UNIT I

Syllabus

INTRODUCTION - The themes of economics – scarcity and

efficiency – three fundamental economic problems –
society’s capability – Production possibility frontiers (PPF)
– Productive efficiency Vs economic efficiency – economic
growth & stability – Micro economies and Macro
economies – the role of markets and government –
Positive Vs negative externalities.
 UNIT 01: MANAGERIAL ECONOMICS

Contents

LEARNING OBJECTIVES ............................................................................2

1.1 INTRODUCTION TO MANAGERIAL ECONOMICS ........2

1.2 FUNDAMENTAL PROBLEMS OF ECONOMICS ..............6

1.3 PRODUCTION POSSIBILITY FRONTIER ....................... 11

1.4 Micro and Macro Economics.............................................. 15

1.5 ECONOMIC GROWTH AND STABILITY ......................... 20

1.6 EXTERNALITIES IN MANAGERIAL ECONOMICS ..... 24

1.7 DEMAND ...................................................................................... 27

1.8 LAW OF DEMAND ................................................................... 33

Learning Outcomes .................................................................................. 43

Short Answer Questions ........................................................................ 43

Long Answer Questions ......................................................................... 43

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LEARNING OBJECTIVES

1. To explain economic systems

2. To impart knowledge about Production Possibility Frontier
3. To introduce the concepts of Macro Economics
4. To introduce concepts of Micro Economics
5. To discuss the determinants of Economic growth and stability
6. To understand the determinants of Demand.
7. Understand the Assumptions of the Law of Demand

1.1 INTRODUCTION TO MANAGERIAL ECONOMICS

1.1.1 Introduction

In this course, I will be discussing about various concepts of micro economics and
macroeconomics with management perspective.

This module will introduce you to the concepts of Economics.

Economics is social science that studies economic action of human being in daily life. An
action taken by human being to satisfy the needs or wants is called as an Economic action.
Economic action means an action undertaken for direct satisfaction of wants/needs. For
instance, our wants for cloths, number of actions are undertaken to satisfy them. For
example, sowing cotton seeds, spinning, weaving, printing, tailoring are all economic
action. All these economic actions are directed towards satisfying the human need for
clothing. A social science deals with all these action namely production, distribution and
consumption of goods and services are called Economics. In order to facilitate these actions
resources are required. Economics is concerned about allocation of resources among
competing need as man has unlimited needs/wants.

Managerial Economics has different approach. It studies the economic aspects of

managerial decision making. Managerial Economics is about analytical tools and
techniques which are useful o to improve the decision making process within the firm.

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Managerial economics is the application of economic theory and methodology to decision
making process of private, public and non-profit organizations. Various concepts of
managerial economics can be applied to both profit and non-profit institutions.

Economics has two major branches: microeconomics and macroeconomics. The Micro
economics deals with the theory of individual choice such as decisions made by a consumer
or a business firm. Macroeconomics is the study of the economic system in its totality. It
deals with broad aggregates as total output (GDP), national income, employment and
unemployment, the general price level as also the growth of the economy.

In this Module. I will give introduction to Managerial Economics.

Let me start with definition of Managerial Economics

1.1.2 Definitions

According to T. J. Coyne, “Managerial Economics is economics applied in decision

making. It combines a broad theory with everyday practice, emphasizing the use of
economic analysis in clarifying problems, in organizing and evaluating information,
and in weighing alternative courses of action”.

This definition can be illustrated in the following figure.

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 Figure 1.1: The role of managerial economics in decision making situations

It necessitates the integration and applications of practices, principles, and techniques from
the areas of accounting, finance, marketing, production, human resource management and
other functions or disciplines associated with economics to make decisions.

The other Definition given by renowned economists are as follows

Mansfield, “Managerial economics is concerned with the application of economic concepts

and economic analysis to the problems of formulating rational managerial decisions”.

Spencer and Siegel man have defined the subject as “the integration of economic theory
with business practice for the purpose of facilitating decision making and forward planning
by management”.

Dr. Alfred Marshall, one of the greatest economists of the nineteenth century, writes
“Economics is a study of man’s actions in the ordinary business of life: it enquires how he
gets his income and how he uses it”. Prof. Lionel Robbins defined Economics as “the
science, which studies human behavior as a relationship between ends and scarce means
which have alternative uses”

1.1.3 Scope of Managerial Economics

Managerial Economics is about the application of economic principles and methodologies

to the process of decision making under uncertain conditions.

Its topics include: demand and its determinants, supply and its determinants, production
functions, cost conditions, capital budgeting techniques, business and economic forecasting
short term and long-term corporate profits, and the problem of pricing in theory and
practice.

Managerial economics also investigates the firm: its place in the industry, its contribution
to the national economy and even its impact on international affairs.

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1.1.4 The Need for Managerial Economics

The major reason for studying managerial economics is that it is useful. Every manager and
every individual has to make economic decisions every day.

The study of managerial economics gives a major benefit for students and practicing
managers. It helps them to learn practical applications of micro and macroeconomic theory.

It is helpful in making such short run and long run decisions such as:

 What are products and services to produce?

 How to produce? What inputs and production techniques to employ?

 How much to produce and what prices should be charged for them?

 What time capital equipment be replaced?

 How should limited capital resources be allocated?

 What are the sizes and locations of new plants?

1.1.5 Significance of Managerial Economics

Managerial economics provides management with a strategic planning tool that can be
fruitfully utilized to gain a clearer perspective of the way the world at large works, and
what can be done to maintain profitability in an ever-changing environment. Much of
managerial economics offers decision makers a way of thinking about changes and a
framework for analyzing the consequences of strategic options.

Managerial economics is primarily or largely concerned with the practical application of

economic principles and theories for strategic decisions made within all types of business
enterprises namely selection of product, methods allocation of resources, promotional
strategy, pricing decisions etc.

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1.2 FUNDAMENTAL PROBLEMS OF ECONOMICS

In this module, I am going to introduce you to the fundamental problems of

Economics.

All countries face the economic problem, the problem of how to make the best use
of limited, or scarce, and resources. The reason for economic problem the fact that
needs and wants of people are endless; the resources available to satisfy these
needs and wants are limited.

1.2.1 Limited Resources

It is generally said that the main purpose of economic activity is to produce of

goods and services to satisfy changing needs and wants of an economy.

Resources are limited in two ways:

1. In physical quantity, as in the case of land, which has a finite quantity?

2. In the case of labor and machinery (in use), which can only be used for
one purpose at any one time
3. The economic problem is about scarcity and choice.

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1.2.2 Scarcity and Efficiency

Let us take scarcity first. If infinite amount of every good could be produced or if human
desires were fully satisfied, what would be the consequences? People would not worry
about stretching out their limited financial resources because they could have everything
they wanted; businesses would not need worry about the labor cost or healthcare;
governments would not need to struggle over expenditure or spending, because nobody
would care. Since all of us have as much as we want, no one would be concerned about the
distribution of incomes among different people or classes. In such case, there would be no
economic goods, that is, goods that are scarce or limited in supply. All goods would be
freely available for everyone likes ands in the desert or seawater at the beach. Prices and
markets would be irrelevant indeed. In such a case, economics would no longer be a useful
subject. But no society has reached up to this limitless possibility. Goods are limited, while
wants are unlimited. Even after few centuries of rapid economic growth, production in the
world is simply not high enough to meet everyone’s consumption desires. Our world
production output would have to be many times larger before the average world could live
at the level of the average person. In some countries, hundreds of millions of people suffer
from hunger and material deprivation. With unlimited wants, it is important that an
economy makes the best use of its limited resources. That brings us to efficiency. Efficiency
is the most effective use of a society’s resources in satisfying people’s wants and needs. An
Economy is producing efficiently when it cannot increase the economic welfare of anyone
without making someone else worse off.

The limited resources and unlimited wants /needs results in Scarcity. The
Economy tries to use the limited resources with efficiency. This makes an
individual /Business Firms/Government to make choice with opportunity cost.

1.2.3 Choice and opportunity cost

Choice and opportunity cost are two concepts in economics. As the resources are limited,
producers and consumers have to make choices between competing alternatives. An
Individuals must choose the best way to use their skill and effort, firms must choose the

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best way to use their workers and machinery, and governments must choose the best way
to use taxpayer’s money.

Making an economic choice results in sacrifice because alternatives must be given up.
Making a choice creates in the loss of benefit that an alternative would have provided. For
example, if an individual has Rs100 to spend, and if books are Rs.10 each and downloaded
music tracks are Rs1 each, buying a book means the loss of the benefit one gets from the 10
downloaded tracks. Similarly, land and other resources, which have been used to build an
apartment, could have been used to build a factory. The loss of the next best option
represents the real sacrifice and is known as opportunity cost. The opportunity cost of
choosing the apartment is the loss of the factory, and what could have been produced.

It is necessary to appreciate that opportunity cost relates to the loss of the next best
alternative, and not just any other alternative. The true cost of any decision is always the
closest option not chosen.

Each and every economy makes choices which incur opportunity cost.

1.2.4 Fundamental problems of Economics

The existence of scarcity creates the fundamental economic problem faced by every society
whether rich or poor, how to make the best use of limited resources to satisfy human
needs and wants. To solve this fundamental problem, every society must answer these
three basic questions

America’s Economist Paul Samuelson, is often credited with providing simple explanation
of the economic problem – namely, that in order to solve the economic problem societies
must endeavor to answer three basic questions – What to produce? How to produce? And,
for whom to produce?

1.2.4.1 What to Produce?

Societies have to make decision about the best combination of goods and services to meet
their wants and needs. Societies must decide on quantities of different resources to be

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allocated to these goods and services. For example, an economy must decide whether they
should produce wheat or weapons, build roads or buy textbooks for schools.

1.2.4.2 How to Produce?

Societies also have to decide the best combination of factors of production to create the
desired output of goods and services. For example, how much land, labor, and capital
should be used to produce goods such as weapon and cars? For example, what should be
used to make pipe? Copper or plastic. Should machines be used to make clothing or should
Human make it by hand? Which fertilizer is best for growing apples?

1.2.4.3 For whom to produce?

All Economy need to decide who will benefit from the output from its economic activity,
and how much they will receive. This is often known as the problem of distribution.
Different societies may develop different ways to answer these questions.

FUNDAMENTAL ECONOMIC PROBLEMS

In considering about economic problems, it must distinguish questions of fact from

questions of fairness. Positive economics describes the facts of an economy, while
normative economics is based on value judgments. It is an approach to economics which
deals with what “is” and how it works.

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Example: Observation that a consumer buys so many cigarettes at specific price is positive
economics.

Normative economics consists of ethical precepts and norms of fairness. It is an approach

to economics which deals with what “ought to be”. It makes value judgments whether the
outcome is good or bad. The consumer should not consume cigarettes because it is bad for
health is an example of normative economics.

1.2.5 Society’s Capability

There are various ways by which a society can answer these questions of what, how and
for whom? Societies are organised through alternative economic systems and economics
studies the various mechanisms that a society can use to allocate its scarce resources.
Generally, there are two distinguish fundamental ways of organising an economy. At one
end, government takes most economic decisions, with those on top of the hierarchy giving
commands to those further down the ladder. At the other end, decisions are made in
markets, where individuals or Business firm voluntarily agree to exchange goods and
services, usually through payments of money.

Let’s briefly study each of these two ways of an economic organisation.

In majority of democratic countries, the market answers most economic questions. Thus
their economic systems are called market economies. In a market economy, an individuals
and private firms make the major decisions about production and consumption. It is a
system of prices, of markets, of profits and losses, of incentives and rewards determines
what, how, and for whom. Firms produce the goods that yield the highest profits (the what)
by the techniques of production that are least costly (the method). Consumption is
determined by individual’s decisions about how to spend the incomes generated by their
labor and property ownership (for whom).

The extreme case of a market economy, in which the government keeps its hands off
economic decisions, is called a laissez-faire economy or free market Economy. In
this economy, firms and households act in self-interest to decide how resources get

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allocated, what goods get produced and who buys the goods. This is opposite to command
economy, where the central government gets to keep the profits.

ECONOMIC SYSTEM

On contrary, a command economy is one in which the government makes all important
decisions about production and distribution. The government answers the major economic
questions through its ownership ofresources and its power to enforce decisions. Many of
contemporary society fall completely into either of these two categories.Rather, all
societies are mixed economies, with elements of market andcommand. There has never
been a 100% market economy.

1.3 Production possibility frontier

The wants in an economy are unlimited in nature.The resources to attain this wants are
limited. When resources are limited, scarcity arises. An economy attempts to solve the
problem by efficient allocation of resources and making choice. In the process of doing so
opportunity cost is incurred where some wants are traded off for another.

Whenever an economic agent chooses between alternative ways of allocating scarce

resources, an opportunity cost arises. The opportunity cost resulting from this decision is
the value of the next best alternative use of scarce resources. Opportunity cost can be
described using production possibility frontiers (PPFs) which provide a simple and
powerful way to illustrate the effects of making an economic choice.

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In this module, I am going to give your insight into Production Possibility Frontier.

The Production Possibility Frontier (PPF) is a point in which an economy produces its
goods and services with utmost efficiently and, thus allocates its resources in the best
possible manner.

If an economy is unable to produce as per PPF, it indicates that the resources are not
allocated effectively and the production shall drop.

There are specific assumptions are to be made to illustrate the production possibility curve.

1. The Economy is operating at full employment and achieving full production. Nor
unemployment nor underemployment exists.
2. The available supplies of factors of production are fixed. They shall be shifted or
reallocated; within limits between different uses for example an unskilled worker
may work in a farm or a car company or supermarket.
3. The technology does not change

4. The resources and technology are fully and efficiently utilized.

5. The technique of production remains constant.

Production possibility is about the balance between inputs and outputs in an economy. A
output is goods or services produced in an economy. Aoutput results from combinations of
different resources in different process. The resources used to produce goods or service is
called as inputs. Another term for input is factors of Production Namely Land, Labor and
capital. As discussed earlier inputs are limited and an economy needs are unlimited. The
need to choose among different products can be explained by Production Possibility
Frontier. Economist Prof. Paul A. Samuelson used the concept of the production possibility
curve to explain the economic problems of a society. Production Possibility Curve (PPC) is
the locus (the path of a moving point) of various combinations of two commodities which
can be produced with given amount of resources and technology. It is also known as
transformation curve

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Let us dramatize the choice considering that an economy can produce only two goods
namely wheat and Machines. Production Possibility curve (PPC)can be drawn based on the
choice of combination of two goods. The combination is made with assumptions held. It is
supposed that the productive resources are being fully utilized and there is no change in
technology. The following table gives the various production possibilities.

Table 1: Production Possibility Schedule

Based on the above schedule we can plot al the coordinates of A, B, C, D, E and F, which
show the combination of two goods, wheat and machines. If all available resources are
employed for the production of machines,15,000 machines are produced and no wheat is
produced. If, on the other hand, all available resources are utilized for the production of
wheat, 5000 tones are produced. These are the two extremes shown as A and F and in
between them are the situations represented by B, C, D and E. At B economy produces
14,000 machines and 1000ton of wheat.

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At C the production possibilities are 12,000 machines and 2000 tons of wheat, as we move
from A to F, we give up some units of machines for some units of wheat For instance,
moving from A to B, we sacrifice 1000 machines to produce 1000 tons of wheat, and so on.
As we move from A to F, we sacrifice increasing amounts of machines. Thus, in a full-
employment economy, more and more of one good can be produced only by reducing the
production of another good. This is due to the basic fact that the economy’s resources are
limited. This is shown in the diagram.

It appears from the PPC that any point within the enclosed area OFA, say, P, indicates that
resources are underutilized. Movement from the point within the enclosed area to any
point on the curve AF shows fuller utilization of resources at present. f the society is able to
increase the resources due to the process of growth, new curve is formed. The rightward
shifting of the curve (new curve) shows the growth of resources. PPC is concave to the
origin. To explain the concavity of PPC we have to understand the meaning of opportunity
cost and marginal opportunity cost too.

Resources are limited and these can of alternative uses. It is, therefore, necessary that we
must make the best possible utilization of resources to maximize output. Therefore shifting

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of resources from present commodity to the production any alternative commodity can
earn more value. An outward shift is an indication of economic growth. When it shifts
inwards, it shows that the economy is shrinking due to a failure in its allocation of
resources and optimal production capability.

PPF plays a crucial role in Business and economics. It can be used to demonstrate the point
that any country ‘s economy reaches its greatest level of efficiency when it produces only
what it is best qualified to produce and trades with other nations for the rest of what it
needs.

1.4 Micro and Macro Economics

The Economics originated with the publication of Adam Smith’s “An Inquiry into The Nature
and Causes of Wealth of Nations” in the year 1776. Adam Smith is known as the father of
Economics. At its origin, the name of economics was ‘Political Economy’. Towards the end
of the 19th century there was a definite change from use of word ‘Political Economy’ to
‘Economics’.

‘Economics’ was derived from Greek words oikou(a house) and nomos(tomanage).

Thus, the word “economics” formerly meant home management with limited funds
available in the most economical manner possible.

Lionel Robbins states economics as “a science of scarcity”. Before 1930, there was only one
‘economics’. The basic problem in an economy was allocation of resources between differ
users. The concern during this period was demand for a commodity, price, amount of
commodity supplied in market and so on .This kind of study is “Micro Economics”. So Micro
economics deals with behavior of individual who may be consumer or producer or market.
The 19030’s great depression had economic contraction and unemployment. The classical
model failed to explain the reason for unsold goods and unemployment .It contributors
were Adam smith, Ricardo, Malthus, Bentham and J.S.Mill.

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The ‘Great depression ‘in 1930‘s paved way to Modern Economics. The source of Modern
Economics has its roots taken from John Maynard Keynes work “The General Theory of
Unemployment, Interest and Money” which was published in 1936. Keynes proposed a
new theory of economics that explained reason for unclear markets , which would evolve
(later in the 20th century) into a group of macroeconomic schools of thought known
as Keynesian economics – also called Keynesianism or Keynesian theory. Keynes found
relation between individual business firms .He stated that “ It is aggregate demand and
not price and wages which determines the level of output and employment “He also
believed that government can control and influence the price , output and employment.
Thus Macro Economics evolved. It is study of economy as whole for example National
income, national output etc. The Economist following Keynes combined the
macroeconomics of the General Theory with neoclassical microeconomic. By the 1950s,
most economists had accepted the view of the macro economy. Few economist like Paul
Samuelson, Franco Modigliani, James Tobin, and Robert Solow later developed formal
Keynesian models and contributed formal theories of consumption, investment, and money
demand that fleshed out the Keynesian basic framework.

Economics has two major branches: microeconomics and macroeconomics

Ragnar Frisch coined the words ‘micro’ and ‘macro’ to denote the two branches of
economic theory, namely, micro economics and macroeconomics.

1.4.1. Micro Economics

The word ‘Micro’ is from the Greek word micros which means small. Micro economicsdeals
with small segments of the society. Microeconomics is defined as” the study of behavior of
individual decision-making units, such as consumers, resource owners and firms”. It is also
known as Price Theory as its major subject-matter deals with the determination of price of
commodities and factors.

Microeconomics has both theoretical and practical importance. It solves the three central
Problems of an economy, i.e., what to produce, how to produce and for whom to produce.

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Micro economics is concerned with

 Supply and demand in individual markets

 Pricing

 Individual consumer behaviour. e.g. Consumer choice theory

 Individual producer behaviour.

 Individual labour markets.

1.4.1.1 Importance of micro economics

Microeconomics has both theoretical and practical importance. It is clear from the

Following points:

1. Microeconomics aids in formulating economic policies which enhance productive

2. Efficiency and results in greater social welfare.
3. Microeconomics describes the working of a capitalist economy where individual
units
4. (Manufacturers and consumers) are free to take their own decision.
5. Microeconomics explains how, in a free enterprise economy, individual units attain
6. Equilibrium position.
7. It aids the government in formulating price policies.
8. It enhances in efficient employment of resources by the entrepreneurs.
9. It makes business economist to make conditional predictions and business
forecasts.
10. It explains gains from trade, disequilibrium in the in the balance of payment
position and determination of international exchange rate.

1.4.1.2 Limitations of Micro economics

Microeconomics does not explain the functioning of an economy as a whole. It does not
explain unemployment, poverty, illiteracy and other problems prevailing in the country

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1.4.2 Macro economics

The word ‘Macro’ is from the Greek word macros meaning large. Macro economicsdeals
with aggregative economics. Macroeconomics is defined as “the study of overall economic
phenomena, such as problem of full employment, GNP, savings, investment, aggregate
consumption, aggregate investment, economic growth, etc.” It is also known as Theory of
Income and Employment since its major subject-matter deals with the determination of
income and employment. The study of macroeconomics is used to solve many problems of
an economy like, monetary problems, economic fluctuations, general unemployment,
inflation, disequilibrium in the balance of payment position, etc.

1.4.2.1 Macro Economics is concerned with

 Employment

 National output

 National Income

 Inflation

 General Price level and stability

 Balance of Trade

1.4.2.2 Importance of macroeconomics

Macroeconomics has emerged as the most challenging branch of economics. In the words of
Samuelson, “no area of economics is today more vital and controversial than
Macroeconomics.”

The importance of macroeconomics on theoretical and practical reasons is clear from the
following points:

1. It explains the complexities of an economic system. It gives tools to explain the

working of the complex economic systems.

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 2. It helps to provide a framework for formulating appropriate macro
economicpolicies (e.g., for inflation, poverty, unemployment, etc.) to direct and
regulate economy towards desirable structure.
3. It helps in find the causes for economic fluctuations and provides remedies.

1.4.2.3 Limitations of macroeconomics

Some of the major limitations of macroeconomics are:

(i) Macroeconomics ignores changes in an individual firm of the aggregate. The results
drawn on the basis of aggregate variables may be misleading.

(ii)Economist Hicks states it as, “most of macro magnitudes which figure so largely in
economic discussions are subject to errors and ambiguities.”

Difference between Microeconomics and Macroeconomics

Attributes Micro Economics Macro Economics

Microeconomics is that part Macroeconomics is that part
of economic theory which of economic theory which
studies the behaviour of studies the behaviour of
individual units of an aggregates of the economy
economy. as a whole.
Definition
Demand and Supply. Aggregate Demand and
Tools of Analysis
It aims to determine price Aggregate Supply.
Main Objective
of a commodity or factors of It aims to determine income
Basic Assumptions
production. and employment level of
Other Name
It assumes all the macro the economy.
Examples
variables to be constant, i.e., It assumes that all the micro
it assumes that national variables, like decisions of
income, consumption, households and firms,
saving, etc., are constant. prices of individual
It is also known as ‘Price products, etc. are constant.

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 Theory’. It is also known as ‘Income
Individual Demand, Firm’s and Employment Theory’
Output. National Income

Although microeconomics and macroeconomics differ from each other, there is a close
relationship between them.

Macroeconomics is based on many principles and results of micro economics in a larger

economic view.

The aggregate production and consumption in macroeconomics is result of production and

consumption of households and individual firms.

It can be stated that the microeconomics is used to study how macroeconomic changes can
affect the behaviour of microeconomic units. For example, an increase in inflation or a
change in the real exchange rate could have an effect on the production of goods in a
particular economy

For example, an increase in inflation could lead to a change in the price of raw materials for
individual firm, which in turn would affect the price of the final product paid by the
consumer.

Hence it can be seen that there is an overlap between these two branches of Economics as
they rely on each other.

1.5 ECONOMIC GROWTH AND STABILITY

1.5.1 Introduction

Economic growth can be indicated in several ways in an Economy.One indicator is an

increase in the production of goods and services over a specific period. Economic growth
creates more profit for businesses. As a result, stock prices rise, which enhances
companies’ capital to invest and hire more employees. As more jobs are created, incomes

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rise. Consumers have more money to buy additional products and services. Purchases drive
higher economic growth, which makes all countries want positive economic growth. Thus
economic growth the most-watched economic indicator.

1.5.2 Economic growth

Economic growth is measured by the increase in a country’s total output or real Gross
Domestic Product (GDP) or Gross National Product (GNP).Gross domestic product is the
best way to measure economic growth. It considers the country's entire economic output. It
in takes into accounts all goods and services that businesses in the country produce for
sale. It does not consider whether they are sold domestically or overseas.

Growth doesn’t occur in isolation. Events in one country and region can have a significant
effect on growth prospects in another .For example Ban in outsourcing in one country may
affect the income of employees in another country. Most of the developed economies has a
slower economic growth compared to developing countries. Economic Growth is not the
similar to Economic Development. Economic Development alleviates people from low
standards of living into proper employment with suitable shelter. Economic Growth does
not consider the depletion of natural resources which might lead to pollution, congestion
&disease. However Development is concerned with sustainability which means meeting the
needs of the present without compromising future needs.

Economic growth in an economy is defined by an outward shift in its Production Possibility

Curve (PPC).

An outward shift in PPF indicates the following

 New Technology
 Increase in labour force
 New Production Method
 New Raw Material
 Division of Labour

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1.5.3 Causes of economic growth

The below six causes of economic growth are key components in an economy.
Improving or increasing their quantity can lead to growth in the economy.

1.5.3.1 Natural resources

Discovery of Natural resources like oil, forest, water, natural gas etc. Enhances the outward
shift of PPF thus economic growth. An economy must balance the demand and supply of
scarce natural resources to attain economic growth.

1.5.3.2 Labour

An increasing population in an economy is the higher number of labour or employees. Thus

availability of labour supply

1.5.3.3 Infrastructure

Higher investment in infrastructure namely machineries, plant, equipments and road will
naturally increase the productivity. For instance a good roadway facilitates the movement
of raw materials across places easily and timely.

1.5.3.4 Technology

Technology increases the productivity the same way as the labour. Technology leads to
growth in long run. It does lower the cost of Production.

1.5.3.5Law

The legal structure of a country must enhance and support the economic activities

1.5.3.6 Human capital

Human capital denotes the expertise or skill of an employee. A skilled worker is a capital
who accelerate the productivity thus economic growth.

There are factors that limits or hiders the growth of an Economy.

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They are as follows

 Lack or Poor Infrastructure

 Low level Education

 Political Instability

 Unsupportive Legal framework

1.5.4. Economic stability

Economic stability is an absence of excessive fluctuations in the overall economy.

An economy with constant output growth and low and stable price inflation is likely to be
considered as stable. An economy with frequent boom-bust cycles and variable price
inflation would be an unstable one.

Economic stability enables other macro-economic objectives to be achieved, such as stable

prices and stable and sustainable growth

1.5.5. Features of a stable economy

A stable economy is steady. There is growth in gross domestic product. There is growth in
employment rate. The economic growth in a stable economy is manageable as it grows at a
sustained rate.
An economy that demonstrated steady growth at one quarter of the year followed by a
decline in GDP and employment rate is considered as a Stable Economy.

1.5.6. Measures of economic stability

A National Economy is very complex to state a single measure for Stable Economy. Though
there are several measures, Economist mainly relies on GDP as a summary of Economic
activity.GDP measures the total output of nation. Changes in the GDP over a time period is a
measure of stability. There are other measures of economic stability which include
consumer prices and the national unemployment rate

23
The data about an economic activity can be collected .This will enable the policy makers
and economist to monitor economic conditions and respond to unstable economy.

1.6 Externalities in managerial economics

1.6.1. Externalities

Externalities are consequences of Economic activities. Externalities occur when producing

or consuming a good/cost cause an impact on third parties not directly related to the
transaction. Externalities can either be positive or negative. They can also occur from
production or consumption.

(i) Positive Externalities

When producing or consuming a good causes benefit to a third party it is positive

externalities.

Examples

A private school in semi urban area, provides employment to neighbourhood

An attractive house shall increase the market value of properties in the neighbourhood.

(ii)Negative Externalities

When producing or consuming a good causes a cost to third party, it is negative

externalities.

Examples

Water Pollution from industry shall affect growth of plant, animals and humans

Cutting tress from forest may cause global warming and affect rainfall

Positive externalities causes benefit and negative externalities causes cost.

24
(iii) Overcoming externalities

To overcome externalities, we require some form of government intervention

 Tax. To reduce consumption of negative externalities, we can place a tax on goods

with negative externalities

 Subsidy. To increase consumption of positive externalities, we can place a subsidy on

these goods.

 Regulation. The government may place regulations which limit the amount of
pollution.

 Nudges and behavioural economics – The government could place incentives and
make it easier to choose less costly environmental choices.

1.6.2. Role of government in Managerial Economics

The role of government in an Economy is viewed in various perspectives by various

economists. The classical economists Adam Smith, J.S. Say and other advocated the doctrine
of laissez faire which means non- intervention of the government in economic matters.
Adam Smith introduced the concept of the invisible hand, which refers to the free
functioning of the price (market) system in the absence of government intervention.

According to Paul Samuelson “An ideal market economy is one where all goods and
services are voluntarily exchanged for money at market prices. Such a system
squeezes the maximum benefits out a society’s available resources without
government intervention”.

The great depression shattered the economies all around the world and made
businesses to abandon the concept of laissez fair. Keynes in his book “The General
Theory “states that the visible hand of the government should replace, at least partly, the
invisible hand of the market. Following Keynesian prescriptions governments in most
countries took on a steadily expanding economic role, regulating monopolies, collecting

25
income taxes and providing social security in the form of unemployment compensation or
pension for the old people.

In a modern economy like our own, the government has to perform various roles mainly to
correct the flaws (defects) of the market mechanism.

Governments may regulate some businesses (such as banking and insurance), while
subsidising others (such as agriculture and small-scale and cottage industries).

The main roles of the government are

(i) Economic Growth and Stability

The government uses various policies to regulate the employment, price and GDP which
are the indicators of Economic growth and stability.

(ii) Efficiency:

The government should attempt to correct market failures to monopoly,

externalities,pollution etc. to ensure efficient functioning of the economic system.

(iii) Fiscal Policy

In order regulate inflationary tendencies, fiscal policy is formulated by government.Fiscal

policycontrols the economy by taxes and expenditures.

(iv) Monetary Policy

The central bank regulates the money supply through commercial Banks. The instruments
used are securities; cash reserve ratio and interest rates.

(v) Growth Policy

The government takes up growth policy to increase the aggregate supply in an Economy.

The aggregate supply is regulated by government investment through borrowings,taxes

etc.

26
Source: Economics –Samuelson

Given above is the summary of government intervention in various failures in Market

Economy and policies to rectify them

1.7 Demand

In this Module , I shall discuss about , Demand , its classification and its determinants

Demand is always indicated in terms of price or quantity demanded in a specific period

of time .

Demand is core for any Business Decisions. The decisions namely Inventory control ,
Production Planning , Distribution Decisions , Financial Decisions , Human Resource
Analysis , selection of projects etc., are done with help of Demand.

In Economics, Demand is stated with reference to price of the product. With change in
Price, quantity demands also changes. In addition to price, demand is stated with
reference point of particular time. For example; during rainy season demand for

27
umbrellas will be high compared to other seasons. Demand is considered as the
quantity of products a buyer is willing to buy at a given price during a specific period of
time. A market demand is sum of all demands of individual consumers.

It is know that human wants are unlimited. All wants cannot be considered as Demand.
For instance an economically poor man desires to buy a car. He cannot be considered as
demand as wanting something does not create demand as he lacks in purchasing power.

Demand is characteristed by three factors namely

(i) Willing to pay

(ii) Interest in the product
(iii) Ability to purchase

1.7.1. Definition

Some of the definitions of Demand are as follows “The demand for anything, at a given
price, is the amount of it which will be bought per unit of time at that price.” -PROF.
BENHAM “By demand, we mean the quantity of a commodity that will be purchased at a
particular price and not merely the desire of a thing.”-HANSEN All firms survive on
Profits .Profits is a function of price and quantity demanded. Price and output decisions
are guided by the interaction of market demand and supply .Supply is control by the
firm whereas Demand being an external factor is more difficult to manage. There are
large number of factors that determine Demand in the market. The determinants of
Demand shall be discussed in the next module.

1.7.2. Classification of Demand

1.7.2.1 Individual Demand and Market Demand:

This demand refers to the demand for goods and services by the single consumer,
whereas the market demand is the demand for a product by all the consumers who buy
that product. Thus, the market demand is the aggregate of the individual demand.

28
1.7.2.2 Total Market Demand and Market Segment Demand:

The total market demand is the aggregate demand for a product by all the consumers in
the market who purchase a particular kind of a product. Further, this aggregate demand
can be sub-divided into the segments on the basis of age ,gender ,size of the market
,geographical areas, price sensitivity etc. are called as the market segment demand.

1.7.2.3 Derived Demand and Direct Demand:

The demand for a product/outcome that is associated with the demand for another
product/outcome is called as the derived demand or induced demand. For instance
demand for cotton yarn is derived from the demand for cotton cloth. Whereas, when the
demand for the products/outcomes is independent of the demand for another
product/outcome is called as the direct demand or autonomous demand. In above
example the demand for a cotton cloth is autonomous.

1.7.2.4 Industry Demand and Company Demand:

The industry demand is the total aggregate demand for the products of a particular
industry, For example demand for bricks in construction industry. Whereas the
company demand is a demand for the product which is particular to the company and is
a part of that industry. For instance demand for tyres manufactured by the MRF. Hence
the company demand can be expressed as the percentage of the industry demand.

1.7.2.5 Short-Run Demand and Long-Run Demand:

The short term demand is more elastic which denotes that the changes in price or
income are reflected immediately on the quantity demanded. While the long run
demand is inelastic, that shows that demand for commodity exists as a result of
adjustments following changes in pricing, promotional strategies, consumption patterns,
etc.

29
1.7.2.6 Price Demand:

The demand is often studied in parlance to price, and is therefore called as a price
demand. The price demand means the amount of commodity a person is willing to
purchase at a given price. When analysing demand, it is often assumed that the other
factors such as income of the consumer, their tastes, and preferences, the prices of other
related goods remain constant. There is a negative relationship between the price and
demand and vice-versa. As the price increases the demand decreases and as the price
decreases the demand increases.

1.7.2.7 Income Demand:

The income demand is the willingness of an individual to buy a certain quantity of goods
at a given income level. In this demand, the price of the product, customer’s tastes and
preferences and the price of the related goods are expected to remain unchanged. There
is a positive relationship between the income and demand. As the income increases the
demand for the commodity also increases and vice-versa.

1.7.2.8 Cross Demand:

When the demand for a commodity depends not on its own price, but on the price of
other related products is called as the cross demand. For example the increase in the
price of coffee, the consumption of tea increases, since tea and coffee are substitutes to
each other. Also, when the price of cars increases the demand for petrol decreases, as
the car and petrol are complimentary to each other.

1.7.3 Determinants of Demand

There are various factors that determine the quantity demanded for a product.

There are factors that determine individual demand and market demand.

Determinants of individual demand

Some of the determinants of individual demand are discussed below

30
 (i) Price

Price is the most important determinant of Demand. The law of Demand is based on
this concept. The increase in price results in decrease in quantity demanded and
vice versa. This is true keeping other factors into constant. Demand is always
represented in terms of price. The concept may not always hold true in some
situations like war, depression etc.

(ii) Income

The next determinant of demand is Income of the individual consumers in an

economy. The increase in income of a person always increases human wants /needs
which inturn increases the quantity of goods demanded by the consumers. The
decrease in income naturally decreases the quantity of goods demanded in the
market.

(iii)Consumer Expectations

Consumers shall be speculative in nature. The consumers expect the price of the
product to be increases in future. The consumer may expect increase in their
income in future. They may try to take advantage of existing price of the product.
Thus the quantity demanded during that period of time shall increase. For instance
demand for gold, silver, petrol etc

(iv) Price of related goods

There are two kinds of goods (a) Complementary goods (b) Substitute goods

(a)Complementary goods

Let two goods namely A and B be complementary to each other .The demand of
good A ice depends on the price of good B and vice-versa, Let us take the example of
pen and ink. The demand for ink depends on the price of pen. If the price of pen
increases, the demand for ink decreases,

31
 The goods pen and ink are complementary to each other.

(b)Substitute goods

Let us assume that A and B are substitute goods. If the price of B increases, the
demand for the B decreases and demand for A increases. If the price of A increases,
the demand of B increases. For instance, Tea and coffee are substitute goods. If the
price of the Tea increases, the demand for tea decreases and demand for coffee
increases. The increase in price of coffee results in increases in the demand for
coffee.

(v)Taste of consumer

The consumers liking and interest influence the demand for the product .The
product which is more liked by consumer will have more demand in the market
irrespective of other determinants.

1.7.4 DETERMINANTS OF MARKET DEMAND

The sum of demand of all the consumer in an economy at given price during a specific
period of time is called as Market Demand. The determinants of market demand are as
follows

(i) Number of Consumers

The size of the market influence the demand for a product .More is the number of
consumers, more is the demand for the product.

(ii) Consumer Expectation

The consumer expectation in the change on future income and future price will
affect the demand of market at a particular point of time. The future expectation of
increase in price will result in increase in demand for the product .For instance if
there is expectation that there will be increase in price of petrol in next two days the
demand for petrol will increase immediately.

32
(iii)Distribution of Income

The distribution of income in an economy determines the demand of product in an

economy.The distribution of income may be in favour of young, old ,rich etc.
Demand is influenced by the group which favours the distribution of income.

1.8Law of Demand

I am going to discuss the most important topic in Economics know as Law of Demand.

In previous module I discussedabout Demand. Economist stated that Demand refers to

quantity of goods or services consumerswilling and able to purchase at different prices.
Theamount consumerpays for a specific goods or service is called price. The total number
of goods or service aconsumers buy at a specific price is called demand.

The law of demand stated that the quantity demanded will change with the change in price

1.8.1 Law of Demand

The law of demand states that there is a negative relationship between price and the
quantity of a good demanded. The demand for quantity of goods is inversely proportional
to price of the good.

In Marshall’s words as “the amount demanded increases with a fall in price, and
diminishes with a rise in price”

An increase in price always results in decrease in demand and a decrease in price will
cause the demand to fall . The law of demand assumes that all other variables that
influence demand remain constant .

1.8.2. Assumption of the law of demand

1. The income of the consumer is constant

2. The taste and preference remains constant
3. There is no substitute for the product
4. There is no change in price of other related products
33
5. There is no change in the quality of the product
6. The habits of the consumers remain unchanged
7. There is no expectations about change in future price .

1.8.3. Demand schedule

The Law of demand can be explained with a Demand schedule .Demand schedule refers to a
tabular representation with various combination of quantity demanded and price by a
consumer during a specific period of time.

An example of demand schedule of Onions are given below.

Price in Rs Quantity Demanded in Kg

5 100
4 200
3 300
2 400
1 600

Demand schedule for onions are shown in the above table and diagram. The x axis
represents of quantity demanded by onion and y axis consists prices of onions. By

34
plotting various combination of price and quantity demanded, demand curve is derived.
The demand curve always slopes downwards.

