volume of output
increases.
RELAX!!!!!!!!!!!!
Page 46
TECHNICAL PROGRESS
By technical progress we mean inventing a new technology and improving it through innovation and
diffusion in the society.
Technical Progress
Neutral Technical Progress Capital Saving technical Labour saving technical

(Produce more of output progress progress
with increase in capital and (Same amount of output (Same amount of output
labour in the same can be produced with can be produced with
proportion, that is, keeping lesser amount of capital) lesser amount of labour)
K/L ratio the same.
The concept of Neutral Technical progress were given by following economists:
1. Hicks’ Neutral technical Progress: Under this, efficiency of all factors increases in the same
proportion and the ratio of marginal productivities of the factors, that is, MPK/MPL is constant
for a given K/L ratio.
y = t.f(K,L) where t = technology index
2. Harrod’s Neutral Technical Progress: Harrod’s Neutral Technical Progress is labour

augmenting, that is, the labour efficiency improves. As a result, marginal productivity of
labour (MPL) increases with a given constant K/L ratio. Relative input shares remain the same
for a given capital-output (K/O) ratio.
y = f(K, T(t)L)
3. Solow’s Neutral Technical Progress: It is capital augmenting. As a result, marginal

productivity of capital (MPK) will increase with a given K/L ratio. Relative input shares
remain the same for a given labour-output (L/O) ratio.
y = F(T(t)K, L)
Page 47
DEPENDANCY MODEL
These models were given in 1970s.
Following are the types of dependency models:
1. Neo-Colonial Dependence Model: It is an extension of Marxian analysis. According to the

model, the dependence relationship between developed and developing nations will occur due to
inequalities between them.
2. False-Paradigm Model: According to the model, the dependency is a result of incorrect

framework of development which is followed by the developing nations. In other words, experts
provide incorrect framework to the developing nations.
3. Dualism: Dualism states the co-existence of two separate worlds. There is a chronic difference
between the two worlds which tends to increase over time. Developed nations do not help the
developing counterparts.
Types of Dualism:
Dualism
Technological
Dualism
Social Dualism By Higgins Ecological Dualism Financial Dualism
By: H.Boeke (Different techniques (Difference in the By: Hla Myint
(Existence of East & of production endowments of the (Unequal access to
West together) (Labour or capital natural resources) financial credit)
intensive) in different
parts of the world)
Page 48
SOME IMPORTANT THEORIES

1. Rostow’s Stages of Economic Growth: It was given in 1960. The theory talks about five stages
of economic growth:
Traditional Stage
(The output per head is very low and tends not
to rise)
Pre-conditions to take-off/Preparatory Stage

(changes in 1) society's attitude towards science, risk
taking, etc. 2) Adaptability of labour force, 3) political
soverignty, 4) development of financial institutions)
Take off stage

(Rate of investment increases, and thus the real output
increases. There is a rise in per capita output)
Drive to Maturity
(less reliance on imports. It is a stage of increasing
sophistication of the economy)
Stage of Mass Consumption and Production

(Affluent population, availability of durable and
sophisticated consumer goods, hi-tech industries, etc. )
According to Rostow, Development depends on six propensities:
a. Propensity to develop fundamental sciences.

b. Propensity to apply sciences to economic needs.
c. Propensity to accept innovations.
d. Propensity to seek material advance.
e. Propensity to consume
f. Propensity to have children
Page 49
Features of Traditional Society:

a. Agriculture: Uses Primitive methods of production.
b. Law of diminishing returns in agriculture.
c. Absence of modern science and technology.
d. Structure of the society is based on inheritance.
e. Political power with big landlords.
f. State’s expenditure done on glory of the rulers, etc.
g. Increase/Decrease in population based on Malthusian Lines.
Features of the Drive to Maturity Stage:

a. Composition of work-force changes: In take off stage, 75% of the population works in agriculture,
while in case of drive to maturity stage, it is only 20%.
b. Character of leadership changes: More efficient managers take the place.
c. Society aspires for new things.
2. Two-Gap Model: The model was given by Chenery and Strout in 1966. The basis of the theory
is Harrod-Domar Model. The theory aims to calculate the amount of foreign aid required to
overcome two constraints:
a. Saving-Investment Gap
b. Foreign Exchange Gap
E–Y=I–S=M–X=F
Where: E = National Expenditure; Y = National Income; I = Investment; S = Savings; M = Import;
X = Export; F = Net Capital Income
The theory suggests that to fill the gap we need the external or foreign aid. In other words,
I – S = M – X (in the ex-post sense)
Assumptions:
a. Savings and foreign exchange cannot be substituted for each other.
b. Potential savings cannot be transformed into exports.
c. Export promotion and import substitution policies are ruled out.
d. Assumes structural rigidities and non-substitutability between different types of goods.
Page 50
TECHNIQUES OF PLANNING
Following are the techniques of planning:
1. Physical Planning: It refers to physical allocation of resources. Under this, we compute the
investment coefficient.
2. Financial Planning: The planning is usually done in monetary terms, that is, it estimates the size
of investment in money terms.
3. Planning by Investment/Indicative Planning: System is free from any restrictions, but there are
still some controls and regulations.
4. Planning by Direction: The central authority directs to achieve the goals.
Classification of Planning
1. Structural and Functional Planning:

Structural Planning:
 Change in socio-economic institution.
 Under-developed countries.
 Big changes.
Functional Planning:
 Work within specified framework.

 Only repair
 Should not be adopted by under-developed countries.
 Economic magnitude changes.
2. Planning by Inducement and Planning by Direction:
Planning by Inducement:
 Objective achieved by persuasion and not compulsion.
 Free play of market forces.
 Relies on monetary and fiscal measures.
Planning by Direction:
Page 51
 Compulsion and controlling authority

 Deprives consumer of their superiority
 Inflexible
 Expensive
 Excessive standardisation and kills initiative
3. Democratic Planning and Socialist Planning
Democratic Planning:
 Planning within democratic framework
 Contradicts free economy
 People participate in determining objectives
Socialist Planning
 Planning authority is supreme

 Execution by orders and direction
 No economic and political freedom.
4. Indicative Planning and Imperative Planning
Indicative Planning:
 Information is provided which is used for forecasting or decision making.
Imperative Planning
 Implementation of plans by enforcement

 Directive planning or planning by direction.
5. Perspective planning and Short Term Planning
Perspective Planning:
 Long term planning (15-20 years)
 Focuses on major problems.
Short-Term Planning
 4-6 years
 Activities like training manpower, road building, etc.
6. National Planning and Regional or Micro Planning
National Planning:
 National boundaries.
 Focuses on optimal utilisation of resources.
Micro Planning: Small region
7. Sectoral Planning and Area Planning

Sectoral Planning: For sectors of the economy like primary, secondary, tertiary.
Area Planning: Specific Area
Page 52
8. Physical Planning and Financial Planning:

Physical Planning: Real Resources
Financial Planning: Monetary resources
9. Centralised and Decentralised Planning
Centralised Planning: Central Authority
Decentralised Planning: Regional or Local Bodies also take part.
HISTORY OF PLANNING IN INDIA
YEAR DETAILS
1934 M. Visvesvary
Book: “Planned Economy for India”
1937 National Planning Committee
Chairman: Pt. Jawaharlal Nehru
Report Submitted: 1948
1943 “A Plan for Economic Development in India” or “Bombay Plan”
Eight Bombay Industrialists
Aimed to increase per capita income by 100% (Rs 65 to Rs 130) in 15 years.
How? By increasing agricultural production by 130% and by increasing industrial
output by 500%.
1943 People’s Plan (M.N. Roy)
Highest priority to agriculture and consumer goods industries
1944 Department of Planning and Development was established.
1950 Planning Commission was established
January 1, NITI Ayog
2015
(National Institute for Transforming India)
Replaced Planning Commission, Involved states in Economic Policy Making in India.
Page 53
NITI AAYOG
(National Institute for Transforming India)
Date of Establishment: January 1, 2015
Replaced Planning Commission. Involved states in Economic

Policy Making in India
Members of NITI Aayog
1. Chairperson: P.M. Narendra Modi

2. CEO: Sindhushree Khullar
3. Vice Chairperson: Arvind Panagariya
4. Ex-Officio Members: Rajnath Singh, Arun Jaitley, Suresh Prabhu, Radha Mohan Singh
5. Special Invitees: Nitin Gadkari, Smriti Zubin Irani, Thawar Chand Gehlot
6. Full-time members: Bibek Debroy and V.K. Saraswat
7. Governing Council: All C.M and Lieutenant Governors of UTs
Objectives and Opportunities of NITI Aayog
1. Government to become an enabler and not the provider of first and last resort.
2. Progress from food security to mix of agricultural production.
3. India to be an active player and debates on the global commons.
4. Potential of vibrant middle-class to be fully realised.
5. Improve India’s entrepreneurial, scientific and intellectual human capital
6. Incorporate geo-economic and geo-political strength of NRIs.
7. Use of technology
Page 54
INVESTMENT CRITERIA
The investment criteria tells us how the resources are allocated in such
a way that profits are maximised.
1. Capital Turnover Criteria/Rate of turnover

criteria/Marginal rate of return criteria: The theory was
given by J.J. Polak and Buchanan. It states that the capital-
output ratio should be minimum. The investments should be
in the projects where minimum capital resources are used to
produce maximum output.
The theory is beneficial for developing nations.
2. Social Marginal Productivity Criteria (SMV Criteria):

The theory was given by Kahn & Chenery. According to the
theory, capital should be used till the time marginal
productivity of capital is equalised in all the uses.
3. Reinvestment Criteria/Marginal Per Capita

Reinvestment Quotient: The theory was given by Galenson
and Leibenstein. The theory focuses on future growth and
hence measure the extent to which we can save for future use.
4. Net Present Value Criteria: To get the net present value, we

deduct the cost from the present value. The main objective of
our investment should be to maximise the present value.
5. Time Series Criterion: Given by A.K. Sen. The main
objective is to maximize output within a given period of time.
Page 55
PLAN MODELS
Aggregative Multi-Sectoral Multi-Sectoral

Models Models Models
• These are also • Plans will be • The planning
known as Macro made for begins from the
Models. It different sectors base. Project level
considers the and those are variables are
entire economy a combined to form given which will
one model. one plan. be used to
However, it Examples: Input- prepare the
doesn’t work for Output Models, models
the developing Mahalanobis
countries. Model
Examples are
Harrod-Domar
Model, Two-Gap
Model
Page 56
INTERNATIONAL
ECONOMICS
Part 1-d Notes by Economics Harbour

International Economics
THEORIES OF TRADE
1. Merchantilists’ View on Trade
According to them, exports should be greater than the imports, which will further help the nation
become rich.
More gold and silver with the nation, implies more powerful and rich it will be.
Government’s role was limited to a. Facilitate exports and b. Restrict Imports
Merchantilists measured wealth of nations in terms of the stock of precious metals it possessed.
2. Absolute Advantage Theory (1776)

Given by Adam Smith. He in his book named “Wealth of Nations” stated that international trade is
beneficial only when the two nations have absolute differences in the cost of production of the
commodity in which they specialise.
Assumptions:
a. Complete specialisation
b. 2x2x1 model, that is, two nations, two goods and one factor of production
d. Full employment
e. Constant returns to scale
f. No transportation cost
g. Perfect mobility of factors within the nation but not outside the nation
Nation U.S. U.K Nation U.S. U.K

Product A 6 1 Product A 6 1
Product B 6 1 Product B 4 5
The above table is given in terms of units produced by one unit of labour.
Page 1
Let us assume, U.S. produces 6 units of product A or
4 units of product B per one unit of labour. On the
other hand, U.K. produces 1 unit of product A or 5
units of product B per one unit of labour (Table 1).
This implies that U.S. specialises in the production of
product A and hence has an absolute advantage in
producing that commodity while U.K. specialises in
production of product B and hence has an absolute
advantage in producing that commodity.
If the nations produced under equal
cost differences (Table 2) then trade was not
possible according to Adam Smith.
Table 2
A point to note here is that the theory of Absolute Advantage is based on the Labour Theory of
Value.
3. Theory of Comparative Advantage (1817)
Given by David Ricardo in his “Principles of Political Economy and Taxation”. The theory of
Comparative Advantage states that “other things being equal, a country tends to specialise in and
export those commodities in the production of which it has maximum comparative cost advantage
or minimum comparative disadvantage.” The country will import the goods which have a relatively
less comparative cost advantage or greater disadvantage.
Assumptions:
a. 2x2x1 model. Labour is the only factor of production
b. Labour is homogenous in terms of efficiency in a particular country.
d. Full employment
e. Constant returns to scale
f. No transport cost.
g. Perfect mobility of factor within the nation and perfect immobility across the nations.
h. Free trade between nations.
i. Included labour theory of value: Value of good is judged by labour input.
j. No change in technology.
k. Trade takes place on barter system.
According to this theory, basis of trade will be the difference in labor productivity.
Trade is possible only when a nation has a comparative advantage in production of one product. For
example,
Nation U.S. U.K
Product A 12 8
Product B 10 9
According to the example given above, U.S. has an absolute advantage in the production of both the
commodities. However, the comparative cost varies.
Nation U.S. U.K
Product A 12/8 = 1.5 8/12 = 0.6
Product B 10/9 = 1.1 9/10 = 0.9
U.S. has a comparative advantage in the production of Product A because 1.5 > 1.1. As a result, U.S.
should produce more of A. On the other hand, U.K. has a comparative advantage in terms of product
because 0.9 > 0.6. Thus it can produce more of B as compared to A. So it should specialise in the
production of product B.
Note that above tables are explained in terms of production and these should not be
confused with the cost tables. In the above tables, the values show the production
capacity of the nations. More the production capacity, better for the economy. While in
case of cost, more the values, worse it is for the economy.
However, trade is not possible when
Nation U.S. U.K
Product A 6 3
Product B 4 2
Page 3
This is because with one unit of labour, U.S. can produce double of both the commodities as
compared to U.K. Comparative costs are equal and hence no trade is possible.
Empirical Evidence
Empirical evidence was given by Mac Dougal (1951), Balassa (1950s) and Stern. It associated the
labour productivity with exports. Mac Dougal took the data from 1937 for 25 years. Output per
workers and exports for U.S.A and U.K.. He found out that when labour productivity increased,
exports also increased. Therefore, he established a positive relationship between them. This was
further proved by Balassa and Stern.
4. Opportunity Cost Theory (1936)

The theory was given by Haberler. According to the theory, difference in opportunity cost leads to
comparative advantage.
Assumptions
a. 2x2x1 model
b. Straight line production possibility curve
c. Perfect Competition
d. Fixed supply of factors
e. Full employment
f. Free trade between countries
g. Price = Marginal Money cost
h. Price of Factor = Marginal Productivity
According to this theory, cost of a commodity is the amount of the second commodity that must be
given up to release just enough resources to produce one additional unit of first commodity.
U.S. U.K.
1 unit of A = 1.5 unit of B 1 unit of A = 2 units of B
So US should produce A because it has an advantage in producing it because he gives up only 1.5 units
of B to produce 1 unit of A while on the other hand, UK gives up 2 units of B to produce 1 unit of A.
Therefore, the cost of producing A is less in case of US.
The theory does not consider supply and demand differences but just the opportunity cost.
5. Modern Theory of Trade (Factor Proportion theory/ Factor Endowment theory)
The theory was given by Hecksher-Ohlin in the years 1919 and 1933 respectively. The Hecksher-
Ohlin Theory states that “countries which are rich in labor will export labor intensive
Page 4
goods and countries which are rich in capital will export capital intensive
goods.”
According to this theory, the basis of trade is the supply of factor resources, that is, difference in
availability of resources.
Assumptions
a. 2x2x2 model, that is, two nations, two commodities, two factors of production.
b. Perfect competition in the product and factor market.
c. Full employment of resources and the demand is identical in both the countries.
d. All production functions are homogenous of degree 1, that is, constant returns to scale.
e. No transport cost
f. Perfect mobility within the nation and perfect immobility between nations.
g. The countries differ in terms of factor supply.
h. Each commodity differs in terms of factor intensity.
i. Free trade
Suppose: Nation 1 is labour abundant and nation 2 is capital abundant. Also, X is a labour intensive
commodity and Y is a capital intensive commodity.
Factor Intensity: (L/K)X > (L/K)Y
Factor abundance: (L/K)1 > (L/K)2

This implies, relative pricing of Labour in nation 1 will be less than that in nation 2 simply
because of its abundance in nation 1. Similarly, capital will be cheaper in nation 2.
The countries should export/produce the good which makes intensive use of the abundant factor
and import the good which makes intensive use of the cheap factor. The theory comes to the
following conclusions:
a. The basis of internal trade is the difference

between the commodity prices in the two
countries.
b. Difference in commodity prices is due to the
difference in cost prices which is further due to
the difference in factor endowments in the two
countries.
c. The country which is rich in capital produces
and exports capital intensive product and the
country which is rich in labour produces and
exports labour intensive product.
Page 5
Limitations of the Theory

a. Unrealistic assumptions.
b. His theory is restrictive in terms of limitations imposed on
the number of commodities, countries and even factors of
production.
c. It is a one sided theory, that is, supply plays a more
important role as compared to the demand.
d. The theory is static in nature.
e. Wijnhold’s criticism: According to him, it is the
commodity prices which determine the factor prices and not
the other way round.
f. The theory ignores consumer’s demand.
g. Haberler’s criticism: According to him, the theory is based
on partial equilibrium analysis. It does not provide the
general equilibrium solution.
h. The theory neglects other factors like technology, qualities
of labour, etc.
Empirical Evidence
a. Factor Price Equalisation:In 1970, Paul Samuelson has proved the factor-price equalisation
theorem, also known as Hecksher-Ohlin-Samuelson theorem. According to this theorem, the
relative and absolute returns to factors after trade will be equalised. This implies that trade will
lead to convergence of factor.
b. Stolper-Samuelson Theorem: The theorem talks about income distribution impact of trade.
When trade takes place, abundant factor will gain and scarce factor will lose. When tariffs are
imposed, then abundant factor will lose.
c. Factor Intensity Reversal: The theory was empirically proved by Minhas in 1962. According to
his theory, the Hecksher-Ohlin Theory and Stolper-Samuelson theory will fail. The reason was
attributed to very large difference in the elasticity of substitution between two nations.
d. Rybinscky Theorem (1955): According to this theory, the impact of increase in factor endowment
on the output of the good using that factor intensively will increase more than proportionately and
output of the other good will decline.
e. Metzler Effect/Paradox (1949): According to this theory, the price of the importable good and
the scarce factor will fall leading to backward bending offer curves.
Page 6
f. Leontief Paradox (1950s): According to this theory, the Hecksher-Ohlin theory does not hold
true. He empirically proved it using the example of the U.S. economy saying that U.S. being a
capital intensive nation imported the capital intensive goods and exported labour intensive product.
6. The Theory of Reciprocal Demand

The term “Reciprocal Demand” was introduced by J.S. Mill to explain the determination of the
equilibrium terms of trade. Reciprocal demand helps in identifying a country’s demand of one
commodity in terms of quantities of other commodities which are to be given up in exchange. The
reciprocal demand helps in determining the terms of trade of a nation which further determines the
relative share of each country.
a. There are two countries, two e. There is perfect competition
commodities f. Full employment
b. The commodities are produced under g. Free trade
constant returns to scale. h. The principle of comparative costs is
c. No transportation costs applicable in trade relations between
d. The demand in two countries are the two countries.
similar
The conclusions of this theory can be summarized into following points:
a. The possible barter terms are given by the

respective domestic terms of trade as set by the
comparative efficiency in each country.
b. The actual terms of trade would depend on each
country’s demand for the other country’s commodity
production.
c. The barter terms will be stable at the point where
exports offered by each country just suffice to pay for
the imports it desires.
7. Specific Factor Model of Trade

The theory was given by Jacob Viner and David Ricardo. It first came in 1971 and in 1974 the
theory’s graphical form was introduced by Michael Mussan. However, the credit of the theory
is given to Jacob Viner. The theory is also associated with Paul Samuelson and Ronald Jones.
Assumptions
a. Perfect competition e. 3 factors of production: Land and
b. Full employment Capital ( Specific factors) and Labour
c. 2 goods: Food and manufacturing (Mobile Factor)
Goods
d. 2 nations f. Production displays diminishing
returns.
Page 7
g. Concave production possibility curve possible only at the cost of other

that is, increasing opportunity cost industry.
because expansion of one industry is
According to this theory, the factor specific to export sector of each country will gain while factor
specific to import sector of each country will lose. Also trade will lead to settling of prices between
the original relative prices between the factors of production.
Page 1
TRADE UNDER IMPERFECT COMPETITION

The theory talks about Intra-Industry trade. Let’s discuss the concept in brief. Economies of scale can
either be external or internal. It is the product difference which leads to imperfection in any industry.
Exporting and importing the same commodity is called intra-industry trade. The difference between
intra and inter industry trade can be noted as follows:
Intra-Industry Trade Inter-Industry Trade

