BUSINESS ECONOMICS

CLASS : I BCOM AM

SUBJECT CODE : 213 B

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 UNIT -1

BUSINESS ECONOMICS

DEFINITION OF ECONOMICS

WEALTH DEFINITION - ADAM SMITH

Adam smith published a book named “An inquiry into the nature and
causes of the wealth of nation” in 1776 A.D. He has defined economics as
the science of the wealth in his book.

According to him,” Prosperity of the individuals

constitute the prosperity of the nation. Gain of wealth or after acquiring the
wealth man can achieve his satisfaction”

Adam Smith defines Economics as a science which deals with wealth.

Economics provides the guide lines to the individuals and society or nation.

WELFARE DEFINITION - ALFRED MARSHALL

“Economics is the study of man in ordinary business

of life. It examines that part of individual and social action, which is most
closely connected with the attainment and with the use of material
requisites of well-being .It is the study of wealth on one side and on the
other side, which is more important, it is a part of the study of man.”

SCARCITY DEFINITION - LIONNEL ROBBINS

“Economics is the science which studies human

behaviour as a relationship between multiple ends and scarce means,
which have alternative uses.”

GROWTH DEFINITION - PAUL SAMUELSON

“Economics is a study of how men and society

choose, with or without the use of money, to employ scarce productive
resources which could have alternate uses; to produce various
commodities over time and distribute them for consumption, now or in
future, among various groups in the society”.

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Meaning of Managerial/Business economics

Managerial / Business economics is economics applied in decision –

making. It is that branch of economics, which serves as a link between
abstract theory and managerial practice. It is based on economic analysis
for identifying problems, organizing information and evaluating alternatives.
Economics as a science is concerned with the problem of allocation of
scarce resources among competing ends. Individuals, households, firms
as well as economies regularly confront these problems of allocation.

Definition of Business Economics

According to Spencer and Siegelman, Business economics is "the

integration of economic theory with business practice for the purpose of
facilitating decision-making and forward planning by management".

According to Mc Nair and Meriam, "Business economics deals with

the use of economic modes of thought to analyse business situation".

CHARACTERISTICS OF BUSINESS/ MANAGERIAL ECONOMICS

1. It is micro economic in character. This is so because it studies the

problems of an individual business unit. It does not study the problems of
the entire economy.

2. Normative science: Managerial economics is a normative science. It is

concerned with what management should do under particular
circumstances. It determines the goals of the enterprise. Then it develops
the ways to achieve these goals.

3. Pragmatic: Managerial economics is pragmatic. It concentrates on

making economic theory more application oriented. It tries to solve the
managerial problems in their day-to- day functioning.

4. Prescriptive: Managerial economics is prescriptive rather than

descriptive. It

prescribes solutions to various business problems.

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5. Uses macro economics: Marco economics is also useful to business
economics. Macro-economics provides an intelligent understanding of the
environment in which the business operates. Managerial economics takes
the help of macro-economics to understand the external conditions such as
business cycle, national income, economic policies of Government etc.

6. Uses theory of firm: Managerial economics largely uses the body of

economic concepts and principles towards solving the business problems.
Managerial economics is a special branch of economics to bridge the gap
between economic theory and managerial practice.

7. Management oriented: The main aim of managerial economics is to

help the management in taking correct decisions and preparing plans and
policies for future. Managerial economics analyses the problems and give
solutions just as doctor tries to give relief to the patient.

8. Multi disciplinary: Managerial economics makes use of most modern

tools of mathematics, statistics and operation research. In decision making
and planning principles such accounting, finance, marketing, production
and personnel etc.

9. Art and science: Managerial economics is both a science and an art. As

a science, it establishes relationship between cause and effect by
collecting, classifying and analyzing the facts on the basis of certain
principles. It points out to the objectives and also shows the way to attain
the said objectives.

OBJECTIVES OF BUSINESS/ MANAGERIAL ECONOMICS

➢ To integrate economic theory with business practice.

➢ To apply economic concepts: and principles to solve business

problems.

➢ To employ the most modern instruments and tools to solve business

problems.

➢ To allocate the scarce resources in the optimal manner.

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 ➢ To make overall development of a firm.

➢ To help achieve other objectives of a firm like attaining industry

leadership, expansion of the market share etc.

➢ To minimise risk and uncertainty

➢ To help in demand and sales forecasting.

➢ To help in operation of firm by helping in planning, organising,

controlling etc.

➢ To help in formulating business policies.

➢ To help in profit maximisation.

NATURE OF MANAGERIAL ECONOMICS

DECISION MAKING AND FORWARD PLANNING

Decision-making means the process of selecting one action from two

or more alternative courses of action

Forward planning means establishing plans for the future.

• The primary function of management executive in a business

organisation is decision making and forward planning.
• Decision making and forward planning go hand in hand with each
other. Decision making means the process of selecting one action
from two or more alternative courses of action. Forward planning
means establishing plans for the future to carry out the decision so
taken.
• The problem of choice arises because resources at the disposal of a
business unit (land, labour, capital, and managerial capacity) are
limited and the firm has to make the most profitable use of these
resources.
• The decision making function is that of the business executive, he
takes the decision which will ensure the most efficient means of
attaining a desired objective, say profit maximisation. After taking the
decision about the particular output, pricing, capital, raw-materials
and power etc., are prepared. Forward planning and decision-making
thus go on at the same time.
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 • A business manager’s task is made difficult by the uncertainty which
surrounds business decision-making. Nobody can predict the future
course of business conditions. He prepares the best possible plans
for the future depending on past experience and future outlook and
yet he has to go on revising his plans in the light of new experience to
minimise the failure. Managers are thus engaged in a continuous
process of decision-making through an uncertain future and the
overall problem confronting them is one of adjusting to uncertainty.
• In fulfilling the function of decision-making in an uncertainty
framework, economic theory can be, pressed into service with
considerable advantage as it deals with a number of concepts and
principles which can be used to solve or at least throw some light
upon the problems of business management. E.g are profit, demand,
cost, pricing, production, competition, business cycles, national
income etc. The way economic analysis can be used towards solving
business problems, constitutes the subject-matter of Managerial
Economics.
• Thus in brief we can say that Managerial Economics is both a science
and an art.

SCOPE OF MANAGERIAL ECONOMICS

• Demand Analysis and Forecasting.

• Cost and production analysis.

• Pricing Decisions, policies and practices.

• Profit Management.

• Capital Management.

DEMAND ANALYSIS AND FORECASTING

A business firm is an economic organism, which transforms

productive resources into goods that are to be to sell in a market. A major
part of managerial decision-making depends on accurate estimates of
demand. Demand analysis helps identify the various factors influencing the
demand for a firm’’ product and thus provides guidelines to manipulating

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demand. Demand analysis and forecasting, therefore, is essential for
business planning and occupies a strategic place in Managerial
Economics.

COST AND PRODUCTION ANALYSIS

A study of economic costs, combined with the data drawn from the
firm’s accounting records, can yield significant cost estimates that are
useful for management decisions. . An element of cost uncertainty exists
because all the factors determining costs are not always known or
controllable. Discovering economic costs and being able to measure them
are necessary steps for more effective profit planning, cost control and
often for sound pricing practices.

PRICING DECISIONS, POLICIES AND PRACTICES

Pricing is a very important area of Managerial Economics. In fact,

price is the genesis of the revenue of a firm and as such the success of a
business firm largely depends on the correctness of the price decisions
taken by it. The important aspects dealt with under this area are: Price
Determination in various market forms, pricing methods, differential pricing,
product-line pricing and price forecasting.

PROFIT MANAGEMENT

Business firms are generally organized for the purpose of making

profits and, in the long run, profits provide the chief measure of success. In
this connection, an important point worth considering is the element of
uncertainty existing about profits because of variations in costs and
revenues which, in turn, are caused by factors both internal and external to
the firm. The important aspects covered under this are Nature and
Measurement of profit, profit policies and Techniques of profit planning like
break-even analysis.

CAPITAL MANAGEMENT

Of the various types and classes of business problems, the

most complex and troublesome for the business manger are likely to be

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those relating to the firm’s capital investments. Relatively not only requires
considerable time and labour but is a matter for top-level decision. Briefly,
capital management implies planning and control of capital expenditure.
The main topics dealt with are: Cost of Capital, Rate of Return and
Selection of Projects.

Distinction between Business Economics and Economics

BUSINESS ECONOMICS ECONOMICS

It involves application of It deals with the body of the

economic principles to the principles itself.
problems of the firm.
Business Economics is micro- Economics is both macro-
economic in character. economic and micro-
economic in character.
It deals only with the firm It deals with both economics
and has nothing to do with an of the individual as well as
individual economic economics of the firm.
problems.
The scope of business The scope of economics is
economics is limited wider than managerial
compared to general economics.
economics.
Business Economics modifies Economics gives the
and enlarges it. simplified model
Business economics Economic Theory makes
introduces certain feedbacks, certain assumptions.
such as objectives of the firm.

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USES OF BUSINESS ECONOMICS

✓ It presents those aspects of traditional economics which are relevant

for business decision making in real life.

✓ It also incorporates useful ideas from other disciplines such as

psychology, sociology, etc. If they found relevant for decision making.

✓ Business Economics helps in reaching a variety of business

decisions in a complicated environment.

✓ Business Economics makes a manager a more competent model

builder.

✓ Business Economics serves as an integrating agent by co-ordinating

the different areas and bringing to bear on the decisions of each
department or specialist the implications pertaining to other functional
areas.

✓ Business economics takes cognizance of the interaction between the

firm and society and accomplishes the key role of business as an
agent in the attainment of social and economic welfare.

ROLES AND RESPONSIBILITIES

• He studies the economic patterns at macro-level and analysis it’s

significance to the specific firm he is working in.

• He has to consistently examine the probabilities of transforming an

ever-changing economic environment into profitable business
avenues.

• He assists the business planning process of a firm.

• He also carries cost-benefit analysis.

• He assists the management in the decisions pertaining to internal

functioning of a firm such as changes in price, investment plans, type
of goods /services to be produced, inputs to be used, techniques of
production to be employed, etc.,

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 • A managerial economist has to analyze changes in macro- economic
indicators such as national income, population, business cycles, and
their possible effect on the firm’s functioning.

• He is also involved in advicing the management on public relations,

foreign exchange, and trade. He guides the firm on the likely impact
of changes in monetary and fiscal policy on the firm’s functioning.

• He also makes an economic analysis of the firms in competition. He

has to collect economic data and examine all crucial information
about the environment in which the firm operates.

• The most significant function of a managerial economist is to conduct

a detailed research on industrial market.

• In order to perform all these roles, a managerial economist has to

conduct an elaborate statistical analysis.

• He must be vigilant and must have ability to cope up with the

pressures.

• He also provides management with economic information such as tax

rates, competitor’s price and product, etc. They give their valuable
advice to government authorities as well.

• At times, a managerial economist has to prepare speeches for top

management.

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 UNIT –II

DEMAND

Demand is not a mere desire but desire with the willingness and capacity to
buy a commodity.

Definition

According to stonier & Hague “ Demand in economics means desire

backed up by enough money to pay for the goods demanded”

Demand Schedule and Curve

Demand Schedule

A Demand schedule is a list of the different quantities of a commodity

which consumers purchase at different period of time.

Individual Demand Schedule: It is defined as the different quantities of a

given commodity which a consumer will buy at all possible prices.

Quantity
Price (Rs)
Demanded

1 6

2 5

3 4

4 3

5 2

Market Demand Schedule:

Market demand schedule is defined as the quantities of a given commodity

which all consumer will buy at all possible prices at a given moment of time

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Price A’s B’s Market
(Rs.) Demand Demand Demand

(1) (2) Schedule (1+2)

1 4 5 4+5=9

2 3 4 3+4=7

3 2 3 2+3=5

4 1 2 1+2=3

5 0 1 0+1=1

Demand curve

A curve showing the relation between the price of a good and quantity
demanded during a given period, other things being constant.

Demand curve

Individual DD curve Market DD curve

Individual Demand Curve : The graphic representation of Individual

Demand schedule is known is Individual Demand Curve

Market Demand Curve : The graphic representation of market demand

schedule is known as Market Demand Curve.
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 DD curve for A DD curve for B

Market Demand Curve

Determinants of Demand

When price changes, quantity demanded will change. That is a movement

along the same demand curve. When factors other than price changes,
demand curve will shift. These are the determinants of the demand curve.

1. Income: A rise in a person’s income will lead to an increase in demand

(shift demand curve to the right), a fall will lead to a decrease in demand for
normal goods. Goods whose demand varies inversely with income are
called inferior goods (e.g. Hamburger Helper).

2. Consumer Preferences: Favorable change leads to an increase in

demand, unfavorable change lead to a decrease.

3. Number of Buyers: the more buyers lead to an increase in demand;

fewer buyers lead to decrease.

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4. Price of related goods:

a. Substitute goods (those that can be used to replace each other): price of
substitute and demand for the other good are directly related.

Example: If the price of coffee rises, the demand for tea should increase.

b. Complement goods (those that can be used together): price of

complement and demand for the other good are inversely related.

Example: if the price of ice cream rises, the demand for ice-cream toppings
will decrease.

5. Expectation of future:

a. Future price: consumers’ current demand will increase if they expect

higher future prices; their demand will decrease if they expect lower future
prices.

b. Future income: consumers’ current demand will increase if they expect

higher future income; their demand will decrease if they expect lower future
income.

6. Effect of Advertisements:

Refers to one of the important factors of determining the demand for a

product. Effective advertisements are helpful in many ways, such as
catching the attention of consumers, informing them about the availability of
a product, demonstrating the features of the product to potential
consumers, and persuading them to purchase the product. Consumers are
highly sensitive about advertisements as sometimes they get attached to
advertisements endorsed by their favorite celebrities. This results in the
increase demand for a product.

vii. Distribution of Income in the Society:

Influences the demand for a product in the market to a large extent. If

income is equally distributed among people in the society, the demand for
products would be higher than in case of unequal distribution of income.
However, the distribution of income in the society varies widely.

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This leads to the high or low consumption of a product by different
segments of the society. For example, the high income segment of the
society would prefer luxury goods, while the low income segment would
prefer necessary goods. In such a scenario, demand for luxury goods
would increase in the high income segment, whereas demand for necessity
goods would increase in the low income segment.

viii. Growth of Population:

Acts as a crucial factor that affect the market demand of a product. If the
number of consumers increases in the market, the consumption capacity of
consumers would also increase. Therefore, high growth of population
would result in the increase in the demand for different products.

ix. Government Policy:

Refers to one of the major factors that affect the demand for a product. For
example, if a product has high tax rate, this would increase the price of the
product. This would result in the decrease in demand for a product.
Similarly, the credit policies of a country also induce the demand for a
product. For example, if sufficient amount of credit is available to
consumers, this would increase the demand for products.

x. Climatic Conditions:

Affect the demand of a product to a greater extent. For example, the

demand of ice-creams and cold drinks increases in summer, while tea and
coffee are preferred in winter. Some products have a stronger demand in
hilly areas than in plains. Therefore, individuals demand different products
in different climatic conditions.

Law of Demand

The law of demand expresses a relationship between the quantity

demanded and its price.

Definition

Marshall defines as “the amount demanded increases with a fall in

price, and diminishes with a rise in price”.

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It expresses an inverse relationship between price and demand.

Price Quantity Demanded

Price Quantity demanded

Assumptions

• There is no change in Taste & Preferences

• The income of the consumer remains constant

• No substitutes for the commodity.

• People should not expect any change in price of a commodity.

Quantity Demanded (in

Price (Rs.)
kgs)

1 6

2 5

3 4

4 3

5 2

When the price of a commodity is rupee 1, the quantity

demanded is 6 Kg, and when price increases to rupees 5, the
quantity demanded decreases to 2 kg. Thus always demand curve
slopes downwards from left to right.

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WHY DOES DEMAND CURVE SLOPES DOWNWARDS

(1) Law of diminishing marginal utility:

A consumer always equalises marginal utility with price. The law states that
a consumer derives less and less satisfaction (utility) from the every
additional increase in the stock of a commodity. When price of a commodity
falls the consumer's price utility equilibrium is disturbed i.e. price becomes
smaller than utility.

The consumer in order to restore the new equilibrium between price and
utility buys more of it so that the marginal utility falls with the rise in the
amount demanded. So long the price of a commodity falls, the consumer
will go on buying more amount of it so as to reduce the marginal utility and
make it equal with new price.

Thus the shape and slope of a demand curve is derived from the slope of
marginal utility curve.

(2) Income effect:

Another cause behind the operation of law of demand is income effect. As

the price of a commodity falls, the consumer has to buy the same amount
of the commodity at less amount of money. After buying his required
quantity he is left with some amount of money.

This constitutes his rise in his real income. This rise in real income is
known as income effect. This increase in real income induces the
consumer to buy more of that commodity. Thus income effect is one of the
reasons why a consumer buys more at falling prices.

(3) Substitution effect:

When the price of a commodity falls, it becomes relatively cheaper than

other commodities. The consumer substitutes the commodity whose price
has fallen for other commodities which becomes relatively dearer.

For example with the fall in price of tea, coffees. Price being constant, tea
will be substituted for coffee. Therefore the demand for tea will go up.

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(4) New consumers:

When the price of a commodity falls many other consumers who were
deprived of that commodity at the previous price become able to buy it now
as the price comes within their reach. For example the units of colour TV.
increases with a remarkable fall in price of it. The opposite will happen with
a rise in prices.

(5) Multiple use of commodity:

There are some commodities which have multiple uses. Their uses depend
upon their respective, prices. When their prices rise they are used only for
certain selected purposes. That is why their demand goes down.

For example electricity can be put to different uses like heating, lighting,
cooling, cooking etc. If its price falls people use it for other uses other than
that. A rise in price of electricity will force the consumer to minimise its use.
Thus with a fall and rise in price of electricity its demand rises and falls
accordingly.

6) Psycological Behaviour :

A Rational human being will always buy more at less price and buy less at
more price. It is a psychological behavior of a human being.

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Exceptions to the Law of Demand

1. Giffen Goods: Giffen goods are the inferior goods whose demand
increases with the increase in its prices. There are several inferior
commodities, much cheaper than the superior substitutes often
consumed by the poor households as an essential commodity.
Whenever the price of the Giffen goods increases its quantity
demanded also increases because, with an increase in the price, and
the income remaining the same, the poor people cut the consumption
of superior substitute and buy more quantities of Giffen goods to
meet their basic needs.

For Example, Suppose the minimum monthly consumption of food

grains by a poor household is 20 Kg Bajra (Inferior good) and 10 Kg
Rice (superior good). The selling price of Bajra is Rs 5 per kg, and
the rice is Rs 10 per kg, and the household spends its total income of
Rs 200 on the purchase of these items. Suppose, the price of Bajra
rose to Rs 6 per kg then the household will be forced to reduce the
consumption of rice by 5 Kg and increase the quantity of Bajra to 25
Kg in order to meet the minimum monthly requirement of food grains
of 30 kg.

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 2. Veblen Goods: Another exception to the law of demand is given by
the economist Thorstein Veblen, who proposed the concept of
“Conspicuous Consumption.” According to Veblen, there are a
certain group of people who measure the utility of the commodity
purely by its price, which means, they think that higher priced goods
and services derive more utility than the lesser priced commodities.

For example, goods like a diamond, platinum, ruby, etc. are bought
by the upper echelons of the society (rich class) for whom the higher
the price of these goods, the higher is the prestige value and
ultimately the higher is the utility or desirability of them.

3. Expectation of Price Change in Future: When the consumer

expects that the price of a commodity is likely to further increase in
the future, then he will buy more of it despite its increased price in
order to escape himself from the pinch of much higher price in the
future.

On the other hand, if the consumer expects the price of the

commodity to further fall in the future, then he will likely postpone his
purchase despite less price of the commodity in order to avail the
benefits of much lower prices in the future.