At point P , the demand for onion is 100 at the price of Rs 5.If the price falls to Rs 4 t Rs 3
and Rs 2 , the quantity demanded will increase to 200, 300 and 400 respectively .This T
the demand is at the maximum i.e 600 for the price of Rs 1.The downward sloping demand
curve shows that the price is inversely proportional to quantity demanded .

The negative relationship between Price and demand can be explained in many ways .

 Substitution Effect

Substitution Effect occurs when goods become relatively more expensive because of high
price . If the price of a good X increases, the consumer shall substitute X with good Y or Z
For example if the price of tea goes up , consumption of coffee increases

 Income Effect

When the price of goods rises, consumer consider themselves poorer as they do not have
sufficient real income to purchase. If the price of petrol increases, as the consumer look
himself as poor , he may reduce his consumption of the product.

 Marginal Utility

The consumption is made based on the value of the product. Product value is benefit
derived by the product by cost incurred. Here cost is the price of the product. The marginal
utility is the benefit. According to law of diminishing marginal utility, when the consumer
buys additional units, the marginal utility of additional unit falls. When the marginal utility
becomes equal to price , the consumer stops buying If the price falls , marginal utility
becomes greater than price then the consumers is prompted to purchase more .

 Opportunity Cost

Let us assume that there are two products A and B. The price of A is Rs 20 and B is Rs 10. If
a consumer buys A . It shows that consumer forgoes 2 units of B for buying one unit of A.If

35
the price of A falls to Rs10 and the price of B is same. When buying one unit of A , the
consumer forgoes only one unit of B .The opportunity cost falls which makes the
consumer purchase more.

1.8.4. Exceptions for the Law of Demand

In some cases, the demand and price are directly related . Law of demand do not always
hold true at this situation .The demand curve slopes upward .The consumer buys more
goods as the price increases.

Some of the exceptions of Law of Demand are as given below

1. Giffen Paradox
Marshall introduced Giffen Paradox .Giffen goods are the inferior goods that are in the
mind of individuals to hard times. These inferior goods are known as Giffen goods that is
named after Sir Robert Giffen. Mr Giffen has pointed out “a rise in the price of bread makes
so large a drain on the resources of the poorer labouring families and raises so much the
marginal utility of money to them, that they are forced to curtail their consumption of meat
and the more expensive farinaceous foods: and, bread being still the cheapest food which
they can get and will take, they consume more, and not less of it. But such cases are rare;
when they are met with they must be treated separately”
Let us understand the concept with help of an illustration. Let us consider two goods maize
and wheat .Maize is giffen good as poor consumer consider as an essential commodity.
consumer spent considerable portion of their income on this product .

36
Consider a poor person has an income of Rs200 and need 30 kg of food grains to survive
.Let the price of maize and wheat be Rs 5 and Rs 10 per kg respectively.

The consumption pattern will be as in the below table.

Quantity Demanded in
Good Price in Rs Amount in Rs
kg
Maize 5 20 100
Wheat 10 10 100
Total 30 200

The consumer consumes 20 kg of maize and 10 kg of wheat for Rs 200. Suppose the price
of the maize increases to Rs6/kg,while that of wheat remains the same .

The possible combination of consumption pattern are as follows

Price in
Goods Quantity Demanded in kg
Rs
Maize 6 20 21 22 23 24 25
Wheat 10 9 8 7.5 7 6 5

As the price of the maize increases, the demand for the product does not fall as per the Law
of Demand .On contrary, the demand for the inferior good increases with increase in price
which is exception to Law of Demand.
2. Luxury Goods
Luxury goods are expensive goods like diamonds, luxury cars, antiques etc .For such goods,
demand increases with increase in the price of the good .The reason is that the utility of

37
such good is proportional to the price. The higher the price, the higher is the utility to the
consumers. These good have prestige value. The upper strata of the society attach a lot of
value to these goods. When the price of these goods increase, the preside value increases
and so is the demand for that good.
3. Demonstration Effect
The second exception to the law of demand is the concept of Demonstration Effect that can be
explained by Veblen goods. Veblen Goods is a concept that is named after the economist
Thorstein Veblen, who introduced the theory of “conspicuous consumption”.
According to Veblen, there are certain goods that become more valuable as their price
increases. If a product is expensive, then its value and utility are perceived to be more, and
hence the demand for that product increases. The people buy a good for the sake of
possession /status value. The increase in price, increases the demand.
4. Speculative Goods
Economist Marshall mentions speculation as one of the important exceptions of law of
demand. It denotes the downward sloping demand curve. Speculation goods such as shares
do not follow the law of demand. Whenever the price rises , the demand for these goods
increases among traders expecting the price to rise further.
5. Necessities of Life
The necessary goods for life namely food, clothing’s etc will not be affected by law of
Demand. The increase in price will not reduce the consumption and the fall in price will not
rise the purchase of these goods.
6. War
During war, the fear of shortage makes the consumers to purchase more goods irrespective
of price
7. Depression
During Depression period, the price of commodities falls still demand will not increase as
the consumer do not have purchasing power.
8. Ignorance Effect
Due to deceptive packaging, label etc consumer may mistake a product for some other
commodity. They buy more at higher price under the impact of the “ignorance effect”.

38
1.8.5. Change in Demand

According to Economists, “Change in quantity demanded and change in demand related

concepts are different. "Change in quality demanded refers to effect on demand to change
in the rate of goods whereas other determinants of demand such as income, taste and price
of other goods remains constant or stable. Because quality demanded on a given price is
shown by a point on the demand curve, so change in the quality demanded has showed
with the different points on same curve or movement along a demand curve. Inversely,
change in demand is not done due to changes in prices of goods; it indicates the effect in
demand of consumer for goods due to change in income, taste, price of other goods,
whereas price of goods remains stable

A shift of demand curve represents the coordination of consumer and upcoming changes
in balanced prices and quantity related to changes in outside matters (as income, taste,
price of other goods etc.).

Change in Quantity Demanded or Movement Along the Demand Curve

When quantity demanded is changed only due to the change in price, then change in
demand is represented by the different points on same demand curve. Rise in demand is
called extension of demand to fall in price, and falling in demand is called contraction of
demand to rise in price. In brief, movement along a demand curve response to price
changes for those goods. In these movements it is accepted that demand has other
unchangeable determinants besides the price. A given demand represents the changes in
quantity demanded on the graph due to change in price of the moving object. In brief,

Change only in price

Changes in quantity demanded

Movement along the demand curve

39
 Figur
e
Y
5 A
Contractionof
Demand
4
B
3 1 2 3 X
4 5
2
Quantit
1 y

Quantity demanded can be of two types:

Extension of demand—Extension of demand refers to a size in the demanded as a result

of fall in price. As shown in table 3, when rate of apples is 5 per Kg then demand of apple is
1 Kg and when price decreases to 1 per Kg the demanded expanded to new demand of 5 Kg
apples

40
Contraction of Demand: Contraction of demand refers to fall in quantity demanded as a
result of rise in price, ceteris paribus which is shown in Table that if rate of apples is1 per
Kg, then demand is 5Kg. If price rises to 5perKg then demand is contracted to new demand
of 1Kg

Table : Contraction of Demand

Price ( ) Quantity Description

Demanded
(Kg)

1 5 Fall in price

5 1

Contraction in
demand

Contraction of demand can be expressed by Fig. 6.10. In this figure AB is the demand curve
of apples. When rate of apples is 1 per Kg, demand is 5 Kg apples. Consumer is on the point

41
‘B’ on the curve. Inversely, when price increases to 5 per Kg, the demand contracted to new
demand of 1 Kg and consumer reaches to point ‘A’. So the shifting from lower point ‘B’ to
upper point ‘A’ in demand curve shows the Contraction of Demand.

Change in Demand or Shift in Demand Curve

Change in any determinant of demand beside price shifts complete demand curve to left to
right side.
Riseindemandisshownbyrightsideanddecreaseindemandisshownbyleftsideshifting.Econom
ists say it is change in demand. Changes in demand are the factors of changing in the
income, taste, price of the other goods. In brief,

Change in Income, Taste or Price of Related Goods

Changes in Demand

Shifting of Demand Curve

Rightward shifting of curve shows a rise and leftward shifting shows the fall in the demand.
Decrease in demand or leftward shift in demand curve has following factors:

 Decrease in income
 Decrease in price of replacement goods
 Increase in price of complementary goods
 Unfavorable changes in taste, likes and preferences
 Expectation of decreasing price in future
 Decrease in population(buyers)
 Just as this increase in demand or rightward shift in demand curve has following
factors:
 Increase in income
 Increase in price of replacement goods
42
Learning Outcomes

1. The law of demand stated that the quantity demanded will change with the change
in price.
2. The students know about the basic economic problems
3. The Students will gain knowledge about determinants of Economic growth
4. The Students gain knowledge about concepts and kinds of demand.
5. The Students understands the role of government in Managerial Economics

Short Answer Questions

1. What is Scarcity?
2. What is Opportunity cost?
3. What is Mixed Economy?
4. What is Micro Economics?
5. What is direct demand?
6. What is income demand?
7. What is market demand?
8. Why demand curve slopes downward?

Long Answer Questions

1. Explain fundamental problems of Economics. Suggest measures to

overcome fundamental economic problems
2. Give a note on the Economic System in different economies.
3. Discuss the significance of production possibility curve in Business Decisions
4. Explain the causes of Economic Growth
5. Compare and contrast Microeconomics and Macroeconomics
6. Discuss the role of government in Managerial Economics.

43
 UNIT II

Syllabus

CONSUMER AND PRODUCER BEHAVIOUR - Market –

Demand and Supply – Determinants – Market equilibrium –
elasticity of demand and supply – consumer behavior –
consumer equilibrium – Approaches to consumer behavior –
Production – Short - run and long - run Production
Function–Returns to scale – economies Vs diseconomies of
scale – Analysis of cost –Short - run and long - run cost
function – Relation between Production and cost function.
 UNIT - 02

Contents

Learning objectives ............................................................................................. 45

2.1. Elasticity of demand ......................................................................... 45

2.2. Demand forecasting ......................................................................... 53

2.3. Supply .................................................................................................... 63

2.4. Consumer’s equilibrium with utility approach ..................... 71

2.5. Utility and consumer behaviour .................................................. 78

2.6. Production Function ........................................................................ 94

2.7. Cost ...................................................................................................... 105

2.8. Market................................................................................................. 114

LEARNING OUTCOME ..................................................................................... 122

Short Answer Questions ................................................................................. 122

Long Answer Questions .................................................................................. 122

44
Learning objectives
1. Define the elasticity of demand
2. To understand the importance of Demand Forecasting
3. To explain the concept of supply
4. To explain law of supply
5. Describe to explain concept of utility
6. To impart knowledge about Production function
7. To discuss about Market
8. To discuss various kinds of Market

2.1. Elasticity of demand

Alfred Marshall, the great neo-classical economist, developed a special measure for the
response of one variable, such as quantity demanded, to change in another variable, such as
price in the year 1890. It is known as elasticity.Elasticity is a measure of market sensitivity
of demand.

The demand rises or falls with the change in Price. Elasticity means sensitiveness or
responsiveness of demand to the change in price.

This change, sensitiveness or responsiveness, may be small or large. A change in the price
of salt will not result in considerable change in the quantity demanded for salt. The
responsiveness or sensitivity to the price change is less in this case. If there is slight
change in price of apple, there is lots of changes in the demand for apple .The demand is
‘inelastic ‘in the first case and ‘elastic’ in the second case.The law of demand describes the
relation between price change and quantity change. The elasticity of demand quantifies
such changes and gives us an accurate measure of how consumers respond to price change.

“The elasticity (or responsiveness) of demand in a market is great or small according as the
amount demanded increases much or little for a given fall in price, and diminishes much or
little for a given rise in price”. – Dr. Marshall.

45
 2.1.2. Kinds of Elasticity of Demand

Based on the determinants of Demand, the elasticity of demand is classified.

The Elasticity of Demand is classifies as

A. Price Elasticity of Demand

B. Income Elasticity of Demand
C. Cross Elasticity of Demand

2.1.2.1 Price Elasticity of Demand

The change in the quantity demanded with change in the price is called as Price Elasticity of
Demand. The variables such as income, price of other products and taste are considered to
be constant. It is measured as a percentage change in the quantity demanded divided by the
percentage change in price. Therefore,

Change in Quantity×100/Original Quantity

Ep =
Change in Price×100/Original Price

Change in Quantity Change in Price

Ep= X
Original Quantity Original Price

(i) Perfectly Elastic Demand (EP = ∞)

If the quantity demanded increases infinitely (or by unlimited quantity) with a slight
decrease in price or quantity demanded falls to zero with a slight increase in price It is
Perfectly Elastic Demand or infinite elasticity. It does not have practical importance as it is
rarely found in real life.

46
In the given figure, price and quantity demanded are measured along the Y-axis and X-axis
respectively. The demand curve PD is a horizontal straight line parallel to the X-axis. It
shows that negligible change in price causes infinite fall or rise in quantity demanded.

(ii). Perfectly Inelastic Demand (EP = 0)

The demand is perfectly inelastic if the demand remains constant irrespective of the price
(i.e. price may rise or fall). Thus it is also called zero elasticity. It also does not have practical
importance as it is rarely found in real life.

In the given figure, price and quantity demanded are measured along the Y-axis and X-axis
respectively. The demand curve QD is a vertical straight line parallel to the Y-axis. It shows
that the demand remains constant whatever may be the change in price. For example: even

47
after the increase in price from P1 to P3 and fall in price from P3 to P1, the quantity
demanded remains at OQ

(iii). Relatively Elastic Demand (EP> 1)

The demand is said to be relatively elastic if the percentage change in demand is morethan
the percentage change in price.. There is a greater change in demand there is a small change
in price. It is also called highly elastic demand or simply elastic demand. For instance if the
price falls by 10% and the demand rises by more than 10% (may 25%), then it is a case of
elastic demand. The demand for luxurious goods such as car, television, furniture, etc. is
considered to be elastic

In the above figure, if the small fall in price from P2 to P1 happens ,there is large increase in
demand from Q1 to Q2 . The increase in demand is more than proportionate to fall in price.

(iv). Relatively Inelastic Ep<1

The change in demand is less than proportionate to the change in price is relatively
Inelastic demand. For instance, if the price falls by 5% , there is less percentage increase in
the demand of product by 2%.It is also called less elastic or simply inelastic demand.

48
In the given figure, there is greater fall in price from P2 to P1. The resulting change in
quantity demanded from Q1 to Q2 is very small. Thus less elastic in nature.

(v).Unitary Elastic Demand Ep =1

When the change in price and resulting change in the quantity demanded is proportionate
,it is known as Unitary Elastic Demand. For example ,If the price falls by 2 % , the quantity
demanded will increase by 2 % .This type of demand is Unitary and it rarely occurs in real
life.

In the above figure, the price falls from P2 to P1, the quantity demanded changes from Q1
to Q2. The change of price (P2 to P1) is equal to change in quantity demanded (Q1 to Q2)

49
 Price Elasticity plays a crucial role making Business decisions.

This can be illustrated by the case of Airline services. They fill the business class and the
other empty seats are being filled with other travellers. This service provided to two
groups of customers based on the price sensitivity or elasticity. Business class customers
are charged high price and other travellers are charged low price. By doing this, firm is able
to maximise the profit.

High elastic consumers are travellers who are sensitive to price and Low elastic consume
the are insensitive. The firm must not reduce the price for attempting to increase the
demand for Low elastic consumers. Low elastic business travellers must not buy cheap
tickets. The price fall must be done only for high elastic travellers. The Airlines carry out
“Price Discrimination Strategy” for managing the two groups of consumers. By this way,
they are able to charge two different pricing for two groups of consumers for the same
airline service. The concept of Price elasticity is used in business to separate customers
with different elasticity of demand.

2.1.2.2. Income Elasticity of Demand

For many Economic decisions, it is important to estimate income elasticity of demand. For
instance if the government is planning new rail network, they have to know whether the
income of individual person in an economy can allow them to use.
Income Elasticity is defined as the percentage change in quantity demanded due to
percentage change in the income.
It is denoted as
% change in quantity demanded
Income Elasticity Ey = ________________________
% change in income

The income Elasticity shows degree of responsiveness/sensitivity of demand for a

commodity to the variation of income.

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The Income Elasticity for product can be positive or negative based on the kind of goods i.e
Normal good or inferior.

Normal goods have positive income elasticity. The change in income causes increase in
quantity demanded. Normal goods like clothing, newspaper, food etc. quantity demanded
will be directly proportional to income.

Luxury goods are expensive goods. They have positive income elasticity.

An inferior good will have negative income elasticity. The increase in the income will
decrease the quantity demand. For instance, cheap goods.

Income elasticity can be one when the percentage change in income is equal to percentage
change in quantity demanded.

The firm has to know about income elasticity for salesforecast, diversification, pricing etc.

2.1.2.3. Cross Elasticity of Demand

If the change in quantity demanded of one good is proportionate to price of the another
goods, it is known as Cross Elasticity.
“The cross elasticity of demand is the proportional change in the quantity of X good
demanded resulting from a given relative change in the price of a related good Y” Ferguson

2.1.3. TYPES OF CROSS ELASTICITY OF DEMAND:

(i). Positive:

When goods are substitute of each other then cross elasticity of demand is positive. In
other words, when an increase in the price of Y leads to an increase in the demand of X. For
instance, with the increase in price of tea, demand of coffee will increase.

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(ii). Negative:

In case of complementary goods, cross elasticity of demand is negative. A proportionate

increase in price of one commodity leads to a proportionate fall in the demand of another
commodity because both are demanded jointly. In fig. 22 quantity has been measured on OX-
axis while price has been measured on OY-axis. When the price of commodity increases from
OP to OP1 quantity demanded falls from OM to OM 1. Thus, cross elasticity of demand is
negative.

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(iii). Zero:

Cross elasticity of demand is zero when two goods are not related to each other. For
instance, increase in price of car does not affect the demand of cloth. Thus, cross elasticity
of demand is zero. For example: Bread and Soda
It has been shown in fig.

Therefore, it depends upon substitutability of goods. If substitutability is perfect, cross

elasticity is infinite; if on the other hand, substitutability does not exist, cross elasticity is
zero. In the case of complementary goods like jointly demanded goods cross elasticity is
negative. A rise in the price of one commodity X will mean not only decrease in the quantity
of X but also decrease in the quantity demanded of Y because both are demanded together.

2.2. Demand forecasting

The process of estimating the quantity of a product or service that consumers will
purchase. Demand forecasting involves techniques including both formal and informal
methods, namely educated guesses, and quantitative methods, such as the use of historical
sales data or current data from test markets. Demand forecasting is significant in making

53
pricing decisions, in assessing future capacity requirements, or in making decisions on
whether or not to enter a new market.

2.2.1. Definitions

According to Cundiff and Still “Demand Forecasting is an estimate of Demand during a

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

In the words of Prof. Philip Kotler. “The company (sales) forecast is the expected level of
company sales based on a chosen marketing plan and assumed marketing environment”

2.2.2. Steps involved in demand forecasting

(i). Identification of business objectives:

In the first stage we should know what is the objective of forecasting.

We should get to know the expected outcome from forecasting. Estimation of factors like
quantity and composition of demand for goods, price to be quoted, sales planning and
inventory control etc., are done in the first stage.

(ii). Determining the nature of goods under consideration:

Different category of goods has their own distinctive demand. Example capital goods,
consumer durables and non-durables good. The category in which a goods fall influence
the way it should be estimated.

(iii). Selecting a proper method of forecasting:

There are various kinds of methods for demand forecasting. The best suited method for the
good must be selected for forecasting.

(iv). Interpretation of results:

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The forecasting that is done and presented by the managerial economist should be
interpreted in elaborate manner. That means it should be easy to understand by the top
management.

2.2.3. Objectives of demand forecasting

The objective of demand forecasting is two folds short term objectives and long term
objectives

a) Short term Objectives

(i) Formulating production policy:

The demand forecasting in short term enhances in covering the gap between the demand
and supply of the product. The demand forecasting helps in estimating the requirement of
raw material in future, so that the regular supply of raw material can be maintained. It
further helps in maximum utilization of resources as operations are planned according to
forecasts

(ii) Formulating price policy:

The formulation of price by the organisation based on demand is enhanced by Demand

Forecasting. For illustration when an economy enters into depression or recession phase,
the demand for products falls at that point of time the organization sets low prices of its
products.

(iii) Controlling sales:

Demand forecasting helps in setting sales targets, which act as a basis for evaluating sales
performance. An organization make demand forecasts for different geographic regions and
fix sales targets for each region accordingly.

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(iv)Arranging finance:

Arranging finance implies that the financial requirements of the enterprise are estimated
with the help of demand forecasting. This helps in ensuring proper liquidity within the
organization.

b. Long-term Objectives:

(i). Deciding the production capacity:

With the help of demand forecasting, an organization can determine the size of the plant
required for production. The size of the plant should conform to the sales requirement of
the organization.

(ii). Planning long-term activities:

Demand forecasting helps in planning for long term. For instance, if the forecasted demand
for the organization’s products is high, then it may plan to invest in various expansion,
growth and development projects in the long term.

2.2.4. Demand forecasting techniques

A.Opinion polling method

a)Collective opinion Survey:

Sales personnel are closest to the customers and know the pulse of the market. Thus they
are most suitable people to assess consumer’s reaction to company's products. A
salesperson makes an estimate of the expected sales in their area, territory, state and/or
region, These estimates are collated, reviewed and revised. In accordance to the product
design, feature sand price is decided. Hence collective opinion survey forms the basis of
market Analysis and demand forecasting.

The simplicity of this method is the main advantage. This method suffer from following
weakness

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 1. Demand forecasted by individual salespersons to obtain total demand of the
country may be risky as each person has knowledge about a small segment of
market only
2. Salesperson may not prepare the demand estimation with theutter seriousness
and care
3. Salesperson may not have the required knowledge and experience because of
limited experience

b) Survey of Customers Intention

Demand forecasting is to carried out by survey on what consumers prefer and intend to
buy. If the product is sold to a few large industrial buyers, survey would involve
interviewing them. Whereas for a consumer durable product, a sample survey is carried
out about what they are planning or intending to buy. It is not east to query all people
through direct contact or through printed questionnaire by mail.

These surveys serve useful purpose in establishing relationships between

a) demand and price

b) demand and income of consumers
c) Demand and expenditure on advertisement etc.

This method is preferred when bulk of the sales made to institutions and industrial buyers
and only a few of them have to be contacted.

Disadvantages are. The respondent may not be able to give precise idea about their
intentions particularly when alternative products are available in the market.

c) Delphi Method

The Delphi technique was developed at RAND Corporation in the 1950s. Delphi method is a
group (members)process which aims at achieving a `single opinion of the members on the

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subject. In this method experts in the field of marketing research and demand forecasting
are engaged in conducting opinion poll, market survey, studying economic conditions etc.

Based on the above, demand forecast is worked out in following steps:

a) Administrator sends out a set of questions in writing to all the experts on the
panel, who are requested to write back a brief predication.
b) Written predictions of experts are collected and combined, edited and
summarized together by the administrator.
c) Based on the summary, administrator designs a new set of questions and gives
them to the same experts who answer back again in writing.
d) Administrator repeats the process of collecting, combining, editing and
summarizing the responses.
e) Steps 3 and 4 are repeated by the administrator to experts with diverse
backgrounds until they come to one single opinion.
f) If there is divergence of opinions and conclusions, administrator has to sort it
out through mutual discussions. Administrator has to have the necessary
experience and background as he plays a key role in designing structured
'questionnaires and synthesizing the data.

d) Nominal Group Technique

This technique was developed by Delbecq and VandeVen. This is a further modification of
Delphi method of forecasting. A panel of 3-4 groups of up to 10 experts are formed and
allowed to interact, discuss and rank all the suggestions in descending (highest to lowest)
order as per the following procedure:

Experts sit around a table in full view of one another and are asked to speak to each other.
An administrator handover copies of questionnaire needing a forecast and each expert is
expected to write down a list of ideas about the questions. After everyone has written
down their ideas, administrator asks each expert to share one idea, out of own list.

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The idea shared is written on the `flip chart' which everyone can see. Experts give ideas in
rotation until all of them are written on the `flip chart'. No discussion takes place in this
phase and usually 15 to 25 ideas emerge from this format. In the next phase, experts
discuss ideas presented by them. Administrator ensures that all ideas have been
adequately discussed. During discussions similar ideas are combined. This reduces the
number of ideas.

After completing group discussions, experts are asked to give in writing ranks to ideas
according to their perception of priority

B.Statistical methods

a)Trend projection method

This technique assumes that past years’ demand pattern will be continued in the future
also. Basing on the historical data that means previous year’s data is used to predict the
demand for the future. In this trend projection method, previous year’s data is presented
on the graph and future demand is estimated.

b) Regression Analysis

Past data is used to establish a functional relationship between two variables.

For Example, demand for consumer goods has a relationship with income of Individuals
and family size; demand for tractors is linked to the agriculture income and demand for
cement, bricks etc. are dependent upon value of construction contracts at any time.
Forecasters collect data and build relationship through co-relation and regression analysis
of variables.

c) Econometric Models

Econometric models are more complex and comprehensive as this model uses
mathematical and statistical tools to forecast demand. This model takes various factors

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which affect the demand. For example, demand for auto service dependent upon the
population of the city, geographical area, industrial units, their location etc.

It is not easy to locate one single economic indicator for determining the demand forecast
of a product. Invariably, a multi-factor situation applies Econometric Models, although
complex, are being increasingly used for market analysis and demand forecasts.

c) Simple Average Method

Simple Average Method is the first and commonly used method among the quantitative
techniques for demand analysis .A simple average of all past periods - simple monthly
average of all consumption figures collected every month for the last twelve months or
simple quarterly average of consumption figures collected for several quarters in the
immediate past and studied.

2.2.5. Factors influencing demand forecasting:

Demand forecasting is a proactive process that helps in deciding what products are needed
where, when, and in what quantities. There are a number of factors that affect demand
forecasting.

The various factors that influence demand forecasting are

i. Types of Goods:

Goods can be producer’s goods, consumer goods, or services. Goods can be established and
new goods. Established goods are those goods which already exist in the market, whereas
new goods are those which are yet to be introduced in the market.

Information regarding the demand, substitutes and level of competition of goods is known
only in case of established goods. On the other hand, it is difficult to forecast demand for
the new goods. Therefore, forecasting is different for different types of goods. Type of
goods affect demand in larger extent.

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ii. Competition Level:

In a highly competitive market, demand for products also depend on the number of
competitors existing in the market. Moreover, in a highly competitive market, there is
always a risk of new entrants. In such a case, demand forecasting becomes difficult and
challenging.

iii. Price of Goods:

Price of the goods acts as a major factor that influences the demand forecasting process.
The demand forecasts of organizations are highly affected by change in their pricing
policies. In such a scenario, it is difficult to estimate the exact demand of products.

iv. Level of Technology:

Technology constitutes an important factor in obtaining reliable demand forecasts. If there

is a rapid change in technology, the existing technology or products may become obsolete.
For instance, there is a high decline in the demand of floppy disks with the introduction of
compact disks (CDs) and pen drives for saving data in computer. In such a case, it is difficult
to forecast demand for existing products for future.

v. Economic Viewpoint:

Economic viewpoint play a crucial role in obtaining demand forecasts. For example, if there
is a positive development in an economy, such as globalization and high level of
investment, the demand forecasts of organizations would also be positive.

vi. Time Period of Forecasts:

The accuracy of demand forecasting depends on its time period thus crucial factor that
affect demand forecasting.

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2.2.6. Significance of demand forecasting:

The significance of demand forecasting is shown in the following points

(i) Preparing the budget:

Demand forecasting plays a crucial role in making budget by estimating costs and expected
revenues. For example, an organization has forecasted that the demand for its product,
which is priced at Rs. 10, would be 10, 00, 00 units. In such a case, the total expected
revenue would be 10* 100000 = Rs. 10,00,000. In this way, demand forecasting enables
organizations to prepare their budget.

(ii) Fulfilling objectives:

Every business unit starts with certain pre-decided objectives. Demand forecasting helps in
fulfilling these objectives. An organization estimates the current demand for its products
and services in the market and move forward to achieve the set goals

(iii) Stabilizing employment and production:

An organization to control its production and recruitment activities by demand forecasting.

Producing according to the forecasted demand of products helps in avoiding the wastage of
the resources of an organization. This further helps an organization to hire human resource
according to requirement. For example, if an organization expects a rise in the demand for
its products, it may opt for extra labour to fulfil the increased demand.

(iv) Expanding organizations:

Demand forecasting helps in deciding about the expansion of the business of the
organization. If the expected demand for products is higher, then the organization may plan
to expand further. On the other hand, if the demand for products is expected to fall, the
organization may cut down the investment in the business.

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(v) Taking Management Decisions:

In making critical decisions, such as deciding the plant capacity, determining the
requirement of raw material, and ensuring the availability of labor and capital, demand
forecasting plays a significant role.

(vi)Evaluating Performance:

Demand forecasting helps in making corrections. For example, if the demand for an
organization’s products is less, it may take corrective actions and improve the level of
demand by enhancing the quality of its products or spending more on advertisements.

(vii)Helping Government:

Demand F0orecasting enables the government to coordinate import and export activities
and plan international trade.

2.3. Supply
2.3.1. Introduction
In this Module, I shall introduce you to the concept of Supply
Supply is the amount of the stock a seller is ready to sell at certain point of time at certain
price Supply is the amount of stock that is brought to the market for selling.
Supply and stock is sometimes confused. Stock is back of supply and is potential supply.

Total quantity which can be offered for sale at certain price is supply but stock is total
amount that is offered for sales when conditions are favourable. The quantity that actually
comes out is the supply. The stock will change into supply and vice versa according as the
market price rises or falls. In case of perishable articles, like fresh milk and vegetables,
there is no difference between stock and supply. The entire stock is supply and has to be
sold off for unless it is disposed of quickly, it will perish.

If the price of goods rises, the seller will offer more goods and if the price falls down, the
seller will offer less to sell.
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2.3.2. Factors affecting supply of a commodity

There are various factor that influence supply of commodity. Some of them are

A. Price of the Commodity

At a higher price, producer offers more quantity of the commodity for sale and at a lower

price, less quantity of the commodity is offered for sale. There is a direct relationship

between price and quantity supplied as shown by law of supply.

B.Price of Related Good

Supply of a commodity depends upon the prices of its related goods, specially substitute
goods. If the price of a commodity remains constant and the price of its substitute good
increases, the producers would prefer to produce substitute good as a result, the supply of
commodity will decrease and that of substitute good will increase. This will shift the supply
curve of good leftward. Thus, an increase in the price of substitute good will lead to
decrease in supply curve of the other good and vice-versa.
C.State of Technology

If there is a change in the technique of production leading to a fall in the cost of production,

supply of commodity will increase.

D. Prices of Inputs

A change in the cost of production, i.e., prices of factors of production also affects the supply
of a commodity.

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E.Government Policy

Government’s policy also affects the supply of a commodity. If heavy excise taxes are
imposed on a commodity, it will discourage producers and as a result, its supply will
decrease. It is because excise duty is levied on the total production cost of a firm.

2.3.3. The supply schedule and the supply

Supply schedule is a tabular statement that gives the law of supply, i.e., it gives the different

quantity supplied of a commodity at different prices per unit of time. A hypothetical supply

schedule of milk is given in

The supply schedule can be represented in the form of a curve, as given below

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Quantities of milk offered for sale are measured along OX and prices along OY. The supply
curve SS’ slopes upwards as we go from the left to the right. This means that as the price
rises, more is being offered for sale and vice versa.

2.3.4. Law of supply

From a study of the supply schedule and supply curve, we can formulate the law of supply

“In a given market, at any time, the quantity of any goods which people are ready to offer
for sale generally varies directly with the price.”

The law of supply may be put in another way. “Other things remaining the same, as the
price of a commodity rises, its supply is extended, and as the price falls, its supply is
contracted.”
When prices are low many individuals and firms do not find it worth-while to sell, for their
costs may be high and profits will be low. But, when prices rise, they are in a position to
carry on production with profit and sell more. Higher prices mean higher profits. The
desire for larger profits carries production to the farthest limit yielding a net profit.

Reasons Behind Upward Sloping Supply Curve

The main reasons behind an upward sloping supply curve are:

(a) Law of Diminishing Marginal Productivity. The law states that as more units of the

variable factor are employed, the addition made to total production falls, i.e., cost of

production rises. Thus, more quantity is supplied only at higher prices so as to cover

the rise in cost of production.

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(b) Goal of Profit Maximisation. The aim of producers is to maximise profits. The aim
can be achieved by raising the price of the goods. At higher price producers increase the
supply of the good.

2.3.5. Elasticity of supply

Alfred Marshall developed the concept of elasticity of supply. Price elasticity of supply is

defined as the responsiveness of quantity supplied of a commodity to changes in its own price.

The value of elasticity of supply will give the degree or quantity of change in supply to a

change in price. It is calculated as:

eS or ES =Percentage Change in Quantity Supplied/ Percentage Change in Price

The elasticity of supply can be positive or negative.

The positive sign indicates that price and quantity supplied of a good are positively

related, i.e., greater units of the good will be placed in the market only at higher prices

and vice-versa.

There are many factors that determine the price elasticity.

The important factors affecting price elasticity of supply are:

1. Time Factor. The longer the time period, more is the time available to adjust the supply

more elastic is the supply curve.

2. Nature of the Good. Inelastic supply in case of perishable goods (e.g. milk, bread, etc.)

because its supply can neither be increased nor be decreased within a short period.

Elastic supply in case of durable goods.

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3. Production Capacity. If unlimited production capacity exists (i.e., production can be

increased easily), then there is elastic supply. If limited production capacity exists,

then there is inelastic supply.

4. Production Methods and Techniques. If an industry uses complicated methods and

techniques of production, supply of the commodity produced by that industry will be

relatively inelastic. On the contrary, if an industry uses simple methods and techniques

of production, supply of the commodity produced by that industry will be relatively

elastic.

5. Stage of Laws of Return. If the law of diminishing return is applied on the production

of a commodity, elasticity of supply for such a commodity will be inelastic. On the

contrary, if the law of increasing return is applied on the production of a commodity,

supply of such a commodity will be elastic.

6. Future Price Expectation. If the producers expect that the price will rise in future,

then they will supply less quantity in the market presently. Thus, supply will become

inelastic. If the producers expect that the price will fall in the future, supply will be

more elastic.

7. Number of Products Being Produced by an Industry. If an industry is producing

many products, supply is elastic as the producers can switch over to the production

of other goods and vice versa

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2.3.6. Kinds of elasticity of supply

There are five types of price elasticity of supply, including perfectly and relatively inelastic,
unit elastic, and perfectly, and relatively elastic. Here’s an example of each of the five price
elasticity of supply curves:

a. Perfect Inelastic Supply

Perfect inelastic supply is when the Es formula equals 0. That is, there is no change in
quantity supplied when the price changes. Examples include products that have limited
quantities, such as land or painting from deceased artists.

b. Relatively Inelastic Supply

The PES for relatively inelastic supply is between 0 and 1. That means the percentage
change in quantity supplied changes by a lower percentage than the percentage of price
change. Inelastic goods include nuclear power, which has a long lead time given the
construction, technical know-how, and long ramp-up process for plants

c. Unit Elastic Supply

Unit Elastic Supply has a PES of 1, where quantity supplied change by the same percentage
as the price change.

d. Relatively Elastic Supply

A price elasticity supply greater than 1 means supply is relatively elastic, where the
quantity supplied changes by a larger percentage than the price change. An example would
be a product that’s easy to make and distribute, such as a fidget spinner. The resources to
make additional spinners are readily available and the total cost would be minimal to ramp
production up or down.

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e. Perfectly Elastic Supply

The PES for perfectly elastic supply is infinite, where the quantity supplied is unlimited at a
given price, but no quantity can be supplied at any other price. There are virtually no real-
life examples of this, where even a small change in price would dissuade, or disallow,
product makers from supplying even a single product.

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2.3.7. Measurement of elasticity of supply

There two main methods for measuring elasticity of supply.

A. Percentage Method

This is also called ‘Proportionate Method’. The percentage change in quantity supplied and
percentage change in price. This is the most common method of measuring elasticity of
supply.

B. Geometric Method

Elasticity is supply is measured at point of supply curve. This method is called Arc method
or Point method.

2.4. Consumer’s equilibrium with utility approach

2.4.1 Introduction

Consumer is one who buys and consumers goods and services for satisfaction of wants.

Consumers needs are unlimited. They demand goods and services to satisfy them.

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Objective of a consumer is to get maximum satisfaction from spending his income on
various goods and services, given prices.

Consumer demands a commodity because they derive or expect utility from the product.
The expected utility from the commodity is the basis for demand.

2.4.2. The concept of utility

The term ‘Utility’ means ‘usefulness. Economists use the term utility to describe the
pleasure or satisfaction that a consumer obtains from his or her consumption of goods and
services. Utility is a subjective measure of pleasure or satisfaction that varies from
individual to individual according to each individual's preferences. For example, if an
individual's choices for an evening are to watch television, go out to dinner, go shopping or
go to a movie, then, depending on that individual's preferences, he or she will attribute
different levels of utility to each of these activities. Of course, it is not possible to measure
utility, nor is it possible to claim that one individual's utility is higher than another's. Utility
is just a unit less measure that economists have found useful in their explanation of
consumer choice.

“Utility is the power of commodity to satisfy human wants.” –Prof Waugh

A commodity has utility for a consumer even when it is not consumed. Further, the same
commodity has different utility for different persons, and also to the same person at
different points of time. Utility is essentially a subjective concept depending upon the
intensity of consumer’s desire or want for that commodity at that time. Thus, utility differs
from person to person, place to place and time to time.

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A.Characteristics of Utility

a. Utility is Psychological:

Utility of a commodity depends on a consumer’s mental attitude and assessment regarding

its power to satisfy his particular want. Thus, utility of a commodity may differ from person
to person.

For instance: A consumer who is fond of burger may find a high utility in burgers in
comparison to the consumer who has no liking for burgers. Similarly, a strictly vegetarian
person has no utility for mutton or chicken.

b.Utility has no Ethical or Moral Significance:

A commodity which satisfies any type of want, whether moral or immoral, socially
desirable or undesirable, has utility, i.e., a knife has utility as a household appliance to a
housewife, but it has also a utility to a killer for stabbing some body.

c.Utility is always individual and relative:

Utility of a commodity varies in different situations in relation to time and place. Even the
same consumer may derive a higher or lower utility for the same commodity at different
times and different places. For example—a person may find more utility in woollen clothes
during the winter than in summer or at Kashmir than at Chennai.

d.Utility cannot be Measured Objectively:

Utility being a subjective phenomenon or feeling of a consumer cannot be expressed in

numerical terms. So utility cannot be measured cardinally or numerically. It cannot be
measured directly in a precise manner. Professor Marshall has however, unrealistically
assumed cardinal measurement of utility in his analysis of demand.