Measure of Intra-
Trade is based on product Trade is based on comparative Industry Trade
differentiation and economies of advantage.
scale. The measure was given by
Grusel and Lloyd in
Capital-Labour proportions can be Capital-Labour proportions 1971.
similar. are not similar.
Intra-Industry Trade (T)
All factors gain. Abundant factor gains and scarce |𝑿−𝑴|
=1- 𝑿+𝑴
factor will lose.
If there is only inter-
industry trade then T = 0
Drawback of the Index
and if there is only intra-
There is a level of biasness because value of T depends on how broadly industry trade the T = 1. So
the goods are defined. If the group is broadly defined, then possibility is the value of the index
that intra-industry trade will take place. ranges between 0 and 1.
Advantages of Intra-Industry Trade

a. Wider extent of market
b. Better prices for consumers
c. Greater variety
Due to intra-industry trade,

Intra-Industry Trade average cost would reduce,
Average cost and Average Price
15
hence further reducing the
Average cost 1 average price and increasing
Average price the number of firms in the
Average cost 2
10 market. As a result, the market
expands, price of the
5
commodity falls and hence
more variety for the
consumers.
0
0 2 4 6
However, in case of external
Number of Firms economies, pattern of trade is
not predictable.
Page 7
TECHNOLOGICAL GAP MODEL

The technological gap model was given by Posney in 1961. Under this, the trade is based on introduction
of new technique of production which gives the country a temporary monopoly for some time. The theory
also talked about lags which are of following types:
1. Imitation lag: It includes:

a. Foreign reaction lag: How foreign firms react to the new product.
b. Domestic reaction lag: Studies the impact of the new product on domestic firms.
c. Learning period lag: Over how much period of time, the other firms learn about new
technology.
2. Demand lag: It is the time taken for the generation/creation of demand due to introduction of new
technology.
Net lag = Imitation lag – Demand lag
PRODUCT LIFE CYCLE MODEL

The product life cycle model was given by Vernon in 1966. The model is based on the concept of
standardisation. According to this theory, the comparative advantage shifts from the advanced nation to
the less developed or developing nations. The product goes through the following stages:
Page 8
The product goes out of the market due to improved technology and new products are launched in the market.
Stage 5: Death stage
Improved products are introduced, which reduces the demand for the original product.
Stage 4: Decline stage
The excess of supply of the commodity in the market and the demand
has reached its maximum. Stage 3: Maturity
phase stage:
for the original product.
The demand for the product grows overtime. Moreover,
efforts are put in behind the formula for the new product
Stage 2: Product
growth phase
Under this phase a new product is introduced in

the market
Stage 1: New product
phase
Page 9
TERMS OF TRADE
The concepts under the topic terms of trade are given below:
1. Exchange Ratios
a. Net Barter Terms of Trade: The concept was given by Taussig in 1927. According to the
concept, the terms of trade are favourable when for given exports we can import more.
𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐞𝐱𝐩𝐨𝐫𝐭
Net Barter Terms of Trade = 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐢𝐦𝐩𝐨𝐫𝐭
More the ratio, more favourable are the terms of trade.
𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐢𝐦𝐩𝐨𝐫𝐭𝐞𝐝
b. Gross Barter Terms of Trade = 𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐞𝐱𝐩𝐨𝐫𝐭𝐞𝐝
The concept too was given by Taussig in 1927.
𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐞𝐱𝐩𝐨𝐫𝐭∗𝐐𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐞𝐱𝐩𝐨𝐫𝐭𝐞𝐝

c. Income Terms of Trade = 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐢𝐦𝐩𝐨𝐫𝐭
The concept was given by Dorrance and Stanley in 1948.
2. Based on Difference in Productivity of Factors
a. Single Factoral Terms of Trade = 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐢𝐦𝐩𝐨𝐫𝐭 ∗ 𝐙𝐱
Where: Zx is the index adjusted for changes in productivity of factors engaged in the country’s
export sector.
The concept was given by Jacob Viner in 1937.
𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐞𝐱𝐩𝐨𝐫𝐭 𝐙𝐱
b. Double Factoral Terms of Trade = 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐢𝐦𝐩𝐨𝐫𝐭 ∗ 𝐙𝐦
Where: Zm is the index adjusted for the changes in productivity of factors engaged in the
import sector.
3. Based on Utility
a. Real Cost Terms of Trade = 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐢𝐦𝐩𝐨𝐫𝐭 ∗ 𝐙𝐱 ∗ 𝐑𝐱
Where: Rx is the disutility per unit of the factors of production engaged in the country’s
exports.
The concept was given by Jacob Viner.
b. Utility Terms of Trade = 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐢𝐦𝐩𝐨𝐫𝐭 ∗ 𝐙𝐱 ∗ 𝐑𝐱 ∗ 𝐔𝐦
Page 10
Where: Um is the relative desirability of imports which could have been produced domestically
by using factors that are used to produce exports.
BALANCE OF PAYMENTS
Structure of Balance of Payment is as follows
1. Current account balance: It includes:

a. Balance of Visible trade: Trade in goods
b. Balance of invisible trade: Trade in services
c. Interest, dividends, profits and unilateral payments.
2. Capital account balance: It includes changes in capital assets or savings. It has following heads:
a. Investments made in the economy.
b. Borrowings and lendings
3. Foreign exchange reserves: It shows the changes in reserves of foreign exchange with the country.
4. Errors and Omissions: All statistical discrepancies are included in this category.
Trade account balance: Also known as ‘Balance of Visible Trade’ or ‘Balance of Merchandise
Trade’. It is the difference between the export and import of goods, or more specifically the tangible
items.
Current Account Balance: The current account of balance of payment includes the export and
import of goods and services, receiving or paying of interests, profits, dividends and unilateral
receipts from and unilateral payments to abroad.
Capital Account Balance: It includes the difference between the receipt and payment under capital
account. It involves inflows and outflows of investments; short term, medium term or long term
borrowings or lending’s. The items can be categorized as:
1. Autonomous capital transactions: The investments which are not concerned with the surplus or
deficit in the current account of the balance of payments are known as autonomous capital
transactions. Due to autonomous transactions, there may be net inflow or outflow in the foreign
exchange of a country, resulting to deficit or surplus in the balance of payments account.
2. Accommodating capital transactions: The transactions which are made due to deficit or surplus
in the balance of payments are known as accommodating capital transactions.
Foreign Exchange Reserves: It shows the reserves which are held in the form of foreign currencies
like dollar, pound, etc and even Special Drawing Rights (SDRs).
Errors and Omissions: This involves all such errors which occur due to statistical discrepancies or
any item which was not recorded in the current or capital accounts.
Types of Balance of Payment Disequilibrium

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1. Structural Disequilibrium: It is due to structural

changes in the economy. These are long term in
nature and are also known as fundamental or
secular disequilibrium. It refers to a persistent
deficit or surplus in the balance of payments account
of a country. Any permanent change in the supply
and demand conditions may lead the economy
towards fundamental disequilibrium. Important
causes of structural disequilibrium are:
a. When country’s foreign demand declines due to
the availability of cheap substitutes, leading to
lower exports and hence deficit in the balance of
payments account.
b. When country’s supply declines due to crop
failure, shortage of raw materials, etc. which
further leads to deficit.
c. A shift in demand due to tastes, incomes, etc.
also leads to disequilibrium in the balance of
payments.
d. Change in the rate of international capital
movements.
e. A war may also cause structural disequilibrium in
the economy.
2. Cyclical Disequilibrium: Disequilibrium, under this case, is caused due to changes in the trade
cycles. Different phases of trade cycles like depression, recovery, boom, and recession cause
disequilibrium in the balance of payments account.
3. Technological Disequilibrium: Any technological advancements like inventions or innovations

of new goods or technique of production cause a disequilibrium in the balance of payments
account.
4. Short-run Disequilibrium: It is the disequilibrium caused on a temporary basis and does not pose
a serious threat to the economy.
Balance of payments is always in balance but only in accounting sense. In general,
Balance of Payment Equilibrium: Receipt = Expenditure

Balance of Payment Disequilibrium: Receipt > Expenditure (Surplus)
Receipt < Expenditure (Deficit)
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5. Monetary Disequilibrium: Such kind of a disequilibrium takes place due to inflation or deflation
in the economy.
In case of disequilibrium in the economy, be it deficit or surplus, some specific policies are required.
Depreciation Increase
BOP Deficit or devalue the exports and BOP
currency decrease Equilibrium
imports
Appreciation Exports
BOP Surplus or Revalue the decrease and BOP
currency imports Equilibrium
increase
Marshall-Lerner Condition
Devaluation or depreciation of a currency can be successful depending on the elasticities of foreign
demand of exports (ex) and elasticity of domestic demand for imports (em).
If ex + em > 1, implies that devaluation is successful.
If ex + em = 1, implies devaluation will have no effect on the balance of payment.
If ex + em < 1, implies that devaluation will worsen the balance of payment.
If ex = 0, then em should be greater than one to improve the balance of payment situation due to
devaluation.
If em = 0, then ex should be greater than one to improve the balance of payment situation.
J-Curve
The concept of J-Curve was given by Harberger and Houthakker in 1960s. They based the
concept on empirical findings on efforts to improve trade balance.
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Initial efforts to improve the trade balance by devaluation or depreciation will keep the balance of payment
in deficit for some time but later it will turn into surplus because import prices move much faster than the
export prices.
Why J-Curve?
1. Pre-existing trade contracts have to be honoured.
2. Elasticities are not very responsive in short run or insensitiveness of demand for exports and
imports.
3. Consumers and producers are also not able to react immediately.
Currency Pass Through
It is the extent to which changing currency values lead to changes in import and export prices. J-Curve
analysis assumes that a given change in exchange rate brings about a proportionate change in the import
prices. This is known as a complete currency pass through.
Partial Currency Pass Through
It means that changes in exchange rate brings less than proportionate change in the import and export
prices. This concept was empirically supported by J-Curve.
Prebisch-Singer Hypothesis
The hypothesis was discussed by Raul Prebisch and Hans Singer in 1950s. The theory is one of the most
influencing theories in terms of “terms of trade and development” in developing countries.
Page 14
The theory states that there will be a long-term deterioration of terms of trade in developing countries due
to long term decline in the prices of primary goods which were exported by developing countries in
comparison to the prices of manufactured goods imported by the developing countries.
Immiserizing growth
The ‘Theory of Immiserizing Growth’ was given by Jagdish Bhagwati in 1958. The theory states that
a country, if focuses on economic growth, could lead it to in the fall in terms of trade and making the
country worse-off than before. According to the theory, if the growth is heavily export biased, it will result
into worsening of the situation of the country. However, such kind of growth is beneficial only when the
country can influence the world prices.
INCOME ABSORPTION APPROACH

The concept was given by Sidney Alexander in 1952. According to this theory, the trade balance of a
country can improve if the domestic absorption is reduced.
X-M = y – C+I
Where: X-M= Exports – Imports = Trade Balance
C+I = Consumption + Investment = Absorption
y = income
So,
Trade balance = Income – Absorption

Trade balance will improve if either there is increase in income or decrease in absorption.
Page 15
MONETARY APPROACH REGARDING BALANCE OF PAYMENT

The concept was given by Robert Mundell and Harey Johnson. The concept was simply an extension
of monetarism. According to them, balance of payment is a monetary phenomenon and money plays a
very important role in it. The concept is explained in terms of both fixed and flexible exchange rates.
1. Fixed Exchange Rate: According to this, disequilibrium will be settled by inflow and outflow of
foreign exchange in the economy.
We know,
Demand for Money (Md) = kPy
Supply of Money (Ms) = m(D+F)
Where: m is the money multiplier and D is the domestic component, F is the foreign exchange.
Case 1: If Md > Ms; This implies excess demand for money which cannot be handled by the
authorities and hence this will lead to inflow of foreign reserves in the economy. As a result, there
will be surplus in the balance of payment.
Case 2: If Md < Ms; this implies excess supply of money which could not be handled by the
authorities and hence there will be outflow of foreign reserves in the economy, leading to deficit
in the balance of payment.
2. Flexible Exchange Rate: Under this, the central authority has the control on the money supply in
the economy. Therefore, the changes in balance of payment will take place with changes in the
exchange rates and domestic prices.
Case 1: Excess supply of money
Deficit in Balance of Payment

Inflationary pressures in the economy
Depreciation of the currency
Demand for money increases
Excess supply will be absorbed
Page 16
Case 2: Excess demand for money
Surplus in Balance of Payment
Currency appreciates
Decrease in demand for money and decrease in domestic

prices as well
Excess demand for money is absorbed
FOREIGN EXCHANGE
1. Nominal Exchange rate: Number of units of

domestic currency required to purchase one unit
of foreign currency.
2. Real Exchange rate: Relative price of two
currencies after adjusting for the price levels in
those two nations.
3. Nominal Effective Exchange Rate (NEER):
The weighted average of nominal exchange rate
where weights are the share of trading partners
in the foreign trade of a country.
4. Real Effective Exchange Rate (REER): The
weighted average of Real Exchange rate where
weights are the shares of a country in foreign
trade.
Page 17
EXCHANGE RATE DETERMINATION

Initially the exchange rate is determined by the market forces of demand and supply. After a certain stage
the central bank of the economy intervenes.
Demand for dollars: When dollar price of rupee falls, implying that rupee appreciates, then imports
increase and demand for dollar will increase.
Supply of dollars: When dollar price of rupee increases, this will discourage the imports and hence supply
of dollar decreases.
Exchange rate determination

15
Demand
Dollar price of rupee
Supply
10
E
5
0
0 2 4 6
Number of US $
Equilibrium is achieved at the intersection level of demand and supply curves, that is, at point E.
How will Exchange rate be determined?

1.

15
Demand
Supply
10
0
0 2 4 6
Number of US $
Page 18
The
diagram can be explained as:
Domestic interest > World interest rate
Capital Inflow in the economy
Supply of dollars increase
Supply curve shifts rightwards

Dollar price of rupee decreases implies that rupee
appreciates
2.

15
Demand
Supply
10
0
0 2 4 6
Number of US $
The diagram can be explained as follows:
Page 19
Domestic interest < World interest rate

Capital outflow
Demand for dollars increase
The demand curve shifts upwards
Rupee depreciates and dollar appreciates
Page 20
MUNDELL-FLEMING MODEL
Mundell-Fleming Model is also known as IS-LM-BP model and was given by Robert Mundell in 1963
and Fleming in 1962.
Assumptions
1. Small open economy

2. Perfect capital mobility
3. Domestic and foreign bonds are perfect substitutes.
4. Tax rates are same everywhere.
5. Perfect equalisation of returns in different countries.
6. Foreign investors do not face political risks.
7. Fixed foreign or world interest rates.
Fixed Exchange Rate
Fiscal Policy
In case of fixed exchange rate, expansionary
15
fiscal policy leads to rightward shift in the
Interest/ Exchange Rate
IS
LM IS curve. As a result, there is a rise in price
BOP
10 of dollars in terms of rupee, leading to
inflow of foreign currency. So to keep it
5 constant, the central bank increases the
money supply by purchasing dollars and
hence shifting the LM curve to the right and
0
0 2 4 6 restoring the equality between IS, LM and
Income BOP curves. Therefore, Fiscal policy is
more effective in case of fixed exchange rate
because there is an increase in income with
no change in the interest rates and exchange
rates.
Page 21
Monetary Policy
15
IS In case of expansionary monetary policy,
Interest/Exchange rate
LM
the LM curve shifts towards the right. This
BOP
10 makes the domestic interest rate to fall
below the world interest rate. As a result,
5
money would flow inside the economy. So
to keep the money supply constant, the
central bank would sell dollars, thus
0 reducing our currency circulation and hence
0 2 4 6
Income level
shifting the LM curve back. Therefore,
monetary policy is not effective.
Flexible Exchange Rate
Fiscal Policy
15
IS
LM
2
10 BOP
5
1
0
0 2 4 6
Income level
Under flexible exchange rate, the role of exports play a very important role.
If fiscal policy is applied in the flexible exchange rate scenario then,
Expansionary Fiscal Policy which shifts the IS curve upwards
Currency appreciates
Imports increase and exports decrease
IS curve shifts back making the fiscal policy ineffective
Page 22
Monetary Policy
15
IS
LM
10 BOP
0
0 2 4 6
Income level
Monetary policy is effective in the case of flexible exchange rate.
Expansionary Monetary Policy which shifts the LM curve

Downwards implying increase in the money supply
Currency depreciates
Imports decrease and exports increase
IS curve shifts upwards making the monetary policy effective by

bringing a rise in the income levels of the economy.
Page 23
OFFER CURVES
The concept of offer curves was given by J.S. Mill. The graphical interpretation of the same was given
by Marshall and Edgeworth. The offer curves are also known as “Reciprocal Demand Curves”.
The offer curves show that how much will a nation import or export at different relative prices. In simple
words, they tell us how much quantity of goods will be imported or exported at different relative prices
by two nations, engaging into trade.
Derivation of Offer Curves
Nation 1
40
P x/P y = 2
30 P x/P y = 1
Good Y 20
10
0
0 2 4 6 8 10
Good X
The offer curve is bent towards the good which will be exported by the country A. When the relative prices
increase from 1 to 2, the willingness to export increases, hence increases the quantity of good X to be
exported.
For Nation 2, the offer curves are as follows:
Nation 2
P x/P y = 2
P x/P y = 4
40
30
Good Y
20
10
0
0 2 4 6 8 10
Good X
Page 24
Nation 2’s offer curve shows how much of Y will be exported in exchange of X. In this case, when the
relative price (Px/Py) decreases, then the willingness to export the good Y by nation 2 increases.
Equilibrium
50
Nation 1
40 Nation 2
Good Y
30
20 Line of equilibrium
10
0
0 2 4 6 8 10
Good X
The equilibrium will exist at the point where the offer curves of the two nations intersect. The line of
equilibrium shows that the supply will always be equal to the demand at this line.
Shift of Offer Curves

The offer curves shift when the willingness to trade enhances, that is, import or export increases. Other
reasons are changes in income, favorable change in tastes.
Willingness to trade increases Shift direction
Nation 1 Offer curve shifts downwards
Nation 2 Offer curve shifts upwards.
Elasticity of Offer Curves

Elasticity of offer curves shows how responsive is the demand for imports to the change in the relative
prices.
For nation 1,
(dy / y )
Elasticity of offer curves =
d ( X / Y ) /( X / Y )
The formula reflects how much export good is given up to get one import food.
For nation 2,
Page 25
(dx / x)
Elasticity of Offer curves =
d ( X / Y ) /( X / Y )
Elasticity of Offer Curves

30
E<1
20
Good Y
E=1
10
E>1
0
0 2 4 6
Good X
E<1 Price changes are less than proportionate to

quantity changes
E=1 Any change in price will lead to

proportionate change in quantity
E>1 Total Revenue increases
Shape of Offer Curves
There are three effects which determine the shape of offer curves. These are:
a. Substitution effect (S.E.) = When (Px/Py) increases, consumer in nation 1 shifts from consumption
of X to consumption of Y, that is, more of income is available for export. This leads to upward
sloping portion.
b. Production effect (P.E.) = If country 1 has an incentive to produce more of X and less of Y, then
price effect reinforces substitution effect and leads to greater availability of X and hence an upward
sloping offer curves.
c. Income effect/Terms of Trade effect (I.E.) = With increase in real income, due to higher price of
export goods, the nation will purchase more of both goods. In other words, there is greater domestic
purchase of X and less availability of X for exports.
Income effect works in the opposite direction to substitution effect and production effect.
Page 26
If S.E. + P.E. > I.E. Upward sloping offer curves
If S.E. + P.E. < I.E. Backward bending/ negative sloping

offer curves
If S.E. + P.E. = I.E. Vertical offer curve
Page 27
TARIFFS
Tariff is a tax levied on export and import of goods. These are the restrictions on free trade.
Types of tariffs
On the basis of Purpose
1. Revenue Tariff: The kind of tariff implemented specially to raise the revenue capacity of the
government is known as the revenue tariff.
2. Protective Tariff: The kind of tariff imposed especially to inflate the prices of imports and protect
the domestic industries from foreign competition is known as protective tariff.
On the basis of origin and Destination

1. Ad Valorem Duty: Ad Valorem duty is charged on the total value of the imported commodity. It
is a fixed proportion of total commodity imported.
2. Specific duty: It is a tariff charged on the specific amount of money which does not vary with the
price of the good. It is charged on the weight of the commodity or the number of units imported of
that commodity.
3. Compound Duty: It is a mixture of both ad valorem and specific duty.
Non-tariff barriers to trade
1. Quotas: It is the ceiling on the quantity to be imported or exported.

a. Tariff Quota: It is a mix of tariff and quota.
b. Unilateral Quota: It is imposed on one nation.
c. Multilateral Quota: Certain proportion is decided to use domestic inputs.
2. Import licencing: Import is dependent on the licenses obtained.
3. Voluntary Export Restraints: Also known as Orderly Market arrangement.
Other regulations to trade
1. Administrative regulations
2. Anti-dumping duties/countervailing duties
3. Export subsidies
Page 28
Difference between Quota and Tariff
Quota Tariff
Trade reducing effects are more certain. Trade reducing effects are less certain.
More vulnerable to corruption. Less vulnerable to corruption.
More restrictive. Less restrictive
Not generating revenue for the economy. Generates revenue for the economy.
Partial and General Equilibrium effects of Quota

1. Partial Equilibrium effects: If a nation imposes quota:
a. Consumption decreases (Consumption effect)
b. Production increases (Production effect)
c. Trade decreases (Trade effect)
d. Revenue decreases (Revenue effect)
Overall, the consumer surplus reduces and producer surplus increases.
2. General Equilibrium effects:

a. In case of large nation:
 The volume of trade decreases.
 Terms of trade may possibly increase.
b. In case of a small nation:
 Overall prices are not affected.
 Volume of trade decreases.
 Terms of trade remains unaffected.
Page 29
FOREIGN EXCHANGE MARKETS

Foreign Exchange Market is a market which deals in foreign currency. It may or may not be physically
located.
Functions:
1. Transfer function: Implies foreign exchange

market transfers the purchasing power of people.
2. Credit function: Providing credit to exporters and
importers.
3. Hedging: Protection against foreign exchange
risk.
Operators or Elements in Foreign Exchange
1. Users of foreign exchange

2. Commercial banks: They act as clearing houses.
3. Brokers: They earn commission on buying and
selling of foreign exchange.
4. Central Banks.
Kind of Operations
1. Spot transaction: Payment has to be made within two business days.
2. Forward or future transactions: Signing an agreement for payments on delivery in future.
Activities in Foreign Exchange Markets:
1. Hedging: Protection against foreign exchange risks.