4. Ignorance: Often people are misconceived as high-priced

commodities are better than the low-priced commodities and rest
their purchase decision on such a notion. They buy those
commodities whose price are relatively higher than the substitutes.
5. Emergencies: During emergencies such as war, natural calamity-
flood, drought, earthquake, etc., the law of demand becomes
ineffective. In such situations, people often fear the shortage of the
essentials and hence demand more goods and services even at
higher prices.
6. Change in fashion and Tastes & Preferences: The change in
fashion trend and tastes and preferences of the consumers negates
the effect of law of demand. The consumer tends to buy those
commodities which are very much ‘in’ in the market even at higher
prices.
7. Conspicuous Necessities: There are certain commodities which
have become essentials of the modern life. These are the goods
which consumer buys irrespective of an increase in the price. For

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 example TV, refrigerator, automobiles, washing machines, air
conditioners, etc.
8. Bandwagon/Demonstration Effect: This is the most common type
of exception to the law of demand wherein the consumer tries to
purchase those commodities which are bought by his friends,
relatives or neighbors. Here, the person tries to emulate the buying
behavior and patterns of the group to which he belongs irrespective
of the price of the commodity.

For example, if the majority of group members have smart phones

then the consumer will also demand for the smartphone even if the
prices are high.

Thus, these are some of the exceptions to the law of demand where the
demand curve is upward sloping, i.e. the demand increases with an
increase in the price and decreases with the decrease in price.

Changes in demand
1. Expansion and Contraction of Demand:

The variations in the quantities demanded of a product with change in its

price, while other factors are at constant, are termed as expansion or
contraction of demand. Expansion of demand refers to the period when
quantity demanded is more because of the fall in prices of a product.
However, contraction of demand takes place when the quantity demanded
is less due to rise in the price o a product.

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For example, consumers would reduce the consumption of milk in case the
prices of milk increases and vice versa. Expansion and contraction are
represented by the movement along the same demand curve. Movement
from one point to another in a downward direction shows the expansion of
demand, while an upward movement demonstrates the contraction of
demand.

When the price changes from OP to OP1 and demand moves from OQ to
OQ1, it shows the expansion of demand. However, the movement of price
from OP to OP2 and movement of demand from OQ to OQ2 show the
contraction of demand.

2. Increase and Decrease in Demand:

Increase and decrease in demand are referred to change in demand due to

changes in various other factors such as change in income, distribution of
income, change in consumer’s tastes and preferences, change in the price
of related goods, while Price factor is kept constant Increase in demand
refers to the rise in demand of a product at a given price.

On the other hand, decrease in demand refers to the fall in demand of a

product at a given price. For example, essential goods, such as salt would
be consumed in equal quantity, irrespective of increase or decrease in its
price. Therefore, increase in demand implies that there is an increase in
demand for a product at any price. Similarly, decrease in demand can also
be referred as same quantity demanded at lower price, as the quantity
demanded at higher price.

Increase and decrease in demand is represented as the shift in demand

curve. In the graphical representation of demand curve, the shifting of
demand is demonstrated as the movement from one demand curve to

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another demand curve. In case of increase in demand, the demand curve
shifts to right, while in case of decrease in demand, it shifts to left of the
original demand curve.

The movement from DD to D1D1 shows the increase in demand with

price at constant (OP). However, the quantity has also increased from OQ
to OQ1.

The movement from DD to D2D2 shows the decrease in demand with

price at constant (OP). However, the quantity has also decreased from OQ
to OQ2.

Elasticity of demand: We know that there is a close relationship between

price and demand. When price rises, demand contracts and when price
falls demand extends. This extension and contraction which takes place in
demand as a result of change in price is called elasticity of demand. The
law of demand only states the direction of change of demand caused by
the change in price. The relative magnitude of the demand is expressed by
the concept of elasticity of demand.

Meaning of elasticity: The term elasticity expresses the degree of

correlation between demand and price. It is the rate at which the quantity
demanded varies with a change in price.

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 It is the measure of the responsiveness of demand to changing price.
The elasticity of demand is a measure of the relative change in amount
purchase in response to a relative change in price on a given demand
curve. It may be carefully noted that elasticity depends primarily on
proportional or percentage changes and not an absolute change in price
and quantity demanded. It is defined as the degree to which a change in
price will change the quantity demanded.

Definition
Mrs. Joan Robinson defines: the elasticity of demand, at any price or at any
output, is the proportional change of amount purchased in response to a
small change in price, divided by proportional change in price. Other things
are assumed to remain constant, e.g., other price, consumer’s income.

In the words of Marshall, “The elasticity (or responsiveness) of demand in a

market is great or small according to the amount demanded increases
much or little for a given fall in price, and diminishes much or little for a
given rise in price ”.

Elastic and inelastic demand:

The change in demand is not always in proportion to change in price. A
small change in price may lead to a great change in demand. In that case,
we shall say that the demand is elastic or sensitive or responsive.
A big change in price is followed only by a small change in demand, it is
said to be a case of inelastic demand, e.g. salt.
The demand is elastic, when a fall in price increases the total amount spent
or the total revenue of seller (i.e. price X quantity).In this case, percentage
change in quantity demanded is greater than the percentage change in
price.
But when a fall in price leads to a small increase in the quantity demanded
so that total outlay of the purchaser or the total revenue of the seller (i.e.
price X quantity) decreases, we say that the demand is inelastic. In this
case the percentage change in quantity demanded is smaller than the
percentage change in price.

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Five cases/degrees of elasticity:

Price Elasticity of Demand

A price elasticity of demand shows a percentage change in

quantity demanded to a percentage change in price.

PED = PROPORTIONATE CHANGE IN QUANTITY DEMANDED

PROPORTIONATE CHANGE IN PRICE

CASES FOR PRICE ELASTICITY OF DEMAND

❑ PERFECTLY ELASTIC DEMAND

❑ PERFECTLY INELASTIC DEMAND
❑ UNIT ELASTIC DEMAND
❑ RELATIVELY ELASTIC DEMAND
❑ RELATIVELY INELASTIC DEMAND

PERFECTLY ELASTIC DEMAND

When a small change or no change in price leads to

an infinitely large changes in demand, it is called perfectly elastic demand.

Ed ∞

It shows that at OP price any amount of commodity is

demanded and if price increases, the consumer will not purchase the
commodity. Elasticity of demand is infinity.

PERFECTLY INELASTIC DEMAND

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 A large change in price fails to bring a change in quantity demanded.
The elasticity of demand equals to zero.

Ed = 0

When the price increases from OP2 to OP1, The quantity

demanded remains the same at OD. The demand curve will be a vertical
straight line.

UNIT ELASTIC DEMAND

The change in quantity demanded is exactly equal to change in

price. When both are equal, elasticity of demand equals to one. It is said to
be unitary. Ed = 1

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When price falls from OP to OPo, Quantity demanded increases from OQ
to OQo. A 10 percent fall in price brings a 10 percent rise in quantity
demanded. Thus a change in price has resulted in an equal change in
quantity demanded.

RELATIVELY ELASTIC DEMAND

A small change in price leads to a big change in quantity

demanded. In this case elasticity of demand is greater than one. The
demand curve is flatter. Ed > 1

When the price falls from OP1 to OP2, there is a large increase in quantity
demanded from OQ2to OQ1.

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RELATIVELY INELASTIC DEMAND

A large change in price leads to a smaller change in quantity

demand. The elasticity of demand is less than 1. The demand curve is
steeper. Ed < 1

When price falls from OP to OPo, the amount demanded increases from
OQ toOQo, which is smaller than changes in price.

Income Elasticity of demand

The income elasticity of demand shows the change in quantity

demanded as a result of change in come. It can be written as

Proportionate change in quantity demanded

YED = Proportionate change in income

Cases for Income Elasticity of demand

1. Zero Income Elasticity

2. Negative Income Elasticity
3. Income Elasticity equal to unity
4. Income Elasticity greater than unity
5. Income Elasticity Lesser than unity

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 1. Zero Income Elasticity

The quantity demanded remains the same even though

money income increases. It can be written as elasticity of income
equal to zero. Ed = 0.

When income increases from OY1 to OY2, the quantity demanded remains
the same at OQ. In this case the demand curve is a vertical straight line.

Negative Income Elasticity

When income increases quantity demanded falls. The

elasticity of demand is negative. Ed < 0.

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 When income increases from OY to OY1, the quantity demanded falls
from OQ to OQ1.The demand curve slopes downwards from left to
right.

Income Elasticity equal to unity

When an increase in income brings about a proportionate increase in

quantity demanded, the elasticity of demand equal to one. Ed = 1

When income increases from OY to OY1, the quantity demanded also

increases to the same extent from OQ to OQ1.

Income Elasticity greater than unity

An increase in income brings about a more than proportionate

increase in quantity demanded. It can be written as income elasticity
greater than 1. The demand curve will be flatter. Ed >1

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When income increases from OY to OY1, the quantity demanded increases
from OQ to OQ1. A small change in income brings a greater changes in
demand.

Income elasticity lesser than unity

When income increases, quantity demanded also increases but less

than proportionately. The income elasticity is less than one. Ed < 1.

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An increase in income from OY to OY1, brings about an increase in
quantity demanded from OQ to OQ1. The demand curve is steeper. But the
increase in quantity demanded is smaller than increase in income.

CROSS ELASTICITY

A change in the price of one commodity leads to a change in

quantity demanded of another commodity. This is called cross elasticity of
demand. It can be written as

Proportionate change in quantity demanded of commodity X

CED = Proportionate change in price of commodity Y

Cases for Cross Elasticity of demand

➢ Substitute Goods
➢ Complementary Goods
➢ Unrelated Goods

Substitute Goods

The cross elasticity of demand is positive in case of substitutes.

When the price of coffee increases, the quantity demanded of tea
increases. Ed = +ve

When the price of coffee increases from OP to OP1, the quantity

demanded of tea increases from OM to OM1.

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Complementary Goods

If two goods are complementary, rise in the price of one leads to fall
in the demand of another. Ex : Car and Petrol. Ed = -ve

A rise in the price of a car will bring fall in their demand together with the
demand for petrol. Since price and demand vary in opposite direction, the
cross elasticity of demand is negative.

Unrelated goods

If the two goods are unrelated a fall in the price of one commodity has
no effect on the demand for another commodity. Ex : Car & bread. Ed = 0

A fall in the price of Car or Y has no effect on the quantity demanded of

bread or X.

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MEASUREMENT OF ELASTICITY OF DEMAND

✓ PERCENTAGE METHOD
✓ TOTAL OUTLAY METHOD
✓ POINT METHOD
✓ ARC METHOD

PERCENTAGE METHOD

It measures elasticity of demand by comparing the ratio of

percentage change in amount demanded to the percentage change in price
of commodity.

Relative change in quantity demanded

Ed = Relative change in price

D3

D2

D1

D4 D5 X

D1 = Ed = 1; D2 = Ed >1 D3 = Ed ∞

D4 = Ed = 0 D5 = Ed < 1

It is also called as formula method or co-efficient of price elasticity of

demand. All the five cases of price elasticity can be illustrated in the
following diagram. The percentage method helps to measure elasticity at a
point on demand curve.

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TOTAL OUTLAY METHOD

This method was given by Alfred Marshall. This method explains the
changes in expenditure on commodities due to changes in price.

(i) Demand showing unit elasticity

A given change in price does not cause any change in total

amount of money spent on commodity, then elasticity of demand equal to
unity.

Price Quantity demanded Total Expenditure

4.5 4 18
4 4.5 18

3 6 18

As Price falls, quantity demanded increases but total outlay remains

constant at rupees 18. Hence the elasticity of demand is equal to unity.

(ii) Demand showing elasticity greater than unity

If the total expenditure increases due to fall in price, the

elasticity of demand is greater than unity.

Price Quantity demanded Total Expenditure

4.5 6 27

4 7 28

3 10 30

When price falls from rupees 4.5 to 3, total outlay increases from rupees 27
to 30. Therefore the elasticity is greater than unity.
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(ii) Demand showing elasticity Lesser than unity

If a given change in price results in a fall in the amount spent or

expenditure, then the elasticity of demand is less than unity.

Price Quantity demanded Total Expenditure

4.5 4 18

4 4.25 17

3 5 15

When the price decreases from rupees 4.5 to 3, the total expenditure
decreases from rupees 18 to 15.

P3 Ed >1

Price P1

Ed = 1

P2

P4

Ed <1

O E3 E4 E2 X

Total Expenditure

When the price falls from P1 toP2, total expenditure remains the
same at E2. Therefore, the elasticity is equal to one. When price falls to P4.
Total expenditure decreases from E2 to E4. Hence elasticity is less than

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one. price decreases from P3 to P1, total expenditure increases from E3 to
E2. In this case elasticity is greater than one.

POINT METHOD

It was given by Marshall. The Elasticity of demand at point p is

measured by using the formula

P= Lower segment of the demand curve

Upper segment of the demand curve

In case of straight line

Price

O Qty B X

Point elasticity at point P = PB / PA

y In case of a curve

Price P

O B X

Quantity demanded

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 Point Elasticity at point P = PB / PA

Elasticity’s at different points

B P2 >1

Price P=1

P1 <1

0∞

O Qty demanded A Y

P = PA / PB =1

P1 = P1A / P1B < 1

P2 = P2A /P2B >1

At a point on the X –axis the elasticity of demand is zero and on

Y- axis it is infinity.

This method is useful to measure price elasticity when there are

minute changes in price and quantity demanded.

ARC METHOD

Since point method gives different result for the same change in
price. Economist has devised arc method. The formula for arc elasticity of
demand is

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 Original Quantity - New Quantity

ED = Original Quantity + New Quantity

Original Price – New Price

Original Price + New Price

Q1 – Q2 Q

Q1 + Q2 Q1 + Q2 Q * P1 + P2

= P1 – P2 = P Q1 +Q2 * P

P1 + P2 P1 + P2

Q (P1 +P2)

= P (Q1+Q2)

Demand Estimation

In Demand estimating manager attempts to quantify the links or

relationship between the level of demand and the variables which are
determinants to it and is generally used in designing pricing strategy of the
firm. In demand estimation manager analyse the impact of future change in
price on the quantity demanded. Firm can charge a price that the market
will ready to wear to sell its product. Over estimation of demand may lead
to an excessive price and lost sales whereas under estimates may lead to
setting of low price resulting in reduced profits. In demand estimation data
is collected for short period usually a year or less and analysed in relation
to various variables to know the impact of each variables mainly the price
on the demand behaviour of the customers. It is for a short period.

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Demand Forecasting

A forecast is a prediction or estimation of future situation. It is an

objective assessment of future course of action. Since future is uncertain,
no forecast can be cent percent correct. Forecasts can be both physical as
well as financial in nature. The more realistic the forecasts, the more
effective decisions can be taken for tomorrow.

Definition

In the words of Cundiff and Still, “Demand forecasting is an estimate

of sales during a specified future period which is tied to a proposed
marketing plan and which assumes a particular set of uncontrollable and
competitive forces”.

Procedure to Prepare Sales Forecast:

Companies commonly use a three-stage procedure to prepare a sales

forecast.

1. Environmental forecast - It calls for projecting inflation,

unemployment, interest rate, consumer spending, and saving, business
investment, government expenditure, net exports and other environmental
magnitudes and events of importance to the company.

2. The industry forecast - It is based on surveys of consumers’ intention

and analysis of statistical trends is made available by trade associations or
chamber of commerce. It can give indication to a firm regarding tine
direction in which the whole industry will be moving.

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3. Company sales forecast - The company derives its sales forecast by
assuming that it will win a certain market share.

Types of Forecasting:

(i)Passive Forecast - Under passive forecast prediction about future is

based on the assumption that the firm does not change the course of its
action.

(ii) Active Forecast - Under active forecast, prediction is done under the
condition of likely future changes in the actions by the firms.

(iii) Short term demand forecasting - In a short run forecast, seasonal

patterns are of much importance. It may cover a period of three months, six
months or one year. It is one which provides information for tactical
decisions. Which period is chosen depends upon the nature of business.
Such a forecast helps in preparing suitable sales policy.

(iv) Long term demand forecasting - Long term forecasts are helpful in
suitable capital planning. It is one which provides information for major
strategic decisions. It helps in saving the wastages in material, man hours,
machine time and capacity. Planning of a new unit must start with an
analysis of the long term demand potential of the products of the firm.

(v) External or national group of forecast - External forecast deals with

trends in general business. It is usually prepared by a company’s research
wing or by outside consultants.

(vi) Internal or company group forecast - Internal forecast includes all

those that are related to the operation of a particular enterprise such as
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sales group, production group, and financial group. The structure of internal
forecast includes forecast of annual sales, forecast of products cost,
forecast of operating profit, forecast of taxable income, forecast of cash
resources, forecast of the number of employees, etc.

(vii)Levels of Forecasting

a)Macro –Level Forecasting - Macro-level forecasting is concerned with

business conditions over the whole economy. It is measured by an
appropriate index of industrial production, national income or expenditure.

b) Industry- level forecasting - Industry-level forecasting is prepared by

different trade associations. This is based on survey of consumers’
intention and analysis of statistical trends.

c) Firm-level forecasting - It is related to an individual firm. It is most

important from managerial view point.

d) Product-line forecasting - It helps the firm to decide which of the

product or products should have priority in the allocation of firm’s limited
resources.

viii) General forecast & Specific forecast

The general forecast may generally be useful to the firm. Many firms
require separate forecasts for specific products and specific areas, for this
general forecast is broken down into specific forecasts.

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METHODS OF DEMAND FORECASTING

Opinion Polling Method:

In this method, the opinion of the buyers, sales force and experts
could be gathered to determine the emerging trend in the market.

(a) Consumer’s Survey Method or Survey of Buyer’s Intentions:

In this method, the consumers are directly approached to disclose their

future purchase plans. I his is done by interviewing all consumers or a
selected group of consumers out of the relevant population. This is the
direct method of estimating demand in the short run.

(i) Complete Enumeration Survey:

Under the Complete Enumeration Survey, the firm has to go for a door to
door survey for the forecast period by contacting all the households in the
area. This method has an advantage of first hand, unbiased information,
yet it has its share of disadvantages also. The major limitation of this
method is that it requires lot of resources, manpower and time.

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 In this method, consumers may be reluctant to reveal their
purchase plans due to personal privacy or commercial secrecy. Moreover,
at times the consumers may not express their opinion properly or may
deliberately misguide the investigators.

(ii) Sample Survey and Test Marketing:

Under this method some representative households are selected on

random basis as samples and their opinion is taken as the generalised
opinion. This method is based on the basic assumption that the sample
truly represents the population.

(iii) End Use Method or Input-Output Method:

This method is quite useful for industries which are mainly producer’s
goods. In this method, the sale of the product under consideration is
projected as the basis of demand survey of the industries using this product
as an intermediate product, that is, the demand for the final product is the
end user demand of the intermediate product used in the production of this
final product.

(b) Sales Force Opinion Method:

This is also known as collective opinion method. In this method, instead of

consumers, the opinion of the salesmen is sought. It is sometimes referred
as the “grass roots approach” as it is a bottom-up method that requires
each sales person in the company to make an individual forecast for his or
her particular sales territory.

(c) Experts Opinion Method:

This method is also known as “Delphi Technique” of investigation. The

Delphi method requires a panel of experts, who are interrogated through a
sequence of questionnaires in which the responses to one questionnaire
are used to produce the next questionnaire. Thus any information available
to some experts and not to others is passed on, enabling all the experts to
have access to all the information for forecasting.

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2. Statistical Method:

Statistical methods have proved to be immensely useful in demand

forecasting.

(i) Trend Projection Method:

A firm existing for a long time will have its own data regarding sales for past
years. Such data when arranged chronologically yield what is referred to as
‘time series’. Time series shows the past sales with effective demand for a
particular product under normal conditions. Such data can be given in a
tabular or graphic form for further analysis. This is the most popular method
among business firms, partly because it is simple and inexpensive and
partly because time series data often exhibit a persistent growth trend.