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e. Utility Depends on the Intensity of Want:

Utility is the function of intensity of want. A want which is unsatisfied and greatly intense
will imply a high utility for the commodity concerned to a person. But when a wan is
satisfied in the process of consumption it tends to experience a lesser utility of the
commodity than before. Such an experience is very common and it is described as a
tendency of diminishing utility experienced with an increase in consumption of a
commodity. In other words, the more of a thing we have, the less we want it.

f. Utility is Different from Pleasure:

A commodity may have utility but its consumption may not give any pleasure to the
consumer, e.g., medicine or an injection. An injection or medicinal tablet gives no pleasure,
but it is necessary for the patient

g. Utility is also Distinct from Satisfaction:

Utility and satisfaction, both are though inter-related but they have not been considered as
the same in a strict sense.

2.4.3. Types of utility:

(i). Form Utility:

When utility is created and or added by changing the shape or form of goods, it is form
utility. When a carpenter makes a table out of wood, he adds to the utility of wood by
converting it into a more useful commodity like furniture. He has created form utility.

(ii). Place Utility:

When the furniture is taken from the factory to the shop for sale, it leads to place utility.
This is because it is transported from a place where it has no buyers to a place where it
fetches a price.

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(iii). Time Utility:

A farmer stores his yield and sell it when its price increases. Thus he creates time utility for
his yield.

(iv). Service Utility

Some professionals satisfy human wants through their services, they create service utility.
Ex doctors, teachers, engineers etc. It acquires through specialised knowledge and skills.

(v). Possession Utility

Utility is changing the possession of a community. For instance, English book has more
utility to a student than a layman.

(vi).Knowledge Utility

The utility of the commodity raises with increase in knowledge about its use then it is the
creation of knowledge utility. This is through advertisement, propaganda etc.

(vii).Natural Utility

Free goods available namely water, air, land etc have a capacity to satisfy human needs.
They have Natural Utility.

2.4.4. Measurement of utility

Utility is a psychological concept. This is different for different people. Therefore, it cannot
be measured directly. Professor Marshall has said that “Utility can be measured and its
measuring rod is ‘money. The price which a consumer is ready to pay for good is practically
its price. Nobody will be prepared to pay more than the utility which we derive from the
article.

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The basic reason for measuring utility arises to study the demand behaviour of individual
consumer and thus the whole market. The consumer compares utility be the price he pays
for the good. There are two approaches in economic theory by which utility are measures.

a. Cardinal Approach
b. Ordinal Approach

A. Cardinal Utility Approach

The numbers 1,2,3 etc are cardinal numbers. Cardinal utilities are measured in cardinal
numbers/units. The units can be subtracted /added/compared. For example, a man buys
tea instead of soft drink. The satisfaction he derives in drinking tea is more in tea than soft
drinks. Thus he gets more utility in tea. The utility can be measured in terms of units. Tea
gives the consumer 20 units of utility and soft drinks gives 10 units of utility.

Pareto, an Economist critised the approach by stating that cardinal utility cannot be
quantifiable. He further stated that it has to be replaced scale of preferences. His approach
was supported by Prof Hicks and Allen.

B. Ordinal Approach to Utility

Ordinal Approach to Utility is purely subjective in nature. The utility is measured not in
numbers but in scale of preference. Utility of two or more sources are ‘ranked’ or ‘ordered
‘in relation to each other. This utility varies from person to person so it cannot be
compared.

According to Marshall, the utility of a commodity can be measured in terms of money. If

consumer is willing to pay Rs.4 for apple and Rs 2 for orange, then the utility of an orange is
equal to Rs.2 and that of an apple is Re. 4 to him.

It means that the utility of one apple is equal to 2 oranges. In other words, the utility of an
apple to the consumer is twice that of the orange. But this analysis does not hold when
there are two different consumers offering two different prices for the same commodity

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2.4.5. Kinds of utility

(i). Marginal Utility(MU):

Marginal utility is the utility derived from the last or marginal unit of consumption. It refers
to the additional utility derived from an extra unit of the given commodity purchased,
acquired or consumed by the consumer. According to Prof. Boulding—”The marginal utility
of any quantity of a commodity is the increase in total utility which results from a unit
increase in its consumption.”

(ii). Total Utility(TU).:

Total Utility is the utility from all units of consumption. According to Mayers—”Total Utility
is the sum of the marginal utilities associated with the consumption of the successive units.

(iii). Average Utility(AU):

Average Utility is that utility in which the total unit of consumption of goods is divided by
number of Total Units. The Quotient is known as Average Utility.

Let us take a hypothetical example, a boy consumes biscuits to satisfy his hunger .It is
assumed that consumer consumes without any time gap and the intensity of hunger is
consumer decreases as he consumes additional unit .

Units of Biscuits MU TU AU

1 st 18 18 18

2nd 16 (18+16)34 (34/2)17

3rd 12 46 15.33

4th 8 54 13.5

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 5th 4 58 11.6

6th 0 58 9.6

7th -4 54 7.7

8th -8 46 5.75

The above table illustrative depicts marginal utility and average utility is decreasing. The
Total utility is increasing initially till 5 th unit of biscuit and the utility starts decreasing as
additional biscuits are consumed.

When a consumer wants to buy a commodity, he decides on the amount to be purchase.

Two approaches are used for deciding on the amount to be purchased.

These are:

1. Utility approach
2. Indifference curve approach

2.5. Utility and consumer behaviour

2.5.1. Law of Diminishing

The law of diminishing marginal utility states that as the stock of a commodity increases
with the consumer, its marginal utility to the consumer decreases. It can eventually fall to
zero and become even negative. The law describes a familiar psychological tendency of the
human beings. Marshall says that “the additional benefit which a person derives from a
given increase in his stock of a thing diminishes with every increase in the stock that he
already has.”

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Assumptions of the Law of DMU.

The law of DMU holds good when the following assumptions are satisfied:

1. Standard unit of measurement is used. If the unit of measurement is very large or very
small, then the law will not hold. Examples of inappropriate units are: rice measured in
grammes, water in drops, diamonds in kilograms.

2. Homogeneous commodity. All units of the commodity consumed are homogeneous and
perfect substitutes.

3. Continuous consumption. The law of DMU holds only when consumption of successive
units of a commodity is without a time gap.

4. Mental and social condition of the consumer must be normal. The law will hold
when consumer’s mental condition is normal. His income and tastes are unchanged and his
behaviour is rational

when the consumer consumes the first apple, Marginal Utility is 10, but the second apple
gives 8 units of Marginal Utility and so on. In this way Marginal utility diminishes, as he
goes on consuming more and more apples.

A point is reached when an additional unit consumed will not yield any utility.

The Marginal Utility becomes zero only when the wants intensity is nil, as it is fully
satisfied. It must however, be remembered that though Marginal Utility varies inversely

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with the acquisition or consumption of the stock of a given commodity, the variation is not
necessarily proportionate or uniform And if any such thing is observed, it is incidental. Any
further addition to consumption after zero marginal. Utility causes a negative Marginal
Utility. Negative Marginal Utility indicates dis-utility or dis-satisfaction resulting from
excessive consumption of a commodity. Schedule in its ascending order, it would be seen
that with a decrease in the stock of consumption, the Marginal Utility increases. Hence,
when one wants to increase, the marginal utility of a commodity, he should consume or
purchase less of it.

Ox and oy are the two axes. A long ox are represented the units of the commodity. ‘apples’
and a long oy is measured the marginal utility corresponding to the consumption of each
unit. Ab is the utility curve. Pd is the utility when one apple is taken. Qe is the additional
utility when two apples are taken. Qe is less than pd. The additional utilities of other
successive units are rf.

It can be seen that at each step, the additional utility becomes smaller and smaller at the s
point there is no addition at all i.e., the marginal utility is zero and then it becomes negative

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which is represented here below the axis of x. To understand clearly we should study initial
utility, total utility, zero utility and negative utility

Initial Utility:

It is the utility of the initial or the first unit of the commodity which we consume the
column 3 of the above Utility Schedule Table. It gives the total utility at each step. For
example—If we consume one apple the total utility is 10; if we consume two, the Total
Utility is 18 and so on.

Zero Utility:

When the consumption of a unit of a commodity makes no addition to the Total Utility, then
it is the point of Zero Utility.

Negative Utility:

If the consumption of a commodity is carried to excess; then instead of giving any

satisfaction it may cause dis-satisfaction. The utility in such cases will be negative. In the
table given above the Marginal Utility of the 5th and 6th units is negative

Exception of Law

To a Wine Taker (drunkard) the Utility of Additional Cup of Wine Increases

In the case of good poetry and good music, it has been experienced that a repeat hearing
gives a better satisfaction than the first one. Hence, the Law of Diminishing Marginal Utility
may not be applicable here. But, we can say that there is a limit to it, as several repeated
hearings of the same music or poetry proves to be monotonous and ultimately yields dis-
unity, So it can be said that it is not a genuine exception to the lawthe Marginal Utility of
money does not diminish as one never gets satisfied even though one gets more and more
of it. But this is not a real exception because money does not satisfy a want directly, (and
Money implies only purchasing power) Certain hobbies like stamp collection, collection of

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antiques, collection of old coins etc., every additional unit gives more pleasure, i.e., the
Marginal Utility tends to increase.

This is not doubt a true statement, but it is not a genuine exception to the Law of
Diminishing Utility because in such cases, the homogeneity condition of the law is violated
More reading gives more knowledge, one would get more and more satisfaction from every
additional book.

But here it can be said that it is not a real exception to the law as the homogeneity
condition is violated. Knowledge and satisfaction increases by reading different books and
not the same one, over and over again.

Uses

The relationship between diminishing marginal utility of a good and its price helps in
explaining the determination of its price in the market. It also helps in explaining
paradoxes like water (which is so essential for life) being cheaper than diamonds which is
luxury given that the law of DMU applies to the good, on is able to derive the law of demand
which states that the quantity demanded of a good is inversely related to its price per unit.

The law of DMU is highly useful to the authorities also in working out their social welfare
programmes. They can take steps by which goods and services are allocated between
members of the society in such a way that marginal utility of each good/service tends to be
the same for every individual. If a particular good does not satisfy this condition, then its
successive units should be transferred from those for whom it has smaller marginal utility
to those for whom it has higher marginal utility.

2.5.2. Law of Equi-Marginal Utility

Prof. Marshall has said that – “If a person has a thing which he can put to several uses he
will distribute it among these uses in such a way that it has the same marginal utility in
all.the law of Equi-marginal Utility has been given by Marshall. This law is one of the basic

82
principles of Economics. It is also known as the Law of Substitution and the Law of
Maximum Satisfaction. This concept is also known as “The Second Law of Gossen”.

Assumptions of the Law of Equi-Marginal Utility

1. Utility can be measured in the Cardinal number system.

2. Consumer is rational that is he wants maximum satisfaction from his income.

3. There is no change in the income of consumer.

4. Marginal Utility of money remains constant.

5. There is no change in the price of commodity and its substitutes.

6. Every unit of the commodity being used is of same quality and size.

Let us assume that there are Rs. 9 with a consumer and he has to allocate the amount on
two commodities in such a way that in the end the marginal utility of two goods are
equalised.

The table reveals that the consumer has Rs. 9 which he can spend on the different
commodities, namely, A and B. We also assume that the each unit of a commodity has the
price of Re. 1. The various units of two commodities have been shown which gives him
different marginal utilities. The MU of A and B are decreasing. He can maximise his
satisfaction when he spends Rs. 5 on commodity A and Rs. 4 on commodity B.

His total utility is 32+28+24+20+16 of A and 28+24+20+16 of B which is 208 units. He

cannot attain more utility by spending his given income in different way.

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The diagram shows that Rs. 5 have been spent on commodity A and Rs. 4 on commodity B.
The bars are showing the marginal utility from different units of the commodities which
are declining showing the applicability of the law of diminishing marginal utility. The last
utility from the 9th and the 8th unit of money equalize the utility which is shown by equi-
MU line where MUA is equal MUB (MUA = MUB) in the diagram. Thus, the consumer attains
his objective Importance

84
(1) Theory of Consumer Behaviour:

Each individual consumer is faced with the problem of choice because he has unlimited
wants and scarce means which have alternative uses. According to this law a consumer can
maximise his satisfaction by equalising the ratio of marginal utility of different
commodities and their prices with other ratios of goods and their prices

Theory of Production:

Every producer aims at maximisation of output at the minimisation of cost. In order to

attain the objective he substitutes more productive factors of production than the less
productive factors of production. He will continue to substitute the factors of production till
the point where marginal productivity of factors are equalised to their prices

Theory of Exchange:

The law of equi-marginal utility is also applicable to the theory of exchange. Buyers and
sellers are exchanging goods for goods or goods for money and both the parties will
maximise their satisfaction at the point where the marginal utility of a commodity is
equalised till the sacrifice in terms of money is equalised.

Theory of Distribution:

The law of equi-marginal utility also applies in the theory of distribution. National income
is shared by various factors of production, namely, land, labour, capital, enterprise and
organization. According to marginal productivity theory of distribution, each factor of
production will get the share on the basis of its marginal productivity from the national
income pool.

Theory of Distribution:

The law of equi-marginal utility also applies in the theory of distribution. National income
is shared by various factors of production, namely, land, labour, capital, enterprise and
organisation. According to marginal productivity theory of distribution, each factor of

85
production will get the share on the basis of its marginal productivity from the national
income pool. When a consumer wants to buy a commodity, he decides on the amount to be
purchase .Two approaches are used for deciding on the amount to be purchased.

These are:

1. Marshallian Approach

2. Indifference Curve Approach

A. Marshallian Approach

Alfred Marshall gave a significant contribution in the study of consumer behavior.

Marshall attempted to derive consumer’s equilibrium in a one commodity framework. He

considers that the consumer allocates his income on one good and the balance money
income is composite good.

To establish his theory, he made the following assumptions:

1. Utility is cardinally measurable.

2. Marginal utility of money remains constant.

3. Demand for any single commodity is satiable i.e. Law of diminishing marginal utility
(DMU) holds true.

4. Two different commodities can never be perfect substitute of each other.

5. Utility functions are independent for different commodities.

6. Consumer is a price taker in the market.

7. Consumer must be rational in nature.

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Marshall considered that the buyer consumes only one commodity A, whose price is P .He
consumes N amount of A out of his money income M. By consuming N units of A consumer
gets U(N), units of utility for which he sacrifices monetary utility of marginal utility of
money PA

In the Marshallian approach, the consumer tries to maximize the utility that he derives
keeping in view the money income he has in hand available to be spent on that good

Limitations:

In spite of some good attempts, Marshallian theory is not free from criticism.
These are:

1. The assumption of constant MU of money is impractical.

2. There are exceptions to the Law of Diminishing Marginal Utility.

3. DMU may not always hold good.

4. The assumption of independent utilities ignores substitute and complement goods,

which is unrealistic in nature.

5. This theory is only applicable for a one-commodity framework, whereas there exist
numerous commodities.

6. Cardinal measurement of utility is unrealistic.

Utility approach suffers from several drawbacks. For this reason, a consumer’s demand
curve derivedwith the help of utility approach also suffers from similar drawbacks.

The technique of indifference curves tries to avoid these drawbacks and provide a
technically superior analysis of demand. It believes that human satisfaction being a
psychological phenomenon cannot be measured quantitatively in monetary terms as was
attempted in Marshall’s approach.

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Indifference curve Approach

In indifference curve approach, the preferences are ordered than to measure them in terms
of money. This approach, is, therefore an ordinal concept based on ordering of preferences
compared with Marshall’s approach of cardinality. This approach to consumer behavior is
best understood in three distinct steps:

 Consumer Preferences (Indifference curve)

 Budget Constraints (Budget Line)
 Consumer Choices (Equilibrium)

Indifference curve

An indifference curve is a curve which represents all those combinations of goods which
give same satisfaction to the consumer. Since all the combinations on an indifference curve
give equal satisfaction to the consumer, the consumer is indifferent among them. In other
words, since all the combinations provide same level of satisfaction the consumer prefers
them equally and does not mind which combination the result

Indifference Schedule

Combination of
Apples Mangoes
Mangoes and Apple

A 1 10

B 2 7

C 3 5

D 4 4

The above schedule shows that the consumer gets equal satisfaction from all the four
combinations A, B, C, D of apples and mangoes. In combination A, the consumer has 1

88
apple plus 10 mangoes, in combination B, he has 2 apples plus 7 mangoes, in combination
C, he has 3 apples plus 5 mangoes and in combination D, he has 4 apples plus 4 mangoes.
The consumer in order to have more apples, sacrifices some quantity of mangoes in such a
way that there is no change in the level of satisfaction out of each combination. Indifference
curve is graphical presentation of indifference schedule. Indifference curve is shown in the
figure .

The quantity of apple is shown on axis OX and quantity of mangoes is shown on axis OY. IC
is an indifference curve.

Figure

Y
IC
Indifference
10 Curve
A(1, 10)
9
B(2, 7)
8
C(3, 5)
7
D(4, 4)
IC
6

5
O X
12345
4
Apples
3

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Different points A, B, C and D on it indicate those combinations of apples and mangoes
which yield equal satisfaction to the consumer. Therefore, it is also known as ISO-utility
curve.

2.5.3. Assumptions

It is assumed that the behaviour of consumer will be rational. The approach assume that
consumer has complete information about the consequences related to consumption
decisions. Consumer has information about every goods and services, their prices and
income. Based on this information, consumer can decide which combination is better, and
which of the combinations provide equal satisfaction. Every consumer will try to get
maximum satisfaction out of his fixed income The consumer is capable of ranking all
conceivable combinations of goods according to the satisfaction he derives. Thus, if he is
given various combinations A, B, C, D, E he can rank them as first preference, second
preference and so on. If a consumer happens to prefer A to B, he cannot tell quantitatively
how much he prefers A to B. If the consumer prefers combination A to B, and B to C, then he
must prefer combination A to C. In other words, he has consistent consumption pattern
behavior. If combination A has more commodities than combination B, then A must be
preferred to B.

Characteristics of Indifference Curve

The following are the main characteristics or properties of indifference curves:

Indifference curves slope downward to the right: This property implies that when the
amount of one good in combination is increased, the amount of the other good is reduced.
This is essential if the level of satisfaction is to remain the same on an indifference curve.

Indifference curves are always convex to the origin: It has been observed that as more
andmore of one commodity (X) is substituted for another (Y), the consumer is willing to
part with less and less of the commodity being substituted (i.e. Y). This is called
diminishing marginal rate of substitution.

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Indifference curves can never intersect each other: No two indifference curves will
intersect each other although it is not necessary that they are parallel to each other. In case
of intersection the relationship becomes logically absurd because it would show that higher
and lower levels are equal which is not possible.

A higher indifference curve represents a higher level of satisfaction than the lower
indifference curve: This is because combinations lying on a higher indifference curve
contain more of either one or both goods and more goods are preferred to less of them.

Budget Line

A budget line or price line represents the various combinations of two goods which can be
purchased with a given money income and assumed prices of goods.

A budget line or price line represents the various combinations of two goods which can be
purchased with a given money income and assumed prices of goods. the two determinants
of the budget line are:

a) The prices of goods, and

b) The consumer’s income to be spent on the goods.

In the fig. the line AF shows the various combinations of goods the consumer can purchase.
This line is called the budget line. It shows 6 possible combinations of packets of biscuits
and packets if coffee which a consumer can purchase weekly. These combinations are
indicated by points A, B, C, D, E and. Point A indicates that 10 packet of biscuits can be
purchased if the entire income of Re 60 is devoted to the purchase of biscuits. Similarly,
point F shows the purchase of 5 packets of coffee for the entire income of Rs60 per week.

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The budget line AF indicates all the combinations of packets of biscuits and packets of
coffee which a consumer can buy given the assumed prices and income. In case, a consumer
decides to purchase combination of goods inside the budget line such as G, then it
involves a total outlay that is smaller than the amount of Rs60 per week. Any point outside
the budget line such as H requires an outlay larger than the consumer’s weekly income of
Rs60.

Slope of budget line is also called market rate of exchange (MRE) because the two goods
can be exchanged at this rate, given their prices in the market. Budget Set Budget set is the
set of all possible combinations of two goods which a consumer can afford, given his
income and market prices of the two goods.

Marginal rate of substitution (MRS) Marginal rate of substitution refers to the rate at which
consumer is willing to give up amount of other good to obtain one extra unit of the good in
question without affecting total satisfaction. So, the rate of substitution of one commodity
for another is called marginal rate of substitution. Marginal rate of substitution (MRS)
Marginal rate of substitution refers to the rate at which consumer is willing to give up
amount of other good to obtain one extra unit of the good in question without affecting

92
total satisfaction. So, the rate of substitution of one commodity for another is called
marginal rate of substitution.

Consumer’s Equilibrium

In indifference curves approach to demand analysis, Budget Line (BL) plays an integral role
in the determination of consumer’s equilibrium. It is a straight line joining two points onY-
axis and X-axis and has a negative slope. Its starting point on Y-axis represents the amount
of Y that can be bought with given income and Price of Y (Py).Its end point on X-axis
represents the maximum amount of X which consumer can buy with given income and
price of X (Px).

Figure Consumer’s Equilibrium

Figure shows consumer’s equilibrium at point E where, Budget line AB is tangent to the
indifference curve IC2. The use of BL in determining a consumer’s equilibrium is illustrated
in Fig. 2.21 where it is labelled AB. It begins from point A on Y-axis and meets X-axis at
point B. All the points along AB curve represent different combinations of X and Y which
the market permits the consumer to have with his given income and prices of two goods.
Figure shows consumer’s equilibrium at point E where, Budget line AB is tangent to the
indifference curve IC2.

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Our assumption of economic rationality of the consumer states that out of the available
alternatives, the consumer will try to choose that combination of X and Y which brings him
to the highest indifference curve which the market permits him to reach. In this context, we
should note that the BPL is a straight line and slopes downwards from left to right, and the
indifference curves are convex to the origin. Therefore, if we take any particular
indifference curve, we come across three possibilities. The BPL does not touch it at all
intersects it twice is tangent to it .It should also be noted that a BPL can be tangent to one
and only one indifference curve.

2.6. Production Function

2.6.1. Introduction

Production is defined as the transformation of inputs into output. For example, inputs of
sugar cane, capital and labour are used to produce sugar. Production includes not only
production of physical goods like cloth, rice, etc., but also production of services like those
of a doctor, teacher, lawyer, etc. The inputs used for Production of goods or services can be
classified into three namely Labour, capital and land or natural resources. They may be
fixed or variable.

Fixed and variable inputs.

In economic sense, a fixed input is one whose supply is inelastic in the short run. Therefore,
all of its users cannot buy more of it in short run. Fixed inputs are the ones that cannot be
changed during the period of consideration. except at a larger expense for example:
Production Plant Conceptually, all its users, cannot employ more of it in the short run. If one
user buys more of it, some other users will get less of it. A variable input is defined as one
whose supply in the short run is elastic, eg: Labour, raw materials etc. Variable input are
the ones that can be easily changed at very short period for example raw materials.

All the users of such factors can employ larger quantity in the short run. In technical sense,
a fixed input remains fixed (constant) up to a certain level of output whereas a variable

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input changes with change in output. The time period in which all the inputs are changed is
Longrun. The time period at which at least one input is fixed is called as shortrun.

A firm has two types of production function: -

1. Shot run production function
2. Long run production function

In general, Business firms operate in short run and plans to increase or decrease its
operations in long run. This module deals with Production Function. A production function
is a function that specifies the output of a firm or industry or a whole economy for all
combination of inputs.

2.6.2. Production Function

Production function shows the technological relationship between quantity of output and
the quantity of various inputs used in production. Production function is economic sense
states the maximum output that can be produced during a period with a certain quantity of
various inputs in the existing state of technology. In other words, it is the tool of analysis
which is used to explain the input - output relationships. In general, it tells that production
of a commodity depends on the specified inputs in its specific term it presents the
quantitative relationship between inputs and output. Inputs are classifiedas:-

1. Fixed input or fixed factors

2. Variable input or variable factors

A. Short run and Long run

Short run refers to a period of time in which the supply of certain inputs (E.g. plant,
building, machines, etc.,) are fixed or inelastic. Thus an increases in production during this
period is possible only by increasing the variable input. In some Industries, short run may
be a matter of few weeks or a few months and in some others it may extent even up to three
or more years. The long run refers to a period of time in which “supply of all the input is
elastic; but not enough to permit a change in technology. In the longrun, the availability of

95
even fixed factor increases. Thus in the longrun, production of commodity can be increased
by employing more of both, variable and fixed inputs. In the strict sense, production
function isdefinedasthetransformationofphysicalinputintophysicaloutputwhereoutputisa
function input.

It can be expressed algebraically as;

Q = f (K, L etc.,)

Where

Q - The quantity of output produced during a particular period.

K, L etc., are the factors of production

f - Denotes the function of or depends on.

The production functions are based on certain assumptions;

1. Perfect divisibility of both inputs and output;

2. Limited substitution of one factor for the others Constant technology
3. Inelastic supply of fixed factors in the shortrun

2.6.3. The Laws of Production

Production function shows the relationship between a given quantity of input and its
maximum possible output. Given the production function, the relationship between
additional quantities of input and the additional output can be easily obtained. This kind of
relationship yields the law of production. The traditional theory of production studies the
marginal input-output relationship under Shortrun; and(II) longrun. In the shortrun, input-
output relations are studied with one variable input, while other inputs are held constant.
The Law of production under these assumptions are called “the Laws of variable
production”. In the long run input output relations are studied assuming all the input to be
variable. The long-run input output relations are studied under `Laws of Returns to Scale.

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2.6.4. Law of Diminishing Returns (Law of Variable Proportions)

The Laws of returns states the relationship between the variable input and the output in
the short term. By definition certain factors of production (e.g.-Land, plant, machinery etc.,)
are available in short supply during the short run. Such factors which are available in
unlimited supply even during the short periods are known as variable factor.

In short-run therefore, the firms can employ a limited or fixed quantity of fixed factors and
an unlimited quantity of the variable factor. In other words, firms can employ in the
shortrun varying quantities of variable inputs against given quantity of fixed factors. This
kind of change in input combination leads to variation in factor proportions. The Law which
brings out the relationship between varying factor properties and output are therefore
known as the Law of variable proportions. The variation in inputs lead to a
disproportionate increase in output more and more units of variable factor when applied
cause an increase in output but after a point the extra output will grow less and less. The
law which brings out this tendency in production is known as “Law of Diminishing
Returns”.

The Law of Diminishing returns levels that any attempt to increase output by increasing
only one factor finally faces diminishing returns. The Law states that when some factor
remains constant, more and more units of a variable factor are introduced the production
may increase initially at an increasing rate; but after appoint it increases only at
diminishing rate. Land and capital remain fixed in the short-term whereas labour shows a
variable nature.

The following table explains the operation of the Law of Diminishing Returns.

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The above table illustrates several important features of a typical production function. With
one variable input –here both Average Product(AP) and Marginal Product(MP) first rise,
reach a maximum-then decline. Average product is the product for one unit of labour. It is
arrived at by dividing the Total Product (TP) by number of worker’s Marginal product is
the additional product resulting term additional labour. It is found out by dividing the
change in total product by the change in the number of workers. The total output increases
a tan increasing rate till the employment of the 4thworker. The rate of increase in the
marginal product reveals this. Any additional labour employed beyond the 4 th labour
clearly faces the operation of the Law of Diminishing Returns. The maximum marginal
product is 16 after which it continues to fall, ultimately becoming negative. Thus when
more and more units of labour are combined with other fixed factors the total output
increase first at an increasing rate then at a diminishing rate finally it becomes negative.

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The graphical representation the above table is shown below:

Stage1 Stage2 Stage3

TP

TP
AP
O MP X

OX axis represents the units of labour and OY axis represents the unit of output. The total
output (TP) curve has a steep rise till the employment of the 4th worker. This shows that
the output increases at an increasing rate till the employment of the 4th labour. TP curve
still goes on increasing but only at a diminishing rate. Finally, TP curve shows a downward
trend.

The Law of Diminishing Returns operation at three stages. At the first stage, total product
increases at an increasing rate. The marginal product at this stage increases at an
increasing rate resulting in greater increases in total product. The average product also
increases. This stage continues up to the point where average product is equal to marginal
product. The law of increasing returns is in operation at this stage. The Law of increasing
Returns operates from the second stage onwards. At the second stage, the total product
continues to increase but at a diminishing rate. As the marginal product at this stage starts
falling, the average product also declines. The second stage comes to an end where total
product become maximum and marginal product becomes zero. The marginal product

99
becomes negative in the third stage. So the total product also declines. The average product
continues to decline in the third stage.

Assumptions of Law Diminishing Returns

 The Law of Diminishing Returns is based on the following assumptions; -

 The production technology remains unchanged.
 The variable factor inhomogeneous.
 Any one factor is constant.
 The fixed factor remains constant.

2.6.5. Law of Returns to Scale

In the long-run all the factor of production are variable and an increase in output is possible
by increasing all the inputs. The Law of Returns to scale explains the technological
relationship between changing scale of input and output. The law of returns of scale explain
how a simultaneous and proportionate increase in all the inputs affects the total output.
The increase in output may be proportionate, more than proportionate or less than
proportionate. If the increase in output is proportionate to the increase in input, it is
constant Returns to scale. If it is less then proportionate it is diminishing returns to scale.
The increasing returns to the scale come first, then constant and finally diminishing returns
to scale happens.

A.Increasing Returns to scale

When proportionate increase in all factor of production results in a more than

proportionate increase in output and this results first stage of production which is known
as increasing returns to scale. Marginal output increases at this stage. Higher degree of
specialization, falling cost etc., will lead higher efficiency which result increased returns in
the very first stage of production.

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Causes of Increasing Returns

The main reason for increasing returns in the first stage is that in the beginning the fixed
factors are larger in quantity than the variable factor. When more units of the variable
factor are applied to a fixed factor, the fixed factor is used more intensively and production
increases rapidly.

In the beginning, the fixed factor cannot be put to the maximum use due to the non-
applicability of sufficient units of the variable factor. But when units of the variable factor
are applied in sufficient quantities, division of labour and specialization lead to per unit
increase in production and the law of increasing returns operates.

Another reason for increasing returns is that the fixed factors are indivisible which means
that they must be used in a fixed minimumsize. When more units of the variable factor are
applied on such a fixed factor, production increases more than proportionately. These
points towards the law of increasing returns.

B.Constant Returns to scale

Firmscannotmaintainincreasingreturnstoscaleindefinitelyafterthefirststage,firmentersastag
ewhen total output tends to increase at a rate which is equal to the rate of increase in
inputs. This stage comes in to operation when the economies of large scale production are
neutralized by the diseconomies of large scale operation.

C.Diminishing Returns to Scale

Inthisstage,aproportionateincreaseinalltheinputresultonlylessthanproportionateincreasein
output. This is because of the diseconomies of large scale production. When the firm grows
further, the problem of management arise which result inefficiency and it will affect the
position of output.

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2.6.6. Economies of Scale

Economies of scale means a fall in average cost of production due to growth in the size of
the industry within which a firm operates. The factors which cause the operation of the
laws of returns the scale are grouped under economies and diseconomies of scale.
Increasing returns to scale operates because of economies of scale and decreasing returns
to scale operates because of diseconomies of scale where economies and diseconomies
arise simultaneously. Increasing returns to scale operates when economies of scale are
greater than the diseconomies of scale and returns to scale decreases when diseconomies
overweight the economies of scale. Similarly when economies and diseconomies are in
balance, returns to scale become constant. Economies of scale exist when long run average
costs decline as output is increased. Diseconomies of scale exist when long run average cost
rises as output is increased.

The economies of scale occur because of (i) Technical economies: the change in production
process due to technology adoption. (ii)Managerial economies(iii)Purchasing
economies,(iv)Marketing economies and (v) Financial economies.

Diseconomies of Scale

Arisesduetomanagerialproblems.Ifthesizeofthebusinessbecomestoolarge,thenitbecomesdiff
icult for management to control the organizational activities therefore diseconomies of
scalearise.

2.6.7. Factors Causing Economies of Scale

There are various factors influencing the economies of scale of an organization. They are
generally classified in to two categories as Internal factors and External factors

INTERNAL FACTORS:

Labour economies:if the labour force of a firm is specialized in a specific skill then the
organization can achieve economies of scale due to higher labour productivity.

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Technicaleconomies:withtheuseofadvancedtechnologytheycanproducelargequantitieswit
h quality which reduces their cost of production.

Managerial economies: the managerial skills of an organization will be advantageous to

achieve economies of scale in various business activities.

Marketing economies: use of various marketing strategies will help in achieving

economies of scale.

Vertical integration: if there is vertical integration then there will be efficient use of raw
material due to internal factor flow.

Financialeconomies:thefirm’sfinancialsoundnessandpastrecordoffinancialtransactionswil
l help them to get financial facilities easily.

Economies of risk spreading: having variety of products and diversification will help
them to spread their risk and reduce losses.

Economies of scale in purchase: when the organization purchases raw material in bulk
reduces the transportation cost and maintains uniform quality.

EXTERNAL FACTORS:

Betterrepairandmaintenancefacilities:Whenthemachineryandequipment’sarerepaireda
nd maintained, then the production process never gets affected.

Research and Development: research facilities will provide opportunities to introduce

new products and process methods.

Training and Development: continuous training and development of skills in the

managerial, production level will achieve economies of scale.

Economiesoflocation:theplantlocationplaysamajorroleincuttingdownthecostofmaterials,
transport and other expenses.

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Economies of Information Technology: advanced Information technology provides
timely accurate information for better decision making and for better services.

Economies of by-products: Organizations can increase the economies of scale by

minimizing waste and can be environmental responsible by using the by- products of the
organization.

2.6.8. Factors Causing Diseconomies of Scale

Labour union: Continuous labour problem and dissatisfaction can lead to diseconomies of
scale.

Poor team work: Poor performance of the team leads to diseconomies of scale.

Lack of co-ordination: Lack of coordination among the work force has a major role to play
in causing diseconomies of scale.

Difficulty in fund raising: Difficulties in fund raising reduce the scale of operation.

Difficulty in decision making: The managerial inability, delay in decision making is also a
factor that determines the economies of scale.

Scarcity of Resources: Raw material availability determines the purchase and price.
Therefore, there is a possibility of facing diseconomies in firms.

Increased risk: Growing risk factors can cause diseconomies of scale in an organization. It
is essential to reduce the same.

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2.7. Cost
2.7.1. Introduction

This module discusses about cost in Economic perspective.

Cost is a derived function. It is derived from production function which describes the most
efficient method of producing a commodity. Cost of producing a commodity is the payment
made to the factors of production which are used in the production of that commodity. Cost
is defined in simple terms as a sacrifice or foregoing which has already occurred or is likely
to occur in future with an objective to achieve a specific purpose measured in monetary
terms. Cost results in current or future decrease in cash or other assets, or a current or
future increase in liability.

2.7.2. Determinants of Cost

 Price of inputs

 Productivity of inputs

 Technology

 Level of output

2.7.3. TYPES OF COST (OR COST CONCEPTS

There are several types of costs (or cost concepts). Following are the important items: -

Money Cost: money cost means the total money expenses incurred by a business firm on
the various items entered into the production of a particular product. For example,
money payments made on wages and salaries to workers and managerial staff, payments
for raw materials purchased, expenses on power and light, insurance, transportation,
advertisement and also payments made on the purchase of machinery and equipment’s
etc., constitute money cost of production. Money cost is also called nominal cost.

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Real Cost: Real cost means the real cost of production of a particular product. It is the
next best alternative sacrificed in order to obtain that product. It also denotes the
“efforts” of workers and sacrifices of owners undergone in the production of a particular
product.

Opportunity Cost: Opportunity cost refers to the cost of foregoing or giving up an

opportunity. It is the cost of the next best alternative. It implies the income of benefit
foregone because a certain course of action has been taken. As Adam smith observed, if a
hunter can bag a deer or a beaver in the single day, the cost of deer is a beaver and the
cost of beaver is a deer. A man who marries a girl is foregoing the opportunity of
marrying another girl. A film actress can either act in films or do modeling work. She
cannot do both the jobs at the same time. Her acting in the film results in the loss of an
opportunity of doing modeling work. Likewise, if an old building is proposed to be used
for a business, where rent of the building is the opportunity cost. The opportunity cost
concept was first developed by an Austrian economist, Wieser. The opportunity cost
concept plays an important role in managerial decisions. It is useful in determination of
relative prices of different goods. It is also useful in fixing the price of an output factor.
Above all, it helps in the best allocation of available resources.

Sunk Cost: Sunk costs are those which have already been incurred and which cannot be
changed by any decision made now or in the future. These are past or historical costs.

Incremental cost: These are additional costs incurred due to a change in the level or
nature of activity.
Differential Cost: It refers to the change in cost due to change in the level of activity or
pattern of production or method of production.
Explicit Cost: Explicit costs are those costs, which are actually paid (or paid in cash.).
They are paid out costs.
Implicit Cost: Implicit costs are those costs, which are not paid in cash to anyone. These
are not actually incurred, but are computed for decision-making purpose. These are the
costs, which the entrepreneur pays to himself. For example, rent charged on owned

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premises, wages of entrepreneur, interest on owned capital etc., Implicit costs are also
known as imputed costs or hypothetical costs.

Accounting cost: Accounting costs represent all such expenditures, which are incurred
by a firm on factors of production. Thus, accounting costs are explicit costs. In short, all
items of expenses appearing on the debit side of trading, profit and loss account of a firm
represent the accounting cost. Since all the expenses on production are in money terms,
the accounting costs are money costs or nominal costs.

Economic Cost: Economic cost refers total of explicit cost and implicit cost. Thus it
includes the payment for factors of production (that is rent, wages etc.,) and the
payments for the self-owned factors (interest on owned capital, rent on owned premises,
salary to entrepreneur etc.,)

Social Cost of Production (or Social Cost)

In the production of goods, costs will be incurred not only by the owner’s business but
also by the society. Cost incurred by a society interms of resources used in the
production of a commodity is known as social cost of production. It is the opportunity
cost borne by a whole society or community. Social costs include not only the cost borne
by the owners of a business (or producers) but also the cost passed on to the society. For
example, production of certain commodities (chemical, rubber, petroleum, steel etc.,)
causes environment pollution. Pollution caused while producing a commodity imposes a
social cost on those residents who suffer ill health.