Types of risks:
a. Transaction exposure: arises due to fluctuations in rates of foreign exchange markets in future
markets.
b. Accounting translation exposure: Interprets accounts in terms of different currencies to
accommodate balance of payment. Includes value inventories held abroad in terms of own
domestic currency for inclusion in balance sheet.
c. Economic exposure: Estimate domestic currency value of future profitability of the firm.
2. Speculation/Speculators: It is the opposite of hedging. More in forward market. The speculators

are willing to take risk or take an open position.
Activities:
a. Stabilising: Buy currency at a low price expecting that the price will be higher in the near
future and sell the currency when the price is higher expecting that it will be lower in the near
future.
Page 30
b. Destabilizing: It is an exact opposite of the stabilizing activities. Buy currency at a higher price
expecting that prices are going to be higher in near future and sell it when the price is lower
expecting that prices will get lower in the near future.
3. Arbitrage: It is a tool to equalise the price. Buying the currency from a country where price is
lower and immediately reselling it in a country where it is higher in order to earn monetary profits.
Purchasing Power Parity (PPP)
The concept was given by Gustav Cassel in 1918. It is the law of one price. The situation occurs when
all the opportunities of arbitrage are exploited and we reach a single price. In the long run, law of one
price prevails, that is, one price for same good will prevail in all the nations.
OPTIMUM CURRENCY AREA

The theory of optimum currency area was developed by Mundell and Mc Kinnon (1963) in 1960s.
It refers to the group of countries whose currencies are permanently tied and will vary with non-members.
It refers to an optimum geographical size within which means of payment is in a single currency and
exchange rates are pegged to one another with unlimited capital and current transactions on the balance
of payment but whose exchange rates fluctuate in unison against the non-members.
Possibility or Conditions in which it will be beneficial:
1. Greater mobility of resources among member nations

2. Greater structural similarities.
3. Countries should be more willing to co-ordinate their monetary and fiscal policies.
Properties of Optimum Currency Areas
1. Mobility of factors
2. Price and wage flexibility
3. Economic openness
4. Diversification in production and consumption
5. Similarity in inflation rates
6. Fiscal and political integration
7. Goods and factor market integration
8. Financial market integration
Benefits of Optimum Currency Area
1. Eliminates the uncertainties regarding exchange rates.

2. Specialisation in production, increases trade volume
3. Advantage of economies of scale
4. Greater price stability
5. Better use of money as a medium of exchange and store of value
6. Saving the cost of official interventions in the forex market.
Page 31
Drawbacks
1. Nations cannot pursue their independent monetary and fiscal policies.
ECONOMIC INTEGRATION
Economic Integration takes place in four stages:
1. Free trade area: Group of nations having no trade restrictions among the members. The countries
in a free trade area can pursue independent tariff policy with non-members. Example: NAFTA
(North American Free Trade Association)
2. Custom Union: Freedom of trade and common tariff policy with non-members.
3. Common market: Has features of free trade area and custom union and also there is a free
movement of labour and capital. European Union became a common market in 1993.
4. Economic Union: It is the highest level of integration. There are no restrictions and there is a free
movement of labour and capital. The countries follow a common tariff policy and also overall there
are common policies for the economy. There is one central bank. This implies that there is
monetary and fiscal unification.
Economic Union
Common market
Custom Union
Free Trade Area
Page 32
TRADE CREATION AND TRADE DIVERSION

The concept of Trade creation and Trade diversion were developed by Jacob Viner in 1950.
Trade Creation: It is the increase in volume of trade because of inclusion of a more efficient producer in
the union.
Trade Diversion: It is the loss of more efficient producer to a relatively less efficient producer. It results
from the non-inclusion of a more efficient producer in a union.
OPTIMUM TARIFF
Optimum tariff is the rate at which the net gain will be maximised. It helps the country to reach its
maximum rate of satisfaction. In simple words, by applying optimum tariff, the country’s social welfare
is maximized. The formula for calculating optimum tariff is:
𝟏
t* =
𝒆−𝟏
where: t* = optimum tariff
e= absolute value of elasticity of nation’s trading partner’s offer curve.
If e = ∞, then t= 0 and when e < ∞, then t > 0.
Lower value of t means greater curvature of the offer curve and greater value of optimum tariff.
Therefore,
Optimum tariff is the rate of tariff that maximizes the net benefit resulting from the improvement in the
nation’s terms of trade against the negative effect resulting from the reduction in the volume of trade.
In other words, optimum tariff is the rate which makes the nation reach its highest trade indifference curve
and this trade indifference curve is tangent to the trade partner’s offer curve.
Page 33
THEORY OF TARIFF STRUCTURE

The theory of tariff structure was developed in 1960s.
Nominal Rate of Protection: It concerns the consumer because it impacts the real income. It is calculated
on the value of the final good and hence is very important to the consumers as it tells by how much price
rises as a result of tariff. It is simply the proportional difference between the domestic and international
price arising from trade policies in question. It is the measure of the total price raising/reducing effects on
goods of the trade policies. It is an impact on the domestic prices which will directly affect real income of
the consumers.
Effective Rate of Protection: The concept was developed by Corden in 1966. It tells us the degree of
protection provided to the domestic good from the export good. Effective rate of protection is the percent
increase in the value added per unit and is calculated on the domestic value added, that is, price of the
final good minus cost of imported inputs going into the production of the good. This rate is important
to the producer as it indicates how much protection is actually provided to the domestic processing of the
import competing commodity. It is used to measure the net effect of trade policies on incentives facing
the domestic producers.
𝒕−𝒂𝒊𝒕𝒊
g=
𝟏−𝒂𝒊
Where: g= rate of effective protection to the producer of final good.
t= nominal tariff rate on consumption of final good.
ai= Ratio of cost of imported input to the price of final good in absence of tariff
ti= nominal tariff on imported inputs
If ti < t then g > t Tariff on imported goods is less than tariff on final goods.
If ti > t, then g < t Nominal tariff on imported goods is greater than nominal
tariff on final goods or in other words, effective rate is
less than nominal rate
If ti = t, then g = t Tariff on imported goods is equal to tariff on final good
Conclusion:
1. If ai = 0 then g=t
2. For given values of ai and ti, g is larger for larger value of t.
3. For given values of t and ti, g is larger for larger values of ai.
4. If aiti > t, then g becomes negative.
Drawback of the formula:
1. It is studied under partial equilibrium framework.

Page 34
2. Assume that inputs are used in fixed proportion in production.
BRETTON WOODS SYSTEM

UN Monetary and Financial Conference was held in 1944 amongst 44 nations’ representatives who
met at New Hampshire.
Reasons for holding a conference:
1. Due to the impact of Great Depression on the world economies.

2. World War II
These two reasons led to the instability in the economies. So countries decided to meet and regulate trading
conditions, leading to the establishment of Bretton-Woods System.
Two plans were proposed:

1. Keynes Plan: The plan proposed to create a clearing house which will be entrusted with powers
to issue international reserve currency.
2. White Plan: The plan proposed to create an “International Fund” which will perform the
following functions:
a. Pool of international reserves.
b. Assist in removing the balance of payment deficits
c. Determine and maintain the exchange rates between currencies.
The White Plan was approved. As a result of this, three institutions were developed:
1. IMF (International Monetary Fund)

2. IBRD (International Bank for Reconstruction and Development)
3. ITO (International Trade Organisation) : It was later replaced by GATT
Exchange System
The system adopted a fixed exchange system, that is, Gold value was fixed in terms of dollars.
1 ounce of gold = $35
All other currencies were linked to dollars.
The collapse of Bretton Woods System
The process of collapse started in 1971. In 1973, the system was completely removed. The reasons
were as follows:
1. Large current account deficit by U.S. As a result the U.S. $ started fluctuating. Therefore,
U.S.$ was unable to commit to the agreement of 1 ounce of gold = $35. Moreover, there was
shortage in supply of $ inside U.S. and excess supply outside U.S.
Page 35
2. Vietnam War (1965-68): U.S. was supporting their military expenditure which led to worsening
the problem of deficit.
3. Two different markets of gold, private market and official market, which led to instability in the
supply demand equilibrium of gold.
On August 15, 1971; US President Nixon, stopped backing the dollars with gold, hence known as Nixon
shock. He took some restrictive steps.
1. U.S. would no longer sell gold to foreign central bank for conversion.
2. On all imports to U.S., 10% tax was imposed and will remain effective until all American partners
revalue their currencies.
3. Did not meet the requirements of exchange $35 for 1 ounce of gold.
Page 36
EUROPEAN MONETARY SYSTEM

In 1969, steps were taken towards European Currency Reform initiatives.
Major Developments:
1. Eliminate the intra-exchange rate movements.
2. Centralising monetary policy decisions.
3. Lowering the remaining trade barriers.
4. Transform it into large unified market.
Wenner report was adopted in 1971. Its task was to recommend suggestions to make a union and fixing
the exchange rates among themselves.
European Monetary System

In 1989, Delors Committee, chaired by Jacques Delors, was formed and it presented its report. The
report suggested steps to convert European market into European Union. The steps were:
Stage 1: All countries that are a part of European Monetary System (EMS) should adopt a specific
exchange rate mechanism. Bands were set which were Exchange rate ± 2.25. A greater degree of co-
operation among central banks of the member nations should be there and also there should be
convergence of macro-economic policies.
Stage 2: Development of European System of Central Bank (ESCB) and exchange rate margins were to
be narrowed.
Stage 3: There will be irrevocable fixing of exchange rates and a unified monetary policy would be taken
care of by the newly created European System of Central Bank.
Page 37
Maastricht Treaty
It was signed on February 7, 1992. It talked about the following amendments:
1. Stage 2 would begin in 1994 and the newly created system of central banks would be called
European Monetary Institution instead of ESCB.
2. Stage 3 to begin on January 1,1997 if a majority of members of the EMS have achieved certain
specified convergence criteria and if qualified majority voted to begin the stage.
Maastricht Convergence Criteria
Countries should specify the following conditions:
1. Countries’ inflation should not be more than 1.5% above the average of three members with lowest
inflation.
2. Countries should have a stable exchange rate under the exchange rate mechanism without having
to revaluate its own initiatives.
3. The country should not have a public sector deficit of more than 3% of its GDP except in
exceptional or temporary circumstances.
4. The country must have a public debt that is below or approaching a reference level of 60% of its
GDP.
Convergence Criteria: There will be an ongoing monitoring of criteria 3 and 4 by European Commission
even after admission to European Monetary Union and imposing penalties on countries that violate these
fiscal rules and do not correct excessive deficit and debt.
In 1997, the European leaders negotiated Stability and Growth Pact (SGP). It will further tighten the fiscal
regulations. Medium term budgetary objective should be in balance or close to balance or in surplus. It
provides a time table for the imposition of financial penalties on countries that failed to correct situations
of excessive deficit and debt.
Page 38
EURO-CURRENCY MARKET
Euro-Currency market is also known as Off-Shore Market. It is an international financial market which
specialises in borrowing and lending of US $ and other European currencies outside their respective
countries of issue.
Participants
1. Government
2. International Organisation
3. Banks (Commercial Banks)
Features of Euro-Currency Market
1. Wholesale Market
2. Inter-Bank transactions: Largest proportion of transactions.
3. Euro banks are concerned with short term lending, essentially short term in nature.
4. Highly competitive market
5. Involves greater risk because it involves normal risk in addition to risk on account of possibility
of imposition of new banking regulations or exchange controls by the Government of the country
in which the transactions are affected.
Development of Euro-currency market started in 1950s. Reasons for development in 1960s and 70s are:
1. Advantage of the London money market: London money market enjoyed locational advantage
on account of greater proximity to some prominent customers.
2. Flow of economic and military aid from U.S. to the West European countries that led to large
transfers of dollars to the European countries.
3. Decline in the importance of pound: Britain became a debtor country because of which there
was a reduced role of its currency and dollar became more important in the European financial
centres.
4. Regulation Q was a restriction imposed by U.S. Federal Bank in 1960s, where in a ceiling was
imposed on the interest rate payable on time deposits with the U.S. Banks. This resulted in U.S.
banks opening their branches in Europe and hence large scale flow of dollars to those branches.
5. In 1963, there was imposition of interest equalisation tax that raised the cost of borrowing in
U.S.
6. Inflationary pressures in U.S. monetary controls. U.S. banks started borrowing in Euro dollar
market through their overseas branches.
7. Expand the borrowing needs.
Negative impact of Euro-Currency Market is that monetary policy cannot be made by the country.
Advantage of Euro-Currency Market
1. Liquidity increases
2. Movements increase, that is, there will be increased mobility of international capital.
Page 39
3. Closer integration in the international capital market.

4. Improvement in the asset portfolio of banks.
5. Extension of services to non-bank private sector.
6. Imparting flexibility in financial market.
7. Reduction in interest rate structures related to deposits and loans.
8. Helps in recycling of funds from the surplus nations to the deficit nations.
9. Increased efficiency.
Disadvantage of Euro Currency Market
1. Has off-setting influence on the domestic monetary policy. The enormous amount of resources
provided by the euro-currency market can result in speculative capital movements and economic
instability, particularly when countries are not protected by trade barriers and exchange controls.
European Union
European Union was formed on November 1, 1993. Euro was formed on January 1, 1999 but was
started using as a currency in 2002.
Number of members in European Union = 28
Headquarters: Belgium
Only 17 members have adopted Euro as their currency.
Terms related to Euro

1. Euro Zone: Group of countries in European Union that have started using Euro as their currency.
2. Euro Group: Group of finance ministers of European Union member states who have adopted the
euro.
3. ESCB: European Central Bank plus the national/Central banks of European Union, whether or not
they have adopted euro.
Page 40
4. Euro System: European central bank plus the central banks of nations in the European Union who
have adopted Euro.
Page 41
GENERAL AGREEMENT ON TARIFFS AND TRADE (GATT)

It was formed post 1944.
Objectives:
1. Formed to provide a code of conduct to countries for trade.

2. Liberalisation of trade, that is, reducing the restrictions on trade.
3. Restrictions on unilateral action
4. Increasing the volume of trade.
5. Increasing the real income
6. Improving the standard of living.
7. Full employment of resources.
Main convention of GATT was that no country can take a one sided action.
Principles of GATT
1. Non-Discrimination: MFN and National treatment

2. Reciprocity
3. Transparency
Structure of GATT
Consists of 38 articles and is divided into 4 parts.
GATT Rounds:
Last round: Uruguay Round (1986), talked about trade in services, Intellectual Property Rights (IPRs)
and promoted the participation of
developing countries.
Page 42
WORLD TRADE ORGANISATION (WTO)

WTO was brought into effect on January 1, 1995.
Principles:
1. Non-Discrimination
2. Free trade or market based liberalism
3. Safety Values/Domestic Safeguards: Trading partners have an option to opt out of those
commitments temporarily.
4. Reciprocity
5. Binding and Enforceable commitments.
Structure of WTO
1. Ministerial Council (MC): Topmost in the hierarchy. It meets once in every two years.
2. General Council (GC): It is functioning at all times when MC doesn’t meet.
Functions:
a. Settles disputes regarding trade. So it functions as a Dispute Settlement Body.
b. Reviews the trade policy of members. Therefore, it acts as a Trade Policy Review Body.
Scope of WTO
1. TRIPS (Trade Related Intellectual Property

Rights): Related to patents, copyrights, etc. There
are 9 categories under intellectual properties and
gives protection to countries having intellectual
properties.
2. TRIMS (Trade Related Investment Measures):
Under this, the foreign domestic investment issues
and conditions/requirements are taken care of.
3. GATS (General Agreement on Trade and
Services): Service trade is protected and included
in WTO.
4. AOA (Agreement on Agriculture): It is specifically related to agriculture and its policies.
Page 43
INTERNATIONAL MONETARY FUND (IMF)

IMF was established officially on December 29, 1945. India holds 8th position and its share in IMF is
2.75%.
Basic Functions or Objectives:
1. Short term lending institution to countries to solve their balance of payment disequilibria.
2. Maintains exchange rate stability.
3. Remove foreign exchange restrictions.
4. Promote international monetary co-operation.
5. Balanced growth of trade.
6. Establish multi-lateral system of payments.
7. Provides consultation and also works as a research institute. It is involved in data collection.
Functions of IMF
1. Exchange arrangements: IMF assists in all matters related to the exchange rates between various
countries. The functions are as follows:
a. It can represent the value of a currency in terms of another.
b. Par value of the currency can be represented in terms of SDRs.
c. Exchange rates can be expressed in terms of currency composite.
d. The countries are not allowed to represent their currencies in terms of gold.
2. Surveillance: IMF performs surveillance function to keep a check on members. It includes:

a. A member should not prefer any one member.
b. The government should participate in foreign exchange markets.
c. The interest of other countries should not be affected due to trade.
3. It keeps a check on countries to avoid any restrictions on the current account.

4. IMF provides consultation and technical assistance.
Page 44
5. IMF lends for BOP difficulties.

Membership in IMF
Members of IMF have to pay: 25% of their quota in the form of gold and 75% of the quota in its own
currency. Quota is decided on the basis of international standing and U.S. has the maximum quota.
Borrowing Limits:
1. Gold Tranche: First 25% of the borrowing limit without restrictions.

2. Credit Tranche: With restrictions.
Quota determines the subscription of funds, drawing rights, voting power, borrowing capacity and share
of a nation in the allocation of Special Drawing Rights (SDRs).
Special Drawing Rights (SDRs): They were formed in 1969. It is a unit of account for IMF members and
each member is given SDRs in proportion to their quotas. Initially value of 1SDR was decided to be
U.S.$ 1 which was further defined in terms of gold. Now valuation of SDRs takes place in every 5 years.
Last valuation was done in 2010. The value is decided in terms of basket of currencies with weights
assigned to them which are as follows:
Currency Weight
U.S. $ 41.9%
Euro 34.7%
Pound 11.3%
Yen 9.4%
A point to remember here is that SDRs are in the form of book-keeping entry form.
Lending Facilities of IMF

1. Supplementary Reserve Facility (SRF): It is the loan given to countries having extreme BOP
crisis.
2. Contingent Credit Lines: It is for vulnerable countries who may suffer from BOP Crisis in near
future.
3. Contemporary Financing Facility: It is for short term or temporary fall in export earnings.
Criticisms of IMF
1. IMF exacerbates Economic Problems

2. All policies of IMF are not suitable for all its members.
3. Takes away political autonomy
Page 45
4. Interference of IMF creates moral hazard as it encourages countries to be ignorant as they can rely
on IMF loans.
NOTE: On july 2004, India and IMF established a joint training programme in National Banking
Management Institute in Pune.
INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT (IBRD)

IBRD was formed in 1945. Its main function is to help poor countries and developing countries by
providing loans which are long term in nature. Help is also extended to the countries affected or
destroyed in wars. It extends loan where private capital is not available and finances projects of economic
development.
Functions of IBRD
1. Assist in reconstruction and development of territories of its member countries.
2. Promote private foreign investments by giving guarantees on loans.
3. Arrange for the loans, made or guaranteed.
4. Promote long term balanced growth of international trade and maintain the equilibrium.
Members of IMF are eligible to become members of World Bank.
Lending Facilities
1. Structural Adjustment Facility: It was introduced in 1985. The main objective is to maintain a
sustainable balance of payment for the countries.
Page 46
2. Enhanced Structural Adjustment Facility: It was introduced in 1987. The main objective was
to increase the availability of concessional resources to low income member countries.
3. Special Action Programme: It was introduced in 1983. The main objective was to strengthen
IBRD’s ability to assist member countries in adjusting to the current economic environment.
Total Subscription
1. 2% in the form of gold or U.S. dollar and is available for lending.
2. 18% is payable in nation’s own currency and is available for lending on consent of the country
involved.
3. 80% is not available for lending and is subject to call as and when required to meet the banks’
obligation.
Under IBRD, loans extended are either medium term of long term.
Other Associates
1. International Finance Corporation (IFC): It was formed in 1956. It is pertaining to private
investors and provides finance to them. Rate of interest is negotiable and it does not seek
government guarantee for repayment of any of its investments.
2. International Development Association (IDA): It was formed in 1960. It is considered to be the
bank for poorest of the poor. It provides them the loans at even zero rate of interest or very low
interest rates. Its main objective is to reduce poverty and providing funds for human and economic
development projects. Initiatives by IDA are under two categories:
a. Debt relief to heavily indebted poor countries through the scheme “Heavy indebted poor”.
b. Multi-lateral debt relief initiatives.
IDA is funded by contributions from governments of richer member countries.
3. International council for Settlement of Investment Disputes (ICSID): It was formed in 1966
and helps in settling the disputes.
4. Multilateral Investment Guarantee Agency (MIGA): It was formed in 1988 and its main
function is to guarantee investment of member nations.
Page 47
GLOBALISATION
Globalization means the integration of different markets in the global economy.
Reasons for the growth of globalisation

1. Developments in the ICT, transport and communications sectors of the economies.
2. Increase in the capital mobility.
3. Development of various different kinds of financial products, like derivatives, etc.
4. Free trade amongst nations, and participation of institutions like WTO, IMF, etc. has facilitated the
process of globalisation.
5. Growth of MNCs have contributed a lot in the process of globalisation.
Advantages of Globalisation
1. Increased specialisation of countries in the production of commodities.
2. Access to larger markets.
3. Access to cheap sources of raw materials, which would reduce the overall cost of production.
4. Less strict regulatory regimes by different countries.
5. Increased flow of investments between countries.
6. Helps in creating employment.
Disadvantage of globalisation
1. Over-standardisation of products through global branding.