Time series has got four types of components namely, Secular Trend
(T), Secular Variation (S), Cyclical Element (C), and an Irregular or
Random Variation (I). These elements are expressed by the equation O =
TSCI.

Secular trend refers to the long run changes that occur as a result of
general tendency.

Seasonal variations refer to changes in the short run weather pattern or

social habits.

Cyclical variations refer to the changes that occur in industry during

depression and boom.

Random variation refers to the factors which are generally able such as
wars, strikes, flood, famine and so on.

When a forecast is made the seasonal, cyclical and random variations are
removed from the observed data. Thus only the secular trend is left. This
trend is then projected. Trend projection fits a trend line to a mathematical
equation.

The trend can be estimated by using any one of the following

methods:

(a) The Graphical Method,

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(b) The Least Square Method.

a) Graphical Method:

This is the most simple technique to determine the trend. All values of
output or sale for different years are plotted on a graph and a smooth free
hand curve is drawn passing through as many points as possible. The
direction of this free hand curve—upward or downward— shows the trend.
A simple illustration of this method is given in Table 2.

Table : Sales of Firm

Year Sales

(Rs. Crore)

1995 40

1996 50

1997 44

1998 60

1999 54

2000 62

In Fig. 1, AB is the trend line which has been drawn as free hand curve
passing through the various points representing actual sale values.

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(b) Least Square Method:

Under the least square method, a trend line can be fitted to the time series
data with the help of statistical techniques such as least square regression.
When the trend in sales over time is given by straight line, the equation of
this line is of the form: y = a + bx. Where ‘a’ is the intercept and ‘b’ shows
the impact of the independent variable. We have two variables—the inde-
pendent variable x and the dependent variable y. The line of best fit
establishes a kind of mathematical relationship between the two variables
.v and y. This is expressed by the regression у on x.

In order to solve the equation v = a + bx, we have to make use of the

following normal equations:

Σ y = na + b ΣX

Σ xy =a Σ x+b Σ x2

(ii) Barometric Technique:

A barometer is an instrument of measuring change. This method is

based on the notion that “the future can be predicted from certain
happenings in the present.” This is accomplished by the use of economic
and statistical indicators which serve as barometers of economic change.

(iii) Regression Analysis:

It attempts to assess the relationship between at least two variables

(one or more independent and one dependent), the purpose being to
predict the value of the dependent variable from the specific value of the
independent variable.. This method starts from the assumption that a basic
relationship exists between two variables.

iv) Econometric Models:

Econometric models are an extension of the regression technique

whereby a system of independent regression equation is solved. The
requirement for satisfactory use of the econometric model in forecasting is
under three heads: variables, equations and data.

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Forecasting Demand for New Products - Joel Dean

(a) Evolutionary Approach: It consists of projecting the demand for a

new product as an outgrowth and evolution of an existing old product.

(b) Substitute Approach: According to this approach the new product is

treated as a substitute for the existing product or service.

(c) Growth Curve Approach: It estimates the rate of growth and potential
demand for the new product as the basis of some growth pattern of an
established product.

(d) Opinion-Poll Approach: Under this approach the demand is estimated

by direct enquiries from the ultimate consumers.

(e) Sales Experience Approach: According to this method the demand for
the new product is estimated by offering the new product for sale in a
sample market.

(f) Vicarious Approach: By this method, the consumers’ reactions for a

new product are found out indirectly through the specialised dealers who
are able to judge the consumers’ needs, tastes and preferences.

CRITERIA FOR DEMAND FORECASTING

1. Accuracy:

Accuracy denotes near to actual demand. A firm should forecast its

demand very close to the actual market demand so that required
quantities could be made available for the market. Inaccurate forecast may
cost huge to the firm. It may create over or under production. Forecast
should be explicit. For example, there would be an increase in sales in the
next year than the current is not a good forecast but there would be an
increase in sales by 20% in the next year is an accurate forecast.

2. Longevity or Durability :

Demand forecast generally takes huge time, money and planning. Since a
forecast takes a lot of time and money, it should be usable for longer span
of time or multiple years. A forecast for short span of time may not be
effective for the organization.

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3. Flexibility or Scale-ability

A demand forecast should be flexible and adaptable to any kind of

changes. Now a days there is a rapid change in the tastes and preferences
of consumers. This affects the demand for different products up to a great
extent. Therefore, the demand forecasts made by a firm should be able to
reflect those changes accordingly. Apart from this, a business firm, while
making forecasts, should consider various business risks that may take
place in the future.

4. Acceptability and Simplicity:

Acceptability is one of the most important criterion of a good demand

forecasting method. That means a forecast should be acceptable to all. It
should also be as simple as possible. A business firm should forecast its
market demand by using simple and easy methods so that the
organizations do not face any complexities. However, some companies
generally prefer advanced statistical methods, which may prove difficult
and complex.

5. Availability:

A good a good demand forecasting method should have adequate and

up-to-date data available. The forecasts should be done in timely manner
so that necessary arrangements could be made related to the market
demand. Data should be available to the decision makers at all time.

6. Plausibility and Possibility:

It denotes that the demand forecasts should be reasonable, so that they

are easily understood by individuals who will use it. Again, it should have
the quality of application in the changing business conditions.

7. Economy:

A good demand forecasting method should have a relationship with costs

and benefits. It should be economically effective. The forecasting should be
made in such a way that the costs do not exceed the benefits that will be
derived from it. Costs should be less and benefits should be high.

************************

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 UNIT –III

Factors of Production

Factors of production is an economic term that describes the

inputs used in the production of goods or services in order to make
an economic profit. They include any resource needed for the
creation of a good or service. The factors of production include land,
labor, capital and entrepreneurship. These production factors are also
known as management, machines, materials and labor, and
knowledge has recently been talked about as a potential new factor
of production.

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Land

The term ‘Land’ in economics is often used in a wider sense. It does not
mean only the surface of the soil, but it also includes all those natural
resources which are the free gifts of nature.

It, therefore, means all the free gifts of nature. These natural gifts include:
(i) rivers, forests, mountains and oceans; (ii) heat of sun, light, climate,
weather, rainfall, etc. which are above the surface of land; (iii) minerals
under the surface of the earth such as iron, coal, copper, water, etc.

According to Marshall, “By land is meant… materials and forces

which nature gives freely for man’s aid in land, water, air, light and heat.”
Therefore, land is a stock of free gifts of nature.

Characteristics of Land:

Land possesses the following characteristics:

1. Free Gift of Nature:

Man has to make efforts in order to acquire other factors of production. But
to acquire land no human efforts are needed. Land is not the outcome of
human labour. Rather, it existed even long before the evolution of man.

2. Fixed Quantity:

The total quantity of land does not undergo any change. It is limited and
cannot be increased or decreased with human efforts. No alteration can be
made in the surface area of land.

3. Land is Permanent:

All man-made things are perishable and these may even go out of
existence. But land is indestructible. Thus it cannot go out of existence. It is
not destructible.

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4. Land is a Primary Factor of Production:

In any kind of production process, we have to start with land. For example,
in industries, it helps to provide raw materials, and in agriculture, crops are
produced on land.

5. Land is a Passive Factor of Production:

This is because it cannot produce anything by itself. For example, wheat

cannot grow on a piece of land automatically. To grow wheat, man has to
cultivate land. Labour is an active factor but land is a passive factor of
production.

6. Land is Immovable:

It cannot be transported from one place to another. For instance, no portion

of India’s surface can be transported to some other country.

7. Land has some Original Indestructible Powers:

There are some original and indestructible powers of land, which a man
cannot destroy. Its fertility may be varied but it cannot be destroyed
completely.

8. Land Differs in Fertility:

Fertility of land differs on different pieces of land. One piece of land may
produce more and the other less.

9. Supply of Land is Inelastic:

The demand for a particular commodity makes way for the supply of that
commodity, but the supply of land cannot be increased or decreased
according to its demand.

10. Land has Many Uses:

We can make use of land in many ways. On land, cultivation can be done,
factories can be set up, roads can be constructed, buildings can be raised
and shipping is possible in the sea and big rivers.

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Labour

Labour includes both physical and mental work undertaken for some
monetary reward. In this way, workers working in factories, services of
doctors, advocates, ministers, officers and teachers are all included in
labour.

For example, the work of a gardener in the garden is called labour,

because he gets income for it. But if the same work is done by him in his
home garden, it will not be called labour, as he is not paid for that work. So,
if a mother brings up her children, a teacher teaches his son and a doctor
treats his wife, these activities are not considered ‘labour’ in economics. It
is so because these are not done to earn income. According to S.E.
Thomas, “Labour connotes all human efforts of body or mind which are
undertaken in the expectation of reward.”

Characteristics of Labour:

Labour has the following peculiarities which are explained as under:

1. Labour is Perishable:

Labour is more perishable than other factors of production. It means labour

cannot be stored. The labour of an unemployed worker is lost forever for
that day when he does not work. Labour can neither be postponed nor
accumulated for the next day. It will perish. Once time is lost, it is lost
forever.

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2. Labour cannot be separated from the Labourer:

Land and capital can be separated from their owner, but labour cannot he
separated from a labourer. Labour and labourer are indispensable for each
other. For example, it is not possible to bring the ability of a teacher to
teach in the school, leaving the teacher at home. The labour of a teacher
can work only if he himself is present in the class. Therefore, labour and
labourer cannot be separated from each other.

3. Less Mobility of Labour:

As compared to capital and other goods, labour is less mobile. Capital can
be easily transported from one place to other, but labour cannot be
transported easily from its present place to other places. A labourer is not
ready to go too far off places leaving his native place. Therefore, labour has
less mobility.

4. Weak Bargaining Power of Labour:

The ability of the buyer to purchase goods at the lowest price and the ability
of the seller to sell his goods at the highest possible price is called the
bargaining power. A labourer sells his labour for wages and an employer
purchases labour by paying wages. Labourers have a very weak
bargaining power, because their labour cannot be stored and they are poor,
ignorant and less organised.

Moreover, labour as a class does not have reserves to fall back upon when
either there is no work or the wage rate is so low that it is not worth

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working. Poor labourers have to work for their subsistence. Therefore, the
labourers have a weak bargaining power as compared to the employers.

5. Inelastic Supply of labour:

The supply of labour is inelastic in a country at a particular time. It means

their supply can neither be increased nor decreased if the need demands
so. For example, if a country has a scarcity of a particular type of workers,
their supply cannot be increased within a day, month or year. Labourers
cannot be ‘made to order’ like other goods.

The supply of labour can be increased to a limited extent by importing

labour from other countries in the short period. The supply of labour
depends upon the size of population. Population cannot be increased or
decreased quickly. Therefore, the supply of labour is inelastic to a great
extent. It cannot be increased or decreased immediately.

6. Labourer is a Human being and not a Machine:

Every labourer has his own tastes, habits and feelings. Therefore,
labourers cannot be made to work like machines. Labourers cannot work
round the clock like machines. After continuous work for a few hours,
leisure is essential for them.

7. A Labourer sells his Labour and not Himself:

A labourer sells his labour for wages and not himself. ‘The worker sells
work but he himself remains his own property’. For example, when we
purchase an animal, we become owners of the services as well as the body
of that animal. But we cannot become the owner of a labourer in this sense.
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8. Increase in Wages may reduce the Supply of Labour:

The supply of goods increases, when their prices increase, but the supply
of labourers decreases, when their wages are increased. For example,
when wages are low, all men, women and children in a labourer’s family
have to work to earn their livelihood. But when wage rates are increased,
the labourer may work alone and his wife and children may stop working. In
this way, the increase in wage rates decreases the supply of labourers.
Labourers also work for less hours when they are paid more and hence
again their supply decreases.

9. Labour is both the Beginning and the End of Production:

The presence of land and capital alone cannot make production.

Production can be started only with the help of labour. It means labour is
the beginning of production. Goods are produced to satisfy human wants.
When we consume them, production comes to an end. Therefore, labour is
both the beginning and the end of production.

10. Differences in the Efficiency of Labour:

Labourer differs in efficiency. Some labourers are more efficient due to their
ability, training and skill, whereas others are less efficient on account of
their illiteracy, ignorance, etc.

11. Indirect Demand for Labour:

The consumer goods like bread, vegetables, fruit, milk, etc. have direct
demand as they satisfy our wants directly. But the demand for labourers is
not direct, it is indirect. They are demanded so as to produce other goods,
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which satisfy our wants. So the demand for labourers depends upon the
demand for goods which they help to produce. Therefore, the demand for
labourers arises because of their productive capacity to produce other
goods.

12. Difficult to find out the Cost of Production of Labour:

We can easily calculate the cost of production of a machine. But it is not

easy to calculate the cost of production of a labourer i.e., of an advocate,
teacher, doctor, etc. If a person becomes an engineer at the age of twenty,
it is difficult to find out the total cost on his education, food, clothes, etc.
Therefore, it is difficult to calculate the cost of production of a labourer.

13. Labour creates Capital:

Capital, which is considered as a separate factor of production is, in fact,

the result of the reward for labour. Labour earns wealth by way of
production. We know that capital is that portion of wealth which is used to
earn income. Therefore, capital is formulated and accumulated by labour. It
is evident that labour is more important in the process of production than
capital because capital is the result of the working of labour.

14. Labour is an Active Factor of Production:

Land and capital are considered as the passive factors of production,

because they alone cannot start the production process. Production from
land and capital starts only when a man makes efforts. Production begins
with the active participation of man. Therefore, labour is an active factor of
production.

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Capital

Meaning

Capital is defined as “All those man-made goods which are used in further
production of wealth.” Capital is that part of wealth which can be used for
further production of wealth. According to Marshall, “Capital consists of all
kinds of wealth, other than free gifts of nature, which yield income.”
Therefore, every type of wealth other than land which helps in further
production of income is called capital.

Characteristics of Capital:

Capital has its own peculiarities which distinguish it from other factors of
production. Capital possesses the following main characteristics:

1. Man Produces Capital:

Capital is that wealth which is used in the production of goods. Capital is

the result of human labour. Thus, every type of capital such as roads,
machines, buildings and factories etc. are produced by man. It is a
produced factor of production.

2. Capital is a Passive Factor of Production:

Capital cannot produce without the help of the active services of labour. To
produce with machines, labour is required. Thus, labour is an active,
whereas capital is a passive factor of production. Capital on its own cannot
produce anything until labour works on it.

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3. Capital is a Produced Means of Production:

The composition or supply of capital is not automatic, but it is produced

with the joint efforts of labour and land. Therefore, capital is a produced
means of production.

4. Capital is Variable:

The total supply of land cannot be changed, whereas the supply of capital
can be increased or decreased. If the residents of a country produce more
or save more from their income, and these savings are invested in factories
or capital goods, it increases the supply of capital.

5. Capital is more Mobile than other Factors of Production:

Of all the factors of production, capital is the most mobile. Land is perfectly
immobile. Labour and entrepreneur also lack mobility. Capital can be easily
transported from one place to another.

6. Capital Depreciates:

As we go on using capital, the value of capital goes on depreciating. When

machines are used continuously for some time, these depreciate and their
value falls.

7. Capital is Stored-up Labour:

Scholars like Marx admit that capital is stored-up labour. By putting in his
labour man earns wealth. A part of this wealth is spent on consumption
goods and the rest of it is saved. When saving is invested, it becomes

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capital. In other words, capital is the result of accumulation of savings of a
man. Therefore, capital is stored-up labour.

8. Capital is Destructible:

All capital goods are destructible and are not permanent. Because of the
continuous use, machines and tools become useless with the passage of
time.

Organisation

Meaning:

An entrepreneur organizes various factors of production like land, labour,

capital, machinery, etc. for channelizing them into productive activities. The
product finally reaches consumers through various agencies. Business
activities are divided into various functions, these functions are assigned to
different individuals.

Various individual efforts must lead to the achievement of common

business goals. Organization is the structural framework of duties and
responsibilities required of personnel in performing various functions with a
view to achieve business goals through organization. Management tries to
combine various business activities to accomplish predetermined goals.

Definitions:

Louis Allen, “Organization is the process of identifying and grouping work to

be performed, defining and delegating responsibility and authority and

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establishing relationships for the purpose of enabling people to work most
effectively together in accomplishing objectives.”

Characteristics of Organisation:

1. Division of Work:

Organisation deals with the whole task of business. The total work of the
enterprise is divided into activities and functions. Various activities are
assigned to different persons for their efficient accomplishment. This brings
in division of labour. It is not that one person cannot carry out many
functions but specialisation in different activities is necessary to improve
one’s efficiency. Organisation helps in dividing the work into related
activities so that they are assigned to different individuals.

2. Co-Ordination:

Co-ordination of various activities is as essential as their division. It helps in

integrating and harmonising various activities. Co-ordination also avoids
duplications and delays. In fact, various functions in an organisation
depend upon one another and the performance of one influences the other.
Unless all of them are properly coordinated, the performance of all
segments is adversely affected.

3. Common Objectives:

All organisational structure is a means towards the achievement of

enterprise goals. The goals of various segments lead to the achievement of
major business goals. The organisational structure should build around

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common and clear cut objectives. This will help in their proper
accomplishment.

4. Co-operative Relationship:

An organisation creates co-operative relationship among various members

of the group. An organisation cannot be constituted by one person. It
requires at least two or more persons. Organisation is a system which
helps in creating meaningful relationship among persons. The relationship
should be both vertical and horizontal among members of various
departments. The structure should be designed that it motivates people to
perform their part of work together.

5. Well-Defined Authority-Responsibility Relationships:

An organisation consists of various positions arranged in a hierarchy with

well defined authority and responsibility. There is always a central authority
from which a chain of authority relationship stretches throughout the
organisation. The hierarchy of positions defines the lines of communication
and pattern of relationships.

Production Function

Meaning

In simple words, production function refers to the functional relationship

between the quantity of a good produced (output) and factors of production
(inputs).

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“The production function is purely a technical relation which connects factor
inputs and output.” Prof. Koutsoyiannis

The new production function brought about by developing technology

displays same inputs and more output or the same output with lesser
inputs. Sometimes a new production function of the firm may be adverse as
it takes more inputs to produce the same output.

Mathematically, such a basic relationship between inputs and outputs may

be expressed as:

Q = f( L, C, N )

Where Q = Quantity of output

L = Labour

C = Capital

N = Land.

Hence, the level of output (Q), depends on the quantities of different inputs
(L, C, N) available to the firm. In the simplest case, where there are only
two inputs, labour (L) and capital (C) and one output (Q), the production
function becomes.

Q =f (L, C)

Definitions:

“Production function is the relationship between inputs of productive

services per unit of time and outputs of product per unit of time.” Prof.
George J. Stigler

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Features of Production Function:

1. Substitutability:

The factors of production or inputs are substitutes of one another which

make it possible to vary the total output by changing the quantity of one or
a few inputs, while the quantities of all other inputs are held constant. It is
the substitutability of the factors of production that gives rise to the laws of
variable proportions.

2. Complementarity:

The factors of production are also complementary to one another, that is,
the two or more inputs are to be used together as nothing will be produced
if the quantity of either of the inputs used in the production process is zero.

The principles of returns to scale is another manifestation of

complementarity of inputs as it reveals that the quantity of all inputs are to
be increased simultaneously in order to attain a higher scale of total output.

3. Specificity:

It reveals that the inputs are specific to the production of a particular

product. Machines and equipment’s, specialized workers and raw materials
are a few examples of the specificity of factors of production. The specificity
may not be complete as factors may be used for production of other
commodities too. This reveals that in the production process none of the
factors can be ignored and in some cases ignorance to even slightest
extent is not possible if the factors are perfectly specific.

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Production involves time; hence, the way the inputs are combined is
determined to a large extent by the time period under consideration. The
greater the time period, the greater the freedom the producer has to vary
the quantities of various inputs used in the production process.

In the production function, variation in total output by varying the quantities

of all inputs is possible only in the long run whereas the variation in total
output by varying the quantity of single input may be possible even in the
short run.