Private Cost of Production (Private Costs)

Private costs are the costs incurred by a firm in production a commodity or service. All
the actual costs incurred by a firm or producers are private costs. Private costs include
both explicit cost and implicit cost. Private costs have to be borne by only those persons
or firms who make decision. These do not include the effect of the produced commodity
on the society.

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Private costs are the costs incurred by a firm while producing a commodity or service.
But social costs are those costs, which are incurred by the society in producing
commodities or services

Fixed and Variable Cost: -

Fixed Cost: Fixed costs are those costs which do not vary with the volume of production.
These costs remain fixed or constant up to a certain level of production. Even if the
production is zero, a firm will have to incur fixed costs. Examples are rent, interest,
depreciation, insurance, salaries etc. The fixed costs are also called supplementary costs,
capacity costs or period costs or overhead costs.

Average fixed cost (fixed cost per unit) changes with a change in the quantity of
production. If the volume of production increases, average fixed cost will decrease. If the
quantity of production decrease, average fixed cost will increase. Thus, there is an
inverse relationship between fixed costs and quantity of production.

Average fixed cost is obtained by dividing total fixed cost by total output. Total fixed cost
curve and average fixed cost curve are shown below

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Source: Samuelson

From the above graph it is clear that the total fixed cost curve is horizontal. On the other
hand the average fixed cost curve slopes from left to right. This implies that as the output
increases, the average fixed cost falls.

Variable Cost:

Variable costs are those costs, which change with the quantity of production. When the
output increases, variable cost also increases. When the output decreases, the variable
cost also decreases. Thus, there is a direct relationship between variable cost and volume
of production.

Variable costs are also known as prime costs or direct costs. Examples are materials,
wages, power, stores etc., Prime or variable cost consist of direct material cost, direct
labour cost and other direct expenses

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Business cost and full cost

Business cost include all the expenses which are incurred to carry out a business. It
cludes all the payments and contractual obligations made by the firm together with the
book cost of depreciation on plant and equipment. These cost concepts are used for
calculating business profits and losses and for filing returns for income- tax and also for
other legal purposes The concept of full costs, includes business costs, opportunity costs
and normal profits

Total cost, Average cost and Marginal cost

Total cost is made up of both the fixed cost and the variable cost

Average Cost: Average cost is the sum of average variable cost and average fixed cost; it
is also called average total cost. If the total cost of producing 60 units of good is 2400
rupees, then average cost will be

Average cost at any output = Total Cost / Units of output

= 2400 / 12 = 20

Marginal Cost: Marginal cost is the cost of producing an additional unit of output. In
other words, marginal cost is the addition made to the total cost by producing one more
unit of output. For example, if the total cost of producing 120 units is 2400 rupees and
the total cost of producing 121 units is 2436 rupees, the marginal costing in this case will
be equal to 36 rupees.

Curve can be drawn to represent costs. The marginal cost (MC) and the average cost (AC)
are shown in the diagram. It will be seen that as output is increased, both average cost
(AC) and marginal cost (MC) fall, but MC is below AC, i.e., marginal cost is less than the
average cost. The fall is due to the economics of scale. But beyond a point (M) i.e. when
output is expanded too much, both AC and MC start rising and now MC is above AC, i.e.,

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the marginal cost is greater than the average cost. That is why MC cuts AC from below at
its lowest point.

2.7.4. Cost function

Cost function is derived from the production function. Time factor is very important in cost
theory. The short-run costs are the costs over a period during which some factors of
production are fixed. The long- run costs are the costs over a period long enough to permit
changes in all factors of production Both in the short-run and in the long-run, cost is a
multivariate function, i.e., it is determined by many factors simultaneously, symbolically,
the long run cost function is given as:

C = f (X, T, Pf)

and the shot-run-run cost function is:

C = f (X, T, Pf, K)

Where,

C = TotalCost

X =Output

T=Technology

Pf = Prices of factors

K = Fixed factor(s)

Graphically, the cost function is generally shown on a two-dimensional diagram by

taking C=f(x),ceteris paribus, If other factors (i.e., T, Pf) to change, then the cost curve
will shift.

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Short Run Cost Function

The short-run refers to that period of time within which a firm can vary its output by
varying only the amount of variable factors, factors such as labor and raw material. In
the short run period the firm cannot alter the fixed factors such capital equipment
management personal, the factory buildings etc., Suppose a firm wants to increase
production in the short run it can do so only by hiring more worker or buying and using
more raw materials.

In the short run a firm cannot enlarge the size of the existing plant or build a new plant
of a bigger capacity. Thus in the short run only variable factors can be varied while the
fixed factors remain the same.

Short-run Fixed and Variable Costs

In the period, the prime costs relating to labour and raw material can be varied whereas
the fixed costs remain the same. On the other hand, in the long period, even the fixed
costs relating to plant and machinery, staff salaries, etc., can be varied. That is, in the
longrun all costs are variable and no costs are fixed.

Short-run Cost Curve

Generally, in the short-run a firm will adjust output to demand by varying the variable
factors. When the factors of production can be used in varying proportions, it means that
the scale of operations of the firm can be changed. It is evident form the above figure that
at any scale of operations in the short-run, a firm will have regions of rising and falling
costs. On the other hand, in the long-run the firm can produce on a completely short-run
cost curve, and there will be an output where the average cost is minimum. This is the
optimum output.

Long-Run Average Cost Curve

The long-run average cost curve LAC is a tangent to all the short run cost curve. The LAC

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curve will therefore, be U-shaped like the short-run cost curve. It will be flatter. That is
why the long-run cost curve is called an ‘Envelope’, because it envelops all the short-run
cost curves. According to Dewettand Varma, the cost curve, whether short-run or long-
run are U-shaped because the cost of production first starts falling as output is increased
owing to the various economies of scale.

But after touching the lowest point at the optimum output level, it starts rising, and goes
on rising if production is continued beyond the optimum level. This obviously makes a U-
shape.

The U-shape of the long-run cost curves is less pronounced. In other words, the long run
average costs are than the short-run curves. The longer the period to which the curve
relates the less pronounced will be the U-shape of the curve. By the long period the size
and organization of the firm can be altered to meet the changed conditions.

For clear business decisions it is necessary to have complete understanding of different

cost concepts. For proper knowledge of cost analysis, various cost concepts include and

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determine cost of production which enables management for correct business decisions.
Various combinations of costs ingredients account for various kind of management
decisions.

In short period, the price cost relating to labor and raw material can be varied whereas
fixed cost remains the same. On the other hand in long period even fixed cost relating to
plant & machinery staff salaries can be varied or in other words in long run all costs are
variable. For Completing profit &loss a firm has to analyses the components or elements
of total costs.

2.8. Market
2.8.1. Introduction

The word ‘Market’ is derived from the Latin word ‘Marcatus’ Meaning merchandise, wares,
traffic, trade or a place where business is conducted. The common uses of market means a
place where goods are brought and sold.

Market includes both place and region in which buyers and sellers are in free competition
with one another – Pyle. ‘The term market refers not to a place, but to a commodity or
commodities and buyers and sellers who are in direct competition with one another’ –
Chapman

Market: Market is a place where goods and services are exchanged. Markets consist of
buyers and sellers with facilities to communicate each other for transactions of goods and
services.

Marketing: Marketing is the economic process by which goods and services are exchanged
between the producers and the consumers and their value determined in terms of money
price

2.8.2. Need for Marketing

For exchange of goods and services.

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  For adjustment of demand and supply by price mechanism.
 For improvement of the quality of life of the society.
 For the introduction of new modes of life.
 For higher production

2.8.3. Conditions for market formation include the existence of:

1. Buyers who expect a pay-off in terms of the satisfaction of a want or a need –

referred to as utility.

2. Purchasing power, which enables buyers to convert their wants or needs into
‘effective demand’.

3. Sellers who expect a pay-off, firstly in terms of the revenue they need to cover their
production costs, and secondly to generate a profit, which is excess revenue over
costs.

4. Means of ‘communication’ between buyers and sellers so that preferences can be

indicated and goods and services offered for sale. In early market forms it was
essential that buyers and sellers met, or at least that their representatives met –
however, new technologies have meant that buyers and sellers no longer need to
meet in the same physical space.

5. Knowledge is balanced between buyers and sellers, so that one partly cannot
persistently exploit the other party by withholding relevant information. Markets
can breakdown when information is not available to all parties.

6. A medium of exchange to facilitate a market transaction – namely, money or credit.

7. The ability to pay at a later date – called deferred payment.

8. A legal system which enables both buyers and sellers to be protected through civil
law, such as contracts, and through criminal law, such as laws against theft.

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 9. Property rights so that individual sellers have the right to sell, and buyers have to
right to buy, and to own what they have bought.
10. In addition, markets require a financial system to enable individuals and firms to
borrow if they need to and to save when they have surplus funds.

2.8.4. Classification of Market

Markets have been classified based on different approaches, in various ways.

 Number of Commodity Area/coverage

 Location
 Time span
 Volume of business
 Nature of transactions
 Degree of competition
 Government interventions/Regulations
 Nature of commodities
 Visibility/vision

A. On basis of Number of Commodity

General market: All type of commodities are sold.

Commodities range from food grains to textile

Specialized market: It deals with a specific commodity

The markets are named after such commodities E.g: Markets transacting goods like
vegetable, wool, jute etc., Vegetable market Wool market Jute market

Local:(village/primary market) The area covered by the market is limited to some group of
villages which are nearby or close to each other. Perishable commodities like vegetable,

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fruits, fish, milk are being transacted E.g: Shandies and fairs Local markets are held
occasionally or on special days Cattle market, Sheep market

B. On basis of Location

Regional market: Area of operation of the market is relatively larger than that of local
market. This market covers 4-5 districts. E.g: Food grain markets/Fruits market at state
level These markets are regular in conducting business transactions in notified
commodities

National market: Area of operation of the market covers the entire country. The national
markets are found for the commodities which are having demand over entire country. E.g:
Textile market Jute market Tea market

International market: The commodities are sold in all the nations of the world. The
market area of operation is extended over the entire globe. The involvement of buyers and
sellers beyond the boundaries of a nation. E.g: Cashew, Coffee, Tea, Spices, Gold, Silver,
Diamond, Machinery

Village market: The area of operation is confined to small village or group of villages
Major transaction of goods and services take place among the buyer and sellers of these
village It may be regular or occasional in nature.

C. Volume of business

Primary wholesale market: These are located in big towns or taluks or mandal
headquarters. All types of agricultural commodities from the village markets are pooled
here. It is transaction between producer and traders

Secondary wholesale market: These are located in districts headquarters dealing with
major agricultural commodities like rice, pulses, oil seeds, chillies. etc., Wholesalers and
village traders are the main participants Bulk of the arrivals come from primary wholesale

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markets or village markets Transaction of commodities occurs in large scale Commission
agents, brokers, hamalies and weighmen facilitate the process

Terminal market: It is located in big cities/State capital/Seaports It is Well organized

markets and controlled by the Government to see that all modern methods of marketing
operations take place Processing and storage activities are predominant in these markets
Consumers, Wholesalers and Marketing agents are seen in these markets with rigorous
transaction activities These markets are generally situated in Big cities like Bengaluru,
Mumbai, Chennai and Kolkata

Seaboard market: Mainly for export and import of commodities Scientifically

standardized and graded commodities are transacted Located at Mumbai, Chennai,
Kolkata, Visakapatnam.

D.Time

Short period Market

Held for brief period in a day Supply of commodity is fixed. Price variation is based on
demand for the commodity in a day Supply is zero elastic E.g: Fish market Vegetable
market Flower market

Long Period

Durable commodities which can be stored for sometime are transacted in these markets
Price for the products are governed by supply and demand E.g: Food grain market Oilseeds
market

Secular market

These are permanent market Manufactured goods and Machinery goods are transacted in
these markets Godown and processing facilities are highly developed Well organized
Deal with Export and Import transactions

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E. Nature of Transaction

Cash Market: (Spot market)

If there are cash transactions in buying and selling of the goods

Forward Market: These are the markets in which future sales and purchase of
commodities take place at the current time. This process also called as Hedging

F. Based on competition

Perfect Competition

A market is said to be perfectly competitive market when there are many sellers (& buyers)
transacting a homogenous product.

There are many sellers. Homogenous products are sold. Sellers do not have control over
the price of the commodity

Feature

Large number of buyers and sellers Homogenous products

Free entry and exit of firm

Prices should be uniform through out the market.

No government regulations

Buyers and sellers have a perfect knowledge of market.

Goods can be moved from one place to another place without any restriction

Imperfect Market

A market is said to be imperfect when:

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 1. Products are similar but not identical.
2. Prices are not uniform throughout the market.
3. There is lack of communication
4. There is restriction on movement of goods from one place to another place.

Monopolistic: Many sellers Pure oligopoly: Few sellers Differentiated oligopoly: Few
sellers Monopoly: One seller Monopsony: One buyer but many sellers Oligopsony: only few
buyers Bilateral monopoly: single seller faces single buyers

G. Based on Government Intervention

Regulated Market

The statutory market committees govern regulated markets and the Government from time
to time makes marketing acts. Marketing costs, Margins and Fees are standardized. Price
prevailing in different markets are displayed through various mass media.

Unregulated Market

Business is conducted without any supervision Absence of rules and regulations

Middleman exploit the producers and consumers to the maximum extent. Producers are
put to loss as middleman exploit them in weighment, measurement and payments etc

H. Nature of commodity

Commodity market: It deals with buying and selling of commodity E.g: Cattle market,
cotton market, silk market, bullion market

Capital market: In which shares, securities and bonds etc are being purchased and sold.

E.g: Share market, Money market

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I. Based on Vision /Visibility

Black Market

In these markets, goods are not placed in shops but are kept in the godowns. The goods
can not be seen at the time of purchase, on demand the goods are delivered to the buyers
on cash transaction. Any goods which is in short of supply and anything which is having
high effective demand will be sold in black market.

Open /Visible Market

These are visible markets and transactions take place between buyers and sellers. Price is
determined by demand and supply

J. On the bases of Finance

1. Stock Market - A form of market where sellers and buyers exchange shares is called
a stock market.

2. Bond Market - A market place where buyers and sellers are engaged in the
exchange of debt securities, usually in the form of bonds is called a bond market. A
bond is a contract signed by both the parties where one party promises to return
money with interest at fixed intervals.

3. Foreign Exchange Market - In such type of market, parties are involved in trading
of currency. In a foreign exchange market (also called currency market), one party
exchanges one country’s currency with equivalent quantity of another currency.

4. Predictive Markets - Predictive market is a set up where exchange of good or

service takes place for future. The buyer benefits when the market goes up and is at
a loss when the market crashes.

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LEARNING OUTCOME
1. To know the concept of elasticity of demand
2. The significance of demand forecasting is learned by the students
3. To know the concept of utility
4. To know about returns to actors
5. To learn about Market

Short Answer Questions

1. What is elasticity of demand?
2. Explain the relationship between total revenue and elasticity
3. What is Demand Forecasting?
4. What is Delphi Method?
5. Define Supply.
6. What is Percentage method?
7. Define Utility
8. What is Buget linde?
9. Define Cost
10. Define Market

Long Answer Questions

1. What is elasticity of demand? Discuss the main methods to measure elasticity of
Demand
2. Explain in detail Price Elasticity of Demand
3. What are the factors influencing Demand Forecasting?
4. Explain the types of Utility
5. Give note on Indifference Curve Approach
6. What are the determinants of Cost?

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 UNIT III

Syllabus

PRODUCT AND FACTOR MARKET - Product market –

perfect and imperfect market – different market structures –
Firm’s equilibrium and supply– Market efficiency–Economic
costs of imperfect competition – factor market – Land,
Labour and capital – Demand and supply –determination of
factor price – Interaction of product and factor market –
General equilibrium and efficiency of competitive
markets.
 UNIT – 03

Contents

Learning Objectives ................................................................124

3.1. Product Market and Factor Market ................124

3.2 Market Structure – Perfect Competition .......128

3.3. Monopoly ...................................................................136

3.4. Monopolistic Competition ..................................144

3.5. Oligopoly ....................................................................151

3.6. Duopoly .......................................................................159

3.7.Market Efficiency and Pricing Strategies ......168

3.8. Macroeconomics .....................................................179

Learning Outcomes .................................................................188

Short Answer Questions .......................................................188

Long Answer Questions ........................................................188

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Learning Objectives

1. To discuss about Product Market

2. To discuss about the interaction between Product Market and Factor Market

3. To discuss the price and output determination under Monopoly competition

4. To discuss the price and output determination under Monopolistic
competition
5. To examine the nature of an oligopoly market.

6. To introduce Market structure and its classification

7. To discuss the price and output determination under perfect competition.

8. To discuss about circular flow of income.

3.1. Product Market and Factor Market

3.1.1 Introduction
A product market refers to a place where goods and services are bought and sold
A factor market refers to the employment of factors of production, such as labour, capital
and land.
The product market represents the purchases of finished goods and services in an
economy. Households are the main buyers of goods and services in the product market, and
businesses are the sellers of goods and services, as shown in the top half of Figure 2.3.
From the circular flow model, it appears that the product market is a single physical
location where products are bought and sold. But this is clearly not the case. Instead, the
product market represents the millions of buy-sell transactions that are made every day in
supermarkets, gas stations, convenience stores, department stores, bakeries, laundries,
dentist and doctor offices, delis, and coffee shops.

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Product markets rely on the operation of supply and demand to determine prices

The transactions that take place in the product market are based on the principle of
voluntary exchange. That is, both the buyer (household) and the seller (business firm)
believe

They will benefit from an exchange; otherwise, it will not take place. The spending by a
household becomes revenue earned by a business. In an expanded version of the circular
flow model, the government also appears as an important buyer of goods and services in
the product market. For example, the government purchases military goods such as
submarines and aircraft from private firms. Household and government spending become
important sources of revenue for businesses.

Figure

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Goods are tangible items. The two main categories of goods are durable goods and
nondurable goods. Durable goods are items designed for long-term use, such as motor
vehicles, household furnishings, and household appliances. Nondurable goods, on the other
hand, are items produced for immediate consumption. Commonly consumed nondurable
goods include clothing and footwear, food and beverages, and gasoline. The larger part of
household spending was on services. Services are activities performed for fees

Factor Markets

The factor market is a place where factors of production (land, labour, capital) are bought
and sold the factor market, sometimes called the resource market, represents the purchase
of resources in an economy. In the factor market, households are the sellers of resources,
and business firms are the buyers of resources, as shown in the bottom half of Figure Again,
the circular flow model makes it appear as though the factor market consists of a single
location where resources are bought and sold. This model is a simplification of reality,
however.

First, resources are owned by households and sold to businesses. These resources are
called the factors of production—things that are used to make goods and services. The
three main factors of production are natural resources, the gifts of nature; human
resources, the human element in production; and capital goods, human-made items that
are used to produce other items. Some economists also include entrepreneurship as a
fourth factor of production.

Entrepreneurship represents the innovative commercial ideas of entrepreneurs working

on their own or within existing businesses. Resources have value because they are the main
ingredients of production. That is, resources are transformed by businesses into items that
households, government, and other businesses are willing to buy.

Second, the costs of production are the payments businesses make in exchange for the
factors of production. Note from Figure that the costs of production eventually make their
way into the pockets of households, who own the factors of production. Some resources are

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owned directly by people in households. For instance, workers directly own their labour,
and entrepreneurs own their special talents or skills. At other times, households own
resources indirectly, mainly through their ownership of business enterprises—including
the natural resources and capital goods that comprise the holdings of these business firms.
he main costs of production incurred by businesses are wages or salaries, which is the
payment for human resources; rents, the payment for natural resources; interest, the
payment for capital goods; and profits, the payment for entrepreneurship. The largest
category of payments—and thus the largest source of household income—is wages and
salaries

Flows of Products, Resources and Money Payments

The circular flow model also shows the two other flows: the flow of products (goods and
services) and resources on the outer circle, and the flow of money payments on the inner
circle. The outer circle shows that households willingly supply resources—human
resources, natural resources, capital goods, and entrepreneurship—to businesses in the
factor market. Businesses, in turn, transform these resources into finished goods and
services for sale in the product market. Thus, the outer circle shows the things that are
purchased in the factor market and the product market.

The inner circle shows the flow of the money payments as these payments travel through
the American economy. In the factor market, businesses make money payments to
households in the form of wages and salaries, interest, rents, and entrepreneurial profits.
These money payments, which are the costs of production for businesses, become sources
of income for households. Households, in turn, use their income to buy finished goods and
services in the product market. This household spending on goods and services becomes
revenues for businesses. Business revenues enable firms to buy resources from
households— and so the money flow continues. In the American market economy, the
flows in both the product market and the factor market are free from most types of
government regulation.

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3.2 MARKET STRUCTURE – PERFECT COMPETITION

Introduction

In economics, the market is the study about the demand for and supply of a particular
commodity and its consequent fixing of prices for instance the market may be a bullion
market, stock market, or even food grains market. The market is broadly divided into two
categories like perfect market and imperfect market. The perfect market is further divided
into pure market (which is a myth) and perfect market. The imperfect market is divided
into monopoly market, monopolistic market, oligopoly market and duopoly market. Based
on the nature of competition and on the number of buyers and sellers operating in the
market, the price for the commodity may be settled at the point where the demand forces
and supply forces agree upon.

Market Structure

The level of production of any commodity depends upon structure of its market. Possible
outcomes of sales, revenues, profits are prices and structured under market structures. The
firms demand curve to the industry demand curve is expected to depend on such things as
the number of sellers in the market and the similarity of their products. These are aspects
of market structures which may be called characteristics of market or generalization that
are likely to influence firm's behaviour and performance. These include the ease of entering
the industry, the nature and size of the purchasers of the firm's products and the firm’s
ability to influence demand by advertising. To reduce the discussion to manageable size,
economists have focused on a few theoretical market structures that are expected to
represent a high proportion of the cases actually encountered market societies
The price and level of production of a commodity depends upon the market structure of its
conditions.

Market demand depends on the following factors:

(i) Nature of the commodity: It is to be taken into account whether the goods are
homogeneous or heterogeneous.

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(ii) Number of buyers and sellers of the product in the market.

(iii) Mutual inter-dependence of buyers and sellers.

In brief the market structure depends on the level or forms of competition which are
as under:

1. Perfect Competition

2. Monopoly

3. Imperfect Competition

Perfect Competition

It is such a market structure where there are large number of buyers and sellers of a
homogeneous product and the price of the product is determined by the industry. There is
one price that prevails in the market. All firms sell the product at the prevailing price.

According to Leftwitch, "Perfect competition is a market in which there are many firms
selling identical product with no firm being large enough relative to the entire market so as

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to be able to influence market price." In other words, a perfectly competitive firm is too
small and insignificant to affect the market price like a wheat farmer. He is a price taker
who can sell all he wishes to sell at the ruling market price. In terms of elasticity of demand,
a perfect competitor faces a horizontal demand curve (parallel to the X-axis) for his
product, coefficient of elasticity being infinite.

According to A. koutsoyiannis, perfect competition is a market structure characterized by a

complete absence of rivalry among the individual firms.

Features or Characteristics of perfectly competitive market:

1. Large number of buyers and sellers in the market: There is a large number of buyers
and sellers of a commodity under perfect competition but each buyer and each
seller is so small in comparison with entire market of product that he cannot
influence the market price by changing the quantity of the product sold by him. If a
seller supplies the entire stock of the product produced by him the total supply will
not increase to such as extent as to lower the price and on the other hand if he
withdraws from the market the total supply will not fall to such an extent as to raise
the price. Thus, every seller has to accept the prevailing price
2. Homogeneous product: The second important characteristic of the perfectly
competitive market is that the products sold by the various firms are homogeneous.
The products are homogenous in the sense that they are perfect substitutes from
the buyer’s point of view. The sellers do not spend on advertisement and publicity
etc., because all the firms sell homogeneous product.
3. Free entry or exit: The third major characteristic of the perfect competition is free
entry and free exit for the firms under perfectly competitive market. The firms are
free to enter or to exit from the industry whenever they want to do so. Any firm can
enter or leave the industry at any time as there are no legal restrictions.
4. Perfect knowledge about the market: There is perfect knowledge on the part of
buyers and sellers about market conditions. The buyers and sellers are fully aware

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 of the price prevailing in the market. Due to this awareness all the firms charge on
price from the buyers.
5. . Perfect mobility of the factors of production: The existence of perfect mobility of
the factors of production is another important characteristic of the perfect
competition for its smooth functioning. It means all the factors of production are
perfectly mobile under perfectly competitive market. Factors will move to the
industry which pays the higher remuneration.
6. Non-Existence of transportation cost: A perfectly competitive market also assumes
the characteristic of non-existence of transport costs as uniform price prevails
throughout the market. It is essential that there is no transportation cost across
different areas of the market.

Equilibrium Price

The demand curve normally slopes downwards showing that more quantity of
commodity will be demanded at a lower price than at higher prices. Similarly supply curve
showing an upward trend where the producers will offer to sell a larger quantity at a
higher price than at a lower price. Thus the quantity demanded and quantity supplied
varies with price. The price that tends to settle down or comes to stay in the market (where
both buyers and sellers are satisfied) is at which quantity demanded equals quantity
supplied. The point so formed is known as equilibrium point and price is known as
equilibrium price. Effect of time on supply According to Marshall, time has great influence
on the determination of price.

The following are the market periods based on time- market period, short period and
long period.

1. Very short period (Market period)

2. Short period

3. Long period Market period or very short period may be only a day or very few days.

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 Change in supply is not possible where the period is very short and quantity
demanded will be the determining factor in this period Further, supply curve in the market
period is remain fixed showing vertical straight line. The short period is a period not
sufficient to make any changes in the existing fixed plant capacity. Increase in supply in the
short period is possible by increasing the variable factors of production only. The supply
curve slopes upward to right showing that some increase in supply is possible when the
price increases. Long period is a time long enough to adjust the supply to any changes in
demand. The long run supply curve is less steep then short run supply curve showing
increase in quantity supplied when price changes.

Short Run and Long Run in Perfect Competition

Equilibrium can be defined as a state of balance when variables under consideration have
no tendencies to change.

The firm is in equilibrium at a point where marginal cost (MC) is equal to the marginal
revenue (MR), and it is when profits are maximised. The firm aims at producing the level of
output which maximises a difference between TR and TC. This is when it pays the firm to
keep output unchanged. The slope of MC must be greater than the slope of MR at the
equilibrium output.

This is when the MC curve cuts the MR curve from below. For the competitive firm which is
maximising profit?

we have P = AR = MR = MC. This can be illustrated in the figure below

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As shown in Figure 7, at point A (output 0Q1), the firm is in equilibrium, i.e. MC = MR.
However, this is not sufficient. It, therefore, requires the firm to increase output to a higher
output e.g. 0Q3 in order to fetch more revenue compared to the cost incurred in its
production.

At point B, the firm fulfils the sufficient condition of equilibrium by producing a high
output 0Q3 where MC= MR and MC is rising. At equilibrium, the firm may either make
abnormal profits or incur losses (sub-normal profits) depending on the level of average
total cost (ATC).

Price and output determining of a firm under perfect competition in the short-run

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Abnormal profits in the short-run

The firm will be in equilibrium at a point where marginal cost (MC) = marginal revenue
(MR) and it will come under the following conditions:

 The average revenue (AR) must be greater than the average cost (AC).
 The average revenue curve determines the price while the average cost
curve determines the cost of the firm.
 Average cost curve must be below the average revenue curve.
 Marginal cost curve cuts the average cost curve at the lowest point.

The firm produces output 0Q at total cost and sells it at price 0P getting total

revenue , hence making abnormal profits CPAB.

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Loss making firm under perfect competition

It comes under the following conditions:

• The average revenue (AR) must be less than average cost (AC).
• The average revenue curve determines the price while the average cost curve
determines the cost of the firm.
• Average cost curve must be above the average revenue curve.
• Marginal cost curve cuts the average cost curve at the lowest point.

The firm produces output 0Q at total cost and sells it at price 0P, getting total
revenue

hence making losses PCED because the AC is greater than the AR.

Price and output determining under perfect competition in the long-run

In the long-run, because of the abnormal profits in the short-run, other firms join the
business hence the abnormal profits will be shared among all firms. Therefore, each firm
will get zero or normal profits as seen below. It comes under the following conditions:

• The average revenue (AR) must be equal to the average cost (AC).
• The average revenue curve determines the price while the average cost curve
determines the cost of the firm.
• Average cost curve must be tangent to the average revenue line.
• Marginal cost curve cuts the average cost curve at the lowest point.
The firm produces output 0Q at total cost OCBQ0 and sells it at price 0P getting

total revenue, OPAQ0, hence making abnormal profits CPAB.

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3.3. Monopoly

Introduction

A monopoly (from the Greek word “mono” meaning single and “polo” meaning to sell) is
that form of market in which a single seller sells a product (good or service) which has no
substitute.

Monopoly exists when there is no close substitute to the product and also when there is a
single producer and seller of the product

E.g. Indian Railway is a monopoly, since there is no other agency in the country that
provides railway service.

Pure monopoly is that market situation in which there is absolutely no substitute of the
product, and the entire market is under control of a single firm

Features

The following are the important features of monopoly:-

1. Sole supplier of the product and large number of buyers: The monopoly is
characterized by
thesolesellerofproductinanindustry.Firmrepresentstheindustryasawholewhichhasc
omplete control over the supply of product. Thus, there is only one firm under

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 monopoly but the buyers of the product are in large number, consequently, no buyer
can influence the price of the product.
2. No close substitutes: Under Monopoly there are no close substitutes of the product.
Monopoly cannot continue if there is availability of substitute goods.
3. One firm industry: There being only one firm, the distinction between the firm and
the industry is no longer inexistence.
4. Monopolymayvaryfromindustrytoindustry:Theformandstructureofamonopolymaya
lso vary from industry to industry.
5. AbsenceofEntry:Undermonopolymarketstructurenootherfirmcanenterthemarket.Iti
mplies the absence of actual entry. The barriers to the entry may be artificial, legal,
natural, economic and institutional etc.
6. Monopolist is a Price maker: Under Monopoly, market structure is a price maker not
the price taker because of the fact that a monopolist has full control over the supply
of the commodity. The fortunate monopolist can fix whatever price he chooses. But
if his sale is not enough, then he may lose instead of gaining.

After discussing monopoly we may note certain other forms which are offshoot of
monopoly. They are

(i) MONOPSONY

(ii)BILATERALMONOPOLY.

In monopsony there is only one buyer but there are large number of sellers.
Priceisdeterminedbynegotiationandoutputisdeterminedonthebasisofordersplacedbythe
buyer.In bilateral monopoly there is one buyer and only one seller of the commodity.

CAUSES OF MONOPOLY

 Restriction by Law

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 When the government restricts competition in the production and distribution
of a particular product.

 Control Over Key Raw Materials

When the strategic raw material to produce a particular commodity is scarce

and is fully controlled by a single firm.

 Specialized Know How

The specific technique of production of a particular commodity may be

restricted through patent or license.

 Economies of Scale

Often referred to as an “innocent” or a structural barrier. When the large firm is

able to charge a low price at which other firms are not able to survive

 Small Market size

When the market is so small that there is no scope for more than one player.

V.Types of Monopoly

 Legal Monopoly

 Created by the laws of a country in the greater public interest.

 To prevent disparity in distribution of wealth, or imbalanced growth of the

economy

 Economic Monopoly

 Created due to superior efficiency of a particular player.

 Attainment of economies of scale leads to monopoly, often referred to as an

“innocent” or a structural barrier.

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  Technical know-how restrained in the hold of single firm

 Natural Monopoly

 Formed when the size of the market is so small that it can accommodate only
one player.

 Regional Monopoly

 Geographical or territorial aspects also help in creation of monopolies such

as natural resources.

Equilibrium at Monopoly at Short Run And Long Run

In equilibrium at a point where MC = MR and the slope of MR must be less than the slope of
MC at the equilibrium output. The price is fixed on the demand curve in such a way that P =
AR > MR = MC.

The AR curve is above the MR curve. The price is fixed at the point where the demand curve
is elastic. It can be illustrated below:

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 As shown in Figure , the firm is in equilibrium at point x where MC=MR.

A firm under monopoly is in equilibrium where MC=MR and in the short-run, the firm can
either make abnormal profitsor losses. Profits are made as seen below:

Conditions

• The average revenue (AR) must be greater than average cost (AC).

• The average revenue curve determines the price while the average cost curve
determines the cost of the firm.

• Average cost curve must be below the average revenue curve.

• Marginal cost curve cuts the average cost curve at the lowest point.

As shown in Figure 16 above, the firm produces output 0Q at total cost 0CbQand sells it at
price 0P getting total revenue

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 0PaQ,hence getting abnormal profits CPab.

Profits = TR-TC. 0PaQ -0CbQ= CPab

Losses under monopoly in the short-run

Conditions

• The average revenue (AR) must be less than the average cost (AC).

• The average revenue curve determines the price while the average cost curve
determines the cost of the firm.

• Average cost curve must be above the average revenue curve.

• Marginal cost curve cuts the average cost curve at the lowest point.

As shown in above, the firm produces output 0Q at total cost 0CeQ and sells it at lower
price 0P, getting total revenue

0PfQ and thus makes losses PCef because the costs are greater than the revenue.

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Equilibrium position of a firm under monopoly in thelong-run

In the long-run, the firm under monopoly will still earn abnormal profits because it is the
only firm in the production process.

The firm will be in equilibrium where the long-run marginal cost curve is equal to long-run
marginal revenue curve. This is shown as follows:

Conditions

• The average revenue (AR) must be greater than average cost (AC).

• The average revenue curve determines the price while the average cost curve
determines the cost of the firm.

• Average cost curve must be below the average revenue curve.

• Marginal cost curve cuts the average cost curve at the lowest point.

In Figure 18, the firm produces output 0Q at total cost 0CbQ and sells it at price 0P,
getting total revenue 0PaQ hence

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 getting abnormal profits CPab.

Profits = TR-TC. 0PaQ-0CbQ= CPab

Advantages and Disadvantages

Advantages of monopoly

There is no duplication of services and this saves resources e.g. if there is one hydroelectric
power plant, there may notbe the need to set up another one in the same area.

• Economies of scale can be enjoyed by the firm because it is capable of

expanding using the abnormal profits earned.

• There is a possibility of price discrimination. (Parallel pricing). This refers to

the selling of the same commodity at different prices to different customers
which benefits the low-income earners.

• Research can easily be carried out using the abnormal profits.

• There is no wastage of resources in persuasive advertising which may

increase prices.

• Public utilities such as roads, telephones, etc. are easily controlled by the
government as a monopolist.

• Infant industries can grow up when they are monopolies and are protected
from foreign competition.

• It encourages innovations by protecting copyright and patent owners.

Disadvantages of monopoly

• Because there is no competition, the firm can become inefficient and produce
low quality products.

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 • Monopoly firms produce at excess capacity, i.e. they under-utilise their plants
so as to produce less output and sell at a high price.

• Monopoly firms may charge higher price than firms in perfect competition.

• In case a monopolist stops operating, there would be shortage of the

commodity.

• Monopoly firms tend to exert pressure on the government and sometimes

they can influence decision making because they are the controllers of
production.

• Discrimination of consumers: This may be based on political or religious

affiliation other than the factors respected by economics.

• Monopoly leads to income inequality. The monopolies who overcharge earn

more compared to others.

• Restriction of choices: A monopolist normally produces one type of

commodity, thus consumers are denied a chance to choose among the
alternatives.

3.4. Monopolistic Competition

Introduction

Monopolistic Competition is that condition of market in which there are many sellers of
any commodity but commodity of every seller is different from commodities of other
sellers in any way. Therefore, product differentiation is main quality of monopolistic
competition. Product differentiation can be in the way of brand’s name, trademark,
differences in properties, packing or services given to customer or differences in services.
Many examples of this type of competition are found in actual life. Firms producing
toothpaste like Forhans, Colgate, Pepsodent, Cibaca, Babool etc. are the examples of
monopolistic competition. In this type of market situation, there are firm monopolies and

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also the competitor, firm monopolies are there because it has limited control on commodity
due to the product differentiation

3.4.2. Characteristics of Monopolistic Competition

Following are the main characteristics of Monopolistic Competition—

1. Large Number of Firms and Buyers: Firm producing differentiated product and sellers
are large in numbers in monopolistic competition.

2. Product Differentiation: Product differentiation is the main feature of monopolistic

competition. Product differentiation means that product of different types, brands, and
qualities will be available to customers in a fixed time period. Product differentiation
occurs when buyer of product can differentiate between two products. In this, firms are in
large number but their products are different from each other in anyway, but these
products are close substitutes of each other. Product Notes differentiation is obtained due
to characteristic of product like shape, measurement, colour, durability, quality etc

3.Freedom of Entry and Exit of Firms:

In the situation of monopolistic competition there is freedom of entry and exit of firms in
the industry like perfect competition. It should be noticed that Chamberlin has used group
at the place of industry for group of firms which produce differentiated products under the
monopolistic competition.

4.Selling Cost: An important characteristic of monopolistic competition is that every firm

spends more money in promoting its product under it. Firm gives advertisements in
newspapers, cinemas, magazines, radio, T.V. etc. for selling its product in the maximum
amount. The investment done on all these is called as Selling Costs.

5. Price Control: Every firm has limited control on the cost of product. Average income and
limit end income curve of a firm fall down like monopoly in monopolistic competition. It

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means that in this situation, firm can slow down the price for selling more products and
raise price for fewer products. In monopolistic competition, a firm has control on cost of its
production due to the product differentiation. But due to the availability of close substitute
of opposite product firms do not have full control on cost in monopolistic competition. The
cost of every firm is affected by cost policy of its competitors in market up to the certain
limit.

6. Limited Mobility: In monopolistic competition, sources of production and products and

do not have mobility in services

7. Imperfect Knowledge: In the situation of monopolistic competition, buyers, sellers of

products, and owners of sources do not have knowledge of different prices of product. The
reason is that comparison between productions of different firms is not possible due to
product differentiation. Customers are fond of the production of any one specific firm. They
only buy the production of that firm even if it costs higher than others. In this way even
sources of production are not able to know fully that how much the different firms are
costing to the sources of services

8. Non-Price Competition: The main characteristic of monopolistic competition is that

under it different firms without changing the costs of products compete with each otherlike
the example of companies producing ‘Surf’ and ‘Ariel’. If you take a box of ‘Surf’, you will get
a glass utensil similarly, with the box of ‘Ariel’ you will get the steel spoon. In this way,
firms, by providing different types of facilities and products etc. to customers to attracts
them toward their products. This type of competition is called as Non-Price Competition.