2. Large MNCs may suffer from diseconomies of scale due to co-ordinated activities of subsidiaries,
etc.
3. Increased power and influence of MNCs.
4. Loss of jobs
Page 48
South Asian Association for Regional Co-operation (SAARC)
Year of formation December 1985
Members Bangladesh, Bhutan, India, The Maldives,

Nepal, Pakistan, Sri Lanka, Afghanistan
(joined in 2005)
Headquarters Kathmandu, Nepal
Objectives:
1. Promote the welfare of the people of South Asia and to improve their quality of life.
2. Accelerate economic growth, social progress and cultural development. Provide all individuals the
equal opportunities to live a life of dignity and help them in realising their true potentials.
3. Promote and strengthen collective self-reliance among the countries in South Asia.
4. Contribute to mutual trust, understanding and appreciation of each other’s problems.
5. Promote active collaboration and mutual assistance in the technical, scientific, and even social and
cultural fields.
6. Strengthen co-operation with other developing countries.
7. Strengthen co-operation among themselves in international forums.
8. Co-operate with other international and regional organisations with similar aims and purposes.
SAARC Preferential Trading Arrangement (SAPTA)
Year Signed on 11 April, 1993
Operational since December 7, 1995
Objective Promote and sustain mutual trade and

economic co-operation with SAARC
South Asian Free Trade Area (SAFTA)
Year January 6, 2004

Free Trade amongst Bangladesh, Bhutan, India, Maldives, Nepal,
Pakistan and Sri Lanka
Objective Reduce custom duties of all traded good to
zero by 2016. Least developed nations like
Nepal, Bhutan Bangladesh and Maldives
have additional three years to reduce the
custom duties to zero.
Page 49
ECONOMETRICS
Part – 1- (e) Notes by Economics Harbour
The application of statistical and mathematical theories to

economics for the purpose of testing hypotheses and
forecasting future trends
Econometrics
Econometrics
INTRODUCTION TO ECONOMETRICS
The term “Econometrics” was given by Ragnar Frisch. The study is a combination of mathematics
and statistics applied together to understand the economic relationships between the variables taken
into consideration.
Econometrics
Theoretical Study
(Forming tools of studying basic Applied Study
method. The study focuses on the (It deals with the tools of
development of appropriate theoretical econometrics which
methods for measuring economic are used to study special field of
relationships in specified economics.)
economic models.
Page 1
Econometrics
Methodology used in Econometrics

Following are the steps which are followed to identify any economic relationships in econometrics:
Statement of the
theory/hypothesis
Specification of
mathematical
model
Formation of
econometric
model
Obtain data
Estimation of the
model and identify
the numerical values
of the parameters
Hypothesis testing
Forecasting or
prediction
Page 2
Econometrics
TYPES OF DATA
Data is classified into following types:
Data
Cross Sectional Pooled Cross-

Time Series Data Data Section and Time Panel Data
Series Data
Time series data refers to the series of data for one variable over a period of time. For example, to see
the trend of inflation levels in the economy, the inflation in the past few years is collected and hence
analysed.
Cross Sectional data refers to the data collected for more than one variables collected at a single point
of time. For example, to analyse the standard of living of people for the year 2013-14, one may collect
data related to income levels, education levels, health status, etc. for the same year, that is, 2013-14.
Pooled cross-section and time series data: Example variables in 2005 combined with variables in
2010.
Panel data is the multidimensional data for more than one variables over a period of time. In simple
words, it is the combination of both time series data as well as cross sectional data.
Page 3
Econometrics
REGRESSION
The term regression was introduced by Francis Galton. It tells us the dependence of one variable on
one or more independent variable and tries to figure it out.
Dependent variable is also known as the Explained

variable, Regressand, Endogenous variable, controlled
variable, Predictand variable, Response.
Independent variable is also known as the Explanatory

variable, Regressor, Predictor, Stimulus, Exogenous
variable, control variable.
To explain the concept of dependent and independent

variable, we take
E(Y/Xi)
The above expression is known as a Conditional

Expected Value or Mean. It states the expected average
value of y given the value of X, hence our y is the
dependent variable and X is the independent variable.
Further elaborating it,
E(Y/Xi) = β1 + β2Xi
It is a Population Regression Function (PRF), also known as Conditional Expectation Function.
Population Regression Line is the locus of the conditional means of the dependent variable for the
fixed values of the explanatory variables.
However, for samples, we have a Stochastic Regression Function (SRF) which is defined as follows:
y – E(y/Xi) = µ
y = E(y/Xi) + µ
This can be expressed as:

̂𝟏 + 𝛃
𝐲=𝛃 ̂𝟐 𝐗 𝐢 + 𝛍̂𝐢
Where: 𝛽̂𝑖 are the sample estimators of population parameter βi
𝜇̂𝑖 is the random quotient which is unexplained, un-systematic and cannot be determined.
̂1 + 𝛽
𝛽 ̂2 𝑋𝑖 is the explained or systematic part which can be determined.
Page 4
Econometrics
Relevance of Stochastic term µi

1. To incorporate the randomness in human behavior.
2. Principle of parsimony that is, lesser the explanatory variables; better will be the results.
3. Vagueness of the theory
4. Unavailability of the data
5. Poor proxy variables
6. Interdependence of variables
General view…..
But not after reading notes…..
Page 5
Econometrics
OLS METHOD
OLS was introduced by Carl Gauss
According to the method,
⅀(𝒚𝒊 − 𝒚̂𝒊 )2 should be minimum
We have to choose the Stochastic Regression Function in such a manner that it is as close as possible
to the actual income (y). The choice among the lines have to be done on the basis of least squares
criteria. This implies, the smaller the deviation from the line, the better the fit of the line.
̂1 − 𝛽
⅀(𝑦𝑖 − 𝛽 ̂2 𝑋𝑖 )2
̂𝟏 = 𝐲̅ − 𝛃
𝛃 ̂𝟐 𝐗
̅
∑ 𝐱 𝐢 𝐲𝐢
̂𝟐 =
𝛃
∑ 𝐱 𝐢𝟐
Assumptions of OLS/Simple Linear Regression Model

Following are the assumptions of OLS Model:
1. Model should be linear.

2. X values are fixed in repeated sampling.
3. 𝑋̅ value or expected value of the random term is zero.
E(ui/Xi) = 0
4. No auto-correlation between the random terms.

Cov (uiuj) = 0
5. Homoscedasticity or constant variance of the error term.
Var (ui/Xi) = E[ui – E(ui/Xi)]2 = σ2
If the assumption is violated then this implies presence of heteroscedasticity. The variance of error
term about its mean is constant for all values of X.
6. No multi-collinearity, that is, explanatory variables should not be related to each other. In other
words, one variable cannot be expressed in terms of other variables.
Page 6
Econometrics
7. Specification of the model should be correct.
8. Error term is independent of the explanatory variables.

Cov (uiXi) = 0
9. Number of observations in the sample should be greater than the number of parameters estimated.
10. Variance of the explanatory variable should be a positive number.
Properties of Estimates
1. Small Sample or Finite Sample Properties:

Following are the properties which should be satisfied regardless of the size of the sample:
a. Unbiasedness: Unbiased means that the expected value should be equal to the actual value.
Therefore, the property can be represented as,
̂ = 𝐄(𝛃
𝛃 ̂)
b. Linearity: The model should be linear.

c. Minimum Variance: OLS estimates give us minimum variance.
d. Efficiency: When the property of unbiasedness and minimum variance hold true, it means
that the model is efficient.
e. Sufficiency property: OLS estimates are sufficient because it utilises all the information a
sample contains about the true parameter. For example, mean is a sufficient estimator.
f. Minimum ‘Mean Square Estimator’ (MSE): An estimator is a minimum MSE if it has a
smallest mean square error.
𝐌𝐒𝐄 = 𝐄(𝛃 ̂ − 𝐛)𝟐
These properties are called the BLUE properties, that is, Best Linear Unbiased Efficient
properties.
2. Large Sample/Asymptotic properties: When sample sizes increases infinitely, then these
properties should be satisfied:
a. Unbiasness: This means that asymptotic mean of the estimator should be equal to the true
value of the parameter. It only holds for large samples and not for finite samples.
b. Asymptotic consistency: Any estimator is consistent then the true population parameters
satisfy the two conditions:
 Asymptotic unbiasness
 Asymptotic variance
c. Asymptotic efficiency: An estimator is efficient if:
 𝑏̂ is consistent
 It has the smallest asymptotic variance as compared to any other consistent
estimator.
Page 7
Econometrics
When the sample size increases, variance becomes minimum. Also, with the increase in sample size,
the estimators converge to unbiasedness.
Gauss Markov Theory
If all the assumptions of classical linear regression model are fulfilled, then the estimates that we obtain
are linear, unbiased or in other words they are best linear unbiased estimators. These properties are also
called BLUE properties.
Multiple Linear Regression Model
Multiple Linear Regression Model is used when there are more than one explanatory variables in the
model. For example,
y = β1 + β2X1i + β3X2i + ui
Where: β2 and β3 are the partial slope coefficients
The assumptions in case of Multiple Linear Regression Models are the same as OLS.
….under both, Simple or Multiple Linear Regression Model if

any of the assumptions are violated, then there can be three consequences:
1. Multi-collinearity
2. Heteroscedasticity
3. Auto-correlation
Page 8
Econometrics
MULTI-COLLINEARITY
The term multi-collinearity was given by Ragnar Frisch. When explanatory variables are related
to each other, it implies existence of multi-collinearity in the model.
Multi-collinearity can be of two types:
1. Perfect Multi-collinearity
β1X1i + β2X2i + ………. + βnXni = 0
If none of the coefficients of X, that is, β is equal to zero, then

one explanatory variable can be converted into another.
2. Imperfect Multi-collinearity
It is the case when one explanatory
variable cannot be perfectly
converted into another, and the model is:
β1X1i + β2X2i + ………. + βnXni + vi = 0
Causes of Multi-collinearity
These are given by Montgomery and Peck
1. Problems in the specification of the model or nature of specification of the model.

2. Data collection methods may impose a limiting range on the values taken by the regressors in a
population.
3. Constraint on the model may also result in the problem of multi-collinearity.
4. Over-determined model also exhibit the problem of multi-collinearity. If number of observations
are greater than the number of parameters, we will not be able to get unbiased and unique solutions.
5. Lagged values of the variables included in the model also lead to multi-collinearity. In other words,
multi-collinearity is more commonly found in time series data.
Consequences of Multi-collinearity
1. Even though the OLS estimates are BLUE, but they have large variances and covariances.
2. Confidence intervals are widened leading to the acceptance of null hypothesis (H0) more
frequently.
3. T-ratio becomes statistically insignificant.
4. R2 is very high but t-ratios are insignificant.
5. OLS estimators and their standard errors can be very sensitive to changes in the data.
Page 9
Econometrics
Estimates’ properties at the time of multi-collinearity
1. The estimates might not be able to determine them uniquely.

2. Variance and standard errors will be infinite
3. 𝛽̂ 𝑠 are unbiased and efficient but have large variances.
Detection of Multi-collinearity
Following are the signs which could help locate multi-collinearity in

our models:
1. High R2 and few significant t-ratios.

2. High pair wise correlations among the regressors will also
indicate multi-collinearity. This is only a necessary condition and
not sufficient, which means that even if the pair wise correlation
coefficients are zero, multi-collinearity can exist.
3. Frisch’s Confluence Test: It regresses the dependent variable on each of the explanatory variable
separately and thus obtain all the possible simple regressions and examine the results on the basis
of:
 Apriori knowledge
 Statistical criteria
Then we choose that elementary regression which has most plausible result on the basis of apriori
and statistical criteria. We gradually then insert additional explanatory variables and examing the
effects on individual coefficients, standard error and overall R2.
If the new explanatory variable improves R2 without rendering the individual coefficient
unacceptable, then this new explanatory variable is retained, otherwise it is rejected as a
superfluous variable. Also if the new variable changes the signs and the values of individual
coefficients considerably, then it is an indication that multi-collinearity is a severe problem in
particular data set and needs to be taken care of.
1
4. Variance Inflation Factor (VIF) = (1−𝑟 2 )
23
1
Tolerance (TOL) = 𝑉𝐼𝐹
If TOL is close to zero, then multicollinearity is present and if it closer to one then less degree of
multicollinearity.
If r2 ~ 1, greater will be the VIF and more is the multicollinearity.
Page 10
Econometrics
5. Auxillary Regression: Under this we exclude one variables and regress it on other variables to
estimate our R2. Steps followed are:
Exclude X and
Regress y on Calculate R2 regress it on Calculate RA2
X2 other
variables (Xs)
6. Condition Index: The method uses Eigen values.
𝑴𝒂𝒙𝒊𝒎𝒖𝒎 𝑬𝒊𝒈𝒆𝒏 𝑽𝒂𝒍𝒖𝒆

Condition Index (CI) = 𝑴𝒊𝒏𝒊𝒎𝒖𝒎 𝑬𝒊𝒈𝒆𝒏 𝑽𝒂𝒍𝒖𝒆
If 100 < CI < 1000 Moderate to strong multicollinearity
If CI > 1000 Severe multicollinearity
If 10 < √𝐶𝐼 < 30 Moderate to strong multicollinearity
If √𝐶𝐼 > 30 Severe multicollinearity
Page 11
Econometrics
Remedies for correcting multi-collinearity
1. Using the apriori information

2. Dropping a variable.
3. Transformation of a variable: Given a set of data, if there is
a problem of multicollinearity, it can also be solved using the
first difference form.
4. Additional or new data: Since multi-collinearity is a sample
phenomenon, it can be reduced by taking another sample or by
increasing the sample size.
5. Reducing polynomial regressions: having lesser number of
polynomial variables in regression equation also takes care of
multicollinearity.
6. Combining cross-section and time series data: In the face of multi-collinearity, one method of
reducing it is pooling of time-series and cross-section data. This is done by estimating regression
coefficient from cross-section data and then incorporating them in the original regression equation.
Page 12
Econometrics
HETEROSCEDASTICITY
. The term heteroscedasticity means that the variance
of error terms is not constant, that is, different error Be Patient..Its a
terms have different variances.
long one…
𝛔𝟐𝐢 = 𝐟(𝐗 𝐢 )
So, hetero-scedasticity is the problem of fluctuating

variances of error terms. Moreover, the variance of the
error terms depends on the value of the explanatory
variables. It is a rule in cross-section data and very rate
in time series data.
Causes of Heteroscedasticity
1. All the models pertaining to learning skills or

error learning models exhibit
heteroscedasticity.
2. Economic variables such as income and wealth
also show heteroscedasticity because as income
or wealth increase, so is the discretion to use it.
3. Some economic variables exhibit the skewness in distribution.
4. Data collection technique improves with time. As a result constant variance is not found for all
those economic variables where data collecting techniques are changing very fast.
5. Specification errors in the models also lead to heteroscedasticity.
6. Incorrect data transformation methods also show heteroscedasticity.
7. Outliers in the data may result into the problem of heteroscedasticity
Consequences of heteroscedasticity
1. The estimators are still linear, unbiased and consistency doesn’t change.
2. However, the estimators are no longer BLUE because they are no longer efficient, therefore, they
are not the best estimators. The estimators do not have a constant variance.
Tests of Heteroscedasticity
1. Graphical Method
Under this method, the error term is plotted against the X-variable
and then observe whether there is any systematic pattern or not. If
the graph shows some pattern, it would imply that there is
heteroscedasticity present in the model.
2. Park Test: Under this test, we assume that variance is a function of

the explanatory variable (X), that is,
𝛔𝟐𝐢 = 𝛔𝟐 𝐗 𝐢 𝛃 𝐞𝐯𝐢
Page 13
Econometrics
Taking log on both sides, we get;
Log σ2i = logσ2 + βlogXi + vi

̂𝑖2 = α + βlogXi + vi
Log 𝑢
̂𝑖2 .
We cannot directly observe σ2i . so for all heteroscedasticity test, we will be using 𝑢
Steps followed under this method are:
Run OLS and calculate 𝑢̂𝑖
̂2 on log X as
Run regression of Log 𝑢𝑖 i
given in the above equation.
Apply t-test and if β1 turns out to be

significantly different from zero, then it
implies heteroscedasticity is present.
3. Gleizer Test: Error term is related to the independent variable through different functional forms.
According to him, following functional forms can be tried and heteroscedasticity can be tested:
 𝑢 ̂𝑖2 = 𝛽1 + 𝛽2 𝑋𝑖 + 𝑣𝑖
 𝑢 ̂𝑖2 = 𝛽1 + 𝛽2 √𝑋𝑖 + 𝑣𝑖
 𝑢 ̂𝑖2 = 𝛽1 + 𝛽2 1 + 𝑣𝑖
𝑋𝑖
̂𝑖2 = 𝛽1 + 𝛽2 1
 𝑢 + 𝑣𝑖
√𝑋𝑖
 ̂𝑖2 = √𝛽1 + 𝛽2 𝑋𝑖 + 𝑣𝑖
𝑢
 ̂𝑖2 = √𝛽1 + 𝛽2 𝑋𝑖 2 + 𝑣𝑖
𝑢
We then judge the statistical significance of β1 & β2 by any standard test. If they are estimated to
be statistically different from zero, then heteroscedasticity is present.
Page 14
Econometrics
There can be two possibilities:
If β1 = 0 & β2 ≠ 0 Pure heteroscedasticity
If β1 ≠ 0 & β2 ≠ 0 Mixed heteroscedasticity
4. Spearman’s Rank Correlation Test: Following

steps are followed to conduct this test:
Step 1: Fit the regression to the data and obtain the residual
𝑢̂𝑖 .
Step 2: Ignoring the sign of 𝑢̂𝑖 by taking the absolute

values, we rank both |𝑢̂𝑖 | and Xis either in ascending
order or descending order.
Step 3: Now compute the Spearman’s Rank Correlation

∑ 𝑑2
𝑟𝑠 = 1 − 6[𝑛(𝑛2 −1)
𝑖
]
Step 4: Now assuming that the population correlation coefficient is zero, we apply the t-test.
𝑟𝑠 √𝑛 − 2
𝑡=
√1 − 𝑟𝑠2
For n-2 degrees of freedom.