Types of production function

1. Linear Homogeneous Production Function,

2. Cobb-Douglas Production Function

3. Constant Elasticity of Substitution Production Function and

4. Variable Elasticity Substitution Production Function.

1. Linear Homogeneous Production Function:

When all the inputs are increased in the same proportion, the production
function is said to be homogeneous. The degree of production function is
equal to one. This is known as linear homogeneous production function. In
order to estimate the production function, it is necessary to express the
function in explicit functional form. Mathematically, this form of production
function is expressed as

nQ = f (nL, nK)

This production function also implies constant returns to scale. That is if L

and К are increased by n-fold, the output Q also increases by n-fold. This
form of production function is a well behaved production function. Which
makes the task of the entrepreneur quite simple and convenient? He
requires only Finding out just one optimum factor proportions.

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So long as relative factor prices remain constant, he has not to make any
fresh decision regarding factor proportions to be used, as he expands his
level of production. Moreover, this feature of the same optimum factor
proportions is also very useful in input- output analysis, In India, farm
management studies have emphasised the constant return to scale and
homogeneous production function.

2. Cobb-Douglas Production Function:

Charles W. Cobb and Paul H. Douglas studied the relationship of inputs

and outputs and formed an empirical production function, popularly known
as Cobb-Douglas production function. Originally, C-D production function
applied not to the production process of an individual firm but to the whole
of the manufacturing production.

The Cobb-Douglas production function is expressed by

Q = ALαKβ

where Q is output and L and A’ are inputs of labour and capital

respectively. A, α and β are positive parameters where α > 0, β > 0. The
equation tells that output depends directly on L and K and that part of
output which cannot be explained by L and К is explained by A which is the
‘residual’, often called technical change.

The marginal products of labour and capital are the functions of the
parameters A, α and β and the ratios of labour and capital inputs. That is,

MPL =∂Q/∂L = αAL α-1K β

MPK = ∂Q/∂K = βAL αK β-1

The two parameters a and P taken together measure the degree of the
homogeneity of the function.

In other words, this function characterizes the returns to scale thus:

α + β >1: Increasing returns to scale

α + β =1: Constant returns to scale

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α +β <1: Decreasing returns to scale.

Although the С-D production function is a multiplicative type and is non-

linear in its general form, it can be transferred into linear function by taking
it in its logarithmic form. That is why, this function is also known as log
linear function, which is

Log Q = log A + a log L + p log K

It is easier to compute С-D function when expressed in log linear form.

Properties of C-D Production Function:

The C-D production function has the following properties:

(i) There are constant returns to scale.

(ii) Elasticity of substitution is equal to one.

(iii) A and p represent the labour and capital shares of output respectively.

(iv) A and p are also elasticities of output with respect to labour and capital
respectively.

(v) If one of the inputs is zero, output will also be zero.

(vi) The expansion path generated by C-D function is linear and it passes
through the origin.

(vii) The marginal product of labour is equal to the increase in output when
the labour input is increased by one unit.

(viii) The average product of labour is equal to the ratio between output and
labour input.

(ix) The ratio α /β measures factor intensity. The higher this ratio, the more
labour intensive is the technique and the lower is this ratio and the more
capital intensive is the technique of production.

Importance of C-D Production Function

The C-D production function possesses the following merits:

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(i) It suits to the nature of all industries.

(ii) It is convenient in international and inter-industry comparisons.

(iii) It is the most commonly used function in the field of econometrics.

(iv) It can be fitted to time series analysis and cross section analysis.

(v) The function can be generalised in the case of ‘n’ factors of production.

(vi) The unknown parameters a and p in the function can be easily

computed.

(vii) It becomes linear function in logarithm.

(viii) It is more popular in empirical research.

Limitations of C-D Production Function

It has the following limitations:

(i) The function includes only two factors and neglects other inputs.

(ii) The function assumes constant returns to scale.

(iii) There is the problem of measurement of capital which takes only the
quantity of capital available for production.

(iv) The function assumes perfect competition in the factor market which is
unrealistic.

(v) It does not fit to all industries.

(vi) It is based on the substitutability of factors and neglects

complementarity of factors.

(vii) The parameters cannot give proper and correct economic implication.

3. Constant Elasticity of Substitution Production Function:

The CES production function is otherwise known as Homohighplagic

production function. Arrow, Chenery, Minhas and Solow have developed

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the Constant Elasticity of Substitution (CES) function. This function consists
of three variables Q, К and L, and three parameters A, a and 0. It may be
expressed in the form

Q = A [α C-ϴ+ (1- α) L -ϴ]-1/ϴ

where Q is the total output, К is capital, and L is labour. A is the efficiency

parameter indicating the state of technology and organisational aspects of
production. It shows that with technological and/or organisational changes,
the efficiency parameter leads to a shift in the production function, a (alpha)
is the distribution parameter or capital intensity factor coefficient concerned
with the relative factor shares in the total output, and 0 (theta) is the
substitution parameter which determines the elasticity of substitution. And
A > 0; 0 < α <1; ϴ > -1.

In the CES production function, the elasticity substitution is constant and

not necessarily equal to unity.

Mukherji has generated the CES function by introducing more than two
inputs.

Properties of CES Production Function:

(i) The value of elasticity of substitution depends upon the value of

substitution parameter.

(ii) The marginal products of labour and capital are always positive if we
assume constant returns to scale.

(iii) The marginal product of an input will increase when other factor inputs
increase.

(iv) When the elasticity substitution is less than unity the function does
reach a finite maximum as one factor increases while other is held
constant.

(v) The marginal product curves are sloping downward.

(vi) The estimation of the elasticity of substitution parameter requires the

assumption of perfect competition.

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Merits of C.E.S. Production Function:

(i) CES production function is more general.

(ii) CES covers all types of returns.

(iii) CES function takes account of a number of parameters.

(iv) CES function takes account of raw material among its inputs.

(v) CES function is very easy for estimation.

(vi) CES function is free from unrealistic assumptions.

Limitations of CES Production Function:

(i) The generated function suffers from the drawback that elasticity of
substitution between any parts of inputs in the same which does not appear
to be realistic.

(ii) In estimating parameters of CES production function, we may encounter

a large number of problems like choice of exogenous variables, estimation
procedure and the problem of multicollinearities.

(iii) Any attempt to remove the problem of multicollinearities would magnify

the errors in measurement of variables.

(iv) Serious doubts have been raised about the possibility of identifying the
production function under technological change.

4. Variable Elasticity Substitution Production Function:

Recently attempts have been made by Bruno, Knox Lovell and Revankar to
get a new production function. The resulting production function is the
generalisation of CES which possesses the desirable properties of variable
elasticity substitution.

Lu and Fletcher have filled a logarithmic relationship containing the wage

rate (W) as well as the capital-labour ratio (K/L) to explain value added per
unit of labour.

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V/L = a + b log W + с log K/L

where

V = Value added

W = Wage rate

K = Capital

L = Labour

a, b and с are the parameters to be estimated.

The elasticity of substitution (σ) is

σ = b/1-c (1+WL/rk)

where, WL and rk are the shares of labour and capital respectively.

Properties of VES Production Function:

(i) VES satisfies the requirements of a neo-classical production function.

(ii) VES function includes the fixed co-efficient models.

(ii) VES production function is more general.

LAW OF VARIABLE PROPORTIONS

The law of variable proportions states that as the quantity of one factor is
increased, keeping the other factors fixed, the marginal product of that
factor will eventually decline. This means that upto the use of a certain
amount of variable factor, marginal product of the factor may increase and
after a certain stage it starts diminishing. When the variable factor becomes
relatively abundant, the marginal product may become negative.

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Assumptions: The law of variable proportions holds good under the
following conditions:

1. Constant State of Technology: First, the state of technology is

assumed to be given and unchanged. If there is improvement in the
technology, then the marginal product may rise instead of
diminishing.
2. Fixed Amount of Other Factors: Secondly, there must be some
inputs whose quantity is kept fixed. It is only in this way that we can
alter the factor proportions and know its effects on output. The law
does not apply if all factors are proportionately varied.
3. Possibility of Varying the Factor proportions: Thirdly, the law is
based upon the possibility of varying the proportions in which the
various factors can be combined to produce a product. The law does
not apply if the factors must be used in fixed proportions to yield a
product.

Illustration of the Law: The law of variable proportion is illustrated in the

following table and figure. Suppose there is a given amount of land in which
more and more labour (variable factor) is used to produce wheat.

Units of Labour Total Product Marginal Product Average Product

1 2 2 2

2 6 4 3

3 12 6 4

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 4 16 4 4

5 18 2 3.6

6 18 0 3

7 14 -4 2

8 8 -6 1

It can be seen from the table that upto the use of 3 units of labour, total
product increases at an increasing rate and beyond the third unit total
product increases at a diminishing rate. This fact is shown by the marginal
product which is the addition made to Total Product as a result of
increasing the variable factor i.e. labour.

It can be seen from the table that the marginal product of labour initially
rises and beyond the use of three units of labour, it starts diminishing. The
use of six units of labour does not add anything to the total production of
wheat. Hence, the marginal product of labour has fallen to zero. Beyond
the use of six units of labour, total product diminishes and therefore
marginal product of labour becomes negative. Regarding the average
product of labour, it rises up to the use of third unit of labour and beyond
that it is falling throughout.

Three Stages of the Law of Variable Proportions: These stages are

illustrated in the following figure where labour is measured on the X-axis
and output on the Y-axis.

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Stage 1. Stage of Increasing Returns: In this stage, total product
increases at an increasing rate up to a point. This is because the efficiency
of the fixed factors increases as additional units of the variable factors are
added to it. In the figure, from the origin to the point F, slope of the total
product curve TP is increasing i.e. the curve TP is concave upwards upto
the point F, which means that the marginal product MP of labour rises. The
point F where the total product stops increasing at an increasing rate and
starts increasing at a diminishing rate is called the point of inflection.
Corresponding vertically to this point of inflection marginal product of labour
is maximum, after which it diminishes. This stage is called the stage of
increasing returns because the average product of the variable factor
increases throughout this stage. This stage ends at the point where the
average product curve reaches its highest point.

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Stage 2. Stage of Diminishing Returns: In this stage, total product
continues to increase but at a diminishing rate until it reaches its maximum
point H where the second stage ends. In this stage both the marginal
product and average product of labour are diminishing but are positive.
This is because the fixed factor becomes inadequate relative to the quantity
of the variable factor. At the end of the second stage, i.e., at point M
marginal product of labour is zero which corresponds to the maximum point
H of the total product curve TP. This stage is important because the firm
will seek to produce in this range.

Stage 3. Stage of Negative Returns: In stage 3, total product declines

and therefore the TP curve slopes downward. As a result, marginal product
of labour is negative and the MP curve falls below the X-axis. In this stage
the variable factor (labour) is too much relative to the fixed factor.

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Iso-quant Curve

Definition: An Iso-quant Curve shows all the possible combinations of

input factors that yield the same quantity of production. In other words, an
iso-quant curve is a geometric representation of the production function,
wherein different combinations of labor and capital are employed to have
the same level of output.

The iso-quant curve is also known as Iso-Product Curve. The term “Iso”
means same and “quant” or “product” means quantity produced.

The slope of an iso-quant curve is called the rate of technical

substitution, which means how much capital are to be substituted for the
labor to give the same quantity of production if the labor is reduced by 1
unit. Thus, the input factors can be substituted for one another to have an
unchanged level of output.

Assumptions of Iso-quant Curve

• Only two factors of production Viz. Labor and capital are taken into
the consideration.
• These factors can be substituted for each other.
• The factors of production can be divided into small parts.
• It is assumed that technology remains constant.
• The shape of the Iso-quant depends on the level of substitutability
between the factors of production.
• Suppose there are two input factors Viz. Labor and Capital. The
different combinations of these factors are used to have the same
level of output as shown in the schedule below:

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 Labor Capital
Combination Output
(unit) (Unit)
A 1 40 50
B 2 30 50
C 3 20 50
D 4 10 50

Iso-quant Map: An iso-quant map shows the different iso-quant curves

representing the different combinations of factors of production, yielding the
different levels of output. Thus, higher the iso-quant curve, the higher is the
level of output.

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Types of Iso-quant Curves

The iso-quant curves can be classified on the basis of the substitutability of

factors of production. These are:

1. Linear Iso-quant Curve: This curve shows the perfect substitutability

between the factors of production. This means that any quantity can
be produced either employing only capital or only labor or through “n”
number of combinations between these two.

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 2. Right Angle Iso-quant Curve: This is one of the types of iso-quant
curves, where there is a strict complementarity with no substitution
between the factors of production. According to this, there is only one
method of production to produce any one commodity. This curve is
also known as Leontief Iso-quant, input-output isoquant and is a
right angled curve.

3. Kinked iso-quant Curve: This curve assumes, that there is a limited

substitutability between the factors of production. This shows that
substitution of factors can be seen at the kinks since there are a few
processes to produce any one commodity. Kinked iso-quant curve is
also known as activity analysis programming iso-quant or linear

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 programming iso-quant.

4. Convex Iso-quant Curve: In this types of iso-quant curves, the

factors can be substituted for each other but up to a certain extent.
This curve is smooth and convex to the origin.

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Thus, the classification of the iso-quant curve can be done on the basis of
the number of labor units that can be substituted for capital and vice-versa,
so as to have the same level of production.

Law of Returns to Scale

In the long run all factors of production are variable. No factor is fixed.
Accordingly, the scale of production can be changed by changing the
quantity of all factors of production.

Definition:

“The term returns to scale refers to the changes in output as all factors
change by the same proportion.” Koutsoyiannis

Returns to scale are of the following three types:

1. Increasing Returns to scale.

2. Constant Returns to Scale

3. Diminishing Returns to Scale

Explanation:

In the long run, output can be increased by increasing all factors in the
same proportion. Generally, laws of returns to scale refer to an increase in
output due to increase in all factors in the same proportion. Such an
increase is called returns to scale.

Suppose, initially production function is as follows:

P = f (L, K)

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Now, if both the factors of production i.e., labour and capital are increased
in same proportion i.e., x, product function will be rewritten as.

The above stated table explains the following three stages of returns
to scale:

1. Increasing Returns to Scale:

Increasing returns to scale or diminishing cost refers to a situation when all

factors of production are increased, output increases at a higher rate. It
means if all inputs are doubled, output will also increase at the faster rate
than double. Hence, it is said to be increasing returns to scale. This

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increase is due to many reasons like division external economies of scale.
Increasing returns to scale can be illustrated with the help of a diagram 8.

In figure 8, OX axis represents increase in labour and capital while OY axis

shows increase in output. When labour and capital increases from Q to Q 1,
output also increases from P to P1 which is higher than the factors of
production i.e. labour and capital.

2. Diminishing Returns to Scale:

Diminishing returns or increasing costs refer to that production situation,

where if all the factors of production are increased in a given proportion,
output increases in a smaller proportion. It means, if inputs are doubled,
output will be less than doubled. If 20 percent increase in labour and capital
is followed by 10 percent increase in output, then it is an instance of
diminishing returns to scale.

The main cause of the operation of diminishing returns to scale is that

internal and external economies are less than internal and external
diseconomies. It is clear from diagram 9.

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In this diagram 9, diminishing returns to scale has been shown. On OX
axis, labour and capital are given while on OY axis, output. When factors of
production increase from Q to Q1 (more quantity) but as a result increase in
output, i.e. P to P1 is less. We see that increase in factors of production is
more and increase in production is comparatively less, thus diminishing
returns to scale apply.

3. Constant Returns to Scale:

Constant returns to scale or constant cost refers to the production situation

in which output increases exactly in the same proportion in which factors of
production are increased. In simple terms, if factors of production are
doubled output will also be doubled.

In this case internal and external economies are exactly equal to internal
and external diseconomies. This situation arises when after reaching a
certain level of production, economies of scale are balanced by
diseconomies of scale. This is known as homogeneous production function.
Cobb-Douglas linear homogenous production function is a good example of
this kind. This is shown in diagram 10. In figure 10, we see that increase in
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factors of production i.e. labour and capital are equal to the proportion of
output increase. Therefore, the result is constant returns to scale.

Supply

Supply is a fundamental economic concept that describes the total amount

of a specific good or service that is available to consumers. Supply can
relate to the amount available at a specific price or the amount available
across a range of prices

Definition of Law of Supply:

There is direct relationship between the price of a commodity and its

quantity offered fore sale over a specified period of time. When the price of
a goods rises, other things remaining the same, its quantity which is offered
for sale increases as and price falls, the amount available for sale
decreases. This relationship between price and the quantities which
suppliers are prepared to offer for sale is called the law of supply.

“Other things remaining unchanged, the supply of a commodity rises i.e.,

expands with a rise in its price and falls i.e., contracts with a fall in its price.
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Explanation of the Law:

This law can be explained with the help of a supply schedule as well as by
a supply curve based on an imaginary figures and data.

This can be shown by diagram as follows:

Here, in this diagram the supply curve SS is sloping upward. It suggests

with the supply schedule, that the market supply tends to expand with the
rise in price and vice-versa. Similarly, the upward slopping curve also
depicts a direct co-variation between price and supply.

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Assumptions

1. No change in the income:

2. No change in technique of production:

3. There should be no change in transport cost:

4. Cost of production be unchanged:

5. There should be fixed scale of production:

This law can be shown in this way also.

In the figure above OX axis shows quantity of demand and OY axis shows
price. SS1 line is the line of supply when the price of the commodity is OP
then quantity of supply is OQ.

When the price rises from OP to OP2 and then supply also rises from OQ to
OQ2. Similarly, if price is reduced from OP to OP1, then supply will reduce
from OQ to OQ1.

By seeing the diagram the conclusion can be drawn that when price rises
supply increases and when the price reduces the supply reduces.

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Meaning of Elasticity of Supply:

The law of supply indicates the direction of change—if price goes up,
supply will increase. But how much supply will rise in response to an
increase in price cannot be known from the law of supply. To quantify such
change we require the concept of elasticity of supply that measures the
extent of quantities supplied in response to a change in price.

It can be calculated by using the following formula:

ES = % change in quantity supplied/% change in price

Types of Elasticity of Supply:

For all the commodities, the value of Es cannot be uniform. For some
commodities, the value may be greater than or less than one.

Like elasticity of demand, there are five cases of ES:

(a) Elastic Supply (ES>1):

Supply is said to be elastic when a given percentage change in price leads

to a larger change in quantity supplied. Under this situation, the numerical
value of Es will be greater than one but less than infinity. SS1 curve of Fig.
4.17 exhibits elastic supply. Here quantity supplied changes by a larger
magnitude than does price.

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(b) Inelastic Supply (ES< 1):

Supply is said to be inelastic when a given percentage change in price

causes a smaller change in quantity supplied. Here the numerical value of
elasticity of supply is greater than zero but less than one. Fig. 4.18 depicts
inelastic supply curve where quantity supplied changes by a smaller
percentage than does price.

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(c) Unit Elasticity of Supply (ES = 1):

If price and quantity supplied change by the same magnitude, then we

have unit elasticity of supply. Any straight line supply Curve passing
through the origin, such as the one shown in Fig. 4.19, has an elasticity of
supply equal to 1. This can be verified in this way.

For any straight line positively-sloped supply curve drawn through the
origin, the ratio of P/Q at any point on the supply curve is equal to the ratio
∆ P/∆ Q. Note that ∆ P/∆ Q is the slope of the supply curve while elasticity
is (1/∆P/∆Q = ∆Q/∆P).Thus, in the formula (∆Q/∆P. P/Q), the two ratios
cancel out each other.

(d) Perfectly Elastic Supply (ES = ∞):

The numerical value of elasticity of supply, in exceptional cases, may reach

up to infinity. The supply curve PS1 drawn in Fig. 4.20 has an elasticity of
supply equal to infinity. Here the supply curve has been drawn parallel to
the horizontal axis. The economic interpretation of this supply curve is that
an unlimited quantity will be offered for sale at the price OS. If price slightly
drops down below OS, nothing will be supplied.