Equilibrium position of a firm under monopolistic competition

The firm under monopolistic competition is in equilibrium when the MC=MR and in the
short-run the firm will either make abnormal profits or losses. The supernormal profits will
exist in the short-run because new firms cannot enter the industry. In the short-run, the
firms may attempt to maximise their profits by changing the quality and the nature of the

146
product and by increasing advertisement expenditure. But since there are many close
substitutes, neither of the strategies would be of much avail in the short-run.

Point x in Figure 21 above shows the equilibrium point where MC=MR.

Price and output determining of a firm under monopolistic competition in the short-run

A firm under monopolistic competition is in equilibrium where MC=MR and in the short-
run the firm can either make

abnormal profits or losses. Abnormal profits are made as seen below:

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The Marginal costs cut the average costcurve at the lowest point

• The average revenue (AR) must be greater than the average cost (AC).
• The average revenue curve determines the price while the average cost
curve determines the cost of the firm.
• Average cost curve must be below the average revenue curve

Losses under monopolistic competition in the short-run

The firm produces output at cost and sells it at a lower price .

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The firm can also make losses when it is in the production processes. This is shown above

Conditions

• The average revenue (AR) must be less than average cost (AC).
• The average revenue curve determines the price while the average cost
curve determines the cost of the firm.
• Average cost curve must be above the average revenue curve.
• Marginal cost curve cuts the average cost curve at the lowest point.

Due to the supernormal profits in the short-run, new firms join the industry with new
brands. Output increases,

Product differentiation increases. Consumer choice widens but the firms reduce the level of
their output since

the market has remained the same.

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The firms that were previously incurring losses leave the industry. Therefore, the demand
curve would keep on shifting to the left until a point is reached where the demand curve is
tangent to the ATC (LAC) curve.

Equilibrium is attained at point where Long-run Marginal Cost Curve (LMC) = Long-Run
Marginal Revenue (LM

The average revenue (AR) must be equal to the average cost (AC).

• The average revenue curve determines the price while the average cost
curve determines the cost of the firm.
• Average cost curve must be tangent to the average revenue line.
• Marginal cost curve cuts the average cost curve at the lowest point

From Figure 24, output is produced at a high total cost and sold at the same
price OP1/C.

The total cost is 0C/ and the total revenue .

The firm produces a lower output as shown by point A. However, it should produce

output as shown

by point x where is excess capacity, i.e. the difference between actual

output and expected output.

Product Differentiation Under Monopolistic Competition

Advantages of monopolistic competition

• Product differentiation enables consumers to get a variety of products.

• Firms compete to make improvement in the quality of products to choose from.
• In case one firm collapses, substitutes are available for the consumers.

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 • The price charged is lower than that of a monopolist because of competition from
substitutes.
• The freedom of entry gives a chance to any willing entrepreneur to enter the
industry which creates employment opportunities in the country.
• Individual firms gain a lot of popularity due to specialisation in their own brands.
• In the short-run, abnormal profits earned are used to improve on the quality of
products; undertake research and expand the size of the firm

Disadvantages of monopolistic competition

• There is under-utilisation of resources in the short-run and in the long-run and

this leads to excess capacity.
• In the long-run, there is no profit to make improvements. So, the firm may not
expand to enjoy economies of scale.
• The price charged on buyers is higher than in perfect competition.
• In the long-run, there are no profits to invest in research since the firm earns
normal (zero) profits.
• To maintain the market share, the seller has to persuasively advertise and this
may increase costs and the price.
• There are limited employment opportunities as firms operate at excess capacity.
• The output produced is less than that in perfect competition

3.5. Oligopoly

Introduction

Oligopoly is a situation in which there are so few sellers that each of the misconscious of
the results upon the price of the supply which individually places upon the market.
Oligopoly Derived from Greek word: “Oligo” (few) “Polo” (to sell).
AccordingtoJ.Stigler “Oligopoly is that situation in which a firm bases its market policy in
part on the expected behaviour of a few close revels”. Further, they may produce
homogeneous or differentiated products.

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A few dominant sellers sell differentiated or homogenous products under continuous
consciousness of rivals’ actions.

Oligopoly looks similar to other market forms; as there can be many sellers (like in
monopolistic competition), but a few very large sellers dominate the market.

Products sold may be homogenous (like in perfect competition), or differentiated (like in

monopolistic competition).

Entry is not restricted but difficult due to requirement of investments.

One aspect which differentiates oligopoly from all other market forms, is the
interdependence of various firms: no player can take a decision without considering the
action (or reaction) of rivals.

CHARACTERISTICS

Oligopoly is a distinct market condition. It has the following features:

1. Relativelysmallnumberofsellers:Therearerelativelysmallnumberofsellersu
nderoligopoly
marketstructuresellingidenticalordifferentiatedproducts.Eachsellercontrolsa
largepartofthe demand and the policies of every seller influence the price
and output of the industry as a whole.

2. Interdependence of the firms: Under the oligopoly market structure all the
firms are sailing in the same boat and every tilting position influences each of
the firm as well with equal proportion. No firm can be neutral. They depend
on each other while determining the price and output of the firm.

3. Pricerigidityandpricewar:Pricerigidityandpricearethecommonfeaturesofan
oligopoly market structure. Each firm retaliates and acts according to the
actions of the other firms andatug of war starts between them which is better
known as 'Price War' which further paves way to price rigidity.

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 4. Difficulty in entry and exit: Under oligopoly the entry and exit of the firms
is banned. The new firms cannot enter the market as the old firms have
complete hold over the market conditions and the firms are also reluctant to
leave because of the huge investment made by them.

5. Selling costs: Under oligopoly market structure, each firm pursues an

aggressive and defensive marketing strategy to control the market.
Advertisement is an important method used by the oligopolists to control the
bigger part of the market.

6. Indeterminateness of the demand curve: Under oligopoly market

structure the shape of the demand curve is broken and is indeterminate
because the firms cannot assume that the rival firms will not make a change
in their price policy in response to change in price affected by it. Thus, the
fact that the reaction pattern of the rival firms is indeterminate leaves the
demand curve in an indeterminate position.

7. Complex Market Structure: The market structure of oligopoly is quite

complex. As there is a possibility of rival firms to end rivalry by working out
some policy of collusion and the collusive oligopoly manifests itself in the
form of combination of rival firms to fix the same price and also share in
output as in case of cartels. Besides it, non-collusive oligopoly is also found in
practice which presents a complex market structure

Price Determination under Oligopoly

Pricing may be in condition of independent pricing, pricing under price leadership

and pricing under collusion.

Independent Pricing (Kinked Demand Model or Price Rigidity Model)

Paul Sweezy (1939) introduced concept of kinked demand curve to explain ‘price
stickiness’ or the indeterminate shape of the demand curve or AR curve.

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The kinked Demand curve is under the following assumptions

1. Assumptions

a. If a firm decreases price, others will also do the same. So, the firm initially
faces a highly elastic demand curve.

b. A price reduction will give some gains to the firm initially, but due to similar
reaction by rivals, this increase in demand will not be sustained.

c. If a firm increases its price, others will not follow. Firm will lose large
number of its customers to rivals due to substitution effect.

d. Thus an oligopoly firm faces a highly elastic demand in case of price fall and
highly inelastic demand in case of price rise.

2. A firm has no option but to stick to its current price.

3. At current price a kink is developed in the demand curve

The demand curve is more elastic above the kink and less elastic below the kink

Under oligopoly, there is no single method of price determining but prices are determined
by any of the following methods:

1.Independent pricing: This is where each firm or seller sets its own price for profit
maximisation.

2.Perfect collusion: This refers to cartel agreement where independent firms within the
same industry come together to determine the price and output with the purpose of
reducing unnecessary competition.

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 z

An example is OPEC.

3. Imperfect collusion: Here there is price leadership where the dominant firm
decides on the price for others to either follows if it is favourable or exit the industry
if it is unfavourable.

The demand curve of an oligopoly firm

The demand curve is kinked because the demand for their products largely depends
on the behaviours of other rival firms.

This brings uncertainties in the industry because no single firm can predict the
reaction of another firm in case they take their own decision. The kinked demand curve is
elastic above the kink and inelastic below it. This is shown above.

From Figure 26 above, P1 is the market price or administered price. Should any firm
increase its price above that price to price P3, it would lose its customers (Q1- Q3) to other
firms. If a firm decides to set price below P1 to price P2, other firms will react by reducing
their price even further or lower to win more customers, hence increase in quantity sold

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will be lower (Q1-Q2) than the reduction in price. Hence, the demand curve has a kink
meaning that the prices will remain rigid/stable for a long period of time.

Non price competition under oligopoly

This is a situation where firms compete on the basis of other things other than price in an
attempt to widen their markets in the same industry. It is a common feature in oligopoly.

The forms of non-price competition used by oligopolistic firms in Rwanda

• Persuasive advertisement using various media such as radios, television,

newspapers, etc. to make people aware of the commodity.
• Branding and blending, i.e. use of appealing brand names such as Rwanda tea.
• Offering credit facilities to customers to encourage them to keep buying.
• Offering gifts and free samples to encourage them to buy more such as petrol
stations giving soap to customers.
• Opening many branches in different locations in the country.
• Offering after sales services such as free delivery of purchases to customers’
premises; guaranteeing spare parts all which attract customers to the firm involved.
• Sponsoring social events such as sports and music, for example GumaGuma with
Primus thus winning the market.
• Organising promotions through raffle draws which are intended to increase the
number of customers who are attracted to buy the commodity in order to join the
draw, for example MTN Sharama, join the millionaires club by Tigo.
• Organising trade fairs and exhibitions to make their products known to customers.
• Offering mobile shops: This is where the firm puts its products in a vehicle/ bicycle
and moves from place to place selling its products, for example bread firms.
• Renovation of premises of customers by rival firms for example telecommunication
networks (Tigo, MTN, Airtel), beer firms (Primus, Skol).• Use of stop-shopping
centres such as supermarkets at fueling stations.
• Use of differentiated attractive packaging and convenient designs of products by
firms to outcompete each other, for example Blue Omo.

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 • Quality improvement and introduction of new variables in order to increase their
market share.
• Use of appealing slogans which attract customers to their products, for example
MTN-everywhere you go, Tigo-live it love it, Airtel-express yourself.

 Equilibrium position and profit maximisation of a firm under oligopoly

Under oligopoly, the firm is in equilibrium where the MC=MR and oligopolists make
abnormal profits both inthe short and long-run as shown in figure Tthe firm produces
output 0q at total cost 0Cxq and sells it at price 0P getting total revenue 0PKq.

The marginal revenue curve is not continuous between sections T and S because of
uncertainties.

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 The firm is, therefore, in equilibrium at point T where MC = MR and earns abnormal
profits shown by the area CPKx.

There are low prices to the consumers due to existence of intensive competition and fear of
other firm’s reaction.

Merits of Oligoploy

• It eases consumer budgeting due to price stability.

• It widens consumer choice production of a variety especially with imperfect
oligopoly due to branding and product differentiation.
• There is production of good quality goods due to competition.
• There is increased innovation due to competition.
• There is increased output due to production on large scale.
• Stable prices are charged due to the presence of price rigidity.
• Consumer awareness of the commodity is high due to extensive advertising.
• Most oligopoly firms operate on large scale, which enables a firm to enjoy
economies of scale.
• Provision of gifts to customers such as books, soap, pens, etc. improves on customer
welfare.
• A lot of abnormal profits earned are spent on research and development which
leads to technological advancement and a high standard of living in the country.

Demerits of oligopoly firms

• There is consumer exploitation through overcharging due to collusion.

• There is duplication, hence wastage of resources.
• Small firms collapse when they are outcompeted.
• There is under-exploitation of resources due to production at excess capacity.
• Industries with large firms exert pressure on government.
• Oligopoly distorts consumer choices due to excessive advertisements.
• It worsens income inequality due to limited entry of other firms.

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 • Some firms at times engage in price wars where each firm keeps on reducing on
prices of its products to outcompete rival firms, which results into losses.
• Profits are limited due to price rigidity and this may affect further expansion.
• Firms incur high costs on advertising, which increases on the price of the
commodity.
• The market structure is characterised by uncertainties about the reactions and
activities of other firms, which limit the ability of an individual firm to make
independent decisions.

3.6. Duopoly

3.6.1. Introduction

Duopoly (from the Greek «duo», two, and «polein», to sell) is a type of oligopoly. This kind
of imperfect competition is characterized by having only two firms in the market producing
a homogeneous good. For simplicity purposes, oligopolies are normally studied by
analysing duopolies. What strategies firms follow and their interactions is a key feature of
this market structure.

A kind of Oligopoly in which two companies operate in market or industry and produce
similar goods and service in duopoly two companies control virtually the entire market
for the products they sell. While other companies are operating on the same market or
industry, these two companies are the major players. Duopoly is about how the two
companies interact and affect each other. It is about how they shape the market they
operate in.

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Characteristics of Duopoly

 Strong barriers to entry

There is a strong barrier to enter in the market,

E.g. brand loyalty is existing (Coca-Cola and Pepsi).

Significant economies of scale which suit a small number of firms (e.g. Airbus and Boeing
airline manufacture

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Suppose industry demand is 4,000 units sold. If the minimum efficient scale is 2,000. Then
the most efficient number of firms is two (duopoly). If there were four firms producing
1,000 units, the average costs would be higher.

 Firms may compete on price or they could seek to collude either tactically or formal
agreement. This will depend on the nature of the industry. For example, Coca-cola
and Pepsi compete on brand image and spend a high share of revenue on
advertising. Price competition is relatively muted. The creation of Airbus in 1970
helped to make airline manufacture more competitive, airlines could now choose a
different company to Boeing forcing more price competition and greater choice of
goods.

 Duopolies are usually quite profitable industries and are likely to have an outcome
similar to monopoly with price above marginal cost and a degree of allocative
inefficiency. The drawbacks of higher prices may be offset be economies of scale and
lower average costs.

 Duopolies there are two variables of interest: the prices set by each firm and the
quantity produced by each firm. Several models have been developed through time,
from which we must highlight the Cournot, Stackelberg, Bertrand and
the Edgeworth solution. The first two models seek the optimum quantity a firm
should produce. Both have different conclusions as they have a different initial
assumption. With time, and as the next two models proved, the focus changed to
target the optimum price a firm should set in order to maximise profits.

 There are also different perspectives in the analysis of duopolies, which deal
with game theory. While the models by Antoine Cournot and Joseph Bertrand occur
under a basis of simultaneous games, Heinrich von Stackelberg’s model depends
on sequential games.

 In the real world, firms interact with each other and have to consider the potential
negative effects a price war may report in the long-run. Edward

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 Chamberlin suggested that in an oligopolistic market, firms would soon recognise
their interdependence and hold monopolistic prices without the implications
of collusion, but that would give the same equilibrium point. Collusion equilibrium
will be maintained for as long as a firm finds it more beneficial to do so. The moment
a firm thinks it can achieve higher profits by deviating from it, it will do so.

TYPES OF DUOPOLY

 Classical and modern economists have developed a variety of models based on

different behaviour assumptions. These models can broadly be classified into two
categories (I) classical duopoly models and modern oligopoly Duopoly Models,
when there are only two sellers a product, there, exists duopoly. Duopoly is a special
case of oligopoly. Duopoly is a special case in the sense that it is limiting case of
oligopoly as there must be at least two sellers to make the market oligopolistic in
nature.

1. The Cournot’s Duopoly Model 2. The Chamberlin Duopoly Model 3. The Bertrand’s
Duopoly Model 4. The Edge worth Duopoly Model 1.Cournot’s Duopoly Model: Augustin
Cournot, a French economist, was the first to develop a formal duopoly model in 1838. To
illustrate his model, Cournot assumed: (a) Tow firms, each owing an artesian mineral water
well;(b) Both operate their wells at zero marginal cost2; (c) Both faces a demand curve
with constant negative slope; (d) each seller acts on the assumption that his competitor
will not react to his decision to change his and price. This is Cournot’s behavioural
assumption. On the basis of this model, Cournot has concluded that each seller ultimately
supplies one-third of the market and charges the same price. While one-third of the market
remains unsupplied.

It has been criticised on the following grounds:

(1) Cournot’s behavioural assumption [assumption (d) above] is naive to the extent that it
implies that firms continue to make wrong calculations about the competitor’s behaviour.

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Each seller continues to assume that his rival will not change his output even though he
reportedly observes that his revel firm does change its output.

(2) The assumption of zero cost of production is totally unrealistic. If this assumption is
dropped, it does not alter his position.

2. Chamberlin’s Duopoly Model a Small Group Model: Chamberlin’s model of duopoly

recognizes interdependence if firms in such a market. Chamberlin argues that in the real
world of oligopoly firms are not so native that they will not learn from the past experience.
However, he makes the same assumptions as the exponents of old classical models have
done. In other words, his model is also based on the assumption of homogeneous products,
firms of equal size with identical costs, no entry by new firms and full knowledge of
demand. Recognition of interdependence of firms in an oligopolistic market given us a
result quite different from that of Cournot. Chambrilin argues that firms are aware of the
fact that their output or price decision will definitely invite reactions of other firms.
Therefore, he goes not visualize any price war in oligopolistic markets. He also rules out the
possibility of firms adjusting their outputs over a period of time and thus reaching the
equilibrium at an output level lower than that would be reached under monopoly.
According to Chamberlin, recognition of possible sharp reactions to an oligopolistic firm’s
price or output manipulations would avert harmful competition amongst the firms in such
a market and would result in a stable industry equilibrium with the monopoly price and
monopoly output. He further stated that no collusion is required for obtained this solution.
In case farms in an oligopolistic market are aware of their mutual dependence, and willing
to learn from their past experience, then in order to maximize their individual and joint
profits they will charge the monopoly price. Chamberlin’s model can be explained in the
frame work of a duopoly market.

Chamberlin, like Cournot, assumes linear demand for the product it has been criticised on
the following grounds: (1) Cournot’s behavioural assumption [assumption (d) above] is
naive to the extent that it implies that firms continue to make wrong calculations about the
competitor’s behaviour. Each seller continues to assume that his rival will not change his

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output even though he reportedly observes that his revel firm does change its output. (2)
The assumption of zero cost of production is totally unrealistic. If this assumption is
dropped, it does not alter his position.

2. Chamberlin’s Duopoly Model A Small Group Model: Chamberlin’s model of duopoly

recognizes interdependence if firms in such a market. Chamberlin argues that in the real
world of oligopoly firms are not so native that they will not learn from the past experience.
However, he makes the same assumptions as the exponents of old classical models have
done. In other words, his model is also based on the assumption of homogeneous products,
firms of equal size with identical costs, no entry by new firms and full knowledge of
demand. Recognition of interdependence of firms in an oligopolistic market given us a
result quite different from that of Cournot. Chambrilin argues that firms are aware of the
fact that their output or price decision will definitely invite reactions of other firms.
Therefore, he goes not visualize any price war in oligopolistic markets. He also rules out the
possibility of firms adjusting their outputs over a period of time and thus reaching the
equilibrium at an output level lower than that would be reached under monopoly.
According to Chamberlin, recognition of possible sharp reactions to an oligopolistic firm’s
price or output manipulations would avert harmful competition amongst the firms in such
a market and would result in a stable industry equilibrium with the monopoly price and
monopoly output. He further stated that no collusion is required for obtained this solution.
In case farms in an oligopolistic market are aware of their mutual dependence, and willing
to learn from their past experience, then in order to maximize their individual and joint
profits they will charge the monopoly price. Chamberlin’s model can be explained in the
frame work of a duopoly market. Chamberlin, like Cournot, assumes linear demand for the
product

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In the above figure, DQ is the market demand curve. If firm A enters the market, it will
produce output OQ1 because, at this level of output, the marginal revenue is equal to
marginal cost. The firm might charge OP1, which is the monopoly price.

This will lead to the maximization of profits. At price OP, the elasticity of demand is unitary.

If firm B enters the market at this stage, it considers its demand curve is CQ. It will produce
Q1Q2 to maximize its profits. It will move to the price OP2.

After realizing that it can no longer sell at QQ1 quantity, it decides to reduce the output to
QQ3. Firm B continues to produce Q1Q2 quantity which is the same as Q3Q1. The industry
output is OQ1and the price raises to OP1. Both the firms, A and B consider it an ideal
situation.

The joint output of both firms is monopoly output and they charge a monopoly price. Thus,
considering this assumption, the market will be shared equally between the two firms.

Bertrand’s Duopoly Model

Bertrand was a French Mathematician who developed his model of the duopoly in 1883.
His model is different from that of Cournot in respect to its behavioural assumption.

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Under Bertrand’s model, each seller determines his price on the assumption that his rival’s
price and not output remains constant.Bertrand’s model focuses on price competition. His
analytical tools are the reaction function of the duopolists. The reaction functions are
derived based on the isprofit curves.

He assumed that there were only two firms, i.e., A and B. The prices are measured along the
horizontal and vertical axes

3.6.5.

EDGE WORTH’S DUOPOLY MODEL

Edge worth’s Duopoly Model came up in 1897. He follows Bertrans’s assumption that each
seller assumes his rival’s price instead of his output, to remain constant.

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In the figure, we have to assume that there are two sellers. These firms, A and B face
identical demand curves. A’s demand curve is DDB. Seller A has the maximum capacity of
output OM and B has the maximum output capacity of OM’. ODA measures the price.

To commence with, let us assume that A is the only seller in the market. He sells OQ and
charges OP2.

The monopoly cost under zero cost is equal to OP2EQ. Now if B enters the market, he
assumes that A will not change his price since he is making maximum profit. Firm B sets its
price slightly below A’s price and can sell his total output. Seller A, on the other hand, has
his sales gone down.

To regain his market, A sets his price slightly below the price of B. This creates a price-war
between the sellers.

The price-war takes the form of price-cutting which continues until price reaches OP1. At
this level both the firms, A and B can sell their entire output- A sells OQ and B sells OQ. The
price of OP1 can be stable. However. According to Edgeworth, price OP1 should not be
stable.

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In all, Edgeworth’s model is based on a naive assumption that a rival will never change his
price even after being proved repeatedly wrong. However, Edgeworth’s model is an
improved version of Cournot’s model.

The Significance of A Duopoly

 Duopolies are significant because they force each company to consider how its
actions will affect its rival, meaning, how the rival firm will respond. It affects how
each company operates, how it produces its goods, and how it advertises its
services, and can ultimately change what and how goods and services are both
offered and priced. When the two firms compete on price in a Bertrand Duopoly
prices tend to dip to or below the cost of production, thereby wiping out any chance
for profit.
 For this reason, most duopolistic firms find it profitable and generally necessary to
agree to form a sort of monopoly, setting prices that allow both firms to take one
half of the market space and thus one half of the market’s profit. However, this is a
tricky tactic if done incorrectly because the Sherman Act and other antitrust laws in
the United States make the collusive activity illegal.

Duopolies, when operating and competing based on production quantity instead of price,
tend to function better, avoiding any potential for legal issues and enabling each firm to
share in the profits, reaching a price and operating homeostasis within their duopolistic
market.

3.7. Market Efficiency and Pricing Strategies

Efficiency in the demand and supply model has the same basic meaning: the economy is
getting as much benefit as possible from its scarce resources and all the possible gains from
trade have been achieved. In other words, the optimal amount of each good and service is
being produced and consumed.

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Consumer Surplus, Producer Surplus, Social Surplus

Consider a market for tablet computers. The equilibrium price is $80 and the equilibrium
quantity is 28 million shown in the demand and supply diagram below. The segment of the
demand curve above the equilibrium point and to the left represents the benefit to
consumers. It shows that at least some demanders would have been willing to pay more
than $80 for a tablet.

For example, point \text{J}J start text, J, end text shows that if the price were $90, 20
million tablets would have been sold. Consumers who would have been willing to pay $90
for a tablet but who were able to pay the equilibrium price of $80 clearly received a benefit
they received the same utility they were willing to pay $90 for at a reduced price.

Remember, the demand curve traces consumers’ willingness to pay for different quantities.
The amount that individuals would have been willing to pay minus the amount that they
actually paid is called consumer surplus. We can understand this concept graphically as
well; consumer surplus is represented by the area labelled \text{F}Fstart text, F, end text in
the diagram below the area above the market price and below the demand curve.

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The supply curve shows the quantity that firms are willing to supply at each price. For
example, point \text{K}K start text, K, end text in the diagram above illustrates that if tablet
computers cost $45, firms still would have been willing to supply a quantity of 14 million.
Those producers who would have been willing to supply the tablets at $45 but who were
instead able to charge the equilibrium price of $80 received an extra benefit beyond what
they required to supply the product.

The amount that a seller is paid for a good minus the seller’s actual cost is called producer
surplus. Graphically, this surplus is represented by the area labelled \text{G}Gstart text, G,
end text in the diagram above the area between the market price and the segment of the
supply curve below the equilibrium.

The sum of consumer surplus and producer surplus is social surplus, also referred to
as economic surplus. In our diagram, social surplus is the area \text{F} + \text{G}F+Gstart
text, F, end text, plus, start text, G, end text. Social surplus is larger at equilibrium quantity
and price than it would be at any other quantity.

At the efficient level of output, it is impossible to produce greater consumer surplus

without reducing producer surplus, and it is impossible to produce greater producer
surplus without reducing consumer surplus. This efficient level is the market equilibrium!

Pricing

Pricing is the process of determining what a company will receive in exchange for its
product or service. A business can use a variety of pricing strategies when selling a product
or service. The price can be set to maximize profitability for each unit sold or from the
market overall. It can be used to defend an existing market from new entrants, to increase
market share within a market or to enter a new market.

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MAJOR PRICING OBJECTIVES

1. Maximizing the Profits

Generating a profit is one of the ultimate pricing objectives of businesses, but is under the
effect of the pricing, either directly or indirectly. In a direct manner, it depends whether
your pricing is capable of covering the costs as well as, putting some bucks in your pocket.

And in an indirect way, it depends on the number of units sold, where those extra sold units
will cover up that profit. For the achievement of the purpose, they shape up their strategies
while keeping an eye on the trends in the past. They set their prices in such a way that the
maximum amount of profits can be ripped up while staying inside some limits. Because
outside these, it is very likely that they can quickly lose most or nearly their entire
customers.

2. Targeting a Particular Return on Investment (ROI)

Targeting return is one of the most interesting pricing objectives for most of the investors.
As its name suggests, Return On Investment is the amount of return (either as a fixed
percentage of sales or profit) generated by a particular degree of investment. A high return
due to the high pricing of the product with the low cost of production and promotion is
what all the investors strive for. But again, they also need to care for their customer base.

3. Increase in Sales

In the sales-oriented pricing objectives, the knowledge gained from the experience curve is
put to some good use in predicting a strategy that’s capable of decreasing long-term costs
while ensuring a long-run profit, by increasing the number of units sold. For this purpose,
companies may alter the prices or even whole pricing policies to improve their chances of
getting a greater number of sales.

Furthermore, brands can use the objective for the purpose of increasing the market shares
also, which is a measure of the sales comparison with another brand’s or in the whole

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industry. Aside from achieving a definite target of market share, companies can also use
pricing to boost up their shares.

4. When Survival is the Only Priority

Although good and bad times are part of life and business too and that’s why we do the
planning, hoping for the best and getting ready for the worst. In times of overcapacity or
market decline, strategists can decrease prices to an extent that could still cover up the
costs and let the business up and running. That’s the case where survival gets higher
priority as compared to profits and sales.

5. Making your Product a Trendsetter

Quality is what determines how much a product should cost. When a product is new in the
market, people are very much interested in it. But when it gets a thorough mixture of high
quality and affordable prices, it is referred as to be the trendsetter in the market. The
primary goal of the companies, setting such pricing objectives, is making a product visible
in the market by price, especially if it’s a new one. Companies set their prices low so as to
attract people, and if guys like it, it works as a trigger to a repetitive chain reaction of
purchases that people make.

6. Stabilizing an Old Business

By the time as a company grows old, it starts seeking stabilization in the market while
maintaining a suitable and stable profit base with a growing customer base and at the same
time, avoiding the price wars with their competitors. Furthermore, it is also a fact that a
stable pricing policy leads to a customer base that looks up to your brand with an attractive
prestige and has a good impression in mind. That’s how big brands keep up their image and
reputation.

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7. Competition Based Objectives

One of the major factors that determine the marketing policies of any company is its
competitor base. As competition gets stronger the easier, it becomes for the company to get
kicked out of business. That’s where pricing comes to be a powerful weapon to attract
customers while facing that fierce competition. Some brands also use the pricing for
preventing any further brand from entering this race. It works on the principle of keeping
the prices low enough so that customers prefer you before going to anyone else.

Well! It just does not end here. Sometimes, situations get bad! Real bad! And you have to go
offensively. In this case, companies sacrifice a lot of their current profits by decreasing the
prices as low as just to cover cost prices. But this strategy secures significant benefits too in
the long run. Once the competition runs out of business, they grow their prices up again,
but this time, it comes with a huge boost in the number of sales.

Kinds of Pricing

Skimming Price

Skimming price is known as short period device for pricing. Here, companies tend to
charge higher price in initial stages. Initial high helps to “Skim the Cream” of the market as
the demand for new product is likely to be less price elastic in the early stages.

Penetration Price

Penetration price is also referred as stay out price policy since it prevents competition to a
great extent. In penetration pricing lowest price for the new product is charged. This helps
in prompt sales and keeping the competitors away from the market. It is a long term
pricing strategy and should be adopted with great caution

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FULL COST PRICING METHOD

Full cost plus pricing is a price-setting method under which you add together the direct
material cost, direct labor cost, selling and administrative cost, and overhead costs for a
product and add to it a mark-up percentage in order to derive the price of the product.

The pricing formula is

Pricing formula = Total production costs − Selling and administration costs –Mark-
up Number of units expected to sell

This method is most commonly used in situations where products and services are
provided based on the specific requirements of the customer. Thus, there is reduced
competitive pressure and no standardized product being provided. The method may also
be used to set long-term prices that are sufficiently high to ensure a profit after all costs
have been incurred.

MARGINAL COST PRICING METHOD

The practice of setting the price of a product to equal the extra cost of producing an extra
unit of output is called marginal pricing in economics. By this policy, a producer charges
for each product unit sold, only the addition to total cost resulting from materials and
direct labor. Businesses often set prices close to marginal cost during periods of poor
sales.

For example, an item has a marginal cost of $2.00 and a normal selling price is $3.00, the
firm selling the item might wish to lower the price to $2.10 if demand has waned. The
business would choose this approach because the incremental profit of 10 cents from the
transaction is better than no sale at all.

TRANSFER PRICING

Transfer Pricing relates to international transactions performed between related parties

and covers all sorts of transactions.

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The most common being distributorship, R&D, marketing, manufacturing, loans,
management fees, and IP licensing.

All intercompany transactions must be regulated in accordance with applicable law and
comply with the "arm's length" principle which requires holding an updated transfer
pricing study and an intercompany agreement based upon the study.

Some corporations perform their intercompany transactions based upon previously

issued studies or an ill advice they have received, to work at a “cost plus X%”. This is not
sufficient, such a decision has to be supported in terms of methodology and the amount of
overhead by a proper transfer pricing study and it has to be updated each financial year.

Dual Pricing

In simple words, different prices offered for the same product in different markets is dual
pricing. Different prices for same product are basically known as dual pricing. The
objective of dual pricing is to enter different markets or a new market with one product
offering lower prices in foreign county.

There are industry specific laws or norms which are needed to be followed for dual
pricing. Dual pricing strategy does not involve arbitrage. It is quite commonly followed in
developing countries where local citizens are offered the same products at a lower price
for which foreigners are paid more.

Airline Industry could be considered as a prime example of Dual Pricing. Companies offer
lower prices if tickets are booked well in advance. The demand of this category of
customers is elastic and varies inversely with price.

As the time passes the flight fares start increasing to get high prices from the customers
whose demands are inelastic. This is how companies charge different fare for the same
flight tickets. The differentiating factor here is the time of booking and not nationality

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Pricing strategies to attract customers / increase profit

 Premium pricing. This occurs when a firm makes a good more expensive to try and
give the impression that it is better quality, e.g. ‘premium unleaded fuel’, fashion
labels.

 Loss Leaders this involves setting a low price on some products to entice customers
into the shop where hopefully they will also buy other goods as well. However, it is
illegal to sell goods below cost, so firms could be investigated by OFT.

 Price Discrimination. This involves charging a different price to different groups of

consumers to take advantage of different elasticity’s of demand. There are different
types of price discrimination from first degree to third degree.

 Reference Pricing. This involves setting an artificially high price to be able to later
offer discounts on previously advertised price.

 Price Matching. The purpose behind price matching is making a promise to match
any price cuts by your competitors. The argument is that this discourages your
competitors from cutting price. This is because they know there is little point in
cutting prices because you will respond straight away. Very clear price matching
stances can thus avoid price wars and give the impression of being very competitive.
For example, Tesco is offering £10 voucher to customers who can prove their
shopping basket would have been cheaper at other supermarkets.

 Retail price mechanism RPM – when manufacturers set minimum prices for
retailers, e.g. net book agreement.

 Psychological pricing. Setting price at important psychological levels to trigger

purchase, e.g. selling good at £9.99 to make it appear cheaper. Some firms use
reverse psychology and charge exact prices, e.g. clothes for £40 to indicate quality
rather than cheapness.

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  Premium decoy pricing. Where a firm sets the price of one good deliberately high
to encourage demand for a lower price. E.g. a car company may bring out a top of
the range sports car, which is very expensive to make the general brand more
attractive.

 Pay what you want. A situation where consumers are left free to decide how much
to pay, e.g. restaurants cafe where there is no cost only tipping. When music
companies release a new recording and ask for donations.

 Bundle pricing. When a firm gives special offers, e.g. buy 3 for the price of 2 very
common for book sales etc.

 Optional pricing. When a firm tries to receive a higher price by selling extras. For
example, if you buy a DVD, you can get sold insurance or additional features.

 Dynamic pricing. When prices are regularly updated in response to shifting market
conditions. For example, if an airline receives high demand for certain flights, it will
increase the price to help fill up other departure times and maximise revenue from
the flight.

Pricing strategies to cement market share/market position

 Limit pricing. This occurs when a monopoly set price lower than profit
maximisation to discourage entry. This enables the firm to make supernormal profit,
but the price is still low enough to deter new firms to enter the market.

 Predatory pricing. Selling price below cost to try and force rival out of business.
Predatory pricing is illegal. Predatory pricing can be made easier through cross
Subsidisation. This occurs when a big multinational may use profits in one area to
subsidise a price war in another. The cross subsidisation enables a firm to sell a
product very competitively (or even at a loss) to try and force the rival firms out of
business.

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Pricing strategies to help determine the price

 Average cost pricing. When a firm sets the price equal to average cost plus a certain
profit margin.

 Market-based pricing. When firms set a price depending on supply and demand. For
example, if football clubs, used market-based pricing, clubs like Manchester United
would probably increase the ticket price because, at the moment, all tickets are sold
out suggesting price is below the equilibrium.

 Mark-up pricing. This involves setting a price equal to marginal cost of production + x.
(where x = the profit margin a firm wants to make on each sale)

 Profit maximisation. Setting price and quantity so MR=MC

Importance of Elasticity

If demand for your products is highly elastic, cutting prices should lead to an increase in
revenue. Increasing prices will lead to a fall in revenue.If demand is price inelastic, then you
can increase your profits by increasing your price.

This is the logic behind price discrimination. Firms charge a higher price to that market
segment where demand is more prices inelastic, but a lower price to where demand is
more price elastic.

What will determine the most effective pricing strategy?

The optimal pricing strategy will depend on the type of firm. For example, if you are
considered to having a premium brand cutting price could be perceived as disastrous as
you lose your brand image, and fail to increase sales. For these products, it might be better
to maintain premium pricing and optional pricing. For normal goods, with firms looking to
increase market share and gain more market dominance, it is more important to offer
competitive prices, through strategies such as penetration pricing and even loss leaders

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3.8. Macroeconomics

Introduction

Macroeconomics is a branch of economics dealing with the performance, structure,

behaviour, and decision-making of an economy as a whole. This includes regional, national,
and global economies.

In macroeconomics, we usually simplify the analysis of how the country’s total production
and the level of employment are related to attributes (called ‘variables’) like prices, rate of
interest, wage rates, profits and so on, by focusing on a single imaginary commodity and what
happens to it.

Macroeconomics and microeconomics are the pairing terms that were coined by Ragnar
Frisch.

Macroeconomics emerged as a separate branch of economics after the British economist John
Maynard Keynes published his famous book The General Theory of Employment, Interest,
and Money in 1936.

There was widespread thinking before Keynes published his book that every worker
willing to work will find work and factories will be running at full capacity. This period was
known as the Classical Tradition.

Keynes’s book was an attempt to counter the great depression of 1929. This event made
them worried about the functioning of the economy. Unlike his predecessors, his approach
was to examine the working of the economy in its entirety and examine the
interdependence of the different sectors.

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Basic of Macroeconomics Concepts

Income

This forms one of the most basic concepts of macroeconomics. It refers to the total amount
of goods produced in a particular country in a specified timeline.

In macroeconomics, economists usually measure national income or output by gross

domestic product or GDP. By measuring GDP, economists can understand the market
swings and changes. Based on the situations they identify what measures they need to take
to improve the GDP of the country.

Unemployment

The next important factor that comes is the unemployment rate. Economists measure the
unemployment rate by calculating the no. of individuals who are without jobs.
Unemployment categories include classic unemployment, frictional unemployment, and
structural unemployment.

Inflation

Inflation is a sustained increase in the general price level of goods and services in an
economy over a period of time. When the general price level rises, each unit of currency
buys fewer goods and services; consequently, inflation reflects a reduction in
the purchasing power per unit of money a loss of real value in the medium of exchange and
unit of account within the economy.

The opposite of inflation is deflation, a sustained decrease in the general price level of
goods and services. Deflation occurs when the inflation rate falls below 0% (a
negative inflation rate). Inflation reduces the value of currency over time, but sudden
deflation increases it. This allows more goods and services to be bought than before with
the same amount of currency. Deflation is distinct from disinflation, a slow-down in the
inflation rate, i.e. when inflation declines to a lower rate but is still positive.

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Sectors of Indian Economy

Household Sector

The household sector includes the entire population of society. It includes all of
the consumption-seeking members of society, the entire population. In this sector, all the
needs related to eating, breathing, fulfilling daily needs are covered.

Government Sector

This sector includes all government entities that impose resource allocation decisions that
might not be made otherwise, on the rest of the economy. It consists of the three primary
levels of federal, state, and local governments responsible for passing and enforcing laws.