If the computed t-value is greater than the table value, heteroscedasticity is present.
If computed t-value is less than the table value, then there is no correlation between
Xi and ui.
5. Goldfeld-Quandt test: This test is only applicable to sample size greater than or equal to 30.
The following assumptions are taken into consideration while applying this test:
a. σui2 = σ2Xi2
b. assumes that ui are not auto-correlated
c. Error term follows a normal distribution.
d. Number of observations is atleast twice the number of parameters.
Page 15
Econometrics
We follow the underlined steps while applying this test:
We assume there is a positive relationship between the

variance and explanatory variables.
The observations are ranked
Divide the series into two parts, that is, (n-c)/2

where c is the central value
Regress the two parts separately and obtain Residual sum of

squares (RSS) or ui2 for each
Use the F-test

F = [(RSS2)/dof] ÷ [(RSS1)/dof]
dof = (n-c-2k)/2
If F > table value, then heteroscedasticity is present and vice
versa.
6. White’s General Heteroscedasticity Test: The main merit of this test is it has no assumptions
like normality.
Steps to perform this test are:
a. Calculate 𝑢̂𝑖 𝑠
b. Regress 𝑢̂𝑖 on our explanatory variable X.
c. 𝑢̂
2 =α +α X +α X +α X 2+α X 2+α X X +v
𝑖 1 2 2i 3 3i 4 2i 5 3i 6 2i 3i i
d. Calculate R2, that is, goodness of fit.

e. Use χ2 test to estimate the model.
f. Test for heteroscedasticity and specification errors. If no cross products are present, that is,
(X2iX3i), then pure heteroscedasticity. If cross products are present, then it reveals the
presence of heteroscedasticity and specification bias.
Page 16
Econometrics
7. Koenkar Basett Test: The method uses the squared residuals to test the presence of
heteroscedasticity. Steps followed under this method are:
a. Run the regression and obtain the residual terms.
̂𝑖2 = 𝛼1 + 𝛼2 𝑦̂𝑖 + 𝑣𝑖
𝑢
b. Regress the squared regressor on squared values of y.
c. Test for hypothesis
Remedial Measures
The problem of heteroscedasticity can be corrected

when variances are known or unknown.
Case 1: When variances are known:

Generalised Least Squares (GLS) or Weighted Least
Squares (WLS) methods are used when we know the
variances. GLS is a procedure of transforming the
original variables of the model in such a way that the
transformed variables satisfy the assumptions of the
classical model and then apply OLS to them. In short,
GLS is simply a kind of OLS done on the transformed
variables that satisfy the standard least squares
assumption.
We minimise the weighted sum of residual squares

which act as weights.
1
𝑤𝑖 =
𝜎𝑖2
Observations coming from a population with a larger σi will get relatively smaller weight and those
from population with smaller σi will get a larger weight in minimising the residual sum of squares.
For estimating the population regression function, we would give more weight to the observations
that are closely clustered around their population mean than to those that are relatively away from
it.
Estimates obtained from GLS are BLUE.
Case 2: When Variance is not known
In such a case, we transform the model in such a way so as to obtain a functional form in which
transformed disturbance term has a constant variance. We may assume any of the below mentioned
functional relationship:
Page 17
Econometrics
1. Assumed error variance or error terms are in proportion to squares of explanatory variables:
Earlier the variance was equal to
ui2 = σ2Xi2
The variance is not constant, thus we need to transform the original model which is;
yi = β1 + β2Xi + ui
Dividing both sides with Xi we get
𝑦𝑖 𝛽1 𝑢𝑖
= + 𝛽2 +
𝑋𝑖 𝑋𝑖 𝑋𝑖
𝑢𝑖
𝐸(𝑢𝑖2 ) = 𝐸( )2
𝑋𝑖
1
𝐸(𝑢𝑖2 ) = 𝐸(𝑢𝑖2 )
𝑋𝑖2
1
𝐸(𝑢𝑖2 ) = 𝑋 2 𝐸(𝜎 2 𝑋𝑖2 )
𝑖
𝐸(𝑢𝑖2 ) = 𝜎 2
2. Error variance is proportional to Xi: It is also known as “Square Root Transformation”.

𝐸(𝑢𝑖2 ) = 𝜎 2 𝑋𝑖
Our model is;
yi = β1 + β2√𝑋𝑖 + ui
We divide both sides by √𝑋𝑖 ;

𝑦𝑖 𝛽1 𝑢𝑖
= + 𝛽2 +
√𝑋𝑖 √𝑋𝑖 √𝑋𝑖
𝑢𝑖 1 2
𝐸 (𝑢𝑖2 ) = 𝐸( )2 = 𝜎 𝑋𝑖 = 𝜎 2
√𝑋𝑖 𝑋𝑖
Page 18
Econometrics
General Rule says that if the variance is of the functional form
σi2 = k2f(Xi)
then we transform the regression model by dividing throughout by √𝑓(𝑋𝑖 )
Another method of removing heteroscedasticity is log transformation
Yi = β1 + β2Xi + ui
We then take log on both sides,
Log Yi = logβ1 + β2 logXi + ui
Then also we are able to reduce/remove heteroscedasticity because log function compress the scale
in which the variables are measured thereby reducing a tenfold difference to a two-fold difference.
Thank God it is
finished.. Now I can
rest for some
time…
Page 19
Econometrics
AUTO-CORRELATION
By the term auto-correlation we mean that the error terms are related to each other over time or over space.
Value of error term in one period is correlated with its value in another period, then they are said to be
serially correlated or auto-correlated.
Auto-correlation
Spatial Auto- Serial Correlation

correlation (Correlation between
(Correlation between error terms over a
cross-sectional units) period of time)
Auto-correlation is more of the time series phenomenon because error term is likely to be related to
successive values of other error terms of the same series. Therefore, because auto-correlation is generally
not found in cross-section data, then it is known as spatial auto-correlation.
Positive auto-correlation is when the variables are going in the same direction.
Negative auto-correlation is when variables are going in different directions.
Causes of auto-correlation
1. More prevalent in time series data.

2. Specification bias: Whenever we exclude an important variable or we use incorrect functional
form, then there is a possibility of auto-correlation in the model.
3. Cobweb Model: In case of cobweb models or whenever economic phenomenon reflects cobweb
phenomenon, that is, supply reacts to the price with a lag of one time period, then we say that
problem of auto-correlation arises in such data.
4. Manipulation of data
Page 20
Econometrics
5. Lags: Whichever economic phenomenon is showing impact of the variables from the previous
time period, problem of auto-correlation is likely to surface in such models. A regression model in
which one of the explanatory variables is the lagged value of the dependent variable, it is known
as an auto-regressive model and such models also exhibit auto correlation.
6. Non-stationarity, that is, mean and variance are not constant.
Impact of Auto-correlation on estimates

1. Estimates are statistically unbiased. However, they are
no longer best because they won’t have minimum
variance.
2. With auto-correlated values of the error term, the OLS
parameters’ estimates are likely to be larger than those
of other econometric models. Therefore, the βs are still
linear and unbiased, but no longer BLUE and best.
3. The estimates are not efficient, but they will be
asymptotically consistent.
4. From application of simple formula, the estimation of
variance will be smaller, that is, the simple OLS
formula will underestimate the true variance of the
estimators.
5. Confidence intervals are likely to be wider than those
which are based on GLS procedure.
Consequences of Auto-correlation
1. t and F-tests are no longer valid and if applied will lead to incorrect results.
2. R2 is likely to be over-estimated.
Detecting Auto-correlation
1. Graphical Method
2. Von-Neumann Ratio: It is the ratio of 1st difference of a variable X to the variance of X. It is

numerically expressed as:
∑𝐧𝐭=𝟐(𝐗 𝐭 − 𝐗 𝐭−𝟏 )𝟐 /(𝐧 − 𝟏)
̅)𝟐 /𝐧
∑(𝐗 𝐭 − 𝐗
However, this method is only applicable for directly observed series and for variables that are
random.
3. Runs Test: It is a non-parametric test. A run is an uninterrupted sequence of one symbol or

attribute. Length of a run means that the number of symbols or elements included in one run.
Page 21
Econometrics
Too many runs may suggest negative serial correlation and too few runs may suggest positive serial
correlation.
N = Total number of observations (N1 + N2)

N1 = Number of positive symbols
N2 = Number of negative symbols
R = Number of runs (we assume that R is asymptotically normally distributed)
𝟐𝐍𝟏 𝐍𝟐
Mean (E(R)) = +𝟏
𝐍
𝟐𝐍𝟏 𝐍𝟐 (𝟐𝐍𝟏 𝐍𝟐 −𝐍)
Variance (σR2) = 𝐍𝟐 (𝐍−𝟏)
Limits of mean = E(R) - 1.96σR < R < E(R) + 1.96 σR
If R is within the limits, then no auto-correlation. However, if they are not in the limits, then auto-
correlation is present.
4. Durbin-Watson test (or d-statistic): The tests incorporate following assumptions:

a. It is applicable to small samples.
b. It based on estimated residuals.
c. Regression model must include an intercept term.
d. The explanatory variables should be non-stochastic.
st
e. Disturbances (𝑢 ̂)𝑡 are generated by the 1 order auto-regressive scheme.
ut = ϱut-1 + v
f. Error terms are assumed to be normally distributed.
g. Regression model does not include lagged values of the dependent variable as one of the
explanatory variables.
h. There are no missing observations in the data.
d is the ration of sum of squared differences in the successive residuals and residual sum of squares
(RSS).
𝟐
∑𝐧𝐭=𝟐(𝐮̂𝐭 − 𝐮̂
𝐭−𝟏 )
𝐝=
∑𝐧 𝐮 ̂𝟐
𝐭=𝟏 𝐭
̂]
𝐝 ≈ 𝟐[𝟏 − 𝛒
∑𝒖
̂𝒖𝒕̂𝒕−𝟏
̂=
Where: 𝛒 ̂𝟐
∑𝒖 𝒕
If 𝜌̂ = 0, this would imply d ≈ 2, there is no auto-correlation
If 𝜌̂ =1, this would imply d = 0, Positive auto-correlation
If 𝜌̂ = -1, this would imply d =4, Negative auto-correlation
Page 22
Econometrics
Testing procedure
Calculate the residuals of the model
Calculate d statistic
Calculate limits of d
Analyse whether the value of d lies within the

limits or not, and accordingly take the decision.
Drawbacks of the d-statistic

a. The test might lead us to inconsistent results. If d falls in
indecisive zone, we cannot conclude whether 1st order
auto-correlation exists or does not exist.
b. We cannot use the test when the model does not have the
intercept term.
c. It is not an appropriate measure if amongst the
explanatory variables, there are lagged values of the
endogenous variables.
d. We cannot test higher order serial correlation through
this test.
e. The test cannot be used in case of large samples.
f. The assumption that the regressors are non-stochastic
makes the d-test invalid in the case of large samples or
for any sample.
5. Breusch-Godfrey Test (LM Test): The test is also known as Durbin’s M-test. It is used when:
a. In case of non-stochastic regressors.
b. In case of lagged values of the regressand.
c. Higher order auto-regressive schemes.
d. Simple or higher order moving average of error terms.
Page 23
Econometrics
Steps followed under this test are:
Run the regression and calculate the value of the residuals.
Regress the residuals on the original Xt and 𝑢

̂𝑡−1 ,
𝑢
̂𝑡−2
From this, auxillary regression, calculate the value of R2
Apply chi-square test, assuming that auto-regressive test is

of pth order.
(n-p)R2 ~ χ2
If (n-p)R2 is greater than critical χ2 value, then reject H0
stating that autocorrelation is present
Drawbacks of the test are:

a. Value of p and length of lag cannot be specified apriori.
b. It is just the derived form of Durbin test if the value of p = 1.
Page 24
Econometrics
Remedies for correcting Auto-correlation in the model:

1. If the source of auto-correlation is omitted variables, then the remedy is to include those
variables in the set of explanatory variables.
2. If auto-correlation is because of misspecification of the mathematical form, then we need
to change the form.
If auto-correlation exists because of reasons other than the above mentioned two, then it is the case
of pure auto-correlation.
 If ϱ is known, then we apply GLS, transforming the original data so as to produce a model
whose random variables satisfy the assumptions of Classical Least Squares and
consequently the parameters can be optimally estimated with this method.
 If ϱ is not known, we then try to calculate p by using the 1st difference method or we can
even calculate p on the basis of Durbin-Watson d statistic.
Other than this, we can use iterative methods to estimate the value of ϱ like:
1. Cohrane-Oraitt Method
2. Durbin 2-step method: FGLS (Feasible Generalised Least Square); EGLS (Estimated Generalised
Least Squares
3. Newey West method
4. White’s General Heteroscedasticity test
Page 25
Econometrics
SIMULTANEOUS EQUATION MODELS

The simultaneous equation models deal with the two-way relationship between the variables. For
example;
Xi = β1 + β2Yi
Yi = α1 + α2Xi
The above equations are known as structural or behavioural equations and β1, β2 , α1 and α2 are
known as structural coefficients.
Reduced form equations
The reduced form equations are deduced/derived from the main equations of the given model in
which the dependent variable is solely expressed in terms of explanatory variables or non-stochastic
variables.
We cannot apply OLS in simultaneous equation model because it will lead to simultaneous bias.
1. 𝛽̂ s will be biased estimators.

2. The error term and explanatory variable become correlated.
3. 𝛽̂ s will not be an efficient estimator.
Under simultaneous equation models, the stochastic term will only be that term which is determined
from inside the model, that is, the dependent variable.
Hope you got everything till now!!!!!
Page 26
Econometrics
IDENTIFICATION PROBLEM
Variables can be either exogenous or endogenous
Structural Equations:
C = a + bY + u
Y=C+I
C = a + b (C+I) + u
C – bC = a + bI + u
C = (a/1-b) + (bI/1-b) + (u/1-b) …

(Reduced form Equation)
Identification:
G = Total number of equations in the model ( Number

of exogenous variables)
K = Total number of variables in the model
M = Number of endogenous and exogenous variables

in a particular condition
Order Condition:
(K – M) ≥ G – 1
It is a necessary condition but not sufficient
K-M = Total number of variables excluded from a particular equation but included in other equations
G – 1 = Number of equations – 1
K-M = G-1 Just Identified
K–M>G–1 Over identified
K–M<G–1 Under-Identified
For a model to be exactly identified, all equations should be exactly identified.
Rank condition
Any equation is identified if and only it is possible to construct atleast one non-zero determinant.
|𝑮 − 𝟏| ≠ 𝟎
Page 27
Econometrics
Methods to Handle Simultaneous Equation Models
Methods of estimation are as follows:
1. Single Equation Method/ Limited Information Method: Each equation will be estimated
individually, not taking into account the restrictions placed on the other equations.
2. Full information Method: Equations in the model are estimated simultaneously, taking into
account all restrictions on such equations by the omission or absence of some variables.
SINGLE EQUATION METHODS OF ESTIMATION

Indirect Least Squares (ILS) Method:
The method of ILS is used in case of Just/Exactly Identified Equations. It is the method of obtaining the
estimates of the structural coefficients from OLS estimates of the reduced form coefficient.
Assumptions in ILS are:
1. Equation is Just/Exactly identified.

2. There must be full information about all equations in the model.
3. Error term from reduced form equations should be independently, identically distributed.
4. Equations must be linear.
5. There should be no multicollinearity among the pre-determined variables of the reduced form
coefficients.
Steps to be followed in applying ILS
Obtain the reduced form equations
Apply OLS to the reduced form equations individually.
Obtain the estimates of the original structural coefficients

from the estimated reduced form coefficient.
Page 28
Econometrics
Properties of ILS Coefficient

The ILS coefficients inherit all asymptotic properties like consistency and efficiency; but the small sample
properties such as unbiasedness do not generally hold true.
Two Stage Least Squares (2SLS) Method
The 2SLS method was introduced by Henri Theil and Robert Bassmann and is mostly used in equations
which are over-identified. Under this method, the OLS is applied twice. The method is used to obtain the
proxy or instrumental variable for some explanatory variable correlated with error term.
2SLS purifies the stochastic explanatory variables from the influence of stochastic disturbance or random
term.
The steps performed under 2SLS are:
Obtain 𝑦̂𝑖 s from the original

equations
Replace the y in the original

equations by 𝑦̂
Apply OLS to the transformed

equation
Point to note is that least squares is applied twice to the same coefficient.
Page 29
Econometrics
Features of 2SLS
1. The method can be applied to an individual equation in the system

without taking into account the other equations.
2. This method is suitable for over-identified equations because it gives one
estimate per parameter.
3. This method can also be applied to unidentified equations but in that case
ILS estimates will be equal to 2SLS estimates.
4. If R2 values in a reduced form
regressions are very high, then
OLS and 2SLS will be very close.
If R2 values in the 1st regressions
are low, then 2SLS estimates will
be meaningless.
DYNAMIC ECONOMETRIC MODELS

The dynamic econometric models include both the lag and the time element in it. They are of two types:
1. Auto-Regressive Models: These models include the lagged values of the dependent/endogenous
variable. Example:
Yt = β1Yt-1 + β2Yt-2 + ……..+ βp Yt-p + ut
2. Distributed Lag Models: These models include the lagged values of the explanatory variables. If
the length of the lag is defined, then it is known as ‘Finite Distributed Lag Models’. If we don’t
know the length of the lag or it is infinite, then it is known as ‘Infinite Distributed Lag Models’.
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Econometrics
Main reasons for including lags in a model are:
Psychological
Reasons
1. Psychological Reasons: As a result of habit formation, consumers do not change their

consumption habits instantly. There is adjustment to changes in income, fashions, etc. over a period
of time. Therefore, to study the impact of any variable on dependent variable, we need to consider
lag in time.
2. Technological reasons: In production, modes of techniques of production can’t change instantly.
So there is an expected time period lag in adjustment to any kind of demand for a product.
3. Institutional reasons: Most of the time, especially in production, firms have contractual
obligations with labourers as well as the suppliers of the raw material.
Koyck Approach
Main points under Koyck Approach
 Treats distributed lag models

βk = β0λk
 Assumes an infinite distributed lag models.
 0 < λ < 1; implies that past elements are given less weightage as compared to those in recent times.
 Sum of βs is finite.
 It is not a linear method. Therefore, we need to apply the least squares method, hence transforming
the model.
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Econometrics
 We take a one-period lag;

 yt – λyt-1 becomes an auto-regressive model.
Problems under Koyck Approach:
1. Error terms are serially correlated.

2. yt-1 becomes stochastic.
3. Cannot use the d-test. Instead, we need to use Durbin-H
test.
Rationalisation of Koyck Approach
1. Adaptive Expectation: The concept was given by

Cagan & Friedman. It is also known as ‘Error
learning hypothesis’. According to the approach, the
present decisions will depend on the past.
Xt* - Xt-1* = λ(Xt – Xt-1*)
If λ = 1, then;
Xt* = Xt , implying that everything is adjusted instantaneously and hence there is perfect
adjustment.
This model is popularly used but has been criticised for taking into account the past values of the
variables and ignoring the present expected rate of interest values. Also the error term of this model
shows that there are going to be major problems in the estimation of the model.
2. Partial Stock Adjustment Model: The concept was given by Mark Nerlove. It is based on
Flexible Accelerator Model. The model suggests us the way in which capital is adjusted for the
desired capital stock.
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Econometrics
TIME SERIES ECONOMETRICS

The concept of time series was developed by Engel & Granger. The method tells us the arrangement of
variables over a period of time.
Time Series
Univariate Multi-variate
(Analysing one sequence of (Analysing a number of
data over a period of time) variables over time)
Example: Yt = F(Yt-1 , Yt-2, Example: Yt = β1 + β2 Yt-1 +
….., Yt-n) + ut β3 Xt +ut
Stationary Time Series

A time series is considered to be stationary if its mean and variance do not change over time.
If we explain it mathematically, the stationary time series will be that series whose:
E(Yt) = µ which is not a function of time
Var(Yt) = E(Yt - µ)2 = σ2 which is not a function of time
Cov(Yt+k, Yt) = Ɣab(h); if a is not equal to b, then the function is known as a cross correlation function
and is the equality is sustained, then autocorrelation is present in the model.
1. Strictly Stationary: It is an extreme form of stationarity. Any series ( Yt, , Yt+1…., Yt+n) is
considered to be strictly stationary if the joint distribution of the first ‘n’ observations is equal to
that of another set of distribution with ‘n’ observations separated by a time lag, say k (Yt+k,
Yt+k+1,……., Yt+k+n). To explain it mathematically,
Assume we have two distributions (Xt1) and (Xt2).
We introduce a lag of say k in the series, (Xt1+k) and (Xt2+k).