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(e) Perfectly Inelastic Supply (ES = 0):

Another extreme is the completely or perfectly inelastic supply or zero

elasticity. SS1 curve drawn in Fig. 4.21 illustrates the case of zero elasticity.
This curve describes that whatever the price of the commodity, it may even
be zero, quantity supplied remains unchanged at OQ. This sort of supply
curve is conceived when we consider the supply curve of land from the
viewpoint of a country, or the world as a whole.

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One important point to note here. Any straight line supply curve that
intersects the vertical axis above the origin has an elasticity of supply
greater than one (Fig. 4.17). Elasticity of supply will be less than one if the
straight line supply curve cuts the horizontal axis on any point to the right of
the origin, i.e. the quantity axis (Fig. 4.18).

Determinants of Supply:

(i) Technology changes. Technology helps a producer to minimize his

cost of production.

(ii) Resource supplies. The producer also has to pay for other resources
such as raw materials and labor. if his money is short on supplying a
certain number of products because of an increase in resource supplies,
then he has to reduce his supply.

(iii) Tax/ Subsidy. A producer aims to maximize his profit, but an increase
in tax will only increase his expenses, decreasing his capacity to buy
resource supplies and forcing him to reduce his supply.

(iii) Price of other goods produced. A producer may not only produce
on product but other products as well. A producer's money is limited
and if he increases his supply in one product, he would have to
decrease his supply in the other product, no unless his sales
increase.

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Types of cost of production / Cost Concepts

Opportunity Cost – Opportunity cost is the next best alternative foregone.

If you invest £1million in developing a cure for pancreatic cancer, the
opportunity cost is that you can’t use that money to invest in developing a
cure for skin cancer.

Economic Cost. Economic cost includes both the actual direct costs
(accounting costs) plus the opportunity cost. For example, if you take time
off work to a training scheme. You may lose a weeks pay of £350, plus also
have to pay the direct cost of £200. Thus the total economic cost = £550.

Social Costs. This is the total cost to society. It will include the private
costs plus also the external cost (cost incurred by a third party). May also
be referred to as ‘True costs’

External Costs. This is the cost imposed on a third party. For example, if
you smoke, some people may suffer from passive smoking. That is the
external cost.

Private Costs. The costs you pay. e.g. the private cost of a packet of
cigarettes is £6.10.

Explicit Costs: This includes those payments which are made by the
producer to those factors of production which do not belong to the producer
himself. These costs are mostly in the nature of contractual payment made
by the producer to the owner of those factors whose services were bought
by him for the purpose of production, e.g., the payment made for raw-
materials, power, light, fuel the wages and salaries paid to the workers and

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other staff, the rent paid on the land and the interest paid on the borrowed
capital etc. Payments on all such accounts will be included in explicit cost.

Implicit Costs: Implicit costs are also known as imputed costs. These
costs arise in the case of those factors which are possessed and supplied
by the producer himself. Here we cannot assign exact money value but can
term them in imputed values, e.g., a producer may contribute his own
building or premises for running the business, his own capital and working
also as Managing Director of the firm.

As such he is entitled to get rent on his own premises, interest on capital

contributed by him and also salary for his work as Managing Director. All
these items will be included in the implicit costs.

Fixed Costs: In the short run, some factors of production are in fixed
supply. When a firm changes its output, the costs of these factors remain
unchanged – they are fixed. For instance, if a firm raised its output, the
interest it pays on past loans would remain unchanged.

If it closed Total fixed cost down during a holiday period, it may still have to
pay for security and rent for buildings. Fig. 1 shows that total fixed cost
(TFC) remains unchanged as output changes.

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 Fixed costs (FC) are also sometimes referred to as overheads or
indirect costs.

Variable Costs:

Variable costs (VC), also sometimes called direct costs, are the costs of the
variable factors. They vary directly as output changes. Production and sale
of more cars will involve an increased expenditure on component parts,
electricity, wages and transport for a car firm. As output increases, total
variable cost rises. It usually tends to rise slowly at first and then rise more
rapidly. This is because productivity often rises at first and then begins to
decline after a certain output.

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 Total Cost

Total cost (TC), as its name implies, is the total cost of producing a
given output. The more the output is produced, the higher the total
cost of production. Producing more units requires the use of more
resources.

TC =TFC +TVC

Average cost: Average cost (AC) is also referred to as unit cost and is
given as total cost divided by output.

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 AC = TC/Q

In the short run, average cost consists of average fixed cost and average
variable cost. The shape of the short run average cost curve is usually U-
shaped.

Marginal Cost is the addition made to the total cost by producing 1

additional unit of output.
Marginal Cost = Total cost of nth unit - Total cost of (n-1)th unit.

MC = TCn – TCn-1 (e.g. – MC of 6 th unit = Total cost of 6th unit – Total

cost of 5th unit)

Marginal cost can also be defined as the change in total cost (∆TC) due to
change in quantity produced(∆Q).

MC = ∆TC/∆Q

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Long Run Cost

In the long run, all the factors of production used by an organization vary.
The existing size of the plant or building can be increased in case of long
run.

There are no fixed inputs or costs in the long run. Long run is a period in
which all the costs change as all the factors of production are variable.

There is no distinction between the Long run Total Costs (LTC) and long
run variable cost as there are no fixed costs. It should be noted that the
ability of an organization of changing inputs enables it to produce at lower
cost in the long run.

1. Long Run Total Cost:

Long run Total Cost (LTC) refers to the minimum cost at which given level
of output can be produced. According to Leibhafasky, “the long run total
cost of production is the least possible cost of producing any given level of
output when all inputs are variable.” LTC represents the least cost of
different quantities of output. LTC is always less than or equal to short run
total cost, but it is never more than short run cost.

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Short run total costs curves; STC1, STC2, and STC3 are shown depicting
different plant sizes. The LTC curve is made by joining the minimum points
of short run total cost curves. Therefore, LTC envelopes the STC curves.

2. Long Run Average Cost:

Long run Average Cost (LAC) is equal to long run total costs divided by the
level of output. The derivation of long run average costs is done from the
short run average cost curves. In the short run, plant is fixed and each
short run curve corresponds to a particular plant. The long run average
costs curve is also called planning curve or envelope curve as it helps in
making organizational plans for expanding production and achieving
minimum cost.

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Suppose there are three sizes of the plant and no other size of the plant
can be built. In short run, the plant sizes are fixed thus, organization
increase or decrease the variable factors. However, in the long run, the
organization can select among the plants which help in achieving minimum
possible cost at a given level of output.

From Figure-11, it can be noted that till OB amount of production, it is

beneficial for the organization to operate on the plant SAC2 as it entails
lower costs than SAC1. If the plant SAC2 is used for producing OA, then
cost incurred would be more. Thus, in the long run, it is clear that the
producer would produce till OB on plant SAC2. On SAC2, the producer
would produce till OC amount of output. If an organization wants to exceed
output from OC, it will be beneficial to produce at SAC3 than SAC2.

Thus, in the long run, an organization has a choice to use the plant
incurring minimum costs at a given output. LAC depicts the lowest possible
average cost for producing different levels of output. The LAC curve is
derived from joining the lowest minimum costs of the short run average
cost curves.

It first falls and then rises, thus it is U- shaped curve. The returns to scale
also affect the LTC and LAC. Returns to scale implies a change in output of
an organization with a change in inputs. In the long run, the output changes
with respect to change in all inputs of production.

In case of increasing returns to scale (IRS), organizations can double the

output by using less than twice of inputs. LTC increases less than the

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increase in the output, thus, LAC falls. In case of constant returns to scale
(CRS), organizations can double the output by using inputs twice.

LTC increases proportionately to the output; therefore, LAC becomes

constant. On the other hand, in case of decreasing returns to scale (DRS),
organizations can double the output by using inputs more than twice. Thus,
LTC increases more than the increase in output. As a result, LAC
increases.

Long Run Marginal Cost:

Long run Marginal Cost (LMC) is defined as added cost of producing an

additional unit of a commodity when all inputs are variable. This cost is
derived from short run marginal cost. On the graph, the LMC is derived
from the points of tangency between LAC and SAC.

LMC curve can be learned through Figure-13:

If perpendiculars are drawn from point A, B, and C, respectively; then they

would intersect SMC curves at P, Q, and R respectively. By joining P, Q,
and R, the LMC curve would be drawn. It should be noted that LMC equals
to SMC, when LMC is tangent to the LAC.

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The Relationship between Average Cost and Marginal Cost

Both marginal cost (MC) and average cost (AC) are derived from the total
cost. They bear unique relationship. The relationship between MC and AC
can be stated as under:

(i) When AC falls with increase in output, MC is lower than AC, i.e., MC
curve lies below the AC curve. However, it is not necessary that MC should
fall throughout this stage. Actually, MC rises earlier than AC.

(ii) When AC rises with increase in output, MC is higher than AC, i.e., MC
curve lies above the AC curve.

(iii) At the level of optimum output, average cost is minimum and constant.
Here, MC stands equal to AC, i.e., MC pulls AC horizontally.

(iv) At zero level of output both AC and MC are indeterminate.

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Economies and Diseconomies of scale

Economies of scale are defined as the cost advantages that an

organization can achieve by expanding its production in the long run.

In other words, these are the advantages of large scale production of the
organization. The cost advantages are achieved in the form of lower
average costs per unit.

It is a long term concept. Economies of scale are achieved when there is

an increase in the sales of an organization. As a result, the savings of the
organization increases, which further enables the organization to obtain
raw materials in bulk. This helps the organization to enjoy discounts. These
benefits are called as economies of scale.

The economies of scale are divided in to internal economies and

external economies discussed as follows:

i. Internal Economies:

Refer to real economies which arise from the expansion of the plant size of
the organization. These economies arise from the growth of the
organization itself.

Types of Internal economies

a. Technical economies of scale:

Occur when organizations invest in the expensive and advanced

technology. This helps in lowering and controlling the costs of production of

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organizations. These economies are enjoyed because of the technical
efficiency gained by the organizations. The advanced technology enables
an organization to produce a large number of goods in short time. Thus,
production costs per unit falls leading to economies of scale.

b. Marketing economies of scale:

Occur when large organizations spread their marketing budget over the
large output. The marketing economies of scale are achieved in case of
bulk buying, branding, and advertising. For instance, large organizations
enjoy benefits on advertising costs as they cover larger audience. On the
other hand, small organizations pay equal advertising expenses as large
organizations, but do not enjoy such benefits on advertising costs.

c. Financial economies of scale:

Take place when large organizations borrow money at lower rate of

interest. These organizations have good credibility in the market. Generally,
banks prefer to grant loans to those organizations that have strong foothold
in the market and have good repaying capacity.

d. Managerial economies of scale:

Occur when large organizations employ specialized workers for performing

different tasks. These workers are experts in their fields and use their
knowledge and experience to maximize the profits of the organization. For
instance, in an organization, accounts and research department are
created and managed by experienced individuals, SO that all costs and
profits of the organization can be estimated properly.

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e. Commercial economies:

Refer to economies in which organizations enjoy benefits of buying raw

materials and selling of finished goods at lower cost. Large organizations
buy raw materials in bulk; therefore, enjoy benefits in transportation
charges, easy credit from banks, and prompt delivery of products to
customers.

ii. External economies:

Occur outside the organization. These economies occur within the

industries which benefit organizations. When an industry expands,
organizations may benefit from better transportation network, infrastructure,
and other facilities. This helps in decreasing the cost of an organization.

Types

a. Economies of Concentration:

Refer to economies that arise from the availability of skilled labor, better
credit, and transportation facilities.

b. Economies of Information:

Imply advantages that are derived from publication related to trade and
business. The central research institutions are the source of information for
organizations.

c. Economies of Disintegration:

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Refer to the economies that arise when organizations split their processes
into different processes.

Diseconomies of scale

Diseconomies of scale occur when the long run average costs of the
organization increases. It may happen when an organization grows
excessively large. In other words, the diseconomies of scale cause larger
organizations to produce goods and services at increased costs.

Types

i. Internal diseconomies of scale:

Refer to diseconomies that raise the cost of production of an organization.

The main factors that influence the cost of production of an organization
include the lack of decision, supervision, and technical difficulties.

ii. External diseconomies of scale:

Refer to diseconomies that limit the expansion of an organization or

industry. The factors that act as restraint to expansion include increased
cost of production, scarcity of raw materials, and low supply of skilled
laborer.

There are a number of causes for diseconomies of scale.

Some of the causes which lead to diseconomies of scale are as

follows:

i. Poor Communication:

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Act as a major reason for diseconomies of scale. If production goals and
objectives of an organization are not properly communicated to employees
within the organization, it may lead to overproduction or production. This
may lead to diseconomies of scale.

Apart from this, if the communication process of the organization is not

strong then the employees would not get adequate feedback. As a result,
there would be less face-to-face interaction among employees- thus the
production process would be affected.

ii. Lack of Motivation:

Leads to fall in productivity levels. In case of a large organization, workers

may feel isolated and are less appreciated for their work, thus their
motivation diminishes. Due to poor communication network, it is harder for
employers to interact with the employees and build a sense of
belongingness. This leads to fall in the productivity levels of output owing to
lack of motivation. This further leads to increase in costs of the
organization.

iii. Loss of Control:

Acts as the main problem of large organizations. Monitoring and controlling

the work of every employee in a large organization becomes impossible
and costly. It is harder to make out that all the employees of an
organization are working towards the same goal. It becomes difficult for
managers to supervise the sub-ordinates in large organizations.

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iv. Cannibalization:

Implies a situation when an organization faces competition from its own

product. A small organization faces competition from products of other
organizations, whereas sometimes large organizations find that their own
products are competing with each other.

**************************

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 UNIT - IV

Meaning of Market:

In common parlance, by market is meant a place where commodities are

bought and sold at retail or wholesale prices.

Thus, a market place is thought to be a place consisting of a number of big

and small shops, stalls and even hawkers selling various types of goods.

In Economics however, the term “Market” does not refer to a particular

place as such but it refers to a market for a commodity or commodities. It
refers to an arrangement whereby buyers and sellers come in close contact
with each other directly or indirectly to sell and buy goods.

Definitions of Market:

As Chapmen has said – “The term market refers not necessarily to a place
but always to commodity or commodities and the buyers and sellers of the
same who are in direct competition with each other.”

According to Prof. Behham – “We must therefore, define a market as any

area over which buyers and sellers are in such close touch with one
another either directly or through dealers that the prices obtainable in one
part of the market affect the prices in other parts.”

Features of Market:

1. One commodity: In practical life, a market is understood as a place

where commodities are bought and sold at retail or wholesale price, but in
economics “Market” does not refer to a particular place as such but it refers

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to a market for a commodity or commodities i.e., a wheat market, a tea
market or a gold market and so on.

2. Area:

In economics, market does not refer only to a fixed location. It refers to the
whole area or region of operation of demand and supply

3. Buyers and Sellers:

To create a market for a commodity what we need is only a group of

potential sellers and potential buyers. They must be present in the market
of course at different places.

4. Perfect Competition:

In the market there must be the existence of perfect competition between

buyers and sellers. But the opinion of modern economist is that in the
market the situation of imperfect competition also exists, therefore, the
existence of both is found.

5. Business relationship between Buyers and Sellers:

For a market, there must exist perfect business relationship between

buyers and sellers. They may not be physically present in the market, but
the business relationship must be carried on.

6. Perfect Knowledge of the Market:

Buyers and sellers must have perfect knowledge of the market regarding
the demand of the customers, regarding their habits, tastes, fashions etc.

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7. One Price:

One and only one price be in existence in the market which is possible only
through perfect competition and not otherwise.

Classification of Markets

Markets can be classified on different bases of which most common bases

are: area, time, transactions, regulation, and volume of business, nature of
goods, and nature of competition, demand and supply conditions. This
classification is off-shoot of traditional approach.

Traditionally, a market was a physical place where buyers and sellers

gathered to buy and sell the goods. Economists describe a market as a
collection buyers and sellers who transact over a particular product or
product class.

A. On the Basis of Area:

Using area, there can be local, regional, national and international markets.
Local markets confine to locality mostly dealing in perishable and semi-
perishable goods like fish, flowers, vegetables, eggs, milk, and others.

Regional market covers a wider area may be a district, a state or inter-state

dealing in durables both consumer and non durables and industrial
products, including agricultural produce.

In case of national markets the area covered are national boundaries

dealing in durable and non-durable consumer goods, industrial goods,
metals, forest products, agricultural produce.

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In case of world or international market, the movement of goods is
widespread throughout the world, making it as a single market. It should be
noted that due to the latest technologies in transport, storage and
packaging, even the most perishable goods are sold all over the world, not
that only durables.

B. On the basis of Time:

The time duration is the factor. Accordingly, there can be short period and
long period markets. Short-period markets are for highly perishable goods
of all kinds and long-period markets are for durable goods of different
varieties may be produced or manufactured.

C. On the basis of Transactions:

Taking the nature of transactions, these can be ‘spot’ and ‘future’ markets.
In ‘spot’ market, once the transaction takes place, the delivery takes place,
while in case of future markets, transactions are finalized pending delivery
and payment for future dates.

D. On the basis of Regulation:

Taking regulation, markets can be regulated and non-regulated. A

‘regulated market’ is one in which business dealings take place as per set
rules and regulations regarding, quality, price, source changes and so on.

These can be in agricultural products or produce and securities. On the

other hand, unregulated market is a free market where there are no rules
and regulations; even if they are there, they are amended as per the
requirements of parties of exchange.
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E. On the Basis of Volume of Business:

Taking volume of business as a basis, there can be two types of markets

namely, “Wholesale” and “Retail”. Wholesale markets are featured by large
volume business and wholesalers.

On the other hand, ‘Retail’ markets are those where quantity bought and
sold is on small-scale. The dealers are retailers who buy from wholesalers
and sell back to consumers.

F. On the basis of Nature of Goods:

Taking the nature of goods, there can be commodity markets, capital

markets. ‘Commodity’ markets deal in favour of material, produce,
manufactured goods may be consumer and industrial and bullion market
dealing precious metals.

‘Capital’ market is a market for finance. These markets can be subdivided

into ‘money’ market dealing in lending, and borrowing of money; ‘Securities’
market or ‘stock’ market dealing in buying and selling of shares and
debentures and ‘foreign exchange’ market where it is a forex market
dealing buying and selling of foreign currencies may be hard or soft.

G. On the basis of Nature of Competition:

Based on competition or competitive forces, there can be variety of markets

for a product or service. However, only two are the most important namely,
perfect and imperfect.

A ‘perfect’ market is one which is characterized by:

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(a) Large number of buyers and sellers

(b) Prevalence of single lowest price for products those are ‘homogeneous’

(c) The perfect knowledge on the part of buyers and sellers

(d) Free entry and exit of firms in market. These types for markets exist
hardly.

The other one is ‘imperfect’ which is featured by:

(a) Products may be similar but not identical

(b) Different prices for a class of goods

(c) Existence of physical and psychological barriers on movement of goods

(d) No perfect knowledge of products and other dimensions on the part of

buyers and sellers.

H. On the basis of Demand and Supply:

Based on demand and supply conditions or hold of buyers and sellers,

there can be seller’s and buyer’s markets. A seller’s market is one where
sellers are in driver’s seat and the buyers are at the receiving end.

In other words, it is a situation where demand for goods exceeds supply.

On the other hand, buyer’s market is one where buyers are in commanding
position. That is, supply is exceeding the demand for the goods.

Perfect competition

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The Perfect Competition is a market structure where a large number of
buyers and sellers are present, and all are engaged in the buying and
selling of the homogeneous products at a single price prevailing in the
market.

Features of a Perfect Market:

1. Free and Perfect Competition:

In a perfect market, there are no checks either on the buyers or sellers.

They are free to buy or to sell to any person. It means there are no
monopolies.

2. Cheap and Efficient Transport and Communication:

Uniform price for the commodity would not be possible if the changes in the
prices are not quickly adjusted or the commodity cannot be quickly
transported. Thus cheap and efficient means of transport and
communication are must.