Government spending can be financed by government borrowing or taxes. A change in

government spending is a significant component of fiscalpolicy used to stabilize the
macroeconomic business cycle.

Business Sector

The Business sector or the service sector is concerned with the intangible aspect of offering
services to consumers and businesses. It involves the retail of manufactured goods.
Services such as insurance and banking are also included in the business sector.

The service sector has grown due to improved labor productivity and higher disposable
income. This sector includes those activities that help in the development of the Household
and Government sectors by supporting the production processes.

Foreign Sector

The foreign sector comes into play when a country is not able to fulfil its requirement
between the closed economies. Countries then deal with each other accordingly to satisfy

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their requirements. Countries need to trade among themselves to strengthen their
economy.

If one country is a producer of some goods that is present in the abundant amount then it
trades with other countries fulfilling their needs and in exchange, they are provided with
something that other countries excel in.

This round business cycle flow helps the economy running and blooming.

Circular Flow of Income

The circular flow of income is a way of representing the flows of money between the two
main groups in society - producers (firms) and consumers (households). These flows are
part of the fundamental process of satisfying human wants.

A free market economy consists of two components, or sectors, as they are called. These
are firms and households. People in households work for firms (selling their factor
services) and receive wages in exchange. On the scale of the whole economy, this is known
as national income - the total amount of income earned over a given time period. This
money is spent on food, clothing, transport, entertainment etc, and so it returns to the
firms. This is the circular flow

Figure 1 Circular flow of income

Households sell their factor services to firms (in the factor markets) and in exchange
receive wages (the left hand side of the flow). In the meantime, households spend this
income on goods and services (in the goods market) and in exchange receive the goods and
services themselves (the right hand side of the flow). Economists call the wages plus the
other forms of income, national income and give it the code 'Y'. Domestic consumption is
given the code 'C'.

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Not all income is spent, however. Some is saved. Savings are coded as 'S'. Other money is
used to buy goods or services produced overseas. The money to buy these goods and
services flows out of the country. It is given the code 'M' for imports.

Figure 2 Circular flows - savings and imports

S and M are called leakages from the circular flow. The effect of these leakages can be seen
in Figure 2. A leakage is any income not passed on in the circular flow. On the other hand,
some firms make and sell exports overseas, and others borrow money and invest it in their
firms in the form of capital goods. These are coded 'X' for exports and 'I'
for investment and are called injections as the money returns into the circular flows. An
injection is any expenditure not originating in the household sector, including investment,
government spending and exports.

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 Figure 3 Circular flows - two sector, open economy

This is a 2-sector, open economy. The flow will be balanced and therefore in equilibrium
when the injections are equal to the leakages

The leakages from the circular flow are:

 Savings (S)

 Taxation (T)

 Purchase of imported goods and services (M)

 The injections areInvestment (I) - expenditure on capital goods

 Sale of exports (X) (goods and services out, but money now flows in)

 Government Expenditure (G)

If the leakages are greater than the injections then national income will fall, while if
injections are greater than leakages national income will rise. This starts to show us some
possible policies to promote growth - policies that help boost exports or investment will
lead to more injections into the circular flow and therefore boost national income.

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We called the economy illustrated in Figure 3 an open economy because it is open to trade
with the outside world. If it did not trade outside of itself, we would call it a 2-sector, closed
economy.

In almost all economies, the government plays an active part. It taxes us, T, and uses this
money to finance its spending. Even though this partly goes to pay themselves and their
bureaucracy, as well as funding schools and hospitals, it finds its way back into the flow.
This spending is coded as 'G' for government expenditure.

Add this to the earlier model and we get the model of a 3-sector, open economy, the most
common type of economy in the real world. We can see the circular flow for this economy
in Figure 4 below.

Figure 4 Circular flows - 3 sector, open economy

Here's an alternative representation of Figure 4. It shows exactly the same flows, but
represents them a little differently.

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 Figure 5 Circular flows - 3 sector, open economy

There is a flow of money between the government sector and firm sector. Money flows
from firms to government when the government realises corporate taxes from the firms.
Money flows from the government to the firms in form of subsidies and payment made for
the goods purchased

Figure 5 Circular flows - 4 sector, open economy

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In a four sector model, an economy moves from being a closed economy to an open
economy. In an open economy imports and exports are made. You must understand that
one country's exports are other country's imports. In case of a country imports, money
flows to the rest of the world and incase of exports, money flows in from the rest of the
world. An economy experiences a trade surplus if its exports exceed its imports. On the
other hand, there is a trade deficit if imports exceed exports.

Imports act as leakages and exports as injection into the circular flow of income in an
economy

An economy is in equilibrium when injections match the leakages.

The standard codes used in this model, and in economics in general are:

Y = National Income
C = Domestic Consumption
S = Savings
M = Imports
T = Taxation
I = Investment
X = Exports
G = Government Spending

In a 4 sector model,

Y = C + I + G +(X-M)

This is the desired state in an Economy.

The circular flow model of an economy is very useful within the study of economics. We
will be looking at the actions and behaviour of firms and households, and how
governments interact with them. We will look at how changes in the leakages and
injections affect the stability of an economy.

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LEARNING OUTCOMES
1. To learn about Product Market
2. To know about Perfect Competition
3. To learn the differences between monopoly, monopolistic and perfect competition.
4. To learn about the concepts of Duopoly
5. To know about Perfect Competition
6. The students understand about circular flow of income

Short Answer Questions

1. Define Factor Market

2. Define Perfect Competition.
3. Define Market Structure
4. What is monopsony?
5. What is Product Differentiation?
6. Define Oligopoly.
7. What is Price rigidity?
8. List any two models of duopoly
9. Define Market Efficiency.
10. What is Producer surplus?
11. What is Trade balance?

Long Answer Questions

1. Discuss the constituents of Product Market.

2. Compare and contrast Monopoly and Perfect competition
3. Compare monopolistic and perfect competition.
4. Define duopoly market and discuss its features
5. Enumerate on different kinds of Pricing
6. Explain the basic concepts of Macroeconomics.

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 UNIT IV

Syllabus

PERFORMANCE OF AN ECONOMY – MACRO ECONOMIC -

Macro - economic aggregates – circular flow of
macroeconomic activity - National income determination –
Aggregate demand and supply – Macro economic
equilibrium - Components of aggregate demand and national
income – multiplier effect – Demand side management –
Fiscal policy in theory.
 UNIT – 04
Contents
Learning Objectives .......................................................................................... 190

4.1 National Income............................................................................... 190

4.2 Measurement of National Income ............................................ 199

4.3 Aggregate Demand and Aggregate Supply ............................ 206

4.4 Keynesian Theory of National Income Determination ..... 214

4.5 Multiplier ............................................................................................ 221

4.6 Business Cycle Part -1 ................................................................... 230

4.7 Business Cycle Part -2 ................................................................... 236

4.8 Fiscal Policy ....................................................................................... 245

Learning outcome ............................................................................................. 251

Short Answer Questions ................................................................................. 251

Long Answer Questions .................................................................................. 252

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LEARNING OBJECTIVES
1. To introduce the concept of National Income
2. To discuss various methods of measuring National Income
3. To explain the concept of aggregate demand
4. To explain the concept of aggregate supply
5. To discuss about Multiplier and it importance
6. Discuss various Phases of Business Cycle
7. To discuss the importance of Fiscal Policy
8. To explain the effectiveness and limitations of Fiscal Policy

4.1 National Income

4.1.1 Introduction

National income of a country means the sum total of incomes earned by the citizens of that
country during a given period, say a year.

It should be noted that national income is not the sum of all incomes earned by all citizens,
but only those incomes which accrue due to participation in the production process.
National income means the value of goods and services produced by a country during
a financial year. Thus, it is the net result of all economic activities of any country during a
period of one year and is valued in terms of money. National income is an uncertain term and is
often used interchangeably with the national dividend, national output, and
national expenditure. The progress of a country can be determined by the growth of the
national income of the country

4.1.2. Definition

Let us try to understand by the definition of National Income According to Marshall: “The labor
and capital of a country acting on its natural resources produce annually a certain net

190
aggregate of commodities, material and immaterial including services of all kinds. This is the
true net annual income or revenue of the country or national dividend.”The definition as laid
down by Marshall is being criticized on the following grounds. Due to the varied category
of goods and services, a correct estimation is very difficult. There is a chance of double
counting; hence National Income cannot be estimated correctly. For example, a product runs
in the supply from the producer to distributor to wholesaler to retailer and then to the
ultimate consumer. If on every movement commodity is taken into consideration then the
value of National Income increases. Also, one other reason is that there are products which
are produced but not marketed.

For example, In an agriculture-oriented country like India, there are commodities which
though produced but are kept for self-consumption or exchanged with other commodities.
Thus there can be an underestimation of National Income. The modern concept of National
income consider the following definition Simon Kuznets defines national income as “the net
output of commodities and services flowing during the year from the country’s productive
system in the hands of the ultimate consumers.”

4.1.3. CONCEPTS OF NATIONAL INCOME

There are various concepts of National Income. These are the various metrics used to
measure National Income in an Economy. These are explained below one by one:

1. Gross National Product (GNP).

2. Net National Product (NNP)/National Income.
3. Gross Domestic Product (GDP).
4. National Income at Factor Cost.
5. Personal Income.
6. Disposable Personal Income.

Gross National Product (GNP)

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Definition and Explanation of GNP:

The concept of Gross National Product (GNP) is comprehensive. It enables us to measure

and analyze as to how much is the aggregate economic production of a country in a given
period. The gross national product of a country (GNP) is defined as:

“The total money value of all final goods and services produced by the residents of a
country in one year period”.

In the words of W.C. Peterson:

“Gross National Product may be defined as the current market value of all final goods and
services produced by the economy during an income period regardless of where the output
is produced“.

Consider the following aspects of GNP:

GNP is a flow concept: GNP represents a flow. It is a quantity produced per unit of time. It is
the value of final goods and services produced in a country during a given time period.

GNP measures final output: While calculating GNP, the market value of only final goods and
services produced in a year are added up. Final goods are those goods that are purchased
for final use in the market.

GNP is the output produced by the citizens of a country: Gross national product is the final
output of goods and services produced by the citizens and businesses of a country during a
given time period which is usually a year. For example, the economic activity carried out by
the citizens and businesses outside the country is counted in GNP. While the income of the
residents who are not citizens is subtracted from GNP.

Components of Expenditures in GNP:

For measuring GNP at market price, the economists use the Expenditure Approach.

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According to this approach, there are four categories of expenditures which are added
together to measure Gross National Product (GNP) at Market Pricethe Actual transacted
price including indirect taxes such as GST, Customs duty etc. Such taxes tend to raise the
prices of goods and services in the economy is known as Market Price.

i. Consumption,
ii. Investment
iii. Government Expenditure and
iv. Net exports.

These four types of expenditures are explained in brief:

(i) Consumption Expenditure (C): It includes all personal expenditures incurred by the
citizens of a country on durable and non-durable goods in a period of one year.

(ii) Investment (I): It is the total expenditure incurred by firms or households on capital
goods.

(iii) Govt. expenditures (G): It includes all types of expenditure incurred by Federal,
Provincial, and Local Councils on the purchases of goods and services such as national
defence, law, and order, street lighting, etc.

(iv) Net Exports (X – M): Net exports of goods and services are the value of exports minus
the value of imports.

The formula for Gross Profit:

GNP = C + I + G + (X – M)

Where:
C = Consumption, I = Investment, G = Government Expenditure and X – M = Net exports

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Gross Domestic Product (GDP)

“Gross domestic product (GDP) is defined as the total market value at current prices of all
final goods and services produced within a year by the factors of production located within
a country”.

The labour and the capital of a country working on its natural resources produce a certain
aggregate of commodities, material, and non-material every year. In addition to this, there
may be foreign firms producing goods in the various sectors of the economy like mining,
electricity, manufacturing, etc.

Different constituents of GDP are:

1. Wages and salaries

2. Rent
3. Interest
4. Undistributed profits
5. Mixed-income
6. Direct taxes
7. Dividend
8. Depreciation

If we add up the money value of all the final goods produced both by domestic and foreign-
owned factors annually in the country and valued at market prices, it will be called gross
domestic product (GDP).

Gross Domestic Product is the value of aggregate or total production of goods and services
in a country in one year.

If we make a detailed list of all such commodities produced annually or measure the total
goods produced during a year by weight or by volume, it will not give us any clear and

194
concise impression about our total national output. So, what generally done is that the
money value of all final goods and service produced during a year at current market prices
is added up. This total current market value of all final goods and services produced in an
economy in a year period is called gross domestic product (GDP).

In the words of Campbell:

“Gross Domestic Product is defined as the total value of all final goods and services
produced in a country in one year”.

According to Shapiro:

“GDP is defined as a flow variable, measuring the quantity of final good and services
produced” during a year”. While calculating the gross domestic product (GDP), the value of
only those goods are added which have reached their final stage of production and are
available for consumption. The primary or intermediate goods are not counted in GDP.

Distinction between GDP and GNP:

Here it is necessary to distinguish between Gross Domestic Product (GDP) and Gross
National Product (GNP).

Gross Domestic Product (GDP) is the total market value of all final goods and services
produced by factors of production within a nation’s border during a period of one year. In
other words, GDP is a flow of products produced within the country by domestically
located resources in a year.

Gross National Product (GNP) on the other hand, is the measure of all final goods and
services produced by the citizens within their own country as well as outside the country
during a period of one year. In other words, GNP expresses the money value of the flow of
goods and services produced within the country and the net income received from abroad
during a period of one year.

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Thus when we move from GDP to GNP, we add factor income receipts from foreigners and
subtract factor income payments to foreigners.

GDP = GNP – Net Foreign Income From Abroad

Net National Product (NNP)/National Income

Net National Product or National Income at Market Prices is the net market monetary value
of all the final goods and services produced in a country during a year.

It is found out by subtracting the amount of depreciation of the existing capital in a year
from the market value of all final goods and services.

If we deduct depreciation allowance from gross national product, we get Net National
Product at current market price.

NNP at Market Price = GNP at Market Price – Depreciation

This fund which is set aside for covering the wear and tear, deterioration and obsolescence
of the machinery is named as Depreciation Allowance.

NNP = GNP – Depreciation

National Income at Factor Cost

National Income can be estimated in terms of either output or total income. When national
income is measured by adding together all income payments made to the factors of
production in a year, it is called national income at factor cost. Factor cost Includes the cost
of factors of production e.g. interest on capital, wages to labor, rent for land profit to the
stakeholders. Thus services provided by service providers and goods sold by the producer is
equal to revenue price

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National income thus is the sum total of all income payments made to the factors of
production.

In the words of J. Sloman:

“National income (Nl) or national income at factor cost is the aggregate earning of the four
factors of production (land, labour, capital and organization) which arise from the current
production of goods and services by the nations’ economy”.

The main components of national income at factor cost are as follows:

The factor incomes are generally divided into four categories:

(i) Compensation to employees – It is the largest component of national income. It

consists of wages and salaries paid by the firms to the workers for their labour services.

(ii) Interest – Interest is the payment for the use of funds in a year. The payment is made
by private businesses to households who have lent money to them.

(iii) Rents – Rent is all income earned by individuals for the use of their real assets such as
building, farms etc.

(iv) Profits – Profit is the amount which is left after compensation to employees, rent,
interest has been paid out. The sum of compensation toemployees, interest, rent and profit
is supposed to equal national income at factor cost.

Personal Income

National income is the sum of factor income. In other words, it is the income which
individuals receive for doing productive work in the form of wages, rent, interest and
profits.

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Personal Income, on the other hand, includes all income which is actually received by all
individuals in a year. It includes income which is not directly earned but is received by
individuals. For example, social security payments, welfare payments are received by
households but these are not elements of national income because they are transfer
payments.

In the same way, in national income accounting, individuals have attributed income which
they do not actually receive. For example, undistributed profits, employee’s contribution to
social security corporate income taxes etc. are elements of national income but are not
received by individuals. Hence they are to be deducted from national income to estimate
the personal income.

PI = Nl + Transfer Payments – Corporate retained earnings, income taxes, social security

taxes.

Disposable Personal Income

Disposable Personal Income is the amount which is actually at the disposal of

households/persons to spend as they like.It is the amount which is left with the
households/persons after paying personal taxes such as income tax, property tax, national
insurance contributions etc.
Disposable personal income = Personal Income – Personal Taxes
DPI = PI – Personal Taxes

The concept of disposable personal income is very important for studying the consumption
and saving behaviour of individuals. It is the amount which households can spend and save.

Disposable Income = Consumption + Saving

DI = C + S

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4.2 Measurement of National Income

4.2.1 Introduction

National income is the total money value of goods and services produced by a country in a
particular period of time. For calculating national income-, an economy is perceived from
three different angles, which are as follows:

1. Production units in an economy are classified into primary, secondary, and tertiary
sectors. On the basis of this classification, value-added method is used to measure national
income.

2. Economy is also viewed as a combination of individuals and households owing different

kinds of factors of production. On the basis of this combination, income method is used for
estimating national income.

3. Economy is viewed as a collection of units used for consumption, saving, and investment.
On the basis of this collection, final expenditure method is used for calculating national
income.

4.2.2. Methods of Measurement National Income

A circular flow of income and expenditure exists within an economy, where factor income
is earned from the production of goods and services, and the income is spent on the
purchase of produced goods. Thus, there are three alternative methods of computing
national income. This includes:

 Product/Value Added Method

 Income/Factor Income Method

 Expenditure Method

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4.2.3. Product/Value Added Method

The value added method/ product method is also known as the output method or
inventory method. In this method, the sum total of the gross value of the final goods and
services in different sectors of the economy like industry, service, agriculture, etc. is
acquired for the current year by determining the total production that was made during the
specific time period. The value obtained is the gross domestic product. Thus, according to
this method,

GDP= Total product of (industry + service + agriculture) sector

Symbolically, GDP= ∑ (P × Q)

Where,

P= Market price of goods and services

Q= Total volume of Output

Sometimes goods produced by one sector is further processed by another sector. These
goods are termed as intermediate goods and are already included while determining the
value of final goods.

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So, in order to avoid the problem of double counting of value of goods, the product method
if further categorized into two approaches:

The Final Goods Approach

In this method, only the value of final goods and services are computed while estimating
GDP, regardless of any intermediate goods and their processing. This method takes into
account only those goods and services that purchased and consumed by the final
consumers in the economy.

The Value Added Method

In the value added method of measuring national income, the value of materials added by
producers at each stage of production to produce the final good is considered. The
difference between the value of output and inputs at each stage of production is the value
added. Thus,

Value added= Value of output – Cost of intermediate goods

If the differences are added up for all production sectors in the economy, the value of GDP
is computed. The table below clearly explains this method:

Stage of Selling Price Cost Price Value Added

Producers
Production (Rs.) (Rs.) (Rs.)
Farmer Wheat 60 0 60
Miller Flour 90 60 30
Baker Bread 100 90 10
Total 250 150 100

Table 1: Estimation of National Income by Value Added Method

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4.2.4. Income/Factor Income Method

Income method is also termed as factor income method or factor share method. Under this
method, national income is measured as the total sum of the factor payments received
during a certain time period.

The factors of production include land, labor, capital, and entrepreneurship. Individuals
who provide these factor services get payment in the form of rent, wages/salaries, interest,
and profit respectively. The total sum of income received by these individuals comprise the
national income for a given period of time.

Besides these, there are professionals who employ their own labor and capital like
advocates, doctors, barbers, CAs, etc. The income of these individuals are called mixed
incomes and are also accounted for calculating the national income. However, income
received in the form of transfer payments are not included.

Thus, according to this method,

GDP= Rent (Rental incomes on agricultural and non-agricultural properties)

+ Wages/Salaries (Wages and salaries earned by employees including supplements)

+ Interest (Net interest earned by individuals other than governmental bodies)

+ Undistributed Profit (Profits earned by businesses before payment of corporate taxes and
liabilities)

+ Dividends

+ Direct taxes

+ Depreciation

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4.2.5. Expenditure Method

The expenditure method measures the national income as the sum total of expenditures
made by individuals on personal consumption, firms on private investments, and
government authorities on government purchases.

Since incomes from production are earned as a result of expenditure made by other entities
on the produced goods and services within the economy, the result of expenditure method
should be same total as the product method. However, with an exception of avoiding
intermediate expenditure in order to evade the problem of double counting, national
income under expenditure method can be expressed as

GDP= C + I + G + (X – M)

Where, C= Consumption Expenditure (Expenditure on durable goods such as furniture,

cars, and non-durable goods such as food

I= Investment Expenditure (Private investment in capital goods or producer goods such as

buildings, machinery, etc.)

G= Government Expenditure (Government expenses for maintaining law and order,

developing pre-requisites of development, etc.)

(X-M)= Net Export (Difference between import and export)

4.2.6. Problems of Measurement of National Income

Problems arise in aggregation largely because of the difficulty of finding an appropriate

unit of measurement. In adding up the total output of a country, there is no single physical
unit of measurement that can be used: the millions of different types of goods and services
are all measured in different units, for example, steel is measured in tonnes and cloth is
measured in metres and it is, of course, impossible to add tonnes to metres!

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The problem is partially overcome by using money as the unit of measurement this greatly
simplifies the adding up, but it gives rise to the problem of distinguishing between real and
nominal values. In addition, there are many problems of measuring national income of an
economy. These problems may be stated as follows

 Firstly, there is the problem of which goods and services should be included. We
know that gross domestic product (GDP) is the money value of all goods and
services currently produced within an economy involving economic activity which
means transforming scarce resources to satisfy human wants.
 The second problem is to exclude transfer payments and capital gains from national
income accounts. Receipts from illegal activities should also be excluded from the
national income calculation.
 The third problem is associated with the valuation of inventories. The general rule is
that when a firm increases its inventory of goods, this investment in inventory is
counted both as past expenditure and as part of income. Thus, production of
inventory increases GDP just as production for final sale does.

There are mainly two methods of valuation of inventories: the market price method and
the cost price method. In the market price method imputed profits are included which are
unlikely to be realised in the same year. However, the cost price method does not include
imputed profit. Another problem of inventory valuation is that the total quantity may
remain the same, but this may not mean that each individual item remains unchanged
during the year.

Now, if prices are rising, the value of the new items are likely to rise faster than the value of
the old items. Similarly, if prices are falling, the value of the new items are likely to fall less
than that of the old items. Moreover, even if the size of the inventories remains unchanged
its value is likely to change, an adjustment may be necessary to take account of the effect of
price change. The adjustment is called the inventory valuation adjustment.

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  The fourth problem is imputed values of the non-market goods, and services.
Although most goods and services are valued at their market prices when
computing GDP, some are not sold in the marketplace and, therefore, do not have
market prices. If GDP is to include the value of these goods and services, we must
use an estimate of their value. Such an estimate is called an imputed value. One in
which imputations are important is housing.

A person who rents a house is buying housing services and is providing income for the
landlord; the rent is part of GDP, both as expenditure by the renter and as income of the
landlord. However, many people live in their own homes. Although they do not pay rent to
a landlord, they are enjoying housing services similar to those of renters.

To take account of the housing services enjoyed by homeowners, GDP includes (he rent
that these homeowners pay to themselves. Of course, homeowners do not in fact pay
themselves this rent but the market rent for a house could be imputed to be included in
GDP. This imputed rent is included both in the house-owner’s expenditure and in the
homeowner’s income.

Another area in which imputations arise is in valuing the services provided by the
government. For example, law and order, fire fighters, defence, etc. provide services to the
public. Measuring the value of these services is difficult because they are not sold in the
marketplace and, therefore, do not have a market price. GDP includes these services by
valuing them at their cost. Thus, the wages of these public servants are used as a measure
of the value of their output.

In many circumstances, an imputation is called for in principle but is not made in practice.
Since GDP includes the imputed rent on owner-occupied houses, one might expect it also to
include the imputed rent on car, jewellery, and other durable goods owned by households.
Yet the value of these services is left out of GDP.

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In addition, some of the output of the economy is produced and consumed at home and
never enters the marketplace. For example, meals cooked at home arc similar to meals
cooked at a restaurant, yet the value- added in meals at home is left out of GDP.

Finally, no imputation is made for the value of goods and services sold in the underground
economy. The underground economy is that part of the economy that people hide from the
government either because they wish to evade taxation or because the activity is illegal.
Since the imputations necessary for computing GDP are only approximations, and since the
value of many goods and services is left out altogether, GDP is an imperfect measure of
economic activity.The size of underground economy varies from country to country .This
imperfections are most problematic when comparing standards of living across countries.

Measuring the level and rate of growth of national income (Y) is important for following
reasons

 The rate of economic growth

 Changes in average living standards
 Changes in distribution of income

4.3 Aggregate Demand and Aggregate Supply

4.3.1. Introduction

In macroeconomics, the focus is on the demand and supply of all goods and services
produced by an economy. Accordingly, the demand for all individual goods and services is
also combined and referred to as aggregate demand. The supply of all individual goods and
services is also combined and referred to as aggregate supply. Like the demand and supply
for individual goods and services, the aggregate demand and aggregate supply for an
economy can be represented by a schedule, a curve, or by an algebraic equation

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4.3.2. Aggregate Demand

The aggregate demand curve represents the total quantity of all goods (and services)
demanded by the economy at different price levels. An example of an aggregate demand
curve is given in Figure1

Figure1. An aggregate demand curve

The vertical axis represents the price level of all final goods and services. The aggregate
price level is measured by either the GDP deflator or the CPI. The horizontal axis represents
the real quantity of all goods and services purchased as measured by the level of real GDP.
Notice that the aggregate demand curve, AD, like the demand curves for individual goods, is
downward sloping, implying that there is an inverse relationship between the price level
and the quantity demanded of real GDP.

The reasons for the downward‐sloping aggregate demand curve are different from the
reasons given for the downward‐sloping demand curves for individual goods and services.
The demand curve for an individual good is drawn under the assumption that the prices of
other goods remain constant and the assumption that buyers' incomes remain constant. As
the price of good X rises, the demand for good X falls because the relative price of other

207
goods is lower and because buyers' real incomes will be reduced if they purchase good X at
the higher price. The aggregate demand curve, however, is defined in terms of the price
level. A change in the price level implies that many prices are changing, including the wages
paid to workers. As wages change, so do incomes. Consequently, it is not possible to assume
that prices and incomes remain constant in the construction of the aggregate demand
curve.

Hence, one cannot explain the downward slope of the aggregate demand curve using the
same reasoning given for the downward‐sloping individual product demand curves.

Reasons for a downward‐sloping aggregate demand curve.

Three reasons cause the aggregate demand curve to be downward sloping. The first is
the wealth effect. The aggregate demand curve is drawn under the assumption that the
government holds the supply of money constant. One can think of the supply of money as
representing the economy's wealth at any moment in time. As the price level rises, the
wealth of the economy, as measured by the supply of money, declines in value because the
purchasing power of money falls. As buyers become poorer, they reduce their purchases of
all goods and services. On the other hand, as the price level falls, the purchasing power of
money rises. Buyers become wealthier and are able to purchase more goods and services
than before. The wealth effect, therefore, provides one reason for the inverse relationship
between the price level and real GDP that is reflected in the downward‐sloping demand
curve.

A second reason is the interest rate effect. As the price level rises, households and firms
require more money to handle their transactions. However, the supply of money is fixed.
The increased demand for a fixed supply of money causes the price of money, the interest
rate, to rise. As the interest rate rises, spending that is sensitive to rate of interest will
decline. Hence, the interest rate effect provides another reason for the inverse relationship
between the price level and the demand for real GDP.

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The third and final reason is the net exports effect. As the domestic price level rises,
foreign‐made goods become relatively cheaper so that the demand for imports increases.
However, the rise in the domestic price level also means that domestic‐made goods are
relatively more expensive to foreign buyers so that the demand for exports decreases.
When exports decrease and imports increase, net exports (exports ‐ imports) decrease.
Because net exports are a component of real GDP, the demand for real GDP declines as net
exports decline.

Figure 2. Shifts of the aggregate demand curve

4.3.2.1 Changes in Aggregate Demand

Changes in aggregate demand are represented by shifts of the aggregate demand curve. An
illustration of the two ways in which the aggregate demand curve can shift is provided in
Figure

209
A shift to the right of the aggregate demand curve. From AD 1 to AD 2, means that at the
same price levels the quantity demanded of real GDP has increased. A shift to the left of the
aggregate demand curve, from AD 1 to AD 3, means that at the same price levels the
quantity demanded of real GDP has decreased.

Changes in aggregate demand are not caused by changes in the price level. Instead, they are
caused by changes in the demand for any of the components of real GDP, changes in the
demand for consumption goods and services, changes in investment spending, changes in
the government's demand for goods and services, or changes in the demand for net
exports.

Consider several examples. Suppose consumers were to decrease their spending on all
goods and services, perhaps as a result of a recession. Then, the aggregate demand curve
would shift to the left. Suppose interest rates were to fall so that investors increased their
investment spending; the aggregate demand curve would shift to the right. If government
were to cut spending to reduce a budget deficit, the aggregate demand curve would shift to
the left. If the incomes of foreigners were to rise, enabling them to demand more
domestic‐made goods, net exports would increase, and aggregate demand would shift to
the right. These are just a few of the many possible ways the aggregate demand curve may
shift. None of these explanations, however, has anything to do with changes in the price
level.

4.3.3. AGGREGATE SUPPLY

The aggregate supply curve depicts the quantity of real GDP that is supplied by the
economy at different price levels. The reasoning used to construct the aggregate supply
curve differs from the reasoning used to construct the supply curves for individual goods
and services. The supply curve for an individual good is drawn under the assumption that
input prices remain constant. As the price of good X rises, sellers' per unit costs of
providing good X do not change, and so sellers are willing to supply more of good X‐hence,
the upward slope of the supply curve for good X. The aggregate supply curve, however, is

210
defined in terms of the price level. Increases in the price level will increase the price that
producers can get for their products and thus induce more output. But an increase in the
price will also have a second effect; it will eventually lead to increases in input prices as
well,. So, there is some uncertainty as to whether the economy will supply more real GDP as
the price level rises. In order to address this issue, it has become customary to distinguish
between two types of aggregate supply curves, the short‐run aggregate supply curve and
the long‐run aggregate supply curve.

4.3.3.1 SHORT-RUN AGGREGATE SUPPLY CURVE

The short‐run aggregate supply (SAS) curve is considered a valid description of the supply
schedule of the economy only in the short‐run. The short‐run is the period that begins
immediately after an increase in the price level and that ends when input prices have
increased in the same proportion to the increase in the price level. Put prices are the prices
paid to the providers of input goods and services. These input prices include the wages
paid to workers, the interest paid to the providers of capital, the rent paid to landowners,
and the prices paid to suppliers of intermediate goods. When the price level of final goods
rises, the cost of living increases for those who provide input goods and services. Once
these input providers realize that the cost of living has increased, they will increase the
prices that they charge for their input goods and services in proportion to the increase in
the price level for final goods.

The presumption underlying the SAS curve is that input providers do not or cannot take
account of the increase in the general price level right away so that it takes some time–
referred to as the short‐run–for input prices to fully reflect changes in the price level for
final goods. For example, workers often negotiate multi‐year contracts with their
employers. These contracts usually include a certain allowance for an increase in the price
level, called a cost of living adjustment (COLA). The COLA, however, is based on
expectations of the future price level that may turn out to be wrong. Suppose, for example,
that workers underestimate the increase in the price level that occurs during the multi‐year

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contract. Depending on the terms of the contract, the workers may not have the
opportunity to correct their mistaken estimates of inflation until the contract expires. In
this case, their wage increases will lag behind the increases in the price level for some time.

During the short‐run, sellers of final goods are receiving higher prices for their products,
without a proportional increase in the cost of their inputs. The higher the price level, the
more these sellers will be willing to supply. The SAS curve depicted in Figure (a) is
therefore upward sloping, reflecting the positive relationship that exists between the price
level and the quantity of goods supplied in the short‐run.

Figure1. The aggregate supply curve

4.3.3.2 Long-Run Aggregate Supply Curve

The long‐run aggregate supply (LAS) curve describes the economy's supply schedule in the
long‐run. The long‐run is defined as the period when input prices have completely adjusted
to changes in the price level of final goods. In the long‐run, the increase in prices that
sellers receive for their final goods is completely offset by the proportional increase in the
prices that sellers pay for inputs. The result is that the quantity of real GDP supplied by all
sellers in the economy is independent of changes in the price level. The LAS curve depicted
in Figure (b) is a vertical line, reflecting the fact that long‐run aggregate supply is not

212
affected by changes in the price level. Note that the LAS curve is vertical at the point
labelled as the natural level of real GDP. The natural level of real GDP is defined as the level
of real GDP that arises when the economy is fully employing all of its available input
resources.

4.3.3.3 Changes in Aggregate Supply

Changes in aggregate supply are represented by shifts of the aggregate supply curve. An
illustration of the ways in which the SAS and LAS curves can shift is provided in Figures (a)
and (b). A shift to the right of the SAS curve from SAS 1 to SAS 2 of the LAS curve
from LAS 1 to LAS 2 means that at the same price levels the quantity supplied of real GDP
has increased. A shift to the left of the SAS curve from SAS 1 to SAS 3 or of the LAS curve
from LAS 1 to LAS 3 means that at the same price levels the quantity supplied of real GDP
has decreased.

Figure 2. Shifts of the aggregate supply curve

Like changes in aggregate demand, changes in aggregate supply are not caused by changes
in the price level. Instead, they are primarily caused by changes in two other factors. The
first of these is a change in input prices. For example, the price of oil, an input good,
increased dramatically in the 1970s due to efforts by oil‐exporting countries to restrict the

213
quantity of oil sold. Many final goods and services use oil or oil products as inputs.
Suppliers of these final goods and services faced rising costs and had to reduce their supply
at all price levels. The decrease in aggregate supply, caused by the increase in input prices,
is represented by a shift to the left of the SAS curve because the SAS curve is drawn under
the assumption that input prices remain constant. An increase in aggregate supply due to a
decrease in input prices is represented by a shift to the right of the SAS curve.

A second factor that causes the aggregate supply curve to shift is economic growth.
Positive economic growth results from an increase in productive resources, such as labor
and capital. With more resources, it is possible to produce more final goods and services,
and hence, the natural level of real GDP increases. Positive economic growth is therefore
represented by a shift to the right of the LAS curve. Similarly, negative economic growth
decreases the natural level of real GDP, causing the LAS curve to shift to the left.

4.4 Keynesian Theory of National Income Determination

4.4.1 Introduction

According to Keynes, there can be different sources of national income, such as

government, foreign trade, individuals, businesses and trusts.

For determining national income, Keynes had divided the different sources of income into
four sectors namely’ household sector, business sector, government sector, and foreign
sector.

The two-sector model of economy involves households and businesses only, while three-
sector model represents households businesses, and government. On the other hand, the
four-sector model contains households, businesses, government, and foreign sector.Let us
discuss these three types of models of income determination given by Keynes.

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4.4.2. Determination of National Income In Two-Sector Economy

The determination of level of national income in the two-sector economy is based on an

assumption that two-sector economy is an economy where there is no intervention of the
government and foreign trade.

The following are the assumptions of this model

a. Comprises only two sectors, namely, households and businesses. The households
are the owners of factors of production and provide factor services to businesses to
earn their livelihood in the form of wages, rents, interest, and profits. In addition the
households are the consumers of final goods and services produced by businesses.
On the other hand, businesses purchase factor services from households to produce
goods and services and sell it to households.

b. Does not have government interference. If government is there, it does not have any
role to play in the economic activity of a country. For example, in the two-sector
economy, the government is not involved in activities, such as taxation, expenditure,
and consumption.

c. Comprises a closed economy in which the foreign trade does not exist. In other
words, import and export services are absent in such an economy.

d. Contains no profit that is undistributed or savings by the organization. In other

words, the profit earned by an organization is completely distributed in the form of
dividends among shareholders

Keeps the prices of goods and services, supply of factors of production, and production
technique constant throughout the life cycle of organization.

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Keynes believed that there are two major factors that determine the national income of a
country. These two factors are Aggregate Supply (AS) and Aggregate Demand (AD) of goods
and services.

In addition, he believed that the equilibrium level of national income can be estimated
when AD=AS. Before representing the relationship between AS and AD on a graph, let us
understand these two concepts in detail.

4.4.3. Aggregate Supply

AS can be defined as total value of goods and services produced and supplied at a particular
point of time. It comprises consumer goods as well as producer goods. When goods and
services produced at a particular point of time is multiplied by the respective prices of
goods and services, it provides the total value of the national output. The national output is
the aggregate supply in the form of money value. The Keynesian AS curve is drawn based
on an assumption that total income is equal to total expenditure. In other words, the total
income earned is fully spent on different types of goods and services.

The correlation between income and expenditure is represented by an angle of 45°,

as shown in Figure-2:

Figure 2: Aggregate Supply Curve

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According to Keynes theory of national income determination, the aggregate income is
always equal to consumption and savings.

The formula used for aggregate income determination:

Aggregate Income = Consumption(C) + Saving (S)

Therefore, the AS schedule is usually called C + S schedule. The AS curve is also named as
Aggregate Expenditure (AE) curve.

4.4.4. Aggregate Demand

AD refers to the effective demand that is equal to the actual expenditure. Aggregate
effective demand refers to the aggregate expenditure of an economy in a specific time
frame. AD involves two concepts, namely, AD for consumer goods or consumption (C) and
aggregate demand for capital goods or investment (I)

Therefore, the AD can be represented by the following formula:

AD = C + I

Therefore, AD schedule is also termed as C+I schedule. According to Keynes theory of

national income determination in short-run investment (I) remains constant throughout
the AD schedule, while consumption (C) keeps on changing. Therefore, consumption (C)
acts as the major determinant or function of income (Y).

The consumption function can be expressed as follows:

C = a + bY

Where, a = constant (representing consumption when income is zero)

b = proportion of income consumed = ∆C/∆Y

By substituting the value of consumption in the equation of AD, we get:

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AD = a + bY + I

Figure-3 represents the graphical representation of national income determination

in the two-sector economy:

Figure 2: Aggregate Supply Curve

In Figure-3, while drawing AS schedule it is assumed that the total income and total
expenditure are equal. Therefore, the numerical value of AS schedule is one. AD schedule is
prepared by adding the schedule of C and I. The aggregate demand and aggregate supply
intersect each other at point E, which is termed as equilibrium point.

The income level at point E is Rs. 200 billion, which represents the national income of the
economy. The schedule curve after point E represents that the AS is greater than AD (AS >
AD). In such a situation, the products and services are costing more than Rs. 200 billion;
therefore, households are not willing to buy them.