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Econometrics
So in a strictly stationary series, even after introducing the lag
Xt1 = Xt1+k;
Xt2 = Xt2+k
Also in a strictly stationary series, the continuous variables tend to be identical to the discrete variables,
that is,
X (t) ≡Xt
Where: X(t) is the continuous variable and Xt is the discrete variable.
One point to remember is that under the strictly stationary series, higher order moment will be constant.
2. Weak Stationary: A series Yt is considered to be a weak stationary series if it’s mean and variance
are independent of time, that is, in such type of a series, it’s only the mean and variance which do not
change. Rest all the variables are a function of time. However, the covariance or auto covariance is the
function of lag but not of time. Mathematically it can be expressed as:
E(Yt) = µ which is not a function of time
Var(Yt) = E(Yt - µ)2 = σ2 which is not a function of time
Cov(Yt+k, Yt)
E(Yt - µ)( Yt+k - µ) = Ɣk which is a function of lag but not time
Non-Stationary Series
The Non-Stationary Stochastic Process is defined as the process whose mean and variance are not constant
over the period of time.
For example, if we have a stochastic process Yt. It will be a non-stationary stochastic process if;
E(Yt) = f{time(t)}
Variance (Yt) = f{time(t)}
Where f denotes ‘a function of’.
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Econometrics
Process generating Time Series
1. Random or Stochastic Process: In such a process, a

variable can take any value at a point of time. It is a
discrete process which consists of a series of
independently, identically distributed (iid) variables,
also known as white noise. We consider a process to be
white noise process if it has zero mean, constant
variance and is serially uncorrelated. Mathematically it
can be expressed as below:
Mean: E(Yt) = 0
Variance = E(Yt – 0)2 = σ2
2. Random Walk: It is a non-stationary process, expressed

as below:
Yt = Yt-1 + ut
Where: ut is our white noise error term which is

independently, identically and normally distributed with
mean equal to zero and a constant variance, that is,
ut ~ iid N (0, σ2)
Current value of the endogenous variable will be embedded in the past term including the error
term. With reference to out equation above, value of Y in time period t is equal to its value in the
previous time period, that is, t-1 plus a random shock/term.
If we take drift and trend in the model, then it would become non-stationary.
Random walk with drift:
Yt = Ϩ + Yt-1 + ut
where:
Ϩ is the drift parameter
ut is the white noise error term
Random Walk with drift and trend:
Yt = Ϩ + Yt-t + βt + ut
Where: Ϩ is the drift variable, β is the trend variable
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Econometrics
3. Integrated Stochastic Process:
a. Auto-Regressive (AR) Process: Any series is said to be generated by Auto-Regressive process if it

is defined as :
Yt = βYt-1 + ut
The above mentioned model is the auto regressive model of order one, denoted as AR(1). This is so
because we include one lag term of our endogenous variable Yt .
One important point to note here is that if β = 1, then the series becomes a random walk process or a
unit root process as explained before.
A series is generated by auto regressive process of order p, that is, AR(p), if;
Yt = β1Yt-1 + β2Yt-2 + ……..+ βp Yt-p + ut
b. Moving Average (MA) Process: A series is said to be generated by moving average if it is defined
as follows;
Yt = ut + Ɣ1ut-1 + Ɣ2 ut-2 + …. + Ɣq ut-q
The above mentioned model is denoted as MA(q); implying Moving Average of order q.
The difference between Auto Regressive and Moving Average Process are:
Auto Regressive Models Moving Average Models
Regression is done on the lagged values of Regression is done on the lagged values of
endogenous variables the error terms
The model is stochastic in nature, thus it has The model is deterministic in nature,
an error term therefore, it has no error terms.
Yt = β1Yt-1 + β2Yt-2 + ……..+ βp Yt-p + ut Yt = ut + Ɣ1ut-1 + Ɣ2 ut-2 + …. + Ɣq ut-q
c. Auto Regressive Moving Average (ARMA): A series is said to be generate by the process of
Auto Regressive Moving Average process if it is defined as follows:
Yt = β1Yt-1 + β2Yt-2 + ……..+ βp Yt-p + ut + Ɣ1ut-1 + Ɣ2 ut-2 + …. + Ɣq ut-q
The above mentioned series is a combination of both Auto Regressive model of order p (AR(p))
and Moving Average model of order q (MA(q)).
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Econometrics
The general ARMA model was first described by Peter Whittle in his thesis in 1951. He used
mathematical analysis like Laurent Series and Fourier analysis with some statistical inference to
explain ARMA models. It was further popularized by George E.P. Box and Jenkins, in their book
in 1971, also introducing a method named after them (Box-Jenkins) method for choosing and
estimating the ARMA models.
The process of Auto Regressive Moving Average can be summarized as
• Yt = β1Yt-1 + β2Yt-2 + ……..+ βp Yt-p + ut

AR(p)
• Yt = ut + Ɣ1ut-1 + Ɣ2 ut-2 + …. + Ɣq ut-q

MA(q)
• Yt = β1Yt-1 + β2Yt-2 + ……..+ βp Yt-p + ut +

ARMA(p,q) Ɣ1ut-1 + Ɣ2 ut-2 + …. + Ɣq ut-q
d. Auto Regressive Integrated Moving Average (ARIMA) Process: Suppose that ∆dYt is a
stationary series that can be represented by an ARMA model of order (p,q); then we can say that
Yt can be represented by an ARIMA process of order (p,q, d)
The model is called integrated because the stationary ARMA model which is fitted to the difference
data has to be integrated to provide a model for non-stationary data.
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FUNCTIONAL FORMS
A linear functional form is of the type:
yi = β1 + β2Xi + ui
However, there can be following types of functional forms as well:
1. Log-Log/ Log-Linear/ Double Log Function: Such type of a functional form is represented as:
Log yi = log β1 + β2 log Xi + ui
Here, β2 is a slope coefficient and remains constant. It tells us per unit changes in yi with per unit
changes in Xi.
This model is also known as Constant Elasticity Model.
2. Log-Lin/Lin-Log Models: These are the semi log models and represented as:
Log-Lin Log yi = β1 + β2Xi + ui
Lin-log yi = β1 + β2log Xi + ui
3. Linear Trend Models: In such models, the regression is done on a time trend and is expressed as
follows:
yi = β1 + β2 t + ui
Where: t is the time trend.
4. Reciprocal Models: Under such models, the OLS cannot be applied directly. The model is
expressed as:
𝟏
Yi = β1 + β2 (𝑿 ) + ui
𝒊
If Xi approaches to infinity, then yi is asymptotic to β1.
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Econometrics
CO-INTEGRATION
The term co-integration was introduced by Engel (1987) & Granger (1981). Co-integration studies
the short run and long run dynamics of the series and links the short run behavior with the long run
behavior.
It is said that if there is a long run relationship between the two given series, then they are said to be
co-integrated.
For example,
Yt = I(1)
Xt = I(1)
Yt – βXt will become I(0), then this process is called co-integration.
If it would have been I(1); we won’t call the series to be co-integrated.
Error Correction Mechanism
It is also known as Granger Representation Theorem.
∆y = f(∆X, u)
Where u is used to correct the disequilibrium.
If u ≠ 0, the equilibrium needs to be established and

accordingly y changes to get back to equilibrium.
Error correction mechanism describes the short run

dynamics. If Xt, Yt are co-integrated then there is a long
term relationship between them. However, in the short
run, there may be a possibility of disequilibrium. So the error term can be treated as an equilibrium
error and this can be used to tie the short run behavior to the long run value.
Granger Representation Theorem states that if two variables are co-integrated, then the relationship
between the two can be expressed as an error correction mechanism.
Tests of Co-integration
1. Dickey-Fuller and Augmented Dickey Fuller Test: It is also called Engel-Granger Test/Augmented
E-G Test.
2. Durbin-Watson Test: It is also called co-integrating Regression Durbin-Watson test.

Under this we take null hypothesis (H0: d=0).
We assume that if d = 0, then we have a unit root, hence the series is non-stationary.
If H0 is rejected, then this would imply that the series is stationary in nature and hence no problem.
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Econometrics
VECTOR AUTO REGRESSION (VAR)

The concept was given by Sims and is related to simultaneous models and Granger Causalty. Under
this, we consider a number of simultaneous equations and also that all variables are dependent. It is a
multiple time series generalization of auto-regressive models.
Advantages of VAR:
1. We do not have to differentiate between endogenous and
exogenous variables.
2. Estimation becomes simple. OLS can be used making our
estimators to be precise in nature.
3. We can forecast a number of variables at a time.
Disadvantages of VAR:
1. We do not consider it as a purely econometric approach because this
kind of approach is based on less a-priori information.
2. Estimates calculated do not have economic implications.
3. Problem of lag length: It is difficult to handle lags and estimate the
number of lags to be taken in a model.
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Part 1 – f Notes by Economics Harbour
Statistics is the grammar of science.

-Karl Pearson
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Statistics
Statistics
MEASURES OF CENTRAL TENDENCY

1. Arithmetic Mean: It is the most common form of average and is used only in case of quantitative
data. It can be calculated for both grouped as well as ungrouped data.
Type of Series Formula for Arithmetic Mean
⅀𝑋
Individual Series 𝑁
Where: X is the item in a series
N: Number of items in a series
⅀𝑓𝑋
Discrete Series 𝑁
Where: f is the frequency
⅀𝑓𝑚
Continuous Series 𝑁
Where: m is the middle value of the class interval
⅀𝒇𝒅
A+
⅀𝒇
Where: A is the assumed mean, d = (X-A)
⅀𝑓𝑑′
Step-Deviation: A + ∗𝑖
⅀𝑓
Where: d’ = (X-A)/i ; i = Class Interval
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Properties of Arithmetic Mean:

a. It is a mathematical average.
b. Sum of deviations of all items from the mean is zero, that is,
⅀(X- X ) = 0
c. Sum of squared deviations from the mean is minimum.
d. If all items are replaced by some number, then mean won’t change.
e. If we add/subtract/multiply/divide all the items with a number, then the mean would be
changed in the same manner.
f. It is capable of further mathematical treatment like combined mean.
Combined mean = ( X 1 N1 + X 2 N2) / (N1 + N2)
g. It can be depicted graphically. The intersection of regression lines show arithmetic mean.
⅀𝑾𝑿
Weighted Arithmetic Mean =
⅀𝑾
Where W are the weights.
Properties of Weighted Arithmetic Mean are:
a. If equal weights are given to all items then simple arithmetic mean becomes equal to weighted
arithmetic mean.
b. If more weights are given to larger items and less weight to smaller items, then arithmetic
mean is less than the weighted arithmetic mean.
c. If larger weights are given to smaller items and smaller weights are given to larger items, then
arithmetic mean is greater than the weighted arithmetic mean.
Merits of Arithmetic Mean

a. It is based on all items of the series, therefore, it is more reliable.
b. Further mathematical treatment can be carried out.
c. It is easy to compute.
Demerits of Arithmetic Mean

a. Sampling fluctuations may not provide us the correct value of
arithmetic mean.
b. It is affected by extreme values.
c. It cannot be easily shown in a graph.
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2. Geometric Mean (GM)
For ungrouped data;

GM = √𝑿𝟏. 𝑿𝟐 … … . . 𝑿𝒏
𝐥𝐨𝐠 𝑿𝟏+𝐥𝐨𝐠 𝑿𝟐+⋯…+𝐥𝐨𝐠 𝑿𝒏
Log GM =
𝒏
For grouped data;

f1 f2 fk
GM = n X1 X 2 ........... Xk
Where n = f1 + f2 + …. fk
Type of Series Formula
Individual Series GM = AL[⅀log X/n]
Discrete Series GM = AL[⅀flog X/⅀f]
Continous Series GM = AL[[⅀flogm/⅀f]
Properties of Geometric Mean

a. Geometric Mean is less than the arithmetic mean, that is, GM<AM
b. The product of all items will remain the same if each item is replaced by the geometric mean.
c. The geometric mean of the ratio of two corresponding observations in a series is equal to the
ratio of their geometric means.
d. The geometric mean of the product of corresponding items in a geometric mean is equal to the
product of their geometric means.
Weighted GM = AL [⅀WlogX/⅀W]
Combined GM = AL [ (N1 logGM1 + N2 logGM2)/N1+N2]
Geometric mean is most suitable for index numbers, ratios and proportion.
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Statistics
Merits of Geometric Mean

a. It is rigidly defined.
b. It gives lesser weight to larger items and vice-versa. As a result,
it is never greater than arithmetic mean.
c. It is capable of further mathematical treatment.
Demerits of Geometric Mean
a. It is not suitable for open-end distributions.
b. It is complicated and difficult to use.
c. It is of limited use. It cannot deal with negative or zero values.
3. Harmonic Mean: It is the reciprocal of the arithmetic mean of the reciprocal of all items in a
series. Harmonic Mean is also applicable in case of quantitative data.
Type of Series Formula
Individual Series HM = N/⅀(1/X)
Discrete Series HM = ⅀f/⅀(f/X)
Continous Series HM = ⅀f/⅀(f/m)
It is used less in economics because it gives largest weight to smallest items. It is used in
probability of time and speed and also in finding their rates.
Merits of Harmonic Mean

a. It is a mathematical average, therefore, represents all the values of a series.
Demerits of Harmonic Mean
a. It is difficult to calculate.
b. It is of limited use.
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Statistics
POSITIONAL AVERAGES
1. Median (M): Median divides the series into two equal parts. The sum of
deviations from the median will be minimum if we ignore the signs, that is,
⅀|X-M| = minimum
Median = (N+1)/2 th item

For continuous series, we first take the sum of frequencies, calculate (N/2) and find the median
class. Then we use the following formula:
𝒏
(𝟐)−𝒄𝒇
Median = L + *i
𝒇
Where: cf = cumulative frequency of the class preceding the median class
f= frequency of the median class
i= class interval
Merits of a Median
a. It can be very easily used even in the open end or non-normal distribution.
b. It can be used in case of qualitative data.
c. It is not affected by extreme values
d. It can be graphically depicted by the intersection point of the ‘more than’ and ‘less than’ ogives.
Demerits of a Median
a. The calculation process is slow.
b. It is not based on all items.
c. It is not capable of further algebraic treatment
d. It is affected by sampling fluctuations.
Relationship between Arithmetic Mean, Geometric

Mean and Harmonic Mean
1. If all items are the same then, AM=GM=HM. If not,
then, AM>GM>HM.
2. GM = √𝑨𝑴 ∗ 𝑯𝑴
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Statistics
 Quartiles: It divides the series into four equal parts.

Q1 = (N+1)/4 = First Quartile
Q2 = 3(N+1)/4 = Third Quartile
 Second Quartile = Median
Deciles: They divide the series into ten equal parts.
 Percentiles: They divide the series into hundred equal parts.

The percentiles and deciles are used in education statistics,
psychological statistics.
Quartiles are used in business and economic statistics.
2. Mode (Z): It is the most frequently occurring item in the
series.
For individual and discrete series, mode is calculated using the most frequently occurring value,
while for continuous series, we first identify the modal class with the highest frequency and then
use the following formula:
𝒇𝟏−𝒇𝟎
Z=L+ ∗𝒊
𝟐𝒇𝟏−𝒇𝟎−𝒇𝟐
Where:
L = Lower limit of the modal class
f1 = frequency of the modal class, f0 = frequency of the class preceding the modal class, f2 =
frequency of the class succeeding the modal class
i= class interval
The series can follow bi-modal distribution, that is, it can have two modes. Bi-modal distribution
occurs because:
a. Either sample size is small.
b. Data is non-homogenous in nature.
Merits of Mode
a. It can be used even in the open end series.

b. It can be graphically depicted using a histogram
c. It is not affected by extreme values.
Demerits of Mode
a. It might not be rigidly defined.
b. It is not based on every item.
c. It is not capable of further algebraic treatment.
d. In case of bi-modal series, it is difficult to find a unique value of mode.
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Statistics
Relationship between Mean, Median and Mode
Mode = 3 Median – 2 Mean
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Statistics
MEASURES OF DISPERSION
Dispersion is the degree or amount by which items in a series are different from the central value. It will
tell us the reliability and representative of an average calculated from the series.
Uses of Dispersion
1. To know the reliability and representativeness of an average.

2. To control the variability.
3. Helps in comparisons.
4. For computing other statistical measures.
Measures of Dispersion
Measures of Dispersion
Absolute Measures Relative Measures

(The result is in the same (It leads to a pure number,
units in which we have the that is, it is independent of
original data) units. It is a ratio of one or
more absolute measures.)
1. Range: It is the difference between the largest and the smallest value of a series.
Range = L - S
(𝐋−𝐒)
Coefficient of Range =
(𝐋+𝐒)
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Statistics
Uses:
a. Helps in weather forecasts
b. Helps in determining share
prices.
c. Helps in Quality control
Merits:
a. It is simple and easy to calculate.
Demerits:
a. It is not based on all items.
b. It is subject to sampling fluctuations.
It must be noted that though Range is very easy to calculate, it is

usually not used as a measure of variability because of its
inherent feature of instability. Therefore, range is considered to
be a very limited measure of variability.
2. Quartile Deviation: It is the difference between the third quartile (Q3) and the first quartile (Q1).
Semi-Quartile Range = (Q3 – Q1)/2

𝐐𝟑−𝐐𝟏
Coefficient of Quartile Deviation =
𝐐𝟑+𝐐𝟏
Quartile deviation measures the variability of the middle 50 percent values, that is, which are
between Q3 and Q1. It plays an important role in the graphical method “boxplot”.
Merits:
a. It is useful in open-end distributions.
b. It is not affected by extreme values.
Demerits:
a. It covers only 50% of the items in a series.

b. It is affected by sampling fluctuations.
c. It is not capable of further mathematical treatment.
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Statistics
3. Mean or Average Deviation: It is the sum of items taken from any central tendency.
⅀|𝐗−𝐌𝐞𝐚𝐧|
Mean Deviation from mean =
𝐍
⅀|𝐗−𝐌𝐞𝐝𝐢𝐚𝐧|
Mean Deviation from median =
𝐍
⅀|𝐗−𝐌𝐨𝐝𝐞|
Mean Deviation from mode =
𝐍
It is usually preferred from median because the deviations from the median are minimum when
ignoring signs.
Coefficient of Mean Deviation
Coefficient of Mean Deviation Formula
From Mean Mean Deviation from mean/Mean
From Median Mean Deviation from mean/Median
From Mode Mean Deviation from mean/Mode
Merits:
a. It is based on all items of a series.
b. It is simple to calculate.
c. It is less affected by the extreme values.
d. Comparisons become easy.
Demerits:
a. It ignores signs which might lead to inaccurate results.

b. No further algebraic treatment is possible.
4. Standard Deviation/Root Mean Square Deviation: It was introduced by Karl Pearson in 1823.
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Statistics
Formula:
(X  X )  f (X  X )
2
2
SD (σ) = or
N N
S.D. (σ) =
d 2
(
d ) 2
or
 fd 2
(
 fd ) 2
N N f f
S.D. (σ) =
d' 2
(
 d ') 2
* i or
 fd ' 2
(
 fd ' ) 2
*i
N N f f
Where d’ = (X-A)/i
i= class interval
d = (X-A)
A = Assumed Mean
Coefficient of Variation (CV): It was given by Karl Pearson.
𝝈
CV = ∗ 𝟏𝟎𝟎
𝑴𝒆𝒂𝒏
Higher the value, poorer the series.
Variance: The concept of variance was given by R.A. Fischer in 1913. It is simply the square of
standard deviation
Variance = σ2
Properties of Standard Deviation
a. Combined Standard Deviation =
N S.D  N SD  N d  N d ) / N  N
2 2 2 2
1 1 2 2 1 1 2 2 1 2
Where: d1 = X1 – Combined Mean

d2 = X2 – Combined Mean
b.
-3σ -2σ -1σ Mean 1σ 2σ 3σ

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Statistics
Area Covered
Mean ± 1 σ 68.27%
Mean ± 2 σ 95.45%
Mean ± 3 σ 99.73%
c. Normal Deviation
Quartile Deviation < Mean Deviation < Standard Deviation
QD = (2/3)*SD
MD = (4/5)*SD
Merits of Standard Deviation

a. Based on all items of the series.
b. Capable of further algebraic treatment.
c. It is used to compute other statistical measures.
Demerits of Standard Deviation
a. It is difficult to compute and is time consuming.
Graphical Method of measuring dispersion is the Lorenz Curve. The concept was given by Musgrave
through Lorenz Curve. The formula used is:
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Statistics
Lorenz Curve
A B
6
C
4
Y
0
0 2 4 6
X
Where, the straight line is considered to be the line of equality. Closer is the curve to the line of equality,
less will be the dispersion.
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SKEWNESS
Skewness measures the direction in which the values are dispersed. It measures the degree of symmetry
or asymmetry of the series.
2. Positively skewed distribution: A

distribution is considered to be positively
skewed when it has a long tail extended
from its right. Under such kind of a
distribution, mean is greater than the
median, implying that mean is sensitive
to each item in the distribution and is
prone to large shifts when the sample
drawn is small and contains extreme
values.
1. Symmetric Distribution: A series is said

to be symmetric when it has the same
shape on both the sides of the centre. A
symmetric distribution which has only
one peak is known as a normal
distribution.
3. Negatively Skewed: A series is said to be

negatively skewed when it has a long tail
extending from its left.
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Tests of Skewness
1. If mean = median = mode, then the series is symmetrical.
2. Shape of the curve also determines whether the series is skewed or not.
3. If Q3 – Median = Median – Q1 then the series is symmetrical.
4. For a series to be symmetrical, the sum of positive deviations from the
median should be equal to the sum of negative deviations from the
median.
5. In case of a symmetrical distribution, the frequencies are equally
distributed at points of equal deviations from the mode.
Measures of Skewness
Absolute Measure Relative Measure
Karl Pearson (Mean – Mode) or (Mean – Mode)/SD or
3(Mean – Median) 3(Mean – Median)/SD
Bowley Q3 + Q1 – 2M (Q3 + Q1 – 2M)/(Q3 –

Q1)
Where M = Median
Kelly D9 + D1 – 2M or D9 + D1 – 2M/ D9 - D1
or
P90 + P10 – 2M
P90 + P10 – 2M/ P90 -
P10
MOMENTS
Moments can be calculated using three ways:
1. Central Moments or Moments about the actual mean (µ)

µr = ⅀(X-Mean)r/N
µ1 = ⅀(X-Mean)1/N = Zero
µ2 = ⅀(X-Mean)2/N = Variance
2. Non-Central Moments or raw moments (Using assumed mean) (µ’)

It is of least utility and is used for conversion purposes only.
µr’ = ⅀(X-A)r / N
3. Moments about the origin or zero (v)
vr = ⅀(X-0)r / N
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v1 = ⅀(X)1 / N = Mean
µ2 and µ3 measures skewness.

µ2 and µ4 measures kurtosis.
Utility of Moments
1. First moment about zero is mean.