3. Wide Extent:

Sometimes wide market is regarded as the same thing as the perfect

market. For wide market, the commodity should have permanent and
universal demand. The commodity should be portable. Means of transport
and communication should be quick. There should be peace and security
and extensive division of labour.

4. Large number of firms:

In this market, a product is produced and sold by large number of firms.

Since there are large number of firms, therefore each firm is supplying only
a small part of the total supply in the market, thus no one firm has any
market power. It implies that no firm can influence the price of the product
rather each must accept the price set by the forces of market demand and
supply. The firms are price-takers instead of price-makers.

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5. Large number of buyers:

In a perfectly competitive market, there are large numbers of buyers each

demanding a small part of the total market supply of the product. As a
result, no single buyer is in a position to influence the market price
determined by the forces of market demand and supply.

6. Homogeneous Product:

In a perfectly competitive market, all the firms produce and supply the
identical products. It means that the products of all the firms are perfect
substitutes of each other. As a result of this, the price elasticity of demand
for a firm’s product is infinite.

7. Free entry and exit:

In a perfectly competitive market, there are no restrictions on the entry of

new firms into market or on the exit of existing firms from the market.

8. Perfect knowledge:

In a perfectly competitive market, the firms and the buyers possess perfect
information about the market. It implies that no buyer or firm is ignorant
about the price prevailing in the market.

9. Perfect mobility of factors of production:

In a perfectly competitive market, the factors of production are completely

mobile leading to factor-price equalization throughout the market.

Price and output determination under perfect competition

Perfect competition refers to a market situation where there are a large

number of buyers and sellers dealing in homogenous products.

Moreover, under perfect competition, there are no legal, social, or

technological barriers on the entry or exit of organizations.

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In perfect competition, sellers and buyers are fully aware about the current
market price of a product. Therefore, none of them sell or buy at a higher
rate. As a result, the same price prevails in the market under perfect
competition.

Under perfect competition, the buyers and sellers cannot influence the
market price by increasing or decreasing their purchases or output,
respectively. The market price of products in perfect competition is
determined by the industry. This implies that in perfect competition, the
market price of products is determined by taking into account two market
forces, namely market demand and market supply.

Price Determination in Short Period:

A short run refers to a period in which organizations do not change their
scale of production. In this period, organizations neither exit the industry
nor do new organizations enter the industry. In this period, it is possible to
increase or decrease the supply of variable inputs. Thus, supply curve is
elastic in nature.

Generally, organizations have to select the level of output and price that
maximizes their profits.

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In perfect competition, profit is maximized at the following conditions:
i. MR=MC= Price
ii. MC curve must be rising at the point of equilibrium
In Figure-6 (a), the price determination for the industry is shown at
the intersection of demand and supply curves at price OP1 and quantity
OQ1. This price is fixed for all the organizations in the industry. At price
OP1, an organization has to adjust output to maximize profit. In Figure-6
(b), the organization’s MR is shown by MR=AR line. When the prevailing
price in the market is P1, the profit is maximized at point E, where MR=
MC.

To determine how much profits are being made by the organization, let us
introduce AC curve in Figure-6(b). Profit is equal to AR (price) minus AC. In
Figure-6 (b), total profits equal EF as AR equals ME and AC equals MF.
Thus, area of profit equals P1EFT. These are the super-normal profits
earned by the organization.

At this level of profits, there is a tendency for new organizations to enter in

the market. However, organizations cannot enter in short run. The
organizations in the industry will be at equilibrium at point E, but industry as
a whole will not be in equilibrium.
Let us take the case when price falls from P1 to P2.

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In Figure-7(a), the demand curve DD shifts to D’D’. This implies that there
is a fall in demand. This reduces the price from P1 to P2. In Figure-7(b), P2
is the prevailing price in the market such that it lies below the AC curve.
The equilibrium is achieved at point E’ where MR’= MC. AR’ is less than
AC, thus organization will make loss.

The losses may force organizations to quit the industry. However, it is

rational for organizations to continue producing in the short run. This is
because if organizations keep on earning revenue, they would be able to
cover fixed costs and variable costs.
Thus, in the short run, perfectly competitive organizations earn profits.
However, in certain situations, they have to incur losses. If the organization
fixes the price higher than the market price, it may not be able to sell its
products in the competitive market. On the contrary, if it fixes the price
below the market price, it has to incur losses.

Equilibrium in Long Run: The Iong run refers to a period in which

organizations can easily change variable and fixed factors, such as labor

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machinery and capital, ill the factors are variable in the long run.
Organizations can expand the fixed equipment or can replace them. In
addition, in this period, organizations can easily enter or exit the industry.
The long run AC and MC curves are relevant for the price and output
decisions. ATC is also the important determinant for equilibrium point in the
long run. In the long period of time, the following two conditions must be
satisfied for attaining equilibrium.
Price = MC
Price = AC
Or, Price = MC = AC

If price is greater than AC, organizations would make supernormal profits,

which would influence new organizations to enter the industry. More
organizations will increase the supply of the product and thus, the price of
the product will fall. This will happen till price reaches AC and all
organizations are earning only normal profits.

On the other hand, if price is below AC, organizations would incur losses.
Organizations start exiting that leads to fail in supply. This increases the
price to AC. Thus, remaining organizations will start making the normal
profits.

It should be noted that when AC falls, MC is less than AC and when AC

rises, MC is more than AC. Thus, MC=AC at the point where AC is neither
falling nor rising that is the minimum point of AC curve.

Thus, the equilibrium condition can be rewritten as:

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Price = MC = Minimum of AC

The long-run equilibrium is shown with the help of Figure-8:

In long run, organizations can enter and exit the industry. In Figure-8, when
price is OP1, equilibrium is achieved at point E’. At this point, AR is greater
than AC, thus profits are gained. This lures other organizations to enter the
industry. This will shift the supply curve of the industry from S1 to S2. Thus,
price will fall from OP1 to OP2.

At this price, organizations start making loss as AR is less than AC. Thus,
most of the organizations will exit the industry. This leads to fall in the
product’s supply, further raising the price till P0. Thus, full equilibrium is
achieved at the price OP0 and output ON where all the organizations under
the industry are earning normal profits.

Here, LMC=Price= minimum LAC. The conclusion that follows from the
long-run equilibrium is that the competition forces organizations to produce

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at the minimum point of AC curve. This is beneficial for consumers as the
product is produced at the cheapest possible cost.

Price Determination under Monopolistic Competition

Imperfect competition covers all situations where there is neither pure

competition nor pure monopoly. Both perfect competition and pure
monopoly are very unlikely to be found in the real world. In the real world, it
is the imperfect competition lying between perfect competition and pure
monopoly. The fundamental distinguishing characteristic of imperfect
competition is that average revenue curve slopes downwards throughout its
length, but it slopes downwards at different rates in different categories of
imperfect competition. The monopolistic competition is one form of
imperfect competition.

FEATURES OF MONOPOLISTIC COMPETITION:

Monopolistic competition refers to the market situation in which many
producers produce goods which are close substitutes of one another. Two
important distinguishing features of monopolistic competition are:

(a) Product differentiation, and

(b) Existence of many firms supplying the market.

(a) Product Differentiation: In contrary to perfect competition where

there is only one homogeneous commodity, in monopolistic competition
there is differentiation of products. In monopolistic competition, products

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 are not homogenous nor are they only remote substitutes. These are the
products produced by competing monopolists that have separate
identity, brand, logos, patents, quality and such other product
features. Product differentiation does not mean that goods are
completely different. Rather it means that products are different in some
ways, but not altogether so. These imaginary differences are created
through advertising, marketing, packaging and the use of trademarks
and brand names.
(b) Existence of Many Firms: Under monopolistic competition, there
is fairly large number of sellers, let say 25 to 70. Each individual firm has
relatively small part of the total market so that each has a very limited
control over the price of the product. And each firm determines its own
price-output policy without considering the reactions of rival firms.
(c) In monopolistic competition, in the long run, there is freedom of
entry and exit.
(d) The commodity sold in a monopolistic competitive market is not a
standardised product but a differentiated product. Hence competition is
no longer exclusive on price basis. Buyers are buying a combination of
physical product and the services which go with it.
(e) Because of consumers’ attachment to a particular brand, the seller
acquires a monopolistic influence on the market. Thus, the demand
curve facing a firm under monopolistic competition is a downward
sloping curve, i.e., if he wants to sell more, he has to lower his
price. The demand curve or AR curve under monopoly also slopes
downwards, but there is a difference between demand curves facing
under monopolistic competition and pure monopoly. The demand curve

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 faced by a ‘competing monopolist’ is more elastic than the demand
curve faced by the ‘monopolist’, because there are no close substitutes
available for the monopolist commodity.

PRICE DETERMINATION UNDER MONOPOLISTIC COMPETITION:

Under monopolistic competition, the firm will be in equilibrium position
when marginal revenue is equal to marginal cost. So long the marginal
revenue is greater than marginal cost, the seller will find it profitable to
expand his output, and if the MR is less than MC, it is obvious he will
reduce his output where the MR is equal to MC. In short run, therefore, the
firm will be in equilibrium when it is maximising profits, i.e., when MR = MC.

(a) Short Run Equilibrium: Short run equilibrium is illustrated in the

following diagram:

Diagram: Monopolistic Competition Short Run Equilibrium

In the above diagram, the short run average cost is MT and short run

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average revenue is MP. Since the AR curve is above the AC curve,
therefore, the profit is shown as PT. PT is the supernormal profit per unit of
output. Total supernormal profit will be measured by multiplying the
supernormal profit to the total output, i.e. PT × OM or PTT’P’ as shown in
figure (a). The firm may also incur losses in the short run if it is facing AR
curve below the AC curve. In figure (b) MP is less than MT and TP is the
loss per unit of output. Total loss will be measured by multiplying loss per
unit of output to the total output, i.e., TP × OM or TPP’T’.

(b) Long Run Equilibrium: Under monopolistic competition, the

supernormal profit in the long run is disappeared as new firms are entered
into the industry. As the new firms are entered into the industry, the
demand curve or AR curve will shift to the left, and therefore, the
supernormal profit will be competed away and the firms will be earning
normal profits. If in the short run firms are suffering from losses, then in the
long run some firms will leave the industry so that remaining firms are
earning normal profits.

The AR curve in the long run will be more elastic, since a large number of
substitutes will be available in the long run. Therefore, in the long run,
equilibrium is established when firms are earning only normal profits. Now
profits are normal only when AR = AC. It is further illustrated in the
following diagram:

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PRICE DETERMINATION UNDER MONOPOLY COMPETITION:

Monopoly refers to a market structure in which there is a single producer or

seller that has a control on the entire market.

This single seller deals in the products that have no close substitutes and
has a direct demand, supply, and prices of a product.

Therefore, in monopoly, there is no distinction between an one organization

constitutes the whole industry.

Features

1. Under monopoly, the firm has full control over the supply of a product.
The elasticity of demand is zero for the products.
2. There is a single seller or a producer of a particular product, and
there is no difference between the firm and the industry. The firm is
itself an industry.
3. The firms can influence the price of a product and hence, these are
price makers, not the price takers.
4. There are barriers for the new entrants.

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 5. The demand curve under monopoly market is downward sloping,
which means the firm can earn more profits only by increasing the
sales which are possible by decreasing the price of a product.
6. There are no close substitutes for a monopolist’s product.

Monopoly Equilibrium:

Single organization constitutes the whole industry in monopoly. Thus, there

is no need for separate analysis of equilibrium of organization and industry
in case of monopoly. The main aim of monopolist is to earn maximum profit
as of a producer in perfect competition.

Unlike perfect competition, the equilibrium, under monopoly, is attained at

the point where profit is maximum that is where MR=MC. Therefore, the
monopolist will go on producing additional units of output as long as MR is
greater than MC, to earn maximum profit.

Let us learn monopoly equilibrium through Figure-11:

In Figure-11, if output is increased beyond OQ, MR will be less than MC.

Thus, if additional units are produced, the organization will incur loss. At

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equilibrium point, total profits earned are equal to shaded area ABEC. E is
the equilibrium point at which MR=MC with quantity as OQ.

In the short run, the monopolist should make sure that the price should not
go below Average Variable Cost (AVC). The equilibrium under monopoly in
long-run is same as in short-run. However, in long-run, the monopolist can
expand the size of its plants according to demand. The adjustment is done
to make MR equal to the long run MC.

Price and output determination under Oligopoly

Oligopoly falls between two extreme market structures, perfect competition

and monopoly. Oligopoly occurs when a few firms dominate the market for
a good or service. This implies that when there are a small number of
competing firms, their marketing decisions exhibit strong mutual
interdependence. By mutual interdependence we mean that a firm's action
say of setting the price has a noticeable effect on its rival firms and they are
likely to react in the some way. Each firm considers the possible reaction of
rivals to its price and product development decisions.

Stigler Hads defined oligopoly:

"As that market situation in which a firm bases its market policy in part on
the expected behavior of a few close rival firms".

In the words of Jackson:

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"Oligopoly is an industry structure characterized by a few firms producing
all or most of the output of some good that may or may not be
differentiated".

Features of oligopoly

Few firms

Under Oligopoly, there are a few large firms although the exact number of
firms is undefined. Also, there is severe competition since each firm
produces a significant portion of the total output.

Barriers to Entry

Under Oligopoly, a firm can earn super-normal profits in the long run as
there are barriers to entry like patents, licenses, control over crucial raw
materials, etc. These barriers prevent the entry of new firms into the
industry.

Non-Price Competition

Firms try to avoid price competition due to the fear of price wars and hence
depend on non-price methods like advertising, after sales services,
warranties, etc. This ensures that firms can influence demand and build
brand recognition.

Interdependence

Under Oligopoly, since a few firms hold a significant share in the total
output of the industry, each firm is affected by the price and output

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decisions of rival firms. Therefore, there is a lot of interdependence among
firms in an oligopoly. Hence, a firm takes into account the action and
reaction of its competing firms while determining its price and output levels.

Nature of the Product

Under oligopoly, the products of the firms are either homogeneous or

differentiated.

Selling Costs

Since firms try to avoid price competition and there is a huge

interdependence among firms, selling costs are highly important for
competing against rival firms for a larger market share.

No unique pattern of pricing behavior

Under Oligopoly, firms want to act independently and earn maximum profits
on one hand and cooperate with rivals to remove uncertainty on the other
hand.

Depending on their motives, situations in real-life can vary making

predicting the pattern of pricing behavior among firms impossible. The firms
can compete or collude with other firms which can lead to different pricing
situations.

Indeterminateness of the Demand Curve

Unlike other market structures, under Oligopoly, it is not possible to

determine the demand curve of a firm. This is because on one hand, there

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is a huge interdependence among rivals. And on the other hand there is
uncertainty regarding the reaction of the rivals. The rivals can react in
different ways when a firm changes its price and that makes the demand
curve indeterminate

Kinked Demand Curve Model:

This model was developed independently by Prof. Paul M. Sweezy.

The assumptions of this model are

(i) There are only a few firms in an oligopolistic market.

(ii) The firms are producing close-substitute products.

(iii) The quality of the products remains constant and the firms do not spend
on advertising.

(iv) A set of prices of the product has already been determined and these
prices prevail in the market at present.

Analysis of the Kinked Demand Curve Model:

In the oligopoly model under discussion, the properties of the kinked

demand curve as well as its significance are especially discussed. In the
first place, as the demand curve or the average revenue (AR) curve of the
firm has a kink, its MR curve cannot be obtained as a continuous curve. We
may, therefore, begin with the properties of the MR curve of the kinked
demand curve with the help of Fig. 14.19.

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The kinked demand curve of the firm in this Fig. is dRD’. There is a kink at
the point R (p1, q1) on this curve, because the curve consists of a segment
dR of the relatively flatter curve dd’ and another segment RD’ of the
relatively steeper curve DD’.

Therefore, in the case of the kinked demand curve dRD’, the firm’s MR
curve, up to q = q1, would consist of the MR curve dM associated with the
dR segment of the kinked demand curve and for q > q1, the MR curve
would be the segment NB associated with the segment RD’ of the demand
curve.

We have obtained above that the firm’s MR curve for its kinked demand
curve would consist of two parts, viz., the segments dM and NB, and there
would be a vertical gap between the points M and N at q = q1.

This implies that as the firm’s output goes on increasing up to q1, its MR
would go on decreasing along the segment dM up to the amount Mq1 and if

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the firm’s output increases even by an infinitesimally small quantity at q =
q1, its MR would fall to Nq1, and, thereafter, as q increases, MR would
decrease along the segment NB.

In other words, there would be no MR value between Mq1 and Nq1, i.e., the
dotted segment MN is the discontinuity in the firm’s MR curve. We may
also say that at the point R on the dR segment of the kinked demand curve,
the firm’s MR would be Mq1 and, at the point R on the RD’ segment of the
demand curve, MR would be Nq1.

We may now easily see that the numerical coefficient of elasticity of

demand (e1) at the point R on the demand curve segment dR is different
from the coefficient (e2) at the point R on the demand curve segment RD’,
and the larger the difference between e1 and e2, the larger would be the
length of the discontinuity of the MR curve at the output q1.

Duopoly

A true duopoly is a specific type of oligopoly where only two producers

exist in one market. A duopoly is a situation in which two companies own
all or nearly all of the market for a given product or service. In reality, this
definition is generally used where only two firms have dominant control
over a market. In the field of industrial organization, it is the most commonly
studied form of oligopoly due to its simplicity.

Duopoly models in economics

There are two principal duopoly models, Cournot duopoly and Bertrand
duopoly:

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 • The Cournot model, which shows that two firms assume each other’s
output and treats this as a fixed amount, and produce in their own
firm according to this.

• The Bertrand model, in which, in a game of two firms, each one of

them will assume that the other will not change prices in response to
its price cuts. When both firms use this logic, they will reach Nash
equilibrium.

Characteristics

The duopoly market have some characteristics which is alike

characteristics of oligopoly market. So the characteristics of duopoly market
are as follows:-

• Presence of monopoly element- products are differentiated and each

product enjoy some amount of customer loyalty as a result firm enjoy
some monopoly power.
• Price rigidity exists in this type of market structure. It means price of
product in this market does not change immediately with change in
demand and supply in market.
• In this type of market structure either advertising is done to increase
its sales volume or by improving quality of its product.
• There is interdependency among firms as no firm can ignore the
action and reaction of its rival firm.
• The demand curve is indeterminate, any step taken by rival firm will
effect firms product demand.

Price discrimination

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Price discrimination refers to the charging of different prices by the
monopolist for the same product.

The difference in the product may be on the basis of brand, wrapper etc.
This policy of the monopolist is called price discrimination.

Definitions:

“Price discrimination exists when the same product is sold at different

prices to different buyers.” -Koutsoyiannis

Types of Discriminating Monopoly:

Price discrimination is of following three types:

1. Personal Price Discrimination:

Personal price discrimination refers to the charging of different prices from

different customers for the same product. For example, a doctor charges
different fees for the same operation from rich and poor patients.

2. Geographical Price Discrimination:

Under geographical price discrimination, the monopolist charges different

prices in different markets for the same product. It also includes dumping
where a producer may sell the same commodity at one price at home and
at the other price abroad.

3. Price Discrimination according to Use: When the monopolist charges

different prices for the different uses of the same commodity is called the
price discrimination according to use.

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Conditions for Price Discrimination:

For price discrimination to exist, it requires the basic conditions.

These are:

1. Difference in Elasticity of Demand:

Price discrimination is possible only when elasticity of demand will be

different in different markets. The monopolist will fix higher price where
demand is inelastic and low price where the demand will be elastic. In this
way, he will be able to increase his total revenue.

2. Market Imperfections:

Generally, price discrimination is possible only when there is some degree

of market imperfections. The individual seller is able to divide his market
into separate parts only if it is imperfect.