Therefore, the supply of products and services exceeds their demand. As a result,
businesses would have a pile of unsold stocks. For example, in Table-1, when the income or

218
aggregate supply is at Rs. 300 then the aggregate demand or expenditure is Rs. 250, which
is less than the aggregate supply.

Similarly, beneath point E, the AD and AS schedules represent that the aggregate demand is
more than aggregate supply. In such a case, the production by businesses is less than the
demand of households. Therefore, businesses start producing more and more products and
services. For example, in Table-1, when the income or aggregate supply is Rs. 100 then the
aggregate demand is Rs. 150, which is more than the aggregate supply.

The equilibrium condition of national income determination can be expressed as

follows:
Aggregate demand = Aggregate supply

C + I = C-HS

Therefore, I = S

Thus, the national income can be determined by using either aggregate demand and
aggregate supply schedules or investment and savings schedules. These two methods of
income determination are classified as income-expenditure approach and saving-
investment approach.

4.4.5. Income Expenditure Approach

Income-expenditure approach refers to the method in which the aggregate demand and
aggregate supply schedules are used for the determination of national income.

In this method, the equilibrium point is achieved when the following condition is
satisfied:
C+I=C+S

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As, C + S = Y, therefore, the equilibrium condition of national income determination
would become:
Y=C+I

At equilibrium point, the consumption is equal to:

C = a + bY

Substituting the value of C in the national income equilibrium condition, we get:

Y = a + bY + I

Or, Y (1- b) = a + I

Thus, Y = 1/1-b (a + I)

4.4.6. Saving Investment Approach

Saving-investment approach refers to the method in which the saving (S) and investment (I)
are used for the determination of national income. The condition for achieving equilibrium
with the help of saving-investment approach is that the saving and investment are equal (I =
S).

Let us take the previous assumption that consumption function is equal to C = 200 + 0.50 Y
and I=150 for the determination of national income by using the saving-investment
approach.

In such a case, the saving function can be determined as follows:

Y=C+S

Or,

S = Y-C

S = Y – (a + bY)

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S = Y – a – bY

S = -a + (l-b) Y

4.5 Multiplier

4.5.1 Introduction

Multiplier is an important theory propounded by Keynes.

The concept of multiplier was first developed by R.F. Kahn. In 1921 he wrote in his essays
entitled “Relation of Home Investment to Unemployment” discussed in detail the concept
multiplier. Kahn‟s multiplier was the Employment Multiplier. Keynes took the idea from
Kahn and formulated the investment Multiplier.

Let us assume that an investment in the economy increases in crores from 100 to 150,
increase in investment is 150-100 = 50. Let us expect that level of income increases by 100.
Since 100 = 2 × 50, it can be said that increase in income is equal to two times the increase
in investment. Given the increase of investment the number which is multiplied with it is
called multiplier.

In this example multiplier is 2.

In the above example we can say that the multiplier 2

2= 100/50

y. Here 100 is the increase in income which is Y. 50 which is increase in investment is

denotes as 'I. The multiplier 2 can be denoted ask. Then we can write that

k= changes Y/ I

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Multiplier coefficient refers to the multiple increases in the equilibrium level of income
caused by a change in the level of aggregate spending. The investment part of the total
spending is determined by the market mechanism ad is relatively more dynamic
determinant of output, employment and income. The value of the multiplier is mainly
determined by the value of marginal propensity to consume.

Spending creates income. It leads to rise in income of those producers on whose goods and
services the spending is made. The spending may be on capital goods (called investment),
on inputs, and on consumption. (It is assumed that there is no government expenditure and
there are no net exports).

If the spending is done out of the increase income without any decrease in the existing
income of the society, it has one impact on income creation. If the spending is done out of
the increased income of one section of the society obtained by reducing the income of other
section of the society, there is another impact.

4.5.2 Types of Multipliers

There are several types of multipliers. We will discuss the major ones.

A. Investment Multiplier
Keynes considers his theory of multiplier s an integral part of his theory of employment.
The multiplier, according to Keynes,

“Establishers a prices relationship given the propensity to consume, between

aggregate employment and incomes and the rate of investment. It tell us that, when
there is an increment of investment, income will increase by an amount which is k
times the increment of investment”

Generally speaking, multiplier is defined as the ratio of change in the equilibrium national
income to change in an autonomous variable. A variable is autonomous when it is assumed
not to be influenced by change in income.

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Investment multiplier is the ratio of change in income due to a given change in investment.
The term ‘multiplier’ signifies that change in income is a multiple of change in investment.
The process of income increase is initiated by the change in investment.

SupposeIrise.Itmeanspurchaseofcapitalgoods,etc.rises.Thisleadstoriseinincomeofthose
from whom these goods are purchased. When income rises, people spend a proportion of
this income (equal to MPC) on consumption.

C rises. With rise in C, producers find their inventories falling. They produce more output,
and purchase more inputs. Income of the input sellers rises. In this way with rise in income,
cycle starts all over again

I increase Y C inventories output income

Size of the Multiplier

The size of multiplier depends upon MPC. A large MPC means a large increase in
consumption spending, a large increase in income and, therefore, a large multiplier. The
process of increase in income initiated by the change in investment reaches new
equilibrium when change in investment becomes equal to change in saving. We can show
that:

Multiplier = 1/MPS –1/1-MPC

Where MPS is Marginal Propensity to save and MPC is Marginal Propensity to consume.

B. Government Spending Multiplier

Suppose government increases G by the amount of G. The multiple impact of G on
equilibrium income is identical with the impact of change in investment. Just like the
investment multiplier is 1/MPS, similarly

Government Spending =1/MPS

C. Tax Multipliers

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Tax multiplier represents the multiple by which gross domestic product (GDP) increases
(decreases) in response to a decrease (increase) in taxes. There are two versions of the tax
multiplier: the simple tax multiplier and the complex tax multiplier, depending on whether
the change in taxes affects only the consumption component of GDP or it affects all the
components of GDP.

D. Balanced Budget Multiplier

In other words, the balanced-budget multiplier indicates the overall impact on aggregate
production of a change in government purchases that is matched (that is, paid for) by an
equivalent change in taxes. The balanced-budget multiplier, as such, is actually the sum of
the expenditures multiplier (for government purchases) and the tax multiplier.

The balanced-budget multiplier is equal to one. The "positive" impact on aggregate

production caused by a change in government purchases is largely, but not completely,
offset by the "negative" impact of the change in taxes. The only part of the impact of the
change in government purchases NOT offset by the change in taxes is the purchase of
aggregate production made by the initial injection. Hence, the change in aggregate
production is equal to the initial change in government purchases.

The balanced-budget multiplier, like the expenditures multiplier and tax multiplier can
come in several different varieties based on assumptions concerning the structure of the
economy and what components are induced by aggregate production.

However, the value of the balanced-budget multiplier is the same whether consumption is
the only induced expenditure or all components are assumed to be induced. The reason is
that all of the "induced" changes in aggregate production caused by changes in government
purchases are cancelled out by opposite changes in taxes. So it matters not what
components are induced.

As such, here is the balanced-budget multiplier (m[bb]) based on the combination of the
simple expenditures multiplier and the simple tax multiplier

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 1 - MPC 1- MPC MPS

m[bb] = + = = =1

MPS MPS MPS MPS

E. Foreign Trade Multiplier

In an open economy we can write the national income identity as

Y+M= C+I+X... (1)

Total = Three ways in supply which total output can be used

Y = domestic supply

M = imports

C = consumption

I =investment

Y = exports

In a closed economy, we know that savings have to equal investments in equilibrium. In an

open economy we have to take into account that there can be a net inflow or outflow of
capital. In an open economy, thus the equilibrium condition is

S= I+X–M...

F. Static and Dynamic Multiplier

Depending on the purpose of analysis, sometimes a distinction is made between the static
multiplier and the dynamic multiplier. The static multiplier is also called ‘comparative
static multiplier’, ‘simultaneous multiplier’, ‘logical multiplier,’ ‘timeless multiplier.’‘lagless
multiplier and ‘instant multiplier’.

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The concept of static multiplier implies that change in investment causes change in income
instantaneously. It means that there is no time lags between the chances in invest merit
and the change in income.

It implies that the moment a rupee is spent on investment projects, society’s income
increases by a multiple of 1. The concept of multiplier explained in the preceding section is
that of static multiplier. Let us explain the concept of the dynamic multiplier also known as
‘period’ and ‘sequence’ multiplier.

The concept of dynamic multiplier recognises the fact that the overall change in income as
a result of the change in investment is not instantaneous. There is a gradual process by
which income changes as a result of change in investment or other determinants of income.
The process of change in income involves time lags. The multiplier process works through
the process of income generation and consumption expenditure. The dynamic multiplier
takes into
accountthedynamicprocessofthechangeinincomeandthechangeinconsumptionatdifferent
stages due to change in investment. The dynamic multiplier is essentially a stage-by-stage
computation of the change in income resulting from the change in investment till the full
effect of the multiplier is realized.

G. The Employment Multiplier

The Employment multiplier was introduced by R.F. Kahn in 1921 as a ratio between the
total increase in employment and primary employment According to him “employment
multiplier is a coefficient relating to an increment or primary and secondary combined”.

k1=pN/N1 Where K1 stands for the employment multiplier and for the increase in
employment isN1. To illustrate it, suppose 20000 additional men are employed in a
specific works so that the (secondary) employment increased by 40000. The total
employment is increased by 60000 = 20000 primary + 40000 secondary). The employment
multiplier would be 60000/20000 =3.

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H. Price Multiplier:

Investment or income multiplier operates only so far as full employment is not reached. In
other words, it has a full employment ceiling. When the full employment ceiling in an
economy is reached, the scarcities of factors, goods and services start appearing: as such,
after the full employment, the multiplier starts working in relation to prices only and is
rightly described as the „price multiplier‟.

Price multiplier may be a necessary explanation of general price increases in an economy

but is not a sufficient explanation of the behaviour of general prices. In advanced
economies, price multiplier manifests itself only after the full employment level has been
attained because the factors of production start becoming scarce.

I. Consumption Multiplier:

Consumption multiplier as enunciated by Dr. P.R. Brahmanand and Prof. C.N. Vakil, is
based on the concept of “saving potential‟ developed by Prof. R. Nurkse in his famous book
“Capital Formation in Underdeveloped Countries‟. It is their belief that if we really want
to break the vicious circle of poverty and generate a process of economic development it is
essential to make use of the saving potential, of the subsistence and un-organised sector in
the economy.

According to them, there is 25 to 30% disguised unemployment in the rural sector of

underdeveloped economies. The „disguised unemployment‟ constitutes the „saving
potential‟. Thus, we can always remove from the land certain unproductive workers, who
seem to be apparently employed but who in fact are not actually employed, i.e., their
removal will not lead to a decline in the production. We can remove those workers who do
not add anything to production, if somehow we are able to provide basic consumption
goods to the batch of workers which is initially removed from the land; this will, in turn,
lead to greater increase in aggregate investment andemployment (consumption
multiplier). The idea underlying the consumption multiplier is that with an initial increase

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in the supply of consumption goods (wage goods), there will be multiple increase in the
ultimate investment.

4.5.3. Limitations of Multipliers

The limitations of Multipliers are as follows:

 If the investment does not come up in sufficient quantity, the multiplier will not
work.

 The greater the time lags, the lower would be the value of the multiplier.

 Multiplier will not work properly if consumers’ goods are not available in plenty.

 There must be the motive of profit maximization and autonomous investment.

The investment must be net investment; otherwise, the value of the multiplier
will be reduced.

 The multiplier can work only if there is under employment

4.5.4. Propensity to Consume

Keynes has made use of four concepts in analysing consumption-income relationship.

These are:
 Average propensity to consume
 Marginal propensity to consume
 Average propensity to save
 Marginal propensity to save

1. Average Propensity to consume

The ratio of total consumption to total income is known as the average propensity to consume
the average propensity to consume (APC) measures the percentage of income that is spent
rather than saved. This may be calculated by a single individual who wants to know where the

228
money is going or by an economist who wants to track the spending and saving habits of an
entire nation.

2. Marginal Propensity to consume

In economics, the marginal propensity to consume (MPC) is defined as the proportion of an

aggregate raise in pay that a consumer spends on the consumption of goods and services, as
opposed to saving it. Marginal propensity to consume is a component of Keynesian
macroeconomic theory and is calculated as the change in consumption divided by the change
in income.

3. Marginal propensity to save

In Keynesian economic theory, the marginal propensity to save (MPS) refers to the proportion
of an aggregate raise in income that a consumer saves rather than spends on the consumption
of goods and services. Put differently, the marginal propensity to save is the proportion of
each added dollar of income that is saved rather than spent. MPS is a component of Keynesian
macroeconomic theory and is calculated as the change in savings divided by the change in
income, or as the complement of the marginal propensity to consume (MPC).

4. Average propensity to save

The average propensity to save (APS) is an economic term that refers to the proportion of
income that is saved rather than spent on goods and services. Also known as the savings ratio,
it is usually expressed as a percentage of total household disposable income (income minus
taxes). The inverse of average propensity to save is the average propensity to consume (APC).

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4.6 Business Cycle Part -1
4.6.1. Introduction

The economic progress the world has been achieved is not a steady and continuous
movement forward. Economic activities faced fluctuations at more or less regular intervals.
There were upward swings and downward swings.

4.6.2. Theories of Business Cycle

Some of the most important theories of business cycles are as follows:

1. Pure Monetary Theory:

The traditional business cycle theorists take into consideration the monetary and credit
system of an economy to analyse business cycles.

Therefore, theories developed by these traditional theorists are called monetary theory of
business cycle. The monetary theory states that the business cycle is a result of changes in
monetary and credit market conditions.

Haw trey, the main supporter of this theory, advocated that business cycles are the
continuous phases of inflation and deflation. According to him, changes in an economy take
place due to changes in the flow of money.

For example, when there is increase in money supply, there would be increase in prices,
profits, and total output. This results in the growth of an economy. On the other hand, a fall
in money supply would result in decrease in prices, profit, and total output, which would
lead to decline of an economy.

Apart from this, Haw trey also advocated that the main factor that influences the flow of
money is credit mechanism. In economy, the banking system plays an important role in
increasing money flow by providing credit.

An economy shows growth when the volume of bank credit increases. This increase in the
growth continues till the volume of bank credit increases. Banks offer credit facilities to

230
individuals or organizations due to the fact that banks find it profitable to provide credit on
easy terms.

The easy availability of funds from banks helps organizations to perform various business
activities. This leads to increase in various investment opportunities, which further results
in deepening and widening of capital. Apart from this, credit provided by banks on easy
terms helps organizations to expand their production.

When an organization increases its production, the supply of its products also increases to
a certain limit. After that, the rate of increase in demand of products in market is higher
than the rate of increase in supply. Consequently, the prices of products increase.

Therefore, credit expansion helps in expansion of economy. On the contrary, the economic
condition is reversed when the bank starts withdrawing credit from market or stop lending
money.

2. Monetary Over-Investment Theory:

Monetary over-investment theory focuses mainly on the imbalance between actual and
desired investments. According to this theory, the actual investment is much higher than
the desired investment. This theory was given by Hayek.

According to him, the investment and consumption patterns of an economy should match
with each other to bring the economy in equilibrium. For stabilizing this equilibrium, the
voluntary savings should be equal to actual investment in an economy.

In an economy, generally, the total investment is distributed among industries in such a

way that each industry produces products to a limit, so that its demand and supply are
equal. This implies that the investment at every level and for every product in the whole
economy is equal. As a result, there would be no expansion and contraction and the
economy would always be in equilibrium.

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According to this theory, changes in economic conditions would occur only when the
money supply and investment - saving relations show fluctuations. The investment - saving
relations are affected when there is an increase in investment opportunities and voluntary
savings are constant.

Investment opportunities increase due to several reasons, such as low interest rates,
increased marginal efficiency of capital, and increase in expectations of businessmen. Apart
from this, when banks start supporting industries for investment by lending money at
lower rates, it results in an increase in investment.

This may result in the condition of over-investment mainly in capital good industries. In
such a case, investment and savings increase, but the consumption remains unaffected as
there is no change in consumer goods industries.

Consequently, profit increases with increase in investment opportunities, which further

results in an increase in the demand for various products and services. The demand for
products and services exceeds the supply of products and services.

This leads to inflation in the economy, which reduces the purchasing power of individuals.
Therefore, with decrease in the purchasing power of individuals, the real demand for
products does not increase at the same rate at which the investment increases. The real
investment is done at the cost of real consumption.

The balance between the investment and consumer demand is disturbed. As a result, it is
difficult to maintain the current rate of investment. The demand of consumer goods would
be dependent on the income of individuals.

An increase in the income level would result in the increase of consumer goods.

However, the increase in consumer goods is more than the increase in capital goods.

Therefore, people would invest in consumer goods rather than in capital goods.
Consequently, the demand for bank credit also increases.

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However, the bankers are not ready to lend money because of the demand for funds from
consumer and capital goods industry both. This leads to recession in the economy. As a
result, economic activities, such as

1. Employment,

2. Investment,

3. Savings,

4. Consumption and

5. Prices of goods and services, start declining.

Schumpeter’s Theory of Innovation:

The other theories of business cycles lay emphasis on investment and monetary expansion.
The Schumpeter’s theory of innovation advocates that business innovations are
responsible for rapid changes in investment and business fluctuations.

According to Schumpeter said, “Business cycles are almost exclusively the result of
innovations in the industrial and commercial organization. Innovations are such changes of
the combination of the factors of production as cannot be effected by infinitesimal steps or
variations on the margin. [Innovation] consists primarily in changes in methods of
production and transportation, or changes in industrial organization, or in the production
of a new article, or opening of a new market or of new sources of material.”

According to Schumpeter, innovation refers to an application of a new technique of

production or new machinery or a new concept to reduce cost and increase profit. In
addition, he propounded that innovations are responsible for the occurrence of business
cycles.

3. Keyness Theory

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Keynes theory was developed in 1930s, which was the period when whole world was going
through great depression. This theory is the reply of Keynes to classical economists.

According to classical economists, if there is high unemployment condition in an economy,

then economic forces, such as demand and supply, would act in a manner to bring back full
employment condition.

In his theory of business cycles, Keynes advocated that the total demand helps in the
determination of various economic factors, such as income, employment, and output. The
total demand refers to the demand of consumer and capital goods.

In such a case, total investment and expenditure on products and services is more, the level
of production would increase. When the level of production increases, it results in the
increase of employment opportunities and income level. However, if the total demand is
low, the level of production would also be less.

Consequently, the income, output and investment would also be low. Therefore,

Changes in income and output level are produced by changes in total demand. The total
demand is further affected by changes in the demand of investment, which depends on the
rate of interest and expected rate of profit.

Keynes referred expected rate of profit as the marginal efficiency of capital. Expected rate
of profit is the difference between the expected revenue generated by the capital employed
and the cost incurred to employ that capital.

In case, the expected rate of profit is greater than the current rate of interest, then the
investors would invest more. On the other hand, the marginal efficiency of capital is
determined by expected return from capital goods and cost involved in the replacement of
capital goods.

Marginal efficiency of a capital increases due to new inventions or innovations in economic

factors, such as product, production technique, investment option, assuming that prices
would rise in future. On the other hand, it decreases due to various reasons, such as
decrease in prices, increase in costs, and inefficiency of the production process.

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According to Keynes theory, in the expansion phase of business cycle, investors are positive
about economic conditions, thus, they overestimate the rate of return from an investment.
The rate of return increases until the full employment condition is not achieved.

When the economy is on the path of achieving full employment, this phase is termed as
boom phase. In the boom phase, investors are not able to diagnose the fall in marginal
efficiency of capital and even do not consider the rate of interest.

As a result, the profit from investments starts Calling due to the increase in the cost of
investment and production of goods and services. This situation results in the contraction
or recession in economy.

This is because the rate of decrease in the marginal efficiency of capital is more than that of
current rate of interest. In addition, in this situation, investment opportunities shrink.
Banks are not also able to provide credit because of the lack of funds.

Current rate of interest is higher that encourages people to save rather than invest. As a
result, the demand for consumer and capital goods decreases. Further, the income and
employment level decreases and economy reaches to the phase of depression.

Keynes has proposed three types of propensities to understand business cycles. These are
propensity to save, propensity to consume, and propensity of marginal efficiency of capital.
He has also developed a concept of multiplier that represents changes in income level
produced by the changes in investment.

Keynes also advocated that the expansion of business cycle occurs due to increase in
marginal efficiency of capital. This encourages investors (including individuals and
organizations) to invest. Organizations replace their capital goods and start production.

As a result, the income of individuals increases, which further increases the rate of
consumption. This increases the profit of organizations, which finally lead to an increase in
the total income and investment level of an economy. This marks the recovery phase of an
economy.

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4.7 Business Cycle Part -2

4.7.1 Samuelson’s Model of Multiplier Accelerator Interaction:

The economists of post-Keynesian period emphasized the need of both multiplier and
accelerator concepts to explain business cycles. Samuelson’s model of multiplier
accelerator interaction was the first model that represents interaction between these two
concepts.

In his model, Samuelson has described the way the multiplier and accelerator interact with
each other for generating income and increasing consumption and demand of investment.
He also describes how these two factors are responsible for creating economic fluctuations.

Samuelson used two concepts, namely, autonomous and derived investment, to explain his
model. Autonomous investment refers to the investment due to exogenous factors, such as
new product, production technique, and market.

On the other hand, derived investment refers to the increase in the investment of capital
goods produced due to increase in the demand of consumer goods. When autonomous
investment occurs in an economy, the income level also increases.

This brought the role of multiplier into account. The income level helps in determining the
marginal propensity to consume. If the income level increases, then the demand for
consumer goods also increases.

The supply of consumer goods should satisfy the demand for consumer goods.

This is possible when the production technique is capable to produce a large quantity of
products and services. This encourages organizations to invest more to develop advanced
production techniques and increase production for meeting consumer demand.

An increase in the income level would increase the demand of consumer goods.

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In this manner, the multiplier and accelerator interact with each other and make the
income grow at a much higher rate than expected.

Autonomous investment leads to multiplier effect that result in derived investment.

This is called acceleration of investment.

Derived investment would make the accelerator to come into action. This is termed as
multiplier-acceleration interaction.

Samuelson made certain assumptions for the explanation of business cycles. Some of the
assumptions are that the production capacity is limited and consumption takes place after
a gap of one year.

Another assumption made by him is that there would be a gap of one year between the
increase in consumption and increase in the demand of investment. In addition, he
assumed that there would be no government activity and foreign trade in the economy.

According to the assumption given by

Samuelson that there would be no government activity and foreign trade, the equilibrium
would be achieved when

Yt = Ct + It

Where, Yt = National income

Ct = Total consumption expenditure

It = Investment expenditure t = Time period

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4.7.2 Hicks’s Theory:

Hicks has associated business cycles to the growth theory of Harrod-Domar. According to
him, business cycles take place simultaneously with economic growth; therefore, business
cycles should be explained in association with the growth theory.

In his theory, he has used the following concepts to explain business cycles:

Saving-investment relation and multiplier concepts given by Keynes

Acceleration concept given by Clark

Multiplier-acceleration interaction concepts given by Samuelson

Growth model of Harrod-Domar

Hicks has also framed certain assumptions for describing business cycle concept.

4.7.3 Under-consumption Theory

Under-consumption theory of business cycles is a very old one which dates back to the
1930s. Malthus and Sismodi criticised Say’s Law which states ‘supply creates its own
demand’ and argued that consumption of goods and services could be too small to generate
sufficient demand for goods and services produced.

They attribute over-production of goods due to lack of consumption demand for them.

This over-production causes piling up of inventories of goods which results in recession.

Under-consumption theory as propounded by Sismodi and Hobson was not a theory of

recurring business cycles. They made an attempt to explain how a free enterprise economy
could enter a long-run economic slowdown.

A crucial aspect of Sismodi and Hobson’s under-consumption theory is the distinction they
made between the rich and the poor. According to them, the rich sections in the society

238
receive a large part of their income from returns on financial assets and real property
owned by them.

Further, they assume that the rich have a large propensity to save, that is, they save a
relatively large proportion of their income and therefore, consume a relatively smaller
proportion of their income. On the other hand, less well-off people in a society obtain most
of their income from work, that is, wages from labor and have a lower propensity to save.

Therefore, these less well-off people spend a relatively less proportion of their income
consumer goods and services. In their theory, they further assume that during the
expansion process, the incomes of the rich people increase relatively more than the wage-
income.

Thus, during the expansion phase, income distribution changes in favor of the rich with the
result that average propensity to save falls, that is, in the expansion process saving
increases and therefore consumption demand declines.

According to Sismodi and Hobson, increase in saving during the expansion phase leads to
more investment expenditure on capital goods and after some time lag, the greater stock of
capital goods enables the economy to produce more consumer goods and services.

But since society’s propensity to consume continues to fall, consumption demand is not
enough to absorb the increased production of consumer goods. In this way, lack of demand
for consumer goods or what is called under-consumption emerges in the economy which
halts the expansion of the economy.

Further, since supply or production of goods increases relatively more as compared to the
consumption demand for them, the prices fall. Prices continue falling and go even below
the average cost of production bring losses to the business firms. Thus, when under-
consumption appears, production of goods becomes unprofitable. Firms cut their
production resulting in recession or contraction in economic activity.

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4.7.4. KARL MARX AND UNDER-CONSUMPTION

It is worth mentioning that Karl Marx, the philosopher of scientific socialism had also
predicted the collapse of the capitalist system due to the emergence of under consumption.

He predicted that capitalism would move periodically through expansion and Contraction
with each peak higher than its previous peak and each crash (i.e., depression) deeper than
the last.

Ultimately, according to Marx, in a state of acute depression when the cup of misery of
working class is full, they will overthrow the capitalist class which exploits them and in this
way the new era of socialism or communism would come into existence.

Like other under-consumption theorists,

Marx argues that driving force behind business cycles is ever increasing income
inequalities and concentration of wealth and economic power in the hands of the few
capitalists who own the means of production.

As a result, the poor workers lack income to purchase goods produced by the capitalist
class resulting in under-consumption or over-production. With the capitalist producers
lacking market for their goods, capitalist economy plunges into depression. Then the
search for ways of opening of new markets is started.

4.7.5. SUN-SPOT THEORY

This is perhaps’ the oldest theory of business cycles. Sun-spot theory was developed in
1875 by Stanley Jevons. Sunspots are storms on the surface of the sun caused by violent
nuclear explosions there.

Jevons argued that sun-spots affected weather on the earth.

Since economies in the olden world were heavily dependent on agriculture, changes in
climatic conditions due to sun-spots produced fluctuations in agricultural output. Changes

240
in agricultural output through its demand and input-output relations affect industry. Thus,
swings in agricultural output spread throughout the economy.

Other earlier economists also focused on changes in climatic or weather conditions in

addition to those caused by sun-spots.

According to them, weather cycles cause fluctuations in agricultural output which in turn
cause instability in the whole economy.

4.7.6. BUSINESS CYCLE

A period of prosperity was generally followed by a period of depression. These ups and
downs in the economic activity moving like a wave at regular intervals are known as
business cycle.

Business cycle simply means the whole course of business activity which passes through
the phases of prosperity and depression. Generally there are two broad phases, viz.
prosperity and depression.

DEFINITION

R. A. Gordon defined business cycle as consisting of “recurring alteration of expansion and

contraction in aggregate economic activity, the alternating movements in each direction
being self-reinforcing and prevailing virtually all parts of the economy.

The Business cycle influence business decision. The cycles affect not only the economy in
general, but each individual business firm. The period of prosperity promotes business. It
provides new investment opportunities.

Likewise, a period of depression slackens business. A manager who is always confronted

with the problem of forward planning takes into consideration the phase of the business
cycle. This helps to take advantage of the chance ahead or to reduce the chance of heavy
losses to the firm.

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4.7.7. CHARACTERISTICS OF A BUSINESS CYCLE

The cycle is synchronic. The upward and downward movements tend to occur at all the
same period in all industries. The waves of prosperity or depression generate a wave in
other industries. When industry picks up to provides more employment, more income etc.

A business cycle is a wave-like movement. The period of prosperity and depression can be
alternately seen in a cycle.

Cyclical fluctuations are recurring in nature. The various phases are repeated is followed by
depression and the depression again in followed by a boom.

Business cycles are cumulative and self-reinforcing in nature. Each movement feeds on
itself and keeps up the movement in the same direction. Once booms starts it goes on
growing till forces accumulate to reverse the direction

There can be no indefinite depression or eternal boom period. Each phase contain in itself
the seed for other phase. The boom, when it reaches its peak, turns to recession.

Business cycles are pervasive in their effects. The cyclical fluctuations affect each and every
part of the economy. Depression or prosperity felt in one part of the economy makes its
impact in other part also. The cyclical movements are even international in character. The
mechanism of international trade makes the boom or depression in one country shared by
other countries also.

Presence of a crisis.

The up and down movements are not symmetrical.

The downward movements are not symmetrical.

The downward movement is more sudden and violent than the upward movement

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4.7.8. Phase of Business Cycle

The following are the phases of Business cycle

Recovery:

In the early period of recovery, entrepreneurs increase the level of investment which in
turn increases employment and income. Employment increases purchasing power and this
leads to an increase in demand for consumer goods.

As a result, demand for goods will press upon their supply and it shall, thereby, lead to a
rise in prices. The demand for consumer’s goods shall encourage the demand for
producer’s goods.

The rise in prices shall depend upon the gestation period of investment. The longer the
period of investment, the higher shall be the price rise. The rise of prices shall bring about a
change in the distribution of income, Rent, wages, interest do not rise in the same
proportion as prices.

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Consequently, the margin of profit improves. The wholesale prices rise more than retail
prices. The prices of raw materials raise more than the prices of semi-finished goods use
more than the prices of finished goods.

Boom:

The rate of investment increases still further. Owing to the spread of a wave of optimism in
business, the level of production increases and the boom gathers momentum. More
investment is possible only through credit creation. During a period of boom, the economy
surpasses the level of full employment and enters a stage of over full employment.

Recession:

The orders for raw materials are reduced on the onset of a recession. The rate of
investment in producers’ goods industries and housing construction declines.

Liquidity preference rises in society and owing to a contraction of money supply, the prices
falls. A wave of pessimism spreads in business and those markets which were sometime
before sellers markets become buyer’s markets now.

Depression:

The main feature of a depression is a general fall in economic activity.

Production, employment and income decline. The prices fall and the main factor
responsible for it is, a fall in the purchasing power. The distribution of national income
changes. As the costs are rigid in nature, the margin of profit declines. Machines are not
used to their full capacity in factories, because effective demand is much less.

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4.8 Fiscal Policy
4.8.1. Introduction
Fiscal policy is carried out by the legislative and/or the executive branches of government.
The two main instruments of fiscal policy are government expenditures and taxes. The
government collects taxes in order to finance expenditures on a number of public goods
and services for example, highways and national defense.

Budget deficits and surpluses. When government expenditures exceed government tax
revenues in a given year, the government is running a budget deficit for that year. The
budget deficit, which is the difference between government expenditures and tax revenues,
is financed by government borrowing; the government issues long‐term, interest‐bearing
bonds and uses the proceeds to finance the deficit. The total stock of government bonds
and interest payments outstanding, from both the present and the past, is known as
the national debt. Thus, when the government finances a deficit by borrowing, it
is adding to the national debt. When government expenditures are less than tax revenues in
a given year, the government is running a budget surplus for that year. The budget surplus
is the difference between tax revenues and government expenditures. The revenues from
the budget surplus are typically used to reduce any existing national debt. In the case where
government expenditures are exactly equal to tax revenues in a given year, the government
is running a balanced budget for that year.

4.8.2. EXPANSIONARY AND CONTRACTIONARY FISCAL POLICY

Expansionary fiscal policy is defined as an increase in government expenditures and/or

a decrease in taxes that causes the government's budget deficit to increase or its budget
surplus to decrease.

Contractionary fiscal policy is defined as a decrease in government expenditures and/or

an increase in taxes that causes the government's budget deficit to decrease or its budget
surplus to increase.

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Classical and Keynesian views of fiscal policy. The belief that expansionary and
contractionary fiscal policies can be used to influence macroeconomic performance is most
closely associated with Keynes and his followers. The classical view of expansionary or
contractionary fiscal policies is that such policies are unnecessary because there are
market mechanisms for example, the flexible adjustment of prices and wages which serve
to keep the economy at or near the natural level of real GDP at all times. Accordingly,
classical economists believe that the government should run a balanced budget each and
every year.

Combating a recession using expansionary fiscal policy. Keynesian theories of output

and employment were developed in the midst of the Great Depression of the 1930s, when
unemployment rates in the U.S. and Europe exceeded 25% and the growth rate of real GDP
declined steadily for most of the decade. Keynes and his followers believed that the way to
combat the prevailing recessionary climate was not to wait for prices and wages to adjust
but to engage in expansionary fiscal policy instead. The Keynesians' argument in favor of
expansionary fiscal policy is illustrated in Figure.

Figure 1 Combating a recession using expansionary fiscal policy

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Assume that the economy is initially in a recession. The equilibrium level of real GDP, Y 1,
lies below the natural level, Y 2, implying that there is less than full employment of the
economy's resources. Classical economists believe that the presence of unemployed
resources causes wages to fall, reducing costs to suppliers and causing the SAS curve to
shift from SAS 1 to SAS 2, thereby restoring the economy to full employment. Keynesians,
however, argue that wages are sticky downward and will not adjust quickly enough to
reflect the reality of unemployed resources.

Consequently, the recessionary climate may persist for a long time. The way out of this
difficulty, according to the Keynesians, is to run a budget deficit by increasing government
expenditures in excess of current tax receipts. The increase in government expenditures
should be sufficient to cause the aggregate demand curve to shift to the right
from AD 1 to AD 2, restoring the economy to the natural level of real GDP. This increase in
government expenditures need not, of course, be equal to the difference
between Y 1 and Y 2. Recall that any increase in autonomous aggregate expenditures,
including government expenditures, has a multiplier effect on aggregate demand. Hence,
the government needs only to increase its expenditures by a small amount to cause
aggregate demand to increase by the amount necessary to achieve the natural level of real
GDP.

Keynesians argue that expansionary fiscal policy provides a quick way out of a recession
and is to be preferred to waiting for wages and prices to adjust, which can take a long time.
As Keynes once said, “In the long run, we are all dead.”

Combating inflation using contractionary fiscal policy. Keynesians also argue that fiscal
policy can be used to combat expected increases in the rate of inflation. Suppose that the
economy is already at the natural level of real GDP and that aggregate demand is projected
to increase further, which will cause the AD curve in Figure to shift from AD 1 to AD 2.

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 Figure 2 Combating inflation using contractionary fiscal policy

As real GDP rises above its natural level, prices also rise, prompting an increase in wages
and other resource prices and causing the SAS curve to shift from SAS 1 to SAS 2. The end
result is inflation of the price level from P 1 to P 3, with no change in real GDP. The
government can head off this inflation by engaging in a contractionary fiscal policy
designed to reduce aggregate demand by enough to prevent the AD curve from shifting out
to AD 2. Again, the government needs only to decrease expenditures or increase taxes by a
small amount because of the multiplier effects that such actions will have.

Secondary effects of fiscal policy. Classical economists point out that the Keynesian view
of the effectiveness of fiscal policy tends to ignore the secondary effects that fiscal policy
can have on credit market conditions. When the government pursues an expansionary
fiscal policy, it finances its deficit spending by borrowing funds from the nation's credit
market. Assuming that the money supply remains constant, the government's borrowing of
funds in the credit market tends to reduce the amount of funds available and thereby
drives up interest rates. Higher interest rates, in turn, tend to reduce or “crowd out”
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aggregate investment expenditures and consumer expenditures that are sensitive to
interest rates. Hence, the effectiveness of expansionary fiscal policy in stimulating
aggregate demand will be mitigated to some degree by this crowding‐out effect.

The same holds true for contractionary fiscal policies designed to combat expected
inflation. If the government reduces its expenditures and thereby reduces its borrowing,
the supply of available funds in the credit market increases, causing the interest rate to fall.
Aggregate demand increases as the private sector increases its investment and
interest‐sensitive consumption expenditures. Hence, contractionary fiscal policy leads to
a crowding‐in effect on the part of the private sector. This crowding‐in effect mitigates the
effectiveness of the contractionary fiscal policy in counteracting rising aggregate demand
and inflationary pressures.

4.8.3. Effectiveness of Fiscal Policy

The following aspects are crucial for the effectiveness of fiscal policy interventions:

First, the effect of a fiscal expansion depends on how the expansion is financed. This applies
not only to the short-term debt-tax mix used to finance a current increase in government
expenditure, but also - and perhaps even more importantly - to the long-term financing
source, i.e., taxes versus spending cuts in the future. The impact of higher current
expenditure is strengthened when complemented with a credible plan that ensures it is
financed at least in part by future
spendingcuts.Futurespendingcutstendtoraisecurrentprivateconsumptionandinvestment

Via their effects on the long-term interest rate. This channel is emphasized by both
Keynesian and neo classical models.

Lowerfuturespendingcommitmentsmeanthatfuturetaxeswon'thavetoriseasmuch.Inother
words, such a financing plan, if credible, will help sustaining the spending plans by firms
and households who are currently not credit-constrained, and who therefore immediately
respond to long-term fiscal prospects.

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Admittedly, a commitment to reduce spending in the future may lack credibility, especially
in a situation like today, when the uncertainty about the length and the overall fiscal
implications of the crisis is enormous.

It may nonetheless pay to identify measures which are inherently temporary, i.e., matched
by future cuts in spending. An obvious example consists of measures that bring forward in
time investment projects that are already planned, thereby raising current spending while
simultaneously reducing future spending. This is not a perfect solution to the commitment
problem, but it may help.

4.8.4. Limitations of Fiscal Policy

In practice there are many limitations of using a fiscal policy. They are:

Disincentives of Tax Cuts: Increasing Taxes to reduce AD may cause disincentives to

work, if this occurs there will be a fall in productivity and AS could fall. However, higher
taxes do not necessarily reduce incentives to work if the income effect dominates.

Side Effects on Public Spending: Reduced government spending to Increase AD could

adversely affect public services such as public transport and education causing market
failure and social inefficiency.

Poor Information: Fiscalpolicywillsufferifthegovernmenthaspoorinformation.Forexample,

if the government believes there is going to be a recession, they will increase AD, however
if this forecast was wrong and the economy grew too fast, the government action would
cause inflation.

Time Lags: If the government plans to increase spending this can take a long time to filter
into the economy and it may be too late. Spending plans are only set once a year. There is
also a delay in implementing any changes to spending patterns.