2. Second central moment is variance.
3. First central moment is zero.
4. Second and third central moments give us the measure of skewness.
5. Second and fourth central moment give us the measure of kurtosis.
KURTOSIS
Kurtosis determines the shape of the curve, Platykurtic: The items in a platykurtic are
that is, degree of flatness or peakedness of the scattered around the shoulder and are not
curve. It refers to how the items in a concentrated around the centre or at the tails.
distribution are concentrated in the centre.
Leptokurtic: The items are more
Mesokurtic: A normal distribution is also concentrated in the centre in case of a
known as mesokurtic. There is neither an leptokurtic curve. As a result of this, such
excess or deficient items in the centre of a curve has a sharp peak.
mesokrutic curve.
Kurtosis
25
20
Leptokurtic
15
10 Mesokurtic
5
Platykurtic
0
0 2 4 6 8 10
Measure of Skewness Measure of Kurtosis
In terms of moments, the skewness can be β2 = µ4 / µ22

measured as follows: Ɣ2 = β2 – 3
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β1 = µ32 / µ23
Ɣ1 = √𝜷𝟏 =
3 β2 = 3 Mesokurtic

3
2 β2 > 3 Leptokurtic
β1 is always positive and hence it does β2 < 3 Platykurtic

not tell us about the direction of change.
Ɣ1 = 0 Symmetrical
Ɣ1 > 0 Positively Skewed
Ɣ1 < 0 Negatively Skewed
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Statistics
CORRELATION
Correlation determines the relationship between two or more variables. It determines the degree and
direction of relationship between two or more than two variables.
Spurious Correlation is the one in which relationship cannot be determined.
Assumptions:
a. There should be a linear relationship between the two variables taken into consideration.
b. The variables should follow a normal distribution.
Types of Correlation
1. Depending upon direction of change

a. Positive correlation: Both the variables move in the same direction.
b. Negative correlation: Both variables change in the opposite directions.
2. Ratio of changes
a. Linear correlation: It reflects the same ratio of change.
b. Curvilinear: Ratio of change between the variables is not the same.
3. Degree of relationship
a. Multiple correlation: Correlation between more than two variables.
b. Simple Correlation: Correlation between two variables.
c. Partial Correlation: Relationship is studied between two variables keeping other variables
constant.
Methods of Measuring Correlation
1. Graphical or Scattered Diagram Method

Perfect Positive Correlation (+1) Perfect Negative Correlation (-1)
6 6
4 4
2 2
0 0
0 2 4 6 0 2 4 6
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High Correlation Low Correlation

15 15
10 10
5 5
0 0
0 2 4 6 0 1 2 3 4 5
No correlation
20
15
10
0
0 2 4 6 8
2. Karl Pearson’s Coefficient of Correlation: It is based on the idea of covariance.

a. Deviations from actual mean: x= X  X ; y = Y  Y
r=
 xy or
x ys 2
r=
 xy or
N x  y
cov( x, y )
r=
 x y
b. Deviations from Assumed Mean
N  dxdy   dx dy
r=
N  dx 2  ( dx) 2 N  dy 2  ( dy ) 2
c. Calculations from Actual Data
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N  XY   X  Y
r=
N  X 2  ( X ) 2 N  Y 2  ( Y ) 2
Properties of ‘r’
a. Its value lies between -1 and +1, that is, -1 ≤ r ≤ +1

b. r is independent of change in origin and change in scale.
c. r is the under-root of the product of two regression coefficients.
d. It is a pure number.
e. It is symmetric, that is, rxy = ryx
f. If the two variables are not related or are independent of each
other, then r is equal to zero. However, other way round may
not be correct, that is, if r is equal to zero may not necessarily
imply that two variables are independent of each other.
Merits of correlation coefficient:
a. The correlation coefficient tells us about both the degree and direction of correlation.
Demerits of correlation coefficient:
a. It is of limited use because of the assumptions linearity and normally distributed.

b. Calculation is time consuming.
c. Value of r is unduly affected by the extreme values.
d. It can only be used for quantitative data.
Probable Error: The probable error is used to test the value and significance of the correlation
coefficient. It helps in testing the reliability of r. we can also find out the exact lower and upper
limits within which r is expected to lie.
(1  r 2 )
Probable Error (P.E.) = 0.6745
N
1 r
2
Standard Error (S.E.) = ( N

)
If |r| < 6P.E. r is not significant
If |r| > 6P.E. r is significant
Limits
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Statistics
Upper limit r+ P.E.
Lower limit r-P.E
3. Spearman’s rank correlation method: The method was developed in 1904. It is useful for finding
the correlation in case of qualitative data. Under this, no assumption is made regarding the
distribution of data.
∑ 𝒅𝟐
rk = 𝟏 − 𝒏(𝒏𝟐 −𝟏)
d = Difference in ranks
n = Number of pairs of items
Properties:
a. ⅀D = ⅀(R1 – R2) = 0
b. R is distribution free and non-parametric.
c. R=r when all values are different and no value is repeated.
Merits of Spearman’s Rank Correlation
a. It is useful for finding the correlation in case of qualitative data.

b. It is distribution free.
Demerits of Spearman’s Rank Correlation
a. It cannot be used in case of group frequency distribution.

b. It becomes difficult to use this method when the number of items is more than 30.
4. Concurrent Deviation:
2c  n
rc = ± ( )
n
Where: c = dxdy or number of positive signs obtained by multiplying dx and dy
n = number of pairs of observation
Merits:
a. Simplest of all.
b. When number of items is very large, this method may be used to form a quick idea about degree
of relationship.
Demerits:
a. Does not differentiate between small and big changes.
b. Only a rough indicator of correlation.
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REGRESSION
The concept of Regression was given by Galton in 1985. Regression gives us an average relationship
between variables where we clearly know which is dependent and independent. It is different from
correlation because values of dependent variable is calculated on the basis of given values of explanatory
variables.
Difference between Correlation and Regression

Correlation Regression
Degree of convariability Nature of relationship (cause and effect)
Symmetric (rxy = ryx) Not Symmetric (bxy ≠ byx)
There can be nonsense correlation. No existence of non-sense regression.
Coefficient: Independent of change in scale and Coefficient: Independent of change in origin but not
origin. of scale.
The regression line can be either:
1. X on Y: It gives the probable values of X given the values of Y.

2. Y on X: It gives the probable values of Y given the values of X.
If r = ±1 Regression lines coincide
If r = 0 Regression lines are right angled
In short, closer the regression lines, greater is the degree of

correlation.
Regression Equations
X on Y X = a + bY
Y on X Y = a + bX
Regression Coefficient: It is the slope coefficient which measures the average change in one variable for
a unit change in the value of another variable.
Regression Coefficient: Regression Coefficient
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Y on X = byx X on Y = bxy
y x
byx = r bxy = r
x y
byx =
 xy bxy =
 xy
x 2
y 2
Cov( x, y ) Cov( x, y )
byx = bxy =
VarX VarY
Cov( x, y ) Cov( x, y )
byx = bxy =
 2
x  y2
From assumed mean
byx =
N  dx 2  ( dx) 2
bxy =
N  dy 2  ( dy ) 2
 ⅀(y-yc)2 should be minimum. This gives  Total variations are divided into two
us the line of best fit. parts:
 Regression lines pass through means of X 1. Explained variations = ⅀(yc – mean
and Y distributions. of y)2
 Positive deviations = Negative 2. Unexplained variations = ⅀(y – yc)2
deviations.
Therefore,
 ( y  y) 2
  ( yc  y) 2   ( y  yc ) 2
Standard Error of Regression Estimate: It measures the dispersion around the average or is commonly
known as the mean relationship. It measures the reliability of regression coefficient.
Coefficient of Determination: It is measured using the following formula:

𝐄𝐱𝐩𝐥𝐚𝐢𝐧𝐞𝐝 𝐕𝐚𝐫𝐢𝐚𝐭𝐢𝐨𝐧
Coefficient of Determination (r2) =
𝐓𝐨𝐭𝐚𝐥 𝐕𝐚𝐫𝐢𝐚𝐭𝐢𝐨𝐧
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Correlation coefficient (r) will be equal to r2 only when r = 0 or 1. Also, r tells the direction of correlation
while r2 doesn’t provide us with any such information.
Coefficient of Non-Determination (k2) = 1 – r2 or

𝐔𝐧𝐞𝐱𝐩𝐥𝐚𝐢𝐧𝐞𝐝 𝐕𝐚𝐫𝐢𝐚𝐭𝐢𝐨𝐧
k2=
𝐓𝐨𝐭𝐚𝐥 𝐕𝐚𝐫𝐢𝐚𝐭𝐢𝐨𝐧
Properties of Regression Coefficient
1. r= . Signs of bxy and byx 3. Regression coefficient is always less than

b xy
* b yx
1.
should be the same. 4. Regression coefficient is not symmetric.
2. Sign of r should be the same as that of 5. Regression coefficients are independent
regression coefficient. of the change in origin but not scale.
6. r ≤ (bxy + byx)/2
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TYPES OF DATA
1. Primary Data:
“By primary data we mean those which are original, that is, those in which little or no grouping
has been made, the instance being recorded or itemized as encountered. They are essentially
raw material.”
-Secrist
Ways:
a. Direct personal investigation d. Schedule filled in by the respondents.
b. Indirect/Telephonic oral investigation e. Schedule filled in by the enumerators.
c. Information through local sources or
correspondents.
Disadvantage: Costly in terms of time, money and effort.
2. Secondary Data: It is the second hand information and is not costly.

Sources:
a. Published Sources: The published data is available
from the following sources:
 International Publications like International monetary
fund, World Bank, International Labour Organisation.
 Government Publications like Reserve Bank of
India’s Bulletin, Economic Survey.
 Reports by Commission and Councils like by
Planning Commission, By National Labour Council.
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 Semi-Government Publications like birth rate and death rate index by Municipal Corporation
and other local bodies.
 Magazines or Newspapers
 Research paers, Thesis, Synopsis
b. Unpublished Sources
Census
Census covers each item of the population and is considered to be very authentic and reliable. However,
it is time consuming and costly.
Sampling
Law of Statistical Regularity: Any sample out of the population will have the properties of the
population.
Inertia of large numbers: Larger the sample size, more authentic is the sample.
Properties or Essentials of Sampling

a. Sample should be representative of the population.
b. Adequate size
c. Sample should be fair and independent.
d. Homogeneity
e. Sample should be based on practical experience.
f. Free from individual bias
Sampling Methods
1. Probability/Random/Chance Sampling: All units of the population have the same chance of
being selected in the sample.
Methods:
a. Simple Unrestricted Probability Sampling: Under this method, the sample is drawn randomly,
that is, each item has equal probability of getting selected in the sample. The techniques for
selecting the Random Sample are:
 Lottery method
 Card technique
 Tippett Table
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b. Stratified Sampling: Under stratified sampling, the population is divided into different strata.
Strata are defined in such a way that the population inside one strata is homogenous in nature.
Later, the sample is drawn from each strata, hence forming our complete sample.
c. Systematic Sampling: Under this, the population is arranged in an order. A sample is so constituted
that every nth term is a part of the sample. For example, I choose every 7th individual to be a part
of my sample.
d. Multi-Stage/Cluster sampling: Under this method, the sample is selected in stages, starting from
an elementary stage.
2. Non-Probability Sampling: It is non-random. All items of the population don’t have the same
chance of being selected.
Types:
a. Judgement Sampling: It is also known as ‘Sampling by Opinion’. Under this, the person,
according to his own judgement, decides on who is to be included in the sample.
b. Quota Sampling: Under this method, a quota is decided on to how much should be the sample.
Further, each investigator is given a quota to interview a specific number of respondents.
c. Convenience Sampling: Under this, the sample is formulated according to the convenience of the
investigator.
Sampling Errors
Error is the difference between sample statistic and population parameters.
Types of errors are:
1. Sampling Error: It can occur because of any procedure involved in sampling.

a. Biased: Due to human element
b. Unbiased: Due to problem in procedure of selection.
With increase in sample size, the sampling errors (especially the unbiased errors) decrease.
2. Non-Sampling Error: It occurs after the selection of a sample. For example, faulty printing,
coding, tabulation of data, etc.
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Merits of Sampling
1. It is saves time and cost.

2. If the sample is a perfect representative of the
population, then the conclusions derived are
accurate.
3. It is convenient for the administration.
4. It is flexible in nature.
Demerits of Sampling
1. It may not be a true representative of the

population.
2. There is a possibility of biasness.
3. It is difficult to stick to a sample.
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PROBABILITY DISTRIBUTION
Distributions
Theoretical Probability
Observed Frequency Distribution
Distribution
a. Binomial
(Based on b. Normal
observations)
c. Poisson
1. Binomial Distribution: It is given by James Bernoulli and thus is also known as Bernoulli
distribution. It is a kind of a discrete possibility distribution where we have only two cases: either
a success or a failure.
Characteristics:
a. Discrete probability distribution
b. Number of trials is finite.
c. There are only two alternatives: Success or Failure
d. Probability of success in each trial is the same.
e. Trials are statistically independent, that is, outcome of any one trial does not affect the outcome
of subsequent trials.
f.
nC qn-rpr
r
where:
n = number of trials
p = probability of success
q = probability of failure
r = number of success
Graphically, binomial distribution will be symmetrical when p = ½. If p > ½ then the

distribution is positively skewed and when p < ½ then it is negatively skewed.
Skewness of binomial distribution will be less pronounced if ‘n’ is increased.
If we increase p for a fixed n, then binomial distribution will shift to the right.
Mode, in this case, is the value of n which has the highest probability.
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Binomial Distribution is also called a limiting case of normal distribution.
Formulae:
Mean n*p
Standard Deviation √𝑛𝑝𝑞
Variance npq
Measure of skewness
(q  p)
2
β1 =
npq
Measure of kurtosis (1−6𝑝𝑞)

3+ 𝑛𝑝𝑞
Binomial distribution is usually used in business and social sciences as well as for quality
control.
2. Poisson distribution: It was given by Denis Poisson in 1937. It is used when the number of trials
are infinite but probability of success is very small and probability of failure is tending towards
one. It is used in case of finding the number of defects, number of accidents, number of causalities,
etc.
Features:
a. Discrete probability distribution
b. It has a single parameter (m) which is the mean of probability distribution. As m increases,
distribution shifts to the right.
c. All probability distributions are skewed to the right because it is the probability distribution of
rare events. So the probability tends to be high for small number of occurrences.
Formula:
e n m r
Poisson Distribution =
r!
Formula:
Mean np
Standard Deviation √𝑛𝑝
Variance np (Mean = Variance
Measure of skewness β1 = 1/m
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Measure of kurtosis 3+ 1/m
3. Normal Distribution: It was given by A.D. Moivre, Karl Gauss and Laplace in 1733.
𝟏
Normal Variate = e-1/2 [(X-Mean)/σ)]2
𝝈√𝟐𝜫
Poisson distribution is a limiting case of normal distribution if m is large.
Properties:
a. The distribution is symmetrical, hence it resembles a bell-shaped curve.

b. The normal curve is symmetrical and is unimodal.
c. The two tails of the curve do not touch the axis, that is, they continue to extend indefinitely.
d. Asymptotic to the base line.
e. Total area under the normal curve is 1.
f. Mean = Median = Mode
g. Standard Normal Distribution is the random variable which has a normal distribution with mean
equal to zero and standard deviation equal to one.
Mean Zero
Standard Deviation One
Variance One
Measure of skewness Zero
Measure of kurtosis Three
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INDEX NUMBERS
First Price Index was given in Italy in 1754. It was used to compare price changes in the time period
1750 to 1760.
1. Simple Index Numbers: It is an Unweighted Index Number.

⅀𝑷𝟏
a. Simple Aggregative Method = ⅀𝑷𝟎 ∗ 𝟏𝟎𝟎
Its major drawback is that it is not free from units.
b. Price Relatives: Firstly the price relatives are calculated using the formula:
𝑷𝟏
Price Relatives = 𝑷𝟎 ∗ 𝟏𝟎𝟎
Then a simple average of price relatives is calculated, that is,
(⅀Price relatives)/n
Advantage of Price relatives:
 These are pure numbers free from units of measurement.
 It satisfies the unit’s test.
 Extreme items do not influence the index since the same importance is given to all
items.
 These index numbers are not influenced by the units in which prices are quoted or by
the absolute level of individual prices.
2. Weighted Index Numbers: Under this, all items are equally weighted.
a. Weighted Aggregative Method:
Method Formula Features
Laspeyer’s Index (L) P01 = (⅀P1Q0/⅀P0Q0 )*100 Under this, the base year quantities
are taken as weights. The index value
has an upwards bias as it over-
estimates the price changes.
Paasche’s Index (P) P01 = (⅀P1Q1/⅀P0Q1 )*100 Under this, the current year
quantities are taken as weights. It
underestimates the price changes and
as a result has a downward bias.
Dorbish-Bowley Index (L+P)/2 It uses both the current and base year
quantities as weights. It is the
arithmetic mean of both Laspeyer’s
and Paasche’s index.
Fischer’s Ideal Index √𝐿 ∗ 𝑃 It is the geometric mean of both

Laspeyer and Paasche’s Index. It is
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considered to be an ideal index

because:
1. Both current year and base

year quantities are taken.
2. It cancels the upward and
downward bias.
3. It satisfies the time reversal
and factor reversal test.
Marshall-Edgeworth P01 = It is the sum of current and base year
Index [( ⅀P1(Q0+Q1))/( ⅀P1(Q0+Q1)) quantities as weights.
*100
Kelly’s Index P01 = (⅀P1q/⅀P0q) *100 It is also known as fixed weight

aggregative method.
Walsch Index P01 = [(⅀P1√𝑞0 𝑞1 ) /

(⅀P0√𝑞0 𝑞1 )] *100
b. Weighted Average of Price Relatives:

P01 = (⅀(P1/P0 *100)*W) / ⅀W
Tests of Adequacy of Index Numbers
Test Formula Satisfied By
Unit Test Formula for index number Apart from simple unweighted
construction should be aggregative index, this test is satisfied
independent of the units in by all other indices.
which prices and quantities
are quoted.
Time Reversal Test P01 * P10 = 1 1. Fischer’s index

2. Marshall-Edgeworth index
It was given by Fischer. With 3. Simple Geometric mean of
the basis reversed, the two price relatives
indices should be reciprocals 4. Aggregates with fixed weights.
of each other, that is, 5. Weighted geometric mean
interchanging the time
periods should not lead to
inconsistent results.
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Factor Reversal Test P01 * Q10 = V01 Fischer’s Index
Given by Fischer.
On interchanging the prices

and quantities, the results
should be consistent.
Circular Test P01* P12 * P20 = 1 1. Simple Geometric mean of

price relatives
It is an extension of time 2. Weighted aggregative with
reversal test and also the fixed weights.
shiftability of weights. The
index should be able to adjust
index values from period to
period without referring to
the original base.
Important Terms
1. Splicing of Index Numbers: Replacing the old series with the new
series.
2. Deflating of Index Numbers: Accounting for price changes.
TIME SERIES
Time series analysis that over a period of time, how does the value
of the variable changes. It forecasts future achievements.
Components of Time Series are:
1. Secular Trend (T): Persisting movement of any variable over a period of time.
2. Seasonal Variations (S): Repetitive movements in every season.
3. Cyclical Variation (C): Business Cycles
4. Irregular Variations (I): Completely random
Additive Model: y = T+S+C+I
Multiplicative Model: y = T*S*C*I
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STATISTICAL INFERENCE
Statistical Inference is that branch of statistics where we use probabilities to deal with uncertainties
in decision making. It involves:
a. Hypothesis Testing
b. Estimation
Hypothesis: It is a general statement made about any relationship. In other words, it is a tentative
assumption made about any relationship/population parameter.
Null Hypothesis (H0): Null hypothesis is stated for the purpose of testing or verifying its validity.
It assumes that there is no difference between population parameter and sample statistics and if
there is any difference, it is by chance.
Alternate Hypothesis (H1): It includes any other admissible hypothesis, other than null
hypothesis. Alternate hypothesis is accepted when the null hypothesis is rejected.
Error H0 When…
Type I Rejected H0 is true
Type II (more Accepted H0 is false

harmful)
Level of Significance: It is the probability of committing Type I error.
Power of a test: It analysis how well the test is working and depends majorly on Type II error.
Power of a test can be measured by 1-β.
Two Tailed Test: In this, the critical region lies on both sides. It does not tell us whether the value
is less than or greater than the desired value. The rejection region under this test is taken on both
the sides of the distribution. For example,
H0: β = 100
H1: β≠ 100
One Tailed Test: Under this, H1 can either be greater than or less than the desired value. The
rejection region, under this test, is taken only on one side of the distribution.
H0: β = 100
H1: β > 100
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Sampling Distribution
Characteristics
1. Sampling distribution is derived from a population distribution, either known or assumed.

2. If we have a given population distribution, then we can generate infinite number of sampling
distributions, each of sample size n.
3. Population may generate sampling distribution for one or more than one statistic.
4. Sampling distribution of means will be normally distributed.
Sample Mean = Population Mean
Any value which is based on the sample data is known to be a sample statistic and the value
calculated from the population is known as population parameter.
Standard error of sampling distribution tells us the standard deviation of a sampling distribution.
Standard error of a sample = σ / √𝒏
Use of Standard Error as a concept
1. Measures the sampling variability due to chance or random forces.