3. Differentiated Product:

Price discrimination is possible when buyers need the same service in

connection with differentiated products. For example, railways charges
different rates for the transport of coal and copper.

4. Legal Sanction:

In some cases price discrimination is legally sanctioned. As, Electricity

Board charges lowest for electricity for domestic use and highest for
commercial houses.

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5. Monopoly Existence:

Price discrimination is also called discrimination monopoly. It is evident that

price discrimination is possible only under conditions of monopoly.

Degree of Price Discrimination:

Prof. A.C. Pigou has given the following three degrees of

discriminating monopoly:

1. Price Discrimination of First Degree:

Price discrimination of first degree is said to exist when the monopolist is

able to sell each separate unit of his product at different prices. It is also
known as the perfect price discrimination. In case of first degree price
discrimination, a seller charges a price equal to what the consumer is
willing to pay. It means the seller leaves no consumer’s surplus with the
consumer. Apart from above, under perfect price discrimination the
demand curve of the buyer, like under simple monopoly, becomes the
marginal revenue curve of the seller.

2. Price Discrimination of Second Degree:

In the price discrimination of second degree buyers are divided into

different groups and from different groups a different price is charged which
is the lowest demand price of that group. This type of price discrimination
would occur if each individual buyer had a perfectly in- elastic demand
curve for good below and above a certain price.

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3. Price Discrimination of Third Degree:

Price discrimination of third degree is said to exist when the seller divides
his buyers into two or more than two sub markets and from each group a
different price is charged. The price charged in each sub-market depends
on the output sold in that sub-market along with demand conditions of that
sub-market. In the real world, it is the third degree price discrimination
which exists.

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 UNIT – V

Meaning of Business Cycle:

The period of high income, output and employment has been called the
period of expansion, upswing or prosperity, and the period of low income,
output and employment has been described as contraction, recession,
downswing or depression.

The economic history of the free market capitalist countries has shown that
the period of economic prosperity or expansion alternates with the period of
contraction or recession.

These alternating periods of expansion and contraction in economic activity

has been called business cycles. They are also known as trade cycles.
J.M. Keynes writes, “A trade cycle is composed of periods of good trade
characterized by rising prices and low unemployment percentages with
periods of bad trade characterized by falling prices and high unemployment
percentages.”

Phases of Business Cycle

1. Prosperity Phase : Expansion or Boom or Upswing of economy.

2. Recession Phase : from prosperity to recession (upper turning
point).
3. Depression Phase : Contraction or Downswing of economy.
4. Recovery Phase : from depression to prosperity (lower turning
Point).

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 The business cycle starts from a trough (lower point) and passes
through a recovery phase followed by a period of expansion (upper turning
point) and prosperity. After the peak point is reached there is a declining
phase of recession followed by a depression. Again the business cycle
continues similarly with ups and downs.

1. Prosperity Phase

When there is an expansion of output, income, employment, prices and

profits, there is also a rise in the standard of living. This period is termed as
Prosperity phase.

The features of prosperity are :-

1. High level of output and trade.

2. High level of effective demand.
3. High level of income and employment.
4. Rising interest rates.
5. Inflation.

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 6. Large expansion of bank credit.
7. Overall business optimism.
8. A high level of MEC (Marginal efficiency of capital) and investment.

Due to full employment of resources, the level of production is Maximum

and there is a rise in GNP (Gross National Product). Due to a high level of
economic activity, it causes a rise in prices and profits. There is an upswing
in the economic activity and economy reaches its Peak. This is also called
as a Boom Period.

2. Recession Phase

The turning point from prosperity to depression is termed as Recession

Phase.

During a recession period, the economic activities slow down. When

demand starts falling, the overproduction and future investment plans are
also given up. There is a steady decline in the output, income, employment,
prices and profits. The businessmen lose confidence and become
pessimistic (Negative). It reduces investment. The banks and the people try
to get greater liquidity, so credit also contracts. Expansion of business
stops, stock market falls. Orders are cancelled and people start losing their
jobs. The increase in unemployment causes a sharp decline in income and
aggregate demand. Generally, recession lasts for a short period.

3. Depression Phase: When there is a continuous decrease of output,

income, employment, prices and profits, there is a fall in the standard of
living and depression sets in.

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The features of depression are :-

1. Fall in volume of output and trade.

2. Fall in income and rise in unemployment.
3. Decline in consumption and demand.
4. Fall in interest rate.
5. Deflation.
6. Contraction of bank credit.
7. Overall business pessimism.
8. Fall in MEC (Marginal efficiency of capital) and investment.

In depression, there is under-utilization of resources and fall in GNP (Gross

National Product). The aggregate economic activity is at the lowest,
causing a decline in prices and profits until the economy reaches its
Trough (low point).

4. Recovery Phase

The turning point from depression to expansion is termed as Recovery or

Revival Phase.

During the period of revival or recovery, there are expansions and rise in
economic activities. When demand starts rising, production increases and
this causes an increase in investment. There is a steady rise in output,
income, employment, prices and profits. The businessmen gain confidence
and become optimistic (Positive). This increases investments. The
stimulation of investment brings about the revival or recovery of the
economy. The banks expand credit, business expansion takes place and
stock markets are activated. There is an increase in employment,

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production, income and aggregate demand, prices and profits start rising,
and business expands. Revival slowly emerges into prosperity, and the
business cycle is repeated.

Thus we see that, during the expansionary or prosperity phase, there is

inflation and during the contraction or depression phase, there is a
deflation.

Monetary Policy

Meaning

Monetary policy refers to the credit control measures adopted by the

central bank of a country.

Johnson defines monetary policy “as policy employing central bank’s

control of the supply of money as an instrument for achieving the objectives
of general economic policy.” G.K. Shaw defines it as “any conscious action
undertaken by the monetary authorities to change the quantity, availability
or cost of money.”

Objectives or Goals of Monetary Policy:

The following are the principal objectives of monetary policy:

1. Full Employment:

Full employment has been ranked among the foremost objectives of

monetary policy. It is an important goal not only because unemployment
leads to wastage of potential output, but also because of the loss of social
standing and self-respect.
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2. Price Stability:

One of the policy objectives of monetary policy is to stabilise the price level.
Both economists and laymen favour this policy because fluctuations in
prices bring uncertainty and instability to the economy.

3. Economic Growth:

One of the most important objectives of monetary policy in recent years has
been the rapid economic growth of an economy. Economic growth is
defined as “the process whereby the real per capita income of a country
increases over a long period of time.”

4. Balance of Payments:

Another objective of monetary policy since the 1950s has been to maintain
equilibrium in the balance of payments.

Instruments of Monetary Policy:

The instruments of monetary policy are of two types: first, quantitative,

general or indirect; and second, qualitative, selective or direct. They affect
the level of aggregate demand through the supply of money, cost of money
and availability of credit. Of the two types of instruments, the first category
includes bank rate variations, open market operations and changing
reserve requirements. They are meant to regulate the overall level of credit
in the economy through commercial banks. The selective credit controls
aim at controlling specific types of credit. They include changing margin
requirements and regulation of consumer credit. We discuss them as
under:
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Bank Rate Policy:

The bank rate is the minimum lending rate of the central bank at which it
rediscounts first class bills of exchange and government securities held by
the commercial banks. When the central bank finds that inflationary
pressures have started emerging within the economy, it raises the bank
rate. Borrowing from the central bank becomes costly and commercial
banks borrow less from it.

The commercial banks, in turn, raise their lending rates to the business
community and borrowers borrow less from the commercial banks. There is
contraction of credit and prices are checked from rising further. On the
contrary, when prices are depressed, the central bank lowers the bank rate.

It is cheap to borrow from the central bank on the part of commercial

banks. The latter also lower their lending rates. Businessmen are
encouraged to borrow more. Investment is encouraged. Output,
employment, income and demand start rising and the downward movement
of prices is checked.

Open Market Operations:

Open market operations refer to sale and purchase of securities in the

money market by the central bank. When prices are rising and there is
need to control them, the central bank sells securities. The reserves of
commercial banks are reduced and they are not in a position to lend more
to the business community.

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Further investment is discouraged and the rise in prices is checked.
Contrariwise, when recessionary forces start in the economy, the central
bank buys securities. The reserves of commercial banks are raised. They
lend more. Investment, output, employment, income and demand rise and
fall in price is checked.

Changes in Reserve Ratios:

This weapon was suggested by Keynes in his Treatise on Money and the
USA was the first to adopt it as a monetary device. Every bank is required
by law to keep a certain percentage of its total deposits in the form of a
reserve fund in its vaults and also a certain percentage with the central
bank.

When prices are rising, the central bank raises the reserve ratio. Banks are
required to keep more with the central bank. Their reserves are reduced
and they lend less. The volume of investment, output and employment are
adversely affected. In the opposite case, when the reserve ratio is lowered,
the reserves of commercial banks are raised. They lend more and the
economic activity is favourably affected.

Selective Credit Controls:

Selective credit controls are used to influence specific types of credit for
particular purposes. They usually take the form of changing margin
requirements to control speculative activities within the economy. When
there is brisk speculative activity in the economy or in particular sectors in
certain commodities and prices start rising, the central bank raises the
margin requirement on them.

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The result is that the borrowers are given less money in loans against
specified securities. For instance, raising the margin requirement to 60%
means that the pledger of securities of the value of Rs 10,000 will be given
40% of their value, i.e. Rs 4,000 as loan. In case of recession in a particular
sector, the central bank encourages borrowing by lowering margin
requirements.

Conclusion:

For an effective anti-cyclical monetary policy, bank rate, open market

operations, reserve ratio and selective control measures are required to be
adopted simultaneously. But it has been accepted by all monetary theorists
that (i) the success of monetary policy is nil in a depression when business
confidence is at its lowest ebb; and (ii) it is successful against inflation. The
monetarists contend that as against fiscal policy, monetary policy
possesses greater flexibility and it can be implemented rapidly.

Fiscal policy
Meaning

Fiscal policy means the use of taxation and public expenditure by the
government for stabilisation or growth. According to Culbarston, “By fiscal
policy we refer to government actions affecting its receipts and
expenditures which we ordinarily taken as measured by the government’s
receipts, its surplus or deficit.” The government may offset undesirable
variations in private consumption and investment by compensatory
variations of public expenditures and taxes.

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Objectives of Fiscal Policy

1. To maintain and achieve full employment.

2. To stabilise the price level.

3. To stabilise the growth rate of the economy.

4. To maintain equilibrium in the balance of payments.

5. To promote the economic development of underdeveloped countries.

3. Fiscal Policy for Economic Growth

The role of fiscal policy for economic growth relates to the stabilisation of
the rate of growth of an advanced country. Fiscal policy through variations
in government expenditure and taxation profoundly affects national income,
employment, output and prices. An increase in public expenditure during
depression adds to the aggregate demand for goods and services and
leads to a large increase in income via the multiplier process; while a
reduction in taxes has the effect of raising disposable income thereby
increasing consumption and investment expenditure of the people.

On the other hand, a reduction of public expenditure during inflation

reduces aggregate demand, national income, employment, output and
prices; while an increase in taxes tends to reduce disposable income and
thereby reduces consumption and investment expenditures. Thus the
government can control deflationary and inflationary pressures in the
economy by a judicious combination of expenditure and taxation
programmes. For this, the government follows compensatory fiscal policy.

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Compensatory Fiscal Policy:

The compensatory fiscal policy aims at continuously compensating the

economy against chronic tendencies towards inflation and deflation by
manipulating public expenditures and taxes. It, therefore, necessitates the
adoption of fiscal measures over the long-run rather than once-for-all
measures it a point of time.

When there are deflationary tendencies in the economy, the government

should increase its expenditures through deficit budgeting and reduction in
taxes. This is essential to compensate for the lack in private investment
and to raise effective demand, employment, output and income within the
economy.

On the other hand, when there are inflationary tendencies, the government
should reduce its expenditures by having a surplus budget and raising
taxes in order to stabilise the economy at the full employment level.

The compensatory fiscal policy has two approaches:

(1) Built-in stabilisers; and

(2) Discretionary fiscal policy.

(1) Built-in Stabilisers:

The technique of built-in flexibility or stabilisers involves the automatic

adjustment of the expenditures and taxes in relation to cyclical upswings
and downswings within the economy without deliberate action on the part

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of the government. Under this system, changes in the budget are automatic
and hence this technique is also known as one of automatic stabilisation.

The various automatic stabilisers are corporate profits tax, income tax,
excise taxes, old age, survivors and unemployment insurance and
unemployment relief payments. As instruments of automatic stabilisation,
taxes and expenditures are related to national income. Given an
unchanged structure of tax rates, tax yields vary directly with movements in
national income, while government expenditures vary inversely with
variations in national income.

In the downward phase of the business cycle when national income is

declining, taxes which are based on a percentage of national income
automatically decline, thereby reducing the tax yield. At the same time,
government expenditures on unemployment relief and social security
benefits automatically increase. Thus there would be an automatic budget
deficit which would counteract deflationary tendencies.

On the other hand, in the upward phase of the business cycle when
national income is rising rapidly, the tax yield would automatically increase
with the rise in tax rates. Simultaneously, government expenditures on
unemployment relief and social security benefits automatically decline.
These two forces would automatically create a budget surplus and thus
inflationary tendencies would be controlled automatically.

It’s Merits:

Built-in stabilisers have certain advantages as a fiscal device:

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1. The built-in stabilisers serve as a cushion for private purchasing power
when it falls and lessen the hardships on the people during deflationary
period.

2. They prevent national income and consumption spending from falling at

a low level.

3. There are automatic budgetary changes in this device and the delay in
taking administrative decisions is avoided.

4. Automatic stabilisers minimise the errors of wrong forecasting and timing

of fiscal measures.

5. They integrate short-run and long-run fiscal policies.

It’s Limitations:

It has the following limitations:

1. The effectiveness of built-in stabilisers as an automatic compensatory

device depends on the elasticity of tax receipt, the level of taxes and
flexibility of public expenditures. The greater the elasticity of tax receipts,
the greater will be the effectiveness of automatic stabilisers in controlling
inflationary and deflationary tendencies. But the elasticity of tax receipts is
not so high as to act as an automatic stabiliser even in advanced countries
like America.

2. With low level of taxes even a high elasticity of tax receipts would not be
very significant as an automatic stabiliser doing a downswing.

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3. The built-in stabilisers do not consider the secondary effects of
stabilisers on after-tax business incomes and of consumption spending on
business expectations.

4. This device keeps silent about the stabilising influence of local bodies,
state governments and of the private sector economy.

5. They cannot eliminate the business cycles. At the most, they can reduce
its severity.

6. Their effects during recovery from recession are unfavourable.

Economists, therefore, suggest that built-in stabilisers should be
supplemented by discretionary fiscal policy.

(2) Discretionary Fiscal Policy:

Discretionary fiscal policy requires deliberate change in the budget by such

actions as changing tax rates or government expenditures or both.

It may generally take three forms:

(i) Changing taxes with government expenditure constant,

(ii) changing government expenditure with taxes constant, and

(iii) variations in both expenditures and tax simultaneously.

(i) When taxes are reduced, while keeping government expenditure

unchanged, they increase the disposable income of households and
businesses. This increase private spending. But the amount of increase will

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depend on whom the taxes are cut, to what extent, and on whether the
taxpayers regard the cut temporary or permanent.

If the beneficiaries of tax cut are in the higher middle income group, the
aggregate demand will increase much. If they are businessmen with little
incentive to invest, tax reductions are temporary. This policy will again be
less effective. So this is more effective in controlling inflation by raising
taxes because high rates of taxation will reduce disposable income of
individuals and businesses thereby curtailing aggregate demand.

(ii) The second method is more useful in controlling deflationary

tendencies. When the government increases its expenditure on goods and
services, keeping taxes constant, aggregate demand goes up by the full
amount of the increase in government spending. On the hand, reducing
government expenditure during inflation is not so effective because of high
business expectations in the economy which are not likely to reduce
aggregate demand.

(iii) The third method is more effective and superior to the other two
methods in controlling inflationary and deflationary tendencies. To control
inflation, taxes may be increased and government expenditure be raised to
fight depression.

It’s Limitations:

The discretionary fiscal policy depends upon proper timing and

accurate forecasting:

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1. Accurate forecasting is essential to judge the stage of cycle through
which the economy is passing. It is only then that appropriate fiscal action
can be taken. Wrong forecasting may accentuate rather than moderate the
cyclical swings. Economics is not an exact science in correct forecasting.
As a result, fiscal action always follows after the turning points in the
business cycles.

2. There are delays in proper timing of public spending. In fact,

discretionary fiscal policy is subject to three time lags.

(i) There is the “decision lag,” the time required in studying the problem and
taking the decision. The lag involved in this process may be too long.

(ii) Once the decision is taken, is an “execution lag.” It involves expenditure

which is to be allocated for the execution of the programme. In a country
like the USA it may take two years and less than a year in the U.K.

(iii) Certain public work projects are so cumbersome that it is not possible
to accelerate or slow them down for the purpose of raising or reducing
spending on them.

Conclusion:

Despite the higher multiplier effect of government spending as against

changes in tax rates, the latter can be operated more promptly than the
former. Emphasis has thus shifted to taxation as the best fiscal device for
controlling cyclical fluctuations. Thus when the turning point of a business
cycle is already underway, discretionary fiscal action tends to strengthen

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the built-in stabilisers, as has been’ the experience of developed countries
like the USA.

4. Budgetary Policy—Contra-cyclical Fiscal Policy

The budget is the principal instrument of fiscal policy. Budgetary policy

exercises control over size and relationship of government receipts and
expenditures. We discuss below the common budgetary policies that can
be adopted for stabilising the economy.

(1) Budget Deficit—Fiscal Policy during Depression:

Deficit budgeting is an important method of overcoming depression. When

government expenditures exceed receipts, larger amounts are put into the
stream of national income than they are withdrawn. The deficit represents
the net expenditure of the government which increases national income by
the multiplier times the increase in net expenditure. If the MPC is 2/3, the
multiplier will be 3; and if the net increase in government expenditure is
Rs.-100 crores it will increase national income to Rs. 300 crores (= 100 x
3).

Thus the budget deficit has an expansionary effect on aggregate demand

whether the fiscal process leaves marginal propensities unchanged or
whether a redistribution of disposable receipts occurs. The E expansionary
effect of a budget deficit is shown diagrammatically in Figure 1. C is the
consumption function. C + I+G represent consumption, investment and
government expenditure (the total spending function) before the budget is
introduced. Suppose government expenditure of ∆G is injected into the
economy.

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As a result, the total spending function shifts upward to C +1 + G1. Income
increases OY from OF to OF, when the equilibrium position moves Income
from E1 to E1 .The increase in income YY1 (= EA = MiE1A) is greater than
the increase in government expenditure E1B (=∆G). BA (E1A – E1B)
represents increase in consumption. Thus the budget deficit is always
expansionary, the rise in national income being (YY1) greater than the
actual amount of government spending (∆G = E1B). In this method of
budget deficit, taxes are kept intact.

Budget deficit may also be secured by reduction in taxes and without

government spending. Reduction in taxes tends to leave larger disposable
income in the hands of the people and thus stimulates increase in
consumption expenditure. This, in turn, would lead to increase in aggregate
demand output, income and employment. This is illustrated in Figure 2,
where С is the original consumption function. Suppose tax is reduced by
ET, it will shift the consumption function upward to C1.Income will increase
from OY to OY1.

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However, reduction in taxes is not so expansionary via increased
consumption expenditure because the tax relief may be saved and not
spent on consumption. Businessmen may not also invest more if the
business expectations are low. Therefore, to safeguard against such
eventualities the government should follow the policy of reduction in taxes
with increased government spending and its multiplier effect will be much
higher in case we also assume that some consumption and investment
expenditures increase due to tax relief.

(2) Surplus Budget—Fiscal Policy during Boom:

Surplus in the budget occurs when the government revenues exceed

expenditures. The policy of surplus budget is followed to control inflationary
pressures within the economy. It may be through increase in taxation or
reduction in government expenditure or both. This will tend to reduce
income and aggregate demand by the multiplier times the reduction in
government or/and private consumption expenditure (as a result of
increased taxes).

This is explained with the aid of Figure 1, where the economy is at the
initial equilibrium position E1. Suppose the government expenditure is

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reduced by ∆G so that the total spending function С + I + G shifts
downward to С + I + G. Now E is the new equilibrium position which shows
that the income has declined to OY from OY1 as a result of reduction in
government expenditure by E1B. The fall in income Y1 Y 1(= AE) > E1 B the
reduction in expenditure because consumption has also been reduced by
BA.

There may be budget surplus without government spending when taxes are
raised. Enhanced taxes reduce the disposable income with the people and
encourage reduction in consumption expenditure. The result is fall in
aggregate demand, output income and employment. This is illustrated in
Figure 3. С is the consumption function before the imposition of the tax.
Suppose a tax equal to ET is introduced. The consumption function shifts
downward to C1. The new equilibrium position is E1. As a result, income
falls from OY to OY1.

(3) Balanced Budget:

Another expansionist fiscal policy is the balanced budget. In this policy the
increase in taxes (∆T) and in government expenditure (∆G) are of an equal
amount. This has the impact of increasing net national income. This is

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because the reduction in consumption resulting from the tax is not equal to
the government expenditure.

The basis for the expansionary effect of this kind of balanced budget is that
a tax merely tends to reduce the level of disposable income. Therefore,
when only a portion of an economy’s disposable income is used for
consumption purposes, the economy’s consumption expenditure will not fall
by the full amount of the tax. On the other hand, government expenditure
increases by the full amount of the tax. Thus the government expenditure
rises more than the fall in consumption expenditure due to the tax and
there is net increase in national income.

The balanced budget theorem is based on the combined operation of the

tax multiplier and the government-expenditure multiplier. In this, the tax
multiplier is smaller than the government-expenditure multiplier. The
government-expenditure multiplier is

Or ∆Y = 1/1-c ∆G

∆Y/∆G = 1/1-c

Which indicates that the change in income (∆Y) will equal the multiplier
(1/1- c) times the change in autonomous government expenditure?

The tax multiplier is

∆Y = –C∆T/1-c

∆Y/∆T = -c/1-c

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Which shows that the change in income (∆Y) will equal multiplier (1/1- c)
times the product of the marginal propensity to consume (c) and the
change in taxes (∆T).

A simultaneous change in public expenditure and taxes may be expressed

as a combination of equations (1) and (2). Thus the balanced budget
multiplier

kb = ∆Y/∆G + ∆Y/∆T = 1/1-c + -c/1-c = 1-c/1-c = 1or kb =1

Since ∆G = ∆T, income will change by an amount equal to the change in

government expenditure and taxes.

To understand it, it is explained numerically. Suppose the value of с – 2/3

and the increase in government expenditure ∆G = Rs 10 crores. Since ∆G
= ∆T, therefore the increase in taxes (lumpsum) ∆T = Rs. 10 crores.

We first calculate the government-expenditure multiplier,

kg = ∆Y/∆G =1/1-c =1/1-2/3 =3

The tax multiplier is kT = ∆Y/∆T =-c/1-c = -2/3/1-2/3 = – 2

To arrive at the increase in income as a result of the combined operation of

the government expenditure multiplier and the tax multiplier, we write the
balanced budget multiplier equation as

kb = ∆Y = 1/1-c ∆G + c/1-c ∆T

and fit in the above values of c, ∆G and ∆T so that

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kb = ∆Y = 3∆G – 2 ∆T

= 3×10 – 2 ×10 = Rs. 10 crores

Thus the increase in income (∆Y) exactly equals the increase in

government expenditure (∆G) and the lumpsum tax (∆T) i.e., Rs. 10 crores.
Hence kb= 1.

This balanced budget multiplier or unit multiplier is explained with the help
of Figure 4. С is the consumption function before the imposition of the tax
with income at OY0 level. Tax of AG amount is imposed. As a result, the
consumption function shifts downward to C1.Now g government
expenditure of GE amount is injected into the и ш economy which is equal
to the tax yield AG.

The new government expenditure line is C1+ G which determines OY

income at point E. The increase in income Y0Y equals the tax yield A G and
the increase in government expenditure GE. This С proves that income has
risen by 1 (one) times the amount of increase in government expenditure
which is a balanced budget expansion.

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Instruments of Fiscal Policy:

The tools of fiscal policy are taxes, expenditure, public debt and a nation’s
budget. They consist of changes in government revenues or rates of the
tax structure so as to encourage or restrict private expenditures on
consumption and investment.

Public expenditures include normal government expenditures, capital

expenditures on public works, relief expenditures, subsidies of various
types, transfer payments and social security benefits.

Government expenditures are income-creating while taxes are primarily

income-reducing. Management of public debt in most countries has also
become an important tool of fiscal policy. It aims at influencing aggregate
spending through changes in the holding of liquid assets.

During inflation, fiscal policy aims at controlling excessive aggregate

spending, while during depression it aims at making up the deficiency in
effective demand for raising the economy from the depths of depression.
The following considerations may be noted in the adoption of proper policy
instruments.

A Contra cyclical Budgetary Policy:

The policy of managed budgets implies changing expenditures with

constant tax rates or changing tax rates with constant expenditures or a
combination of the two. Budget management may be used to tackle
depression and inflationary situations. Deliberate attempts are made under

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this policy to adjust revenues, expenditures and public debt to eliminate
unemployment during depression and to achieve price stability in inflation.

Contra cyclical policy implies unbalanced budgets. An unbalanced budget

during depression implies deficit spending. To make it more effective, the
government may finance its deficits by borrowing from the banks. During
periods of inflation, the policy is to have a budget surplus by curtailing
government outlays.

The government may partly utilize the budget surplus to retire the
outstanding government debt. The belief is that a surplus budget has
deflationary effect on national income while a deficit budget tends to be
expansionary. During depression when we need an increase in the flow of
income, deficit budgets are desired. Conversely, in inflation when we need
to check the overflow of income, surplus budgets are favoured.

However, following a contra cyclical budgetary policy is not an easy task.

Predicting a recession or an inflationary boom is a difficult job. Adjusting
the budget to the fast changing economic conditions is still more difficult
especially when budget is a political decision to be taken after a good deal
of delay and discussion. Therefore, emphasis has also to be laid on
adjustment of individual items of the budget in order to make it more
effective as a contra cyclical fiscal policy weapon.

Taxation Policy:

The structure of tax rates has to be varied in the context of conditions

prevailing in an economy. Taxes determine the size of disposable income
in the hands of general public and therefore, the quantum of inflationary

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and deflationary gaps. During depression tax policy has to be such as to
encourage private consumption and investment; while during inflation, tax
policy must curtail consumption and investment.

During depression, a general reduction in corporate and income taxation

has been favoured by economists like Prof. A H. Hansen, M. Kalecki, and
R.A. Musgrave on the ground that this leaves higher disposable incomes
with people inducing higher consumption while low corporate taxation
encourages ‘venture capital’, thereby promoting more investment.

But there are others who express grave doubts about the supposed
stimulating effect of taxation reliefs on investment. It has been argued that
even a heavy reduction in taxes does not alter an entrepreneur’s decisions.

Mr. Kalecki expressed the view that the policy of reducing taxes for
increasing consumption and stimulating private investment is not a practical
solution of the unemployment problem because income-tax cannot be
changed so often. The government will have to evolve a long-term fiscal
policy.

During inflation, new taxes can be levied to wipe off the surplus purchasing
power. Caution, however, should be taken not to raise the taxes so high as
to stifle new investment and generate a business recession. Expenditure
tax and excise duties are anti-inflationary in character. During inflation fiscal
authority should aim at levying such taxes as reduce current excessive
demand for specific commodities rather than aggregate demand.

Redistributive taxation is probably the best measure for raising and

stabilising the consumption function. Redistributive taxation implies a

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progressive tax structure. This implies taxing the high-income groups at
higher rates, and the middle and low-income groups at lower rates with a
view to raising consumer spending.

Public Debt:

A sound programme of public borrowing and debt repayment is a potent

weapon to fight inflation and deflation. Government borrowing can be in the
form of borrowing from non-bank financial intermediaries, borrowing from
commercial banking system, drawings from the central bank or printing of
new money.

Borrowing from the public through the sale of bonds and securities which
curtails consumption and private investment is anti-inflationary in effect.
Borrowing from the banking system is effective during depression if banks
have got excess cash reserves.

Thus, if unused cash lying with banks can be lent to the government, it will
cause a net addition to the national income stream. Withdrawals of
balances from treasury are inflationary in nature but these balances are
likely to be so small as to be of little importance in the economic system.
However, the printing of new money is highly inflationary.

During war, borrowing becomes necessary when inflationary pressures

become strong. In a period of inflation, therefore, public debt has to be
managed in such a way as reduces the money supply in the economy and
curtails credit. The government will do well to retire debt through a budget
surplus.

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During depression, on the opposite, taxes are reduced and public
expenditures are increased. Deficits are financed by borrowings from the
public, commercial banks or the central bank of the country. The public
borrowing of otherwise idle funds will have no adverse effect on
consumption or on investment. When budgets are deficit, it is very difficult
to retire debts.

Actually, it pays to accumulate debt during depression and redeem it during

a period of expansion. Along with this, the monetary authority (the central
bank) must aim at a low bank rate to keep the burden of debt low. Thus,
‘public debt becomes an important tool of anti-cyclical policy.

Public Expenditure:

Public expenditure can be used to stimulate production, income and

employment. Government expenditure forms a highly significant part of the
total expenditure in the economy. A reduction or expansion in it causes
significant variations in the total income. It can be instrumental in adjusting
consumption and investment to achieve full employment.

During inflation, the best policy is to reduce government expenditure in

order to control inflation by giving up such schemes as are justified only
during deflation. While expenditures are reduced, attempts are made to
increase public revenues to generate a budget surplus.

Though it is true that there is a limit beyond which it may not be possible to
reduce government spending (say on account of political, and military
considerations), yet the government can vary its expenditure to some
extent to reduce inflationary pressures.

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It is during depression that public spending assumes greater importance. A
distinction is made between the concepts of public spending during
depression, that is, the concepts of pump priming and the ‘compensatory
spending’. Pump priming means that a certain volume of public spending
will help to revive the economy which will gradually reach satisfactory levels
of employment and output. What this volume of spending may be is not
specific. The idea is that, when private spending becomes deficient, then a
small dose of public spending may prove to be a good starter.

Compensatory spending, on the other hand, means that public spending is

undertaken with the clear view to compensating for the decline in private
investment. The idea is that when private investment declines, public
expenditure should expand and as long as private investment is below
normal, public compensatory spending should go on. These expenditures
will have multiplier effects of raising the level of income, output and
employment.

The compensatory public expenditure may take the forms of relief

expenditure, subsidies, social insurance payments, public works etc.

Public Works:

Public expenditures meant for stabilisation are classified into two

types:

(i) Expenditures on public works such as roads, schools, parks, buildings,

airports, post-offices, hospitals, canals and other projects.

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(ii) Transfer payments, such as interest on public debt, pensions, subsidies,
relief payment, unemployment insurance, social security benefits etc.

The expenditure on building up of capital assets is called capital

expenditure and transfer payments are called current expenditure. It has
been recommended that governments should keep ready with them a list of
public works which may be taken up when the economy shows signs of
recession.

Such a programme of public investment will tone up the general morale of

businessmen for investing. The primary employment in public works
programmes will induce secondary and tertiary employment. As soon as
the economy is put on the expansion track, such programmes may be
slackened and may be given up completely so that at any time public
investment does not compete with private investment.

Public works programmes suffer from a few limitations and practical

difficulties. It is unrealistic to expect that public works will fill all the
investment gaps of the private sector of the economy. To be genuinely
effective in promoting investment during depression, public works require
proper timing, proper financing and general approval of business and
investing opportunities.

Public works programmes cannot be varied easily along with the trade
cycle because many projects like river dams take a long time for
completion and many others like schools and hospitals cannot be
postponed, for if these are needed, these have to be built anyway.

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Again, certain heavy projects requiring a long time for completion and
started during depression cannot be given up without serious loss of
goodwill to the government. Then, there are problems of forecasting, of
being able to know when a period of inflation or deflation may set in and of
determining quickly the exact nature of programmes to be undertaken.
Besides, there are delays in getting them started. Again, they impose a
heavy debt burden and sometimes cause misallocation of resources, for
projects may be located in one region while the unemployed resources are
located in another region.

It is because of these limitations of public works that some economists

favour a comprehensive programme of social security measures like
pensions, subsidies, unemployment, insurance etc. These will not only
raise consumption during depression but also stabilise it in the long-run. If
such a programme of social security is financed through progressive
taxation, the purpose would be better served. The wise course would be to
coordinate the programmes of social security measures and public works.

Inflation

Inflation is a situation in which the general price level rises or it is the same
thing as saying that the value of money falls.

According to Coulbrun, “too much money chasing to few goods”. Crowther

defines, “inflation is a state in which the value of money is falling”.

Types of Inflation:
Inflation can be categorized on the following basis

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A) On the basis of Rate of Inflation:
Following are the types of inflation on the bases of rate of inflation.
1. Creeping Inflation
2. Walking Inflation
3. Running Inflation
4. Galloping Inflation

1. Creeping Inflation:
When the increase in the price level is not more than 2% per annum, the
inflation is called creeping inflation.

2. Walking Inflation:
In walking inflation, the price level increases more rapidly than in creeping
inflation. It may go to 5% p.a.

3. Running Inflation:
A general rise in price level upto 8% to 10% p.a. is called running inflation.

4. Galloping or Hyper Inflation:

In a situation where price level rises very rapidly within a short period of
time, the inflation is called galloping inflation.

B) On the basis of Degree of Control

Inflation is classified into the following categories on the basis of degree of
control:

1. Open Inflation
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2. Suppressed Inflation

1. Open Inflation:
The situation when inflation gets out of control and cannot be suppressed
by the government price control or any other similar steps.

2. Suppressed Inflation:
The situation when government is in a position to control inflation by its
price control policy.

C) On the basis of Causes

Inflation can be divided into categories on the basis of its causes.
1. Demand Pull Inflation
2. Cost Push Inflation
3. Profit Induced Inflation
4. Budgetary Inflation
5. Monetary Inflation
6. Wage Spiral Inflation
7. Imported Inflation
8. Devaluation Inflation

1. Demand Pull Inflation:

When demand for goods and services is more than their supply, the price
level of these goods and services will rise causing demand pull inflation.

2. Cost Push Inflation:

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When the cost of production or the remuneration of factors of production
increases, there will be an increase in prices causing cost push inflation.

3. Profit Induced Inflation:

Sometimes the businessmen increase the prices of their products only to
increase their profit margin. It causes profit induced inflation.

4. Budgetary Inflation:
When the government covers the budget deficit by borrowing money,
budgetary inflation will be caused.

5. Wage Spiral Inflation:

Workers often demand increase in wages. If wages are increases, the cost
of production will rise and prices of the products will go up. This inflation is
called wage spiral inflation.

6. Imported Inflation:
Imported inflation is caused by the increase in the prices of the imported
goods which are used as raw material in domestic production.

7. Devaluation Inflation:
Devaluation makes the domestic currency cheaper in terms of foreign
currencies. It results in the increased prices. The inflation thus caused is
known as devaluation inflation.

Causes of Inflation
Inflation is mainly of two types
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1. Demand pull inflation
2. Cost push inflation

1. Demand pulls inflation:

Demand pulls inflation occurs when there is a general increase in price
level due to increase in aggregate demand for goods.

2. Cost pushes inflation:

Cost push inflation occurs where there is an increase in the prices due to
increase in cost of production.
Causes of Demand Pull Inflation
Following are the causes of demand pull inflation.

A) Deficit financing:
Sometimes government may prepare deficit budget to complete its various
projects. The govt. takes loans from various sources to spend on roads,
bridges etc. As a result of such projects the income of the people increases
but there is no increase in the output of the goods.

B) Decrease in production:
In under-developed countries, the population growth causes low output of
goods and services. These factors keep production and output low and
cause a rise in prices.

C) Expansion of currency:

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When govt. issues currency more than the requirements of the trade in
economy, the circulation of currency increases causing inflation.

D) Expansion in credit:
The credit expansion also creates inflation. When commercial banks issue
loans to the private an d public sector it results in increase in money supply
which increases demand for goods and as a result price level increases.

E) Evils of society:
Black marketing earned by people through evils like smuggling, hoarding,
black marketing cause’s inflation.

F) Foreign remittances:
Foreign remittances increase the supply of money of the receiving country
without increasing production which results in inflation.

G) Increase in wages:
With the increase in wages, the purchasing power of the people increases
which result increase in demand and prices go up.

H) Consumption habits:
Many people of poor countries have consumption habit of rich countries.
This trend gives rise to demand and caused inflation.

I) Increase in investment:
Investment gives rise to wages, cost of production and savings. All these
factors bring more money and create inflation.
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J) Tendency of increasing population:
Increase in population causes increase in demand when demand goes up
the price rise.

Causes of Cost Push Inflation

Following are the causes of cost push inflation

A) Increase in wages
B) Rise in price of imported goods
C) Increase in taxes
D) Devaluation
E) Increase in the prices of inputs.

A) Increase in wages:
An increase in wages of individuals increases the income and on the other
hand it causes an increase in the cost of production. This increase results
in rise in prices.

B) Rise in the price of imported goods:

When the prices of the imported raw material used in local manufacturing
increases, the cost of manufacturing goods goes up. This cause inflation.

C) Increase in taxes:
The taxes that the govt imposes on manufacturers increase the cost of
production, this again result in the rise in prices.

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D) Devaluation:
Devaluation of currency decreases the purchasing power of the local
currency. The imported goods become dearer that ultimately increase the
cost of production.

E) Increase in price of inputs:

If there is an increase in the price of inputs, raw material, gas, electricity,
etc. the cost will go up and result will be increase in inflation.

Deflation

Meaning and Effects of Deflation!

The opposite of inflation is deflation. It is “a state in which the value of

money is rising i.e. prices are falling.” It is usually associated with falling
activity and employment. As pointed out by Coulborn, “Involuntary
unemployment is the hall-mark of deflation.” Deflation is caused when
prices are falling more than proportionately to the output of goods and
services in the economy as a result of decrease in the money supply.

Sometimes, deflation is confused with disinflation. Deflation is a situation

when prices fall along with reduction in output and employment.
Disinflation, on the other hand, is a situation when prices are reduced
deliberately but output and employment remain unaffected. According to
Coulborn, “A lowering of prices, income, and expenditures, when they
would be beneficial, would be disinflation.”

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Effects of Deflation:

The effects of deflation are the reverse of inflaton. Deflation affects different
groups differently. Persons with fixed incomes such as workers, white collar
salaried workers, pensioners the rentier class, etc. gain because the value
of money rises with falling prices.

On the other hand, all types of producers such as industrialists and farmers
lose with falling prices. Traders and equity holders also lose. Thus deflation
affects adversely the distribution of income and wealth. When prices are
falling, the purchasing power is increasing.

So the lower, middle, and other classes with low incomes gain. On the
other hand, businessmen, industrialists, traders, real estate holders, and
others with variable incomes are hit hard and their profits decline with
deflation.

But this does not mean that there is improvement in income distribution.
Rather, the low income groups suffer more because of the fall in
employment and income. So both the better off and the worse off feel
discontented under deflation.

Deflation also affects production adversely. With falling prices, production

falls because income and employment are also declining and the
aggregate demand is on the decline. Commodities start accumulating.
Profits fall. Small firms close down. Unemployment spreads. This vicious
circle of fall in demand, production, employment, income and aggregate
demand leads to a depression.

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The government also suffers under deflation. Revenues from direct and
indirect taxes decline. The real burden of public debt increases.
Development of the economy suffers because the government is unable to
increase public expenditure.

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