2. Helps in testing the hypothesis.
3. It gives an idea about the reliability or precision of a sample.
Reliability = 1/standard error
4. Helps in determining the limits within which the parameter values are expected to lie.
Steps of Testing Hypothesis
1. Set your hypothesis.

2. Choose a level of significance
3. Choose a test
4. Make calculations or computations using the test.
5. Decision making stage.
Degrees of freedom: It is the freedom to assign values.
Estimators
There are two kinds of estimators
1. Point estimators
2. Interval estimators: They are the confidence intervals in which lower and upper value of the
parameter will lie.
Properties of estimators
1. Unbiasedness 3. Efficiency
2. Consistency
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4. Sufficiency: should include maximum

information about the population parameter.
Testing of Attributes
To test the attributes, we calculate the standard error, and the difference between the actual and the
observed values. If the difference is greater than the standard error at a particular level of significance,
we reject the null hypothesis. If the difference is less than the standard error, we accept the hypothesis.
Formula for calculating standard error:
To test the number of successes Standard Error(S.E.) = √𝒏𝒑𝒒
To test the probability of successes S.E. = √(𝑝𝑞)/𝑛
To test the difference between 1 1

(𝑝𝑞)(𝑛1 + 𝑛2)
proportions S.E. = √
Large Sample Tests
Assumptions:
1. The random sampling distribution of a statistic is

approximately normal.
2. Values given by the samples are sufficiently close
to the population value and can be used in its place
for calculating the standard error of an estimate.
Uses
1. Large sample tests are used for checking the significance of the difference between the means of two
samples which are independent and drawn from the same population.
1 1
 (n  n )
2
S.E. =
1 2
2. If samples are drawn from two different populations,
 
2 2
S.E. = 1 2
n1 n 2
Small Sample Test

1. T-Test: It was given by William Gosset in 1905 and is also known as Student’s T-test.
Assumptions:
Page 35
Statistics
a. Number of observations is less than 30.

b. Random sampling distribution is approximately normal.
c. It is used when standard deviation of population is not known.
Uses: If calculated value is greater than the table

value, then difference is significant and we
a. To test the significance of reject the null hypothesis. If calculated value mean of a
random sample. is less than the table value, then we accept the
null hypothesis implying that there is no
X  significant difference.
t
S .E.
s
S.E. =
n
(X  X )
2
s=
n 1
b. To test the difference between means of two independent samples
X1  X 2
t
S .E.
s
S.E. =
n1 n2
n1  n2
s
(X 1  X1)2

(X 2  X 2 )2
n1  n2  2 n1  n2  2
Page 36
Statistics
c. Used to test the difference between

means of two dependent samples
d
t n
s
Where: d = difference of means of two
samples and its average
(d  d ) 2
s
n 1
d. Significance of coefficient of
correlation (r)
r
t n2
1 r2
We take our null hypothesis (H0) as r=0
If calculated value (t) is greater than the table value, then we reject H0 else we accept it.
Properties of t-distribution
a. The distribution is lower at the mean and flatter across the axis. T-distribution has greater area under
its tails than the normal distribution.
b. It is not symmetrical, that is, variance is greater than one. To make it symmetrical, we can increase
the degrees of freedom which would lead the t-distribution towards normal distribution.
2. Z-test: The test was given by Fischer and is used when population standard deviation is known. The
test is used when we need to identify whether the two samples are from the same population or not.
Assumptions:
a. Sample size is large, that is, n > 30.
b. Population variance is known.
c. Population is normally distributed.
Applications of Z-Test
a. Z-test is used to compare the sample mean to a hypothesized mean of the population in case of large
samples.
b. It is also used to test the difference between the mean of two samples, assuming that they have been
drawn from the same population.
c. It is also used to test the difference between the two sample means, when the sample drawn is from
two different population.
Page 37
Statistics
Uses of Z-Test are:

a. To test the significance of ‘r’
z 
S .E. 
1
n3
Where: 1
1 1 r
z  log( ) ;
2 1 r
1 1 
  log( )
2 1 
b. To test the significance of the difference between two independent correlation coefficient derived
from different samples.
z1  z 2
S .E. 
1 1

n1  3 n2  3
3. F-test: The test was given by Fischer in 1920s and is closely related with ANOVA. It is also known
as Variance Ratio Test.
Assumptions:
a. Normality: Normal Distribution

b. Homogeneity: Variance in each group should be equal for all groups.
c. Independence of error: Variance of each value around its mean should be independent.
Used when:
a. To find out whether two independent estimates and population variances differ significantly or
whether two samples may be regarded as drawn from the normal population having the same
variance.
2
zs 1
2
s 2
Where: s 2

(X 1  X1)2
and is a large estimator of variance
n1  1
1
2

(X 2  X 2 )2
and is a small estimator of variance
s 2
n2  1
Page 38
Statistics
Chi-Square Test
It is a non-parametric test and does not make any assumptions about population from which samples
are drawn. It was first used by Karl Pearson in 1900.
χ2 = ⅀(O – E)2 / E
Where: O is the observed value and E is the expected value.
Features of the test:
1. It is a test of independence.
2. It is a test of goodness of fit.
3. It is a test of homogeneity, where two or more samples are drawn from same population or different
population.
4. Chi-Square distribution is skewed to the right and the skewness can be reduced by increasing the
degrees of freedom.
5. Value of χ2 is always positive and upper limit is infinity.
6. It applies Yates Correction (developed in 1934) to reduce the inflated difference between the observed
and theoretical frequencies.
Application of Chi-Square tests:
1. It is used to test the discrepancies between the observed frequencies and the expected frequencies.
2. It is also used to test the goodness of fit.
3. It is used to determine the association between two or more attributes.
Page 39
MATHEMATICAL ECONOMICS
Part 1 – g Notes by Economics Harbour
Page 0
Mathematical Economics
INPUT-OUTPUT MODEL
The Input-Output Model was given by Leontief in 1951. Before this, Quesney Tableau was used to
analyze the interdependence between industries.
Assumptions:
1. Constant Returns of Scale 7. Factor supplies are given

2. Fixed input coefficient or requirements 8. Input prices are given
3. No externalities 9. Demand is given
4. No economies and diseconomies of scale 10. Perfect competition in the production
5. No technical change or technical progress sector
6. Homogenous good 11. No input is unutilised or underutilised
Demand for any product should be large enough so that it can be used as inputs. The theory is based
on general equilibrium and also involves empirical investigation. The input-output model is
concerned only with production.
Types of Input-Output Model

1. Closed Input-Output Model: It does not consider any external demand but only internal demand
which can be satisfied by the industries. There is no final demand sector.
2. Open Input-Output Model: It involves inter-industry demand. Final demand is by the

households. The primary input in this model is the Labour.
3. Static Input-Output Model: In this, investment is exogenous in nature and includes both inter-
industry and final demand.
4. Dynamic Input-Output Model: It is given by Dorfman, Samuelson, Solow. It is an extension of

static model but treats Investment as an endogenous variable. It highlights the capital requirements
of different sectors. Part of the output is kept to add to the capital stock. However, the output should
be large enough so that it covers:
a. Current Production
Page 1
b. Current consumption
c. Addition to the capital stock
Capital in the beginning of any period should be large enough to be able to produce the output in
the current period.
Production Output Input Requirement Final

Sector Demand
I II III
I X1 x11 x12 x13 D1
II X2 x21 x22 x23 D2
III X3 x31 x32 x33 D3
Primary L L1 L2 L3
Input
Columns: Production (Buyer of inputs)
Rows: Each sector acts as a supplier to other sectors.
Technological Coefficient
𝒙𝒊𝒋
aij = ; it implies per unit requirement of inputs to produce an output
𝒙𝒋
Balancing Equations
X1 = a11X1 + a12X2 + a13X3 + D1
X2 = a21X1 + a22X2 + a23X3 + D2
X3 = a31X1 + a32X2 + a33X3 + D3
Forming a matrix out of these, we get;

𝑋1 𝑎11 𝑎12 𝑎13 𝑋1 𝐷1
𝑋2 = 𝑎21 𝑎22 𝑎23 * 𝑋2 + 𝐷2
𝑋3 𝑎31 𝑎32 𝑎33 𝑋3 𝐷3
We can modify the above matrix into an equation form:
X = AX + D
Where: X = Output Matrix; A = Technical coefficient matrix; D = Final Demand Matrix
X – AX = D
Page 2
X(I-A) = D
X = (I-A)-1D Where: (I-A)-1 is the Leontief Inverse Matrix
Features of Technology Coefficient Matrix (A) are:
1. Each element in the matrix should be greater than or equal to zero.

2. No element can exceed unity, that is, aij < 1.
Hawkins-Simon Conditions
These conditions are used to maintain the feasibility and viability of the system. The conditions
are as follows:
1. Determinant of (I-A) should be positive.

2. Diagonal elements of (I-A) should be positive.
3. All principal minors in the matrix should be positive.
4. Sum of input coefficient should be less than one. This condition is also known as Solow’s
condition.
Mathematically it is expressed as:
⅀aij < 1
3. Sum of all elements in each column of the matrix including the labour coefficient should be equal
to one, that is, ⅀aij = 1 including labour. If we do not include labour, then ⅀aij < 1.
Conditions which must be satisfied:
1. Viability Condition: It means that no element of technology coefficient matrix can be less than
zero.
2. Feasibility Condition: Sum of elements in each column of Inverse coefficient matrix must be
equal to one.
(I-A)-1 gives information regarding direct and indirect requirements of per unit of final demand.
Direct requirements per unit of output are given by A.
Uses of Input-Output Model

1. It was used in a study conducted in Kerala in 1950-51.
Page 3
2. The fifth five year plan is based on the Input-Output model.

3. It is used for national accounting purposes.
4. It is used for checking the internal consistency of planning.
5. For determination of final demand and output targets, input-output model is used.
LINEAR PROGRAMMING PROBLEM

The concept of Linear Programming Problem was given by Dantzig. It is used to maximize or minimize
the objective subject to certain constraints in the form of inequalities.
Linear programming is an optimizing technique which is aimed at maximizing or minimizing an

objective function subject to a number of constraints in the form of inequalities.
Objective function is also known as the criterion function. It is the function required to be maximized
or minimized.
Structural Constraints: These are the limitations within which optimization has to be accomplished.
They are the bounds that are imposed on the solution and are expressed in the form of inequalities.
Important terms
Feasible Solution: All possible solutions that

satisfy the constraints.
Infeasible Solution: It is the situation when
the feasible region is empty.
Feasible Region: It is a set of all possible,
feasible solutions.
Optimal Solution: It is the feasible solution
with the largest objective function.
Unbounded region: It is the region where the
feasible region is continuing endlessly.
Page 4
Assumptions of Linear Programming Problem
1. Linearity/Proportionality: It simply means that the relations between the variables can be
depicted in the form of straight lines, revealing the constant returns to scale.
2. Divisibility: All decision variables can take non-negative fractional values, that is, they are
continuous quantities and need not necessarily be complete units.
3. Additivity: Total value of objective function equals the sum of contributions of each variable to
the objective function.
4. Certainty: The parameters are known with certainty and the optimum solution that is derived is
predicted on perfect knowledge of all parameters.
5. Constant prices: It implies perfect competitive situation. Input-Output prices remain constant and
therefore, a perfectly competitive approach is followed.
6. Finiteness: A finite number of activities and constraints are considered in any problem.
7. Homogeneity: All units of the same resource are identical.
Page 5
NON-LINEAR PROGRAMMING
Kuhn-Tucker Conditions
Maximization:
 F’(X) ≤ 0
 X≥0
 F’(X)*X = 0
Minimization:
 F’(X) ≥ 0
 X≥0
 F’(X)*X = 0
Kuhn-Tucker Sufficiency Theorem
Max y = f(X)
Subject to:
gi ≤ rj
X≥0
1. Objective function f(X) must be differentiable and concave (f’(X) ≤ 0)

2. Each constraint must be differentiable and it should be convex.
3. Kuhn-Tucker conditions must satisfy the conditions for maximisations.
Page 6
SOME IMPORTANT FORMULAE:
𝒑 𝒅𝒒
1. Price elasticity of demand = − 𝒒 ∗ 𝒅𝒑
Where: p = price of the commodity, q = quantity demanded of the commodity
𝒑 𝒅𝒒
2. Price elasticity of supply = 𝒒 ∗ 𝒅𝒑
Where: p = price of the commodity, q = quantity supplied of the commodity
𝒚 𝒅𝒒
3. Income elasticity of demand = 𝒒 ∗ 𝒅𝒚
Where: y = income of the consumer, q = quantity demanded of the commodity
Income elasticity of demand Type of good
Positive Normal good
Negative Inferior good
NORMAL GOODS
0 < income elasticity of demand < 1 Necessities
Income elasticity > 1 Luxuries
4. Total Revenue (TR) = Price (p) * Quantity (q)

5. Average Revenue (AR) = TR / q
𝑑𝑇𝑅
6. Marginal Revenue (MR) = 𝑑𝑞
1
7. MR = AR [ 1 - 𝐸]
1
8. Slope of Average Cost (AC) = 𝑞 [𝑀𝐶 − 𝐴𝐶]
Where MC = Marginal Cost
𝐶
9. Average Propensity to Consume (APC) = 𝑌
Where: C= consumption, Y = Income
𝑑𝐶
10. Marginal Propensity to Consume (MPC) = 𝑑𝑌
1
11. Multiplier = 1−𝑀𝑃𝐶
𝑆
12. Average Propensity to Save (APS) = 𝑌
Where S = Savings
Page 7
𝑑𝑆
13. Marginal Propensity to Save (MPS) = 𝑑𝑌
14. APC + APS = 1
15. MPC + MPS = 1
16. Elasticity of Average Cost (eAC) = elasticity of total cost (ec) – 1
Page 8
Game Theory
Part 1- h Notes by Economics Harbour
Game theory is the formal study of conflict and cooperation

Game Theory
Game is a strategic situation given by Neumann-Morgenstein in Theory of Games and Economic

Behaviour in 1944. It is the study of decision making where several players must make choices that
potentially affects the interest of other players.
Players, here, are the decision making agents. Moves are the actions undertaken by the players and are
thus also known as strategies.
Important Terms in Game Theory:
1. Game: It is a situation in which two or more participants or players confront one another in pursuit
of achieving some objectives. The game should have the following features:
a. Finite number of players
b. Finite number of strategies available to each player.
c. Each player should know the rules governing the choice of each action
2. Pay-Off: Utility that a player gets given a certain outcome of the game.
3. Pay-Off Matrix: Shows players, their actions and their pay-offs in a game.
For example:
Player A’s Pay Off Matrix Player B’s Pay Off Matrix
Player B Player B
1 2 3 1 2 3
1 -A11 -A12 -A13 1 A11 A12 A13
Player A
2 -A21 -A22 -A23

Player A
2 A21 A22 A23

3 -A31 -A32 -A33 3 A31 A32 A33
4. Pure Strategy: The player will surely follow a particular action. It provides a complete definition
of how a player plays a game. It determines the move a player will make for any situation he or
she could face. The probability of a pure strategy is equal to one.
5. Mixed Strategy: An assignment of probability to each player in which he will randomly select a
pure strategy. So a course of action will be selected according to the probability distribution.
Page 1
6. Dominant Strategy: In a game if one or more strategies of a player are inferior to atleast one of
the remaining strategies, then it is known as a dominant strategy.
Adapted from:
7. Optimal Strategy: Optimal strategy is the course of plan which puts the player into the most
favourable situation, irrespective of what are the strategies followed by other player.
8. Two Person Game or N-People Game: The game which has two players is called a Two-person
game, while the game having more than two players, is known as N-Person game.
9. Zero-Sum Game: When the gain of one competitor is the loss of the other, then it is a zero sum
game. It is also known as a matrix or rectangular game.
Assumptions:
a. Each firm has one goal, that is, to maximise the market share.
b. Each firm knows the strategies that are available to it and to its rival.
c. Each firm knows with certainty the pay-offs from each combination of strategies.
Page 2
d. Actions taken by the firms do not affect the size of the market.
e. Each firm chooses its strategy expecting that the rival will choose the best possible counter-
strategy open to him.
f. There is no possibility of collusion.
g. Aims of the two firms are completely opposite to each other.
10. Constant Sum Game: Sum of shares of two players add upto the same amount.
11. Minimax: Out of maximum losses, minimum value is chosen. In simple words, it is the minimum
loss out of the maximum losses. It is a decision rule in game theory for minimising the maximum
losses and is called the lower value of the game.
12. Maximin: It is the maximum out of the minimum and the concept is used in case of profits. It is
also known as the upper value of the game.
13. Fair Game: It is the point where minimax and maximin are equal to zero.
14. Nash Equilibrium: Each player believes that it is doing the best it can, given the strategy of the
other player. No player can improve upon the strategy unilaterally.
15. Saddle Point:
1 2 3
I 10 9 7
II 8 8 6
A III 9 9 6
II < III < I
I is the Pure strategy (Max. Gains ) (A)
In case of (B)
(1) < (2) < (3)
Where 1: Max Losses and 3:Minimum Losses
Saddle Point → Maximin = Minimax
16. Co-operative Game: Game in which participants can negotiate binding contracts that allow them
to plan joint strategies. Example: Bargain between buyers and sellers.
17. Non-cooperative Game: Game in which negotiations and enforcements of binding contracts are
not possible.
18. Repeated Game: Game in which actions are taken and payoffs received over and over again.
Example: Firms’ pricing strategies.
19. Tit-for-Tat Strategy: Repeated game strategy in which a player responds in kind to an opponent’s
previous play, co-operating with co-operative opponents and retaliating against un-cooperative
ones.
Page 3
20. Sequential Game: Game in which players move in turn, responding to each other’s actions and
reactions.
21. Strategic Move: Action that gives a player an advantage by constraining his behaviour.
Game theory: Childs

Play??
Page 4

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UGC-NET STUDY MATERIAL

Part 1- a Notes by Economics Harbour

Notes by Economics Harbour www.economicsharbour.com

According to him, the demand can be represented by following words:

Difference between “Demand Changes” and “Quantity Demanded Changes”

Due to any other factor

Demand Curve: It is the graphical presentation of the law of demand

Demand Schedule: It is the tabular presentation of the law of demand.

Notes by Economics Harbour (2nd Edition) www.economicsharbour.com

Reasons for downward sloping demand curve

Decrease Increase in Increase in Increase in

4. Different uses of a commodity

Decrease in Commodity Demand

5. Size of the market

Decrease in More Demand

Exceptions to the Law of Demand

Notes by Economics Harbour (2nd Edition) www.economicsharbour.com

2. Giffen goods: The concept was given by Robert

The demand curve for a giffen goods is an upward

Factors Determining Demand

Factor Relation with the Demand

1. Tastes and Preferences of Demand +

Notes by Economics Harbour (2nd Edition) www.economicsharbour.com

2. Income of the people +

3. Change in the price of Related Goods Substitutes (+)

5. Number of customers in the market +

6. Future Expectations about the price +

Increase or Decrease in Demand

 Leads to shift in the demand curve.

 Leads to movement in the demand curve.

Notes by Economics Harbour (2nd Edition) www.economicsharbour.com

The differences between quantity demanded and elasticity of demand are:

Demand Elasticity of demand

It is qualitative in nature. It is quantitative in nature.

1. Elasticity of Substitution (Es) :

Where: x = Good 1, y = Good 2, MRSxy = Marginal Substitution of good x for good y

Perfect Substitutes Constant Infinity

Perfect Complements Zero Zero

Notes by Economics Harbour (2nd Edition) www.economicsharbour.com

Degrees of Price Elasticity:

Notes by Economics Harbour (2nd Edition) www.economicsharbour.com

Measurement of Price Elasticity of Demand

It is used when price and quantity changes are somewhat large.

e. Total Expenditure Method: Evolved by Marshall

Situation  in Price  in Qty  in Elasticity of

C   Decreases Ed < 1 (Less than

Notes by Economics Harbour (2nd Edition) www.economicsharbour.com

3. Income Elasticity: It is the

Notes by Economics Harbour (2nd Edition) www.economicsharbour.com

𝐏𝐫𝐨𝐩𝐨𝐫𝐭𝐢𝐨𝐧𝐚𝐭𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐭𝐡𝐞 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐝𝐞𝐦𝐚𝐧𝐝𝐞𝐝 𝐨𝐟 𝐗

Qx = Quantity Demanded of Good X

Notes by Economics Harbour (2nd Edition) www.economicsharbour.com

Goods Cross Elasticity

Notes by Economics Harbour (2nd Edition) www.economicsharbour.com

Assumptions of cardinal analysis are as follows:

a. Utility can be measured.

Notes by Economics Harbour (2nd Edition) www.economicsharbour.com

Diminishing Marginal Utility

This law operates to:

The law of diminishing marginal utility depends on the following factors:

Significance of Law of Diminishing Marginal Utility

 It explains the relationship between demand and price.

Notes by Economics Harbour (2nd Edition) www.economicsharbour.com

Criticisms of Marshallian Analysis