Budget Deficit: Expansionary fiscal policy(cutting taxes and increasing G)will cause an
increase in the budget deficit which has many adverse effects. Higher budget deficit will
require higher taxes in the future and may cause crowding out.

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Crowding Out: Increased government spending (G) to increased AD may cause "Crowding
out" Crowding out occurs when increased government spending results in decreasing the
size of the private sector.
Monetarist Critique: Monetarists argue that in the long run AS is inelastic therefore an
increase in AD will only cause inflation to increase.

Learning outcome
1. The students are able to understand the concept of National Income
2. The students learn various methods of measuring National Income
3. The students learn about the concept of aggregate supply
4. The Students will know about Multiplier and it importance.
5. The Students learn various Phases of Business Cycle.
6. The Students learn the effectiveness and limitations of Fiscal Policy.

Short Answer Questions

1. Define Gross domestic product.
2. Define National Income.
3. What are methods of measuring national income?
4. What is meant by aggregate demand?
5. What is consumption?
6. List the types of Multiplier.
7. Define Business cycle.
8. What is Recession?

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Long Answer Questions
1. Discuss what are Gross Domestic Product and Net National Product?
2. Discuss the significance of National Income in an Economy
3. Explain the concept of Aggregate Demand.
4. Explain the types of Multiplier.
5. Explain any three theories of Business cycle.
6. Discuss the features of Recession, trough, expansion and recovery phase of
business cycle?
7. What is trade cycle? Write the impact of trade cycle on the business strategy.
8. Explain the characteristics and significance of Fiscal Policy.

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 UNIT V

Syllabus

AGGREGATE SUPPLY AND THE ROLE OF MONEY - Short -

run and Long - run supply curve – Unemployment and its
impact – Okun’s law –Inflation and the impact – reasons
for inflation – Demand Vs Supply factors –Inflation Vs
Unemployment tradeoff – Phillips curve –short - run and
long - run –Supply side Policy and management - Money
market - Demand and supply of money – money - market
equilibrium and national income – the role of monetary
policy.
 UNIT – 05

Contents

Learning Objectives .......................................................................................... 254

5.1 Unemployment and Okun’s Law ............................................... 254

5.2 Inflation ............................................................................................... 261

5.3 Philip Curve ....................................................................................... 270

5.4 Money Part - 01................................................................................ 276

5.5 Money Part - 02................................................................................ 285

5.6 Demand and Supply for Money.................................................. 293

5.7 Money Market................................................................................... 303

Learning Outcomes........................................................................................... 319

Short Answer Questions ................................................................................. 319

Long Answer Questions .................................................................................. 320

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Learning Objectives

1. To explain the kinds , causes and effects of Unemployment

2. To explain about Inflation
3. To discuss about Philip Curve
4. Discuss the concept of money
5. Explain the different approaches to money
6. To discuss about Money Market
7. To discuss the types of Monetary Policy

5.1 Unemployment and Okun’s Law

5.1.1 Introduction

Unemployment is an important element of Macroeconomics.

In economics, unemployment occurs when people are without work while actively
searching for employment. The unemployment rate is a percentage, and calculated by
dividing the number of unemployed individuals by the number of all currently employed
individuals in the labor force.

5.1.2. Employment

When someone is of working age, and is willing and able to work, but cannot find a job. It is
unemployment.

According to A.C. Pigou “Unemployment means, all those who are willing to work are not
able to find job”.

An unemployed person is defined as:

(i) Who has actively looked for work during the previous four weeks, or

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(ii) Is waiting to be recalled to a job after being laid off, or

(iii) Is waiting to report for a new job within four weeks.

The unemployment rate measures the percentage of the total civilian labor force that are
currently unemployed. The formula for the unemployment rate is given by

The Natural Unemployment Rate

The natural unemployment rate, sometimes called the structural unemployment rate, was
developed by Friedman and Phelps in the 1960s. It represents the hypothetical
unemployment rate that is consistent with aggregate production being at a long-run level.
The natural rate of unemployment is a combination of structural and frictional
unemployment. It is present in an efficient and expanding economy when labor and
resource markets are at equilibrium. The natural unemployment rate occurs within an
economy when disturbances are not present.

5.1.3. Type of Employment

Cyclical unemployment

Cyclical unemployment exists when individuals lose their jobs as a result of a downturn in
aggregate demand (AD). If the decline in aggregate demand is persistent, and the
unemployment long-term, it is called either demand deficient, general,
or Keynesian unemployment.

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Demand deficient unemployment

This is caused by a lack of aggregate demand, with insufficient demand to generate full
employment.

Structural unemployment

Structural unemployment occurs when certain industries decline because of long term
changes in market conditions. Globalisation is an increasingly significant cause of structural
unemployment in many countries.

Regional unemployment

When structural unemployment affects local areas of an economy, it is called ‘regional’

unemployment. For example, unemployed workers in a particular region add to regional
unemployment in these areas. Geographical immobility makes regional differences more
extreme.

Classical unemployment

Classical unemployment is caused when wages are ‘too’ high. This explanation of
unemployment dominated economic theory before the 1930s, when workers themselves
were blamed for not accepting lower wages, or for asking for too high a wage. Classical
unemployment is also called real wage unemployment.

Seasonal unemployment

Seasonal unemployment exists because certain industries only produce or distribute their
products at certain times of the year. Industries where seasonal unemployment is common
include farming, tourism, and construction.

Frictional unemployment

Frictional unemployment, also called search unemployment, occurs when workers lose
their current job and are in the process of finding another one. There may be little that can
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be done to reduce this type of unemployment, other than provide better information to
reduce the search time. This suggests that zero unemployment is impossible at any one
time because some workers will always be in the process of changing jobs.

Voluntary unemployment

Voluntary unemployment is defined as a situation when workers choose not to work at the
current equilibrium wage rate. For one reason or another, workers may elect not to
participate in the labour market. There are several reasons for the existence of voluntary
unemployment including excessively generous welfare benefits and high rates of income
tax. Voluntary unemployment is likely to occur when the equilibrium wage rate is below
the wage necessary to encourage individuals to supply their labour.

5.1.4. Causes of Employment

There are several reasons of Unemployment.

A.Structural unemployment and labour mobility

Labour immobility is likely to increase structural unemployment. This is because those

industries that are growing and need labour, often called sunrise industries, and are not
necessarily able to employ the same workers who have been displaced in the
declining, sunset industries.

There are three types of labour immobility:

Geographical immobility

Geographical immobility occurs when workers are not willing or able to move from region
to region, or town to town. Geographical mobility is made worse by immense house
price variation between regions. It may be extremely difficult for workers in rural area to
sell their home and buy an equivalent one in city.

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Other factors also contribute to geographical immobility, such as strong social and family
ties, and parents being unwilling to disrupt their children’s education by changing schools.
The stresses of moving home can also be a deterrent to mobility for some.

Industrial immobility

Industrial immobility occurs when workers do not move between industries, such as
moving from employment in motor industry to employment in the insurance industry.
Industrial immobility many industrial countries, as the growth of service industries, and
the decline of manufacturing industries, has increased the need for mobility.

Occupational immobility

Occupational immobility occurs when workers find it difficult to change jobs within an
industry. For example, it may be very difficult for a doctor to retrain to be a dentist.

Industrial and occupation immobility are most likely to happen when skills are not
transferable between industry and job.

Information failure also contributes to labour immobility because workers may be

immobile because they do not know where all the suitable jobs for them are.

A resulting problem with labour market immobility is that it can create regional
unemployment, which is a type of structural unemployment. This means that a change in
the structure of industry leaves some people unable to respond by changing job, industry,
or location and as a result, they remain temporarily or permanently unemployed.

Immobility can also lead to rising labour costs, as firms have to increase wages to
encourage workers to re-locate.

B. Increase in Population:

Constant increase in population has been a big problem in India. It is one of the main
causes of unemployment. The rate of unemployment is 11.1% in 10th Plan.

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C.Agriculture is a Seasonal Occupation:

Agriculture is underdeveloped in India. It provides seasonal employment. Large part of

population is dependent on agriculture. But agriculture being seasonal provides work for a
few months. So this gives rise to unemployment.

D. Less Savings and Investment:

There is inadequate capital in India. Above all, this capital has been judiciously invested.
Investment depends on savings. Savings are inadequate. Due to shortage of savings and
investment, opportunities of employment have not been created.

E. Defective Planning:

Defective planning is the one of the cause of unemployment. There is wide gap between
supply and demand for labour. No Plan had formulated any long term scheme for removal
of unemployment.

F.Fall of Cottage and Small industries:

The industrial development had adverse effect on cottage and small industries. The
production of cottage industries began to fall and many artisans became unemployed.

G. Slow Growth of Industrialisation:

The rate of industrial growth is slow. Though emphasis is laid on industrialisation yet the
avenues of employment created by industrialisation are very few.

H. Causes of Under Employment:

Inadequate availability of means of production is the main cause of under employment.

People do not get employment for the whole year due to shortage of electricity, coal and
raw materials.

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5.1.5. EFFECTS OF EMPLOYMENT

When unemployment rates are high and steady, there are negative impacts on the long-run
economic growth. Unemployment wastes resources, generates redistributive pressures
and distortions, increases poverty, limits labor mobility, and promotes social unrest and
conflict. The effects of unemployment can be broken down into three types:

 Individual: people who are unemployed cannot earn money to meet their financial

obligations. Unemployment can lead to homelessness, illness, and mental stress. It can also
cause underemployment where workers take on jobs that are below their skill level.

 Social: an economy that has high unemployment is not using all of its resources

efficiently, specifically labor. When individuals accept employment below their skill level
the economies efficiency is reduced further. Workers lose skills which causes a loss of
human capital.

 Socio-political: high unemployment rates can cause civil unrest in a country.

5.1.6. Okun’s Law

Okun’s law was postulated by Yale professor and economist Arthur Okun in the early
1960s.Okun’s law investigates the statistical relationship between a
country’s unemployment rate and the growth rate of its economy.

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It is most important to note that Okun’s law is a statistical relationship that relies
on regression of unemployment and economic growth. As such, running the regression can
result in differing coefficients that are used to solve for the change in unemployment, based
on how the economy grew. It all depends on the time periods used and inputs, which are
historical GDP and employment data. Below is an example of an Okun's law regression: The
law has indeed evolved over time to fit the current economic climate and employment
trends. One version of Okun’s law has stated very simply that when unemployment falls by
1%, gross national product (GNP) rises by 3%. Another version of Okun’s law focuses on a
relationship between unemployment and GDP, whereby a percentage increase in
unemployment causes a 2% fall in GDP

Despite the fact that there are crtism to the relationship between unemployment and
economic growth, there does appear to be empirical support for the law

5.2 Inflation

5.2.1. Introduction

Inflation may be defined as ‘a sustained upward trend in the general level of prices’ and not
the price of only one or two goods. G. Ackley defined inflation as ‘a persistent and
appreciable rise in the general level or average of prices’. In other words, inflation is a state
of rising prices, but not high prices.

It is not high prices but rising price level that constitute inflation. It constitutes, thus, an
overall increase in price level. It can, thus, be viewed as the devaluing of the worth of
money. In other words, inflation reduces the purchasing power of money. A unit of money
now buys less. Inflation can also be seen as a recurring phenomenon.

Inflation is a quantitative measure of the rate at which the average price level of a basket of
selected goods and services in an economy increases over a period of time.

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It is the rise in the general level of prices in a period where the same money buys less than
it did in previous periods.

Usually shown as a percentage, inflation indicates a decrease in the purchasing power of a

nation’s currency.

Rate of Inflation = (Price Level in year N – Price level in year N-1) * 100

Price level in year (N-1)

5.2.2. Main Features of Inflation

i. Inflation is always accompanied by a rise in the price level. It is a process of

uninterrupted increase in prices.

ii. Inflation is a monetary phenomenon and it is generally caused by excessive money

supply.

iii. Inflation is essentially an economic phenomenon as it originates in the economic

system and is the result of action and interaction of economic forces.

iv. Inflation is a dynamic process as observed over the long period.

v. A cyclical movement of prices is not inflation.

vi. Pure inflation starts after full employment.

vii. Inflation may be demand-pull or cost-pus

viii. Excess demand in relation to the supply of everything is the essence of inflation

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5.2.3. TYPES OF INFLATION

There are several bases for classifying Inflation

A. On the Basis of Government Reaction:

On the basis of Government reaction, inflation can be open or suppressed:

Open Inflation: In a free market economy, prices go up freely due to supply-demand

imbalances leading to open inflation.

Suppressed Inflation: Suppressed inflation occurs in a controlled economy where the

upward pressure on prices is not allowed to influence the quoted or managed prices. But
inflation reveals itself in other forms

B. On the Basis of Speed:

On the basis of speed, inflation can be classified as:

Creeping Inflation

Creeping inflation also known as mild inflation is as the name suggests a very slow rise in
prices of goods and services. If the prices increase by 3% or less annually, then such inflation
is creeping inflation. Such inflation is not harmful to the economy. In fact, as per the Federal
Reserve, a 2% inflation rate is desirable. It is necessary for the economic growth of a country.

Walking Inflation

In this case, the inflation rate falls between 3% to 10%. Such inflation can be harmful to the
economy. The economic growth of the country is too accelerated to sustain. Consumers start
stocking goods fearing the prices will rise further. This causes excess demand and the prices
increase further.

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Galloping Inflation

When creeping and walking inflation are left unchecked, the rate of inflation will rise above
10%. This is galloping inflation. The currency of the country will lose value in the global
economy. The salaries and income of common people will not be able to keep up with the
ever-increasing prices of commodities. This will lead to the general instability of the economy
and the country as a whole.

Hyperinflation

Next in the classification of inflation is hyperinflation. This when the inflation is completely
out of control. No measures taken by the monetary authorities can control the prices. The rate
of inflation can be 50% on a monthly basis. This is the last stage of inflation

C. On the basis of employment level

On the basis of employment level, inflation can be Partial or full inflation:

1. Partial Inflation:

The price rise as a result of expansion of money supply in the pre-full employment stage is
called partial inflation. The increase in the money supply before full employment tends to
mobilise the idle resources of the economy and thus leads to the expansion of output and
employment. There is only a slight rise in the price level under partial inflation.

2. Full Inflation:

The increase in the money supply after the full employment level leads to full inflation. In
this case, output and employment will not increase and there will be an uninterrupted rise
in prices.

5.2.4. CAUSES OF INFLATION

Inflation is mainly caused by excess demand/ or decline in aggregate supply or output.

Former leads to a rightward shift of the aggregate demand curve while the latter causes

264
aggregate supply curve to shift leftward. Former is called demand-pull inflation (DPI), and
the latter is called cost-push inflation (CPI). Before describing the factors, that lead to a rise
in aggregate demand and a decline in aggregate supply, we like to explain “demand-pull”
and “cost-push” theories of inflation

a. Demand-Pull Inflation Theory:

There are two theoretical approaches to the DPI one is classical and other is the Keynesian.

According to classical economists or monetarists, inflation is caused by an increase in

money supply which leads to a rightward shift in negative sloping aggregate demand curve.
Given a situation of full employment, classicists maintained that a change in money supply
brings about an equipproportionate change in price level.

That is why monetarists argue that inflation is always and everywhere a monetary
phenomenon. Keynesians do not find any link between money supply and price level
causing an upward shift in aggregate demand.

b. Cost-Push Inflation Theory:

In addition to aggregate demand, aggregate supply also generates inflationary process. As

inflation is caused by a leftward shift of the aggregate supply, we call it CPI. CPI is usually
associated with non-monetary factors. CPI arises due to the increase in cost of production.
Cost of production may rise due to a rise in cost of raw materials or increase in wages.

However, wage increase may lead to an increase in productivity of workers. If this happens,
then the AS curve will shift to the right ward not leftward direction. We assume here that
productivity does not change in spite of an increase in wages.

Such increases in costs are passed on to consumers by firms by raising the prices of the
products. Rising wages lead to rising costs. Rising costs lead to rising prices. And, rising
prices again prompt trade unions to demand higher wages. Thus, an inflationary wage-
price spiral star

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The Causes of Cost-Push Inflation:

There are essentially three causes of cost-push inflation:

1. Wage-push due to union monopoly power,

2. Profit-push due to business monopoly power, and

3. Increasing raw material prices. Accordingly, cost-push inflation can take the forms of
wage-push or profit-push or material-push inflation.

1. Wage-Push Inflation:

Wage-Push has been considered the main determinant of cost-push inflation because, in
the modern times, the trade unions have become very strong and they succeed securing
higher wages for their members.

This increases the cost of production and, to maximise their profits, the businessmen raise
the prices of their products. Critics of wage-push inflation theory put forward the
arguments against wage rise as a sufficient and independent cause of inflation.

(i) In a number of cases, wage increases are not autonomous, but are induced by the
operation of demand-pull factors.

For example:

(a) Wage rise may be induced by an excess demand for labour, which may be the
result of excess demand conditions in the commodity market.

2. Profit-Push Inflation:

Cost-push inflation also occurs when the monopoly power of the businesses enables
them to raise prices to increase their profits. Once started by a few powerful firms, the
smaller firms also tend to mark-up their profit margins, partly following the example of

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 leading firms and partly through inter-industry relations, because their material costs
have gone up. This kind of price increase is called profit- profit spiral.

3. Material-Push Inflation:

Cost-push inflation is also caused by increase in the prices of some key materials, such
as steel, basic chemicals, oil, etc. Since, these materials are used, directly or indirectly, in
almost all the industries, the increases in their prices affect the whole of the economy
and the prices everywhere tend to increase.

The other causes of Inflation are Increase in Public Spending

In any modern economy, Government spending is an important element of the total spending.
It is also an important determinant of aggregate demand.

Usually, in lesser developed economies, the Govt. spending increases which invariably creates
inflationary pressure on the economy. Deficit Financing of Government Spending There are
times when the spending of Government increases beyond what taxation can finance.
Therefore, in order to incur the extra expenditure, the Government resorts to deficit financing.

For example, it prints more money and spends it. This, in turn, adds to inflationary pressure.
Increased Velocity of Circulation In an economy, the total use of money = the money supply
by the Government x the velocity of circulation of money.

When an economy is going through a booming phase, people tend to spend money at a faster
rate increasing the velocity of circulation of money.

Population Growth

As the population grows, it increases the total demand in the market. Further, excessive
demand creates inflation.

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Hoarding

Hoarders are people or entities who stockpile commodities and do not release them to the
market. Therefore, there is an artificially created demand excess in the economy. This also
leads to inflation.

Genuine Shortage

It is possible that at certain times, the factors of production are short in supply. This affects
production. Therefore, supply is less than the demand, leading to an increase in prices and
inflation.

Exports

In an economy, the total production must fulfill the domestic as well as foreign demand. If it
fails to meet these demands, then exports create inflation in the domestic economy.

Trade Unions

Trade union work in favor of the employees. As the prices increase, these unions demand an
increase in wages for workers. This invariably increases the cost of production and leads to a
further increase in prices.

Tax Reduction

While taxes are known to increase with time, sometimes, Governments reduce taxes to gain
popularity among people. The people are happy because they have more money in their
hands.

However, if the rate of production does not increase with a corresponding rate, then the
excess cash in hand leads to inflation.

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The imposition of Indirect Taxes

Taxes are the primary source of revenue for a Government. Sometimes, Governments impose
indirect taxes like excise duty. On businesses.

As these indirect taxes increase the total cost for the manufacturers and/or sellers, they
increase the price of the product to have a minimal impact on their profits.

Price-rise in the International Markets

Some products require importing commodities or factors of production from the international
markets like the United States. If these markets raise prices of these commodities or factors of
production, then the overall production cost in India increases too. This leads to inflation in
the domestic market.

Non-economic Reasons

There are several non-economic factors which can cause inflation in an economy. For
example, if there is a flood, then crops are destroyed. This reduces the supply of agricultural
products leading to an increase in the prices of the commodities.Investment in Gold, Real
estate, stocks, mutual funds, and other assets are some of the ways to deal with Inflation.

5.2.5. Effects of Inflation

Effects of inflation are both at the micro and macro levels. Various players the economy is
affected in varied ways. Lenders suffer and borrowers benefit when the inflation rises and
vice versa when the inflation falls. Higher price levels reduce the purchasing power of the
money in the short run but in the long run income levels also increase. As money loses
value with increase in inflation holding physical currency reduces its value. Rising inflation
depletes the saving rate in an economy. With the rise in inflation consumption levels
decreases (high prices) and investment expenditure increases (lower cost of finance). The
taxpayer pays higher taxes because of increased income and crossing their respective slabs
of Direct tax and increased prices in case of indirect tax. The currency of the economy

269
depreciates and loses its exchange value. Exports increase due to currency depreciation
and gain competitive prices in the world market. Import decrease as foreign goods become
costlier. Employment increases in the short run but becomes neutral or negative in the long
run. The nominal value of the wages increases while the real value decreases and there is a
negative impact on purchasing power.

5.2.6. METHODS TO PREVENT INFLATION

To prevent inflation, the primary strategy is to change the monetary policy by adjusting the
interest rates. Higher interest rates decrease the demand in the economy. Higher Income
Tax rate can reduce the spending, and hence resulting in lesser demand and Inflationary
pressures. Introducing policies to increase the efficiency and competitiveness of the
economy helps in reducing the long term costs. Inflation is controlled by monetary and
fiscal policy.

5.3 Philip Curve

5.3.1. Introduction

This module discuss about the relationship between Inflation and employment.

The Phillips curve shows the relationship between unemployment and inflation in an
economy. Since its ‘discovery’ by New Zealand economist AW Phillips, it has become an
essential tool to analyse macro-economic policy.

5.3.2. Evolution of Philip Curve

W.H. Phillips analysed annual wage inflation and unemployment rates in the UK for the
period 1860 – 1957, and applied statistical techniques to establish that there was
an inverse and stable relationship between wage inflation and unemployment. Later
economists substituted price inflation for wage inflation and the Phillips curve was born.
When economists from other countries undertook similar research, they also found very
similar curves for their own economies. Phillips analysed

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annual inflation and unemployment rates in the UK for the period 1860 – 1957, and then
plotted them on a scatter diagram.

Source:economiconline

The curve suggested that changes in the level of unemployment have a direct and
predictable effect on the level of price inflation. The accepted explanation during the 1960’s
was that a fiscal stimulus, and increase in AD, would trigger the following sequence of
responses:

1. An increase in the demand for labour as government spending generates growth.

2. The pool of unemployed will fall.

3. Firms must compete for fewer workers by raising nominal wages.

4. Workers have greater bargaining power to seek out increases in nominal wages.

5. Wage costs will rise.

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6. Faced with rising wage costs, firms pass on these cost increases in higher price

7. It quickly became accepted that policy-makers could exploit the tradeoff between
unemployment and inflation a little more unemployment meant a little less inflation.

8. During the 1960s and 70s, it was common practice for governments around the world to
select a rate of inflation they wished to achieve, and then expand or contract the
economy to obtain this target rate. This policy became known as stop-go, and relied
strongly on fiscal policy to create the expansions and contractions required.

9. The breakdown of the Phillips curve

10. By the mid 1970s, it appeared that the Phillips Curve trade off no longer existed there
no longer seemed a stable pattern. The stable relationship between unemployment and
inflation appeared to have broken down. It was possible to have a number of inflation
rates for any given unemployment rate.

11. American economists Friedman and Phelps offered one explanation namely that there
is not one Phillips curve, but a series of short run Phillips Curves and a long run Phillips
Curve, which exists at the natural rate of unemployment (NRU). Indeed, in the long-run,
there is no trade-off between unemployment and inflation.

5.3.3. Philip Curve

The below curve consists unemployment in x axis and Inflation in the Y axis. It
quickly became accepted that policy-makers could exploit the tradeoff between
unemployment and inflation – a little more unemployment meant a little less inflation.

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During the 1960s and 70s, it was common practice for governments around the world to
select a rate of inflation they wished to achieve, and then expand or contract the economy
to obtain this target rate. This policy became known as stop-go, and relied strongly on fiscal
policy to create the expansions and contractions required.

By the mid 1970s, it appeared that the Phillips Curve trade off no longer existed there no
longer seemed a stable pattern. The stable relationship between unemployment and
inflation appeared to have broken down. It was possible to have a number of inflation rates
for any given unemployment rate.

American economists Friedman and Phelps offered one explanation namely that there is
not one Phillips curve, but a series of short run Phillips Curves and a long run Phillips
Curve, which exists at the natural rate of unemployment (NRU). Indeed, in the long-run,
there is no trade-off between unemployment and inflation.

Although there are disagreements between new-Classicaleconomists and monetarists, the

general line of argument about the breakdown of the Phillips curve runs as follows.

Assume that the economy starts from an equilibrium position at point A, with inflation
currently at zero, and unemployment at the natural rate of 10% (NRU = 10%). Secondly,
given the public’s concern with unemployment, assume the government attempts to

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expand the economy quickly by way of a fiscal (or monetary) stimulus, so that AD increases
and unemployment falls.

Initially, the economy moves to B, and there is a fall in unemployment to 3% (at U1) as jobs
are created in the short term. Having more bargaining power, workers bid-up their
nominal wages. As wage costs rise, prices are driven-up to 2% (at P1). The effects of the
stimulus to AD quickly wear out as inflation erodes any gains by households and firms. Real
spending and output return to their previous levels, at the NRU. According to the new-
Classical view, what happens next depends upon whether the price inflation has been
understood and expected in which case there is no money illusionor whether it is not
expected in which case, money illusion exists. If workers have bid-up their wages in nominal
terms only, they have suffered from money illusion, falsely believing they will be better off
in this case, the economy will move back to point A at the NRU, but with inflation only a
temporary phenomenon. However, if they understand that price inflation will erode the
value of their nominal wage increases, they will bargain for a wage rise that compensates
them for the price rise. Again, the economy will move back to the NRU (with
unemployment at 10%), but this time carrying with it the embedded inflation rate of 2%

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and move to point C. The economy will hop to SRPC2 (which has a higher level of expected
inflation i.e. 2%, rather than 0%). Any further attempt to expand the economy by
increasing AD will move the economy temporarily to D. However, in the long-run the
economy will inevitably move back to the NRU.

The conclusion drawn was that any attempt to push unemployment below its natural rate
would cause accelerating inflation, with no long-term job gains. The only way to reverse
this process would be to raise unemployment above the NRU so that workers revised their
expectations of inflation downwards, and the economy moved to a lower short-run Phillips
curve

New Keynesian interpretation

New Keynesians explain the breakdown of the simple Phillips curve in terms of the Non-
Accelerating Inflation Rate of Unemployment (NAIRU).

NAIRU

NAIRU, which exists at the Long Run Phillips Curve, is the rate of unemployment at which
inflation will stabilize in other words, at this rate of unemployment, prices will rise at
the samerate each year.

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The government must choose between the feasible combinations of unemployment and
inflation. After 1945, fiscal demand management became the general tool for managing the
trade cycle. The consensus was that policy makers should stimulate aggregate demand
(AD) when faced with recession and unemployment, and constrain it when
experiencing inflation. It was also generally believed that economies faced either inflation
or unemployment, but not together and whichever existed would dictate which macro-
economic policy objective to pursue at any given time. In addition, the accepted wisdom
was that it was possible to target one objective, without having a negative effect on the
other. However, Phillips’s research in 1958, both of these assumptions were called into
question.

5.4 Money Part - 01

Before money, people acquired and exchanged goods through a system of bartering, which
involves the direct trade of goods and services. Bartering is a direct trade of goods and
services; for example, a farmer may exchange a pack of wheat for a pair of shirts from
cloth maker. However, these arrangements take time. These traded goods served as the
medium of exchange

Sometime around 770 B.C., the Chinese moved from using actual usable objects–such as
tools and weapons–as a medium of exchange to using miniature replicas of these same
objects that had been cast in bronze

Although China was the first country to use an object that modern people might recognize
as coins, the first region of the world to use an industrial facility to manufacture coins that
could be used as currency was in Europe, in Lydia (now western Turkey)

Today, this type of facility is called a mint, and the process of creating currency in this way
is referred to as minting. In 600 B.C., Lydia's King minted the first official currency. The
coins were made from electrum, a mixture of silver and gold that occurs naturally, and the
coins were stamped with pictures that acted as denominations

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Around 700 B.C., the Chinese moved from coins to paper money. Parts of Europe were still
using metal coins as their sole form of currency all the way up to the 16th century.
However, banks eventually started using paper banknotes for depositors and borrowers to
carry around in place of metal coins.

These notes could be taken to the bank at any time and exchanged for their face value in
metal usually silver or gold coins. This paper money could be used to buy goods and
services. In this way, it operated much like currency does today in the modern world. The
first paper currency issued by European governments was actually issued by colonial
governments in North America The 21st century has given rise to two novel forms of
currency: mobile payments and virtual currency. Mobile payments are money rendered for
a product or service through a portable electronic device, such as a cell phone, smartphone,
or a tablet device. Mobile payment technology can also be used to send money to friends or
family members. Bit coin, released in 2009 by the pseudonymous Satoshi Nakamoto,
quickly became the standard for virtual currencies.6s Virtual currencies have no physical
coinage. The appeal of virtual currency is it offers the promise of lower transaction fees
than traditional online payment mechanisms. Despite many advances, money still has a
very real and permanent effect on how we do business today.

5.4.1. Introduction

The evolution of money has proved to be an unending and continuous process which can
evident from the fact that apart from the commodity money and metallic money, there is an
emergence of paper money and a variety of other financial instruments.

It is noteworthy that money is not something which, having come into existence continues
to be in its original form. Various things have been used and served as money at different
times and places. These have varied from rice, wheat, cows, and rice to silver and gold
pieces and to coins, paper currency, notes and to demand deposits of bank. Money was
brought into existence to overcome the difficulties of barter, but in the process it has
helped economy in such a way that its use has become indispensable. It has responded to
the ever changing nature of the economy and its growing complexity. In turn, it has helped

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the economy in acquiring those complex features without which the latter could not
develop.

5.4.2. Characteristics of Money

There are some general characteristics that are usually important for whatever serves as
money in a modern economy. Portability, The money can be movable from place to place to
be used as monetary transaction to be exchanged for goods and services. Portability also
means that consumers are now able to carry money along with them to be used as
transactions for goods and services. In modern days, money is carried from one location to
another without needing much effort as all types of money such as cash notes, coins and
cards are carried easily in a wallet

5.4.3. Divisibility

It is a characteristic which means the money can be divided into small units and that it can
be used in exchange for goods and services. As to function as the medium of exchange, as it
is divisible, it can be used to purchase all kinds of goods with different values. As money
functions as the medium of exchange it must have denominations to be traded for all goods
and services, and everything in between.

5.4.3. Uniformity

Uniformity of money means that all types of the same denomination of money must consist
of purchasing power. It is a characteristic to perform the function of standard of deferred
payments.

5.4.4. Limited Supply

Limited supply is a characteristic which helps in storing the value of money, meaning that
constraints on the amount of money in the monetary circulation ensure that values remain
constant for the currency. Most of government takes the responsibility to control an

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adequate money supply based on market with their monetary policies, such as
expansionary monetary policy and contractionary monetary policy.

5.4.5. Acceptability

It supports the function of medium of exchange. The essential quality of money is that it
must act as an item being acceptable to all, without having any hesitation in the exchange
for goods and services.

Acceptability means that everyone must be able to accept the money for transactions.
Money is universally accepted around the world as a universal mean for transaction

5.4.6. Durability

Durability is when an item is able to withstand all the hardships and is still able to maintain
to be undamaged and usable after a long term of usage. Durability is crucial for money to be
able to perform the following functions of medium of exchange and store of value. Coins
and paper bills are made to perform and to act as the currency.

Nowadays, Money is manufactured with the materials such as paper, metal and plastics,
which results to a long lasting medium.

5.4.7. Non-Counterfeit Ability

The function as the store of value means that money cannot be easily duplicated. As money
cannot be easily duplicated, it prevents the unrestricted and illegal creating of duplication
of money. Besides, preventing the duplication of money to happen is one of the main
reasons of government existence.

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5.4.8. Kinds of Money

Various kinds of Money are

1. Commodity Money

Commodity money is known as full bodied money. This money has intrinsic value. Intrinsic
value means that the commodity has value even if it not used as money. It is a means of
payment made out of precious metals such as gold or silver or other valuable commodities.

It is known as full bodied money because its value is materially equivalent to that of its
stuff.

It acts not only a medium of exchange but is also a store of purchasing power.

2. Representative Money

Representative money is generally made either of cheap metals or paper notes.

The intrinsic value of the representative money is less than its face value.

Currency notes are good examples of representative money in India. Representative money
may or may not be converted into full-bodied money.

3. Credit Money or Near Money

Near money refers to those objects which can be held with little loss of liquidity. Near
money includes cheques, drafts, bills of exchange etc.

It is also known as bank money as this consists of the deposits of the people held with
banks, which are payable on demand by the depositors.

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4. Legal Tender Money

Legal tender money is the currency which has got legal sanction or approval by the
government. It means that the individual is bound to accept it in exchange for goods and
services; it cannot be refused in settlement of payments of any kind.

It is of two types:

Limited legal tender money: It is that money which no person can be forced to accept
beyond a certain limit.

For example: In India small coins of denomination of 1,2,5 paises are legal tender only up to
Rs. 25. Beyond this limit, anybody can refuse the payment.

Unlimited legal tender money: It is that money which a person has to accept up to any limit.
For example: All Indian currency notes are unlimited legal tender money.

5. ELECTRONIC MONEY

Electronic money involves computer networks to perform financial transactions

electronically.

Electronic Funds Transfer (EFT) and direct deposits are examples of electronic money.

The financial institutions transfer the money from one bank account to another by means
of computer and communication links. A country wide computer network would monitor
the credits and debits of all individuals, firms and government as transactions take place in
the economy.

It exchanges funds every day without the physical movement of any paper money. This
would eliminate the use of cheques and reduce the need for the currency.

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6. Fiat Money

Fiat money is any money whose value is determined by legal means. It is the money that
has no intrinsic value but that has value as money because government decreed that it has
value for that purpose.

Fiat money is possible because the three functions of money- a medium of exchange, a
measure of value and a store of value are fulfilled as long as all people in society
acknowledge that the fiat money is a valid form of currency.

Faced with the difficulties in defining money, the economists used the different approaches
to arrive at an appropriate definition to it.

Fig. 5.1: Functions of Money II. Approaches/Functions of Money

There are two approaches adopted by economists to define money; namely

5.4.9. Functional Approach

Liquidity or Generalized Purchasing Power Approach.

A. Functional Approach

The functions of money can be classified under three main heads:

Primary Functions or Original Function

Contingent Functions

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 Fig. 5.1: Functions of Money

1. Primary Function

The main functions performed by money are called primary or original function.

The primary functions of money are as follows:

1. a Medium of Exchange:

Money is used as medium of exchange. .This medium of exchange function is one of the
most important and oldest functions of money. Money works as a medium of exchange. Due
to the lack of double coincidence of wants, the exchange was difficult in barter system.

With the invention of money, the limitation of barter system was tide over. Money has
purchasing power which is earned by selling ones goods and services and used to buy
another set of goods and services.

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The basic concept involved is that a seller may be accepting, by way of sales proceeds, an
item which has no intrinsic value for him, that is, which has no economic use or utility for
him.

Over the period of history, thousands of items have performed the role of money, that is, a
medium of exchange. Now a day, money exists in a variety of forms. Legal tender, that is,
official currency [both coins and currency notes] happens to be the dominant form of
money

However, quantity-wise, non-currency forms of money namely Cheques, Credit Cards etc.
are far exceeding the currency money. Money provides economic freedom to the larger
extent. It helps to bring others product within our reach. The vital feature for money to
serve as medium of exchange is to have a general acceptability. Anything that is to serve
this function of money must be acceptable generally by all. In other words, all should accept
money for payment of goods and services. Hence, all things serving merely as a medium of
exchange cannot be called money.

1. b Measure of Value:

Money serves as common measure of value or unit of account in terms of which the values
of all goods and services are expressed. This enhances a meaningful accounting system by
adding up the values of a wide variety of goods and services whose physical quantities are
measured in different units. In the traditional barter economy, the evaluation of a
commodity was a difficult task as it varied with the variation in the commodity exchanged.
For similar reasons, it was almost impossible to keep accounting records. The invention of
money has served as common denominator for value determination. The prices of goods
and services are expressed in money. This helps the computation of ratio of exchange
between any pair of goods.

Unlike other invariant physical units of measures (kilograms, meter, liters etc.), the value of
money changes from place to place and time to time. To be satisfactory measure of value. It
is essential that monetary units must be invariable. It must maintain the stable value.

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Money as a measure of value is not perfect. For its own value does not stay constant A
fluctuating monetary unit always results in a number of social economic problems.
Generally, it may be noted that value of money i.e. purchasing power, does not remain
constant; it rises during the period of falling process and falls during the period of rising
prices. Hence, some economists opined that the unit of account function is desirable but not
necessary quality of money.

5.5 Money Part - 02

Fig. 5.5.1: Functions of Money

5.5.2. Secondary Function

The relatively less important functions of money are called secondary function. Since, this
function originates from primary functions. These functions are also called derived
functions. The secondary functions of money are as follows: -

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5.5.2 a. Standard of Deferred Payment:

Money serves as the standard of deferred payment or units in which future or deferred
payments are made. This function applies to interests, rents, salaries, pensions, insurance
premium etc. The lending and borrowing acts are easily expressed in money. General
acceptability and durability caused due to the qualities of stability in value. Hence money is
regarded best for these transactions.

The process of credit was possible in barter system too but was inconvenient and uncertain
in terms of quality and quantity due to the changing nature of commodities; some of which
were perishable also. The purchasing power of money falls when there is rapid rise in the
price of goods and services. Money stops to be the good store of value and men lose faith in
money. Money stops to work as a standard of deferred payment after it loses faith.

5.5.2. b Store of Value

The money can be easily spent and easily stored. Thus the function of money is to serves as
a store of value. Money serves as store of value in the short run as well as long run. By this
function of store of value, the money provides security to individuals to meet unpredictable
contingencies and to pay debt in terms of money. Money has a unique nature of durability
and stability in value; thus it is can be stored for a long time which was not possible in
barter exchange system. This made people, a trend of making savings from the incomes for
future purposes. This function of money; store of value is necessary but not sufficient
condition to term anything as money.

Although, money functions as a store of value, but all things functioning as store of value
cannot be termed as money. For instance: things like diamond, jewellery work as a store of
value.

But, these do not serve the primary functions of money, hence are not termed as money;
therefore, not used as money.

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5.5.2. c Transfer of Value

Money serves as the function of transfer of value or purchasing power. People transfer
value by selling commodities or property to others and by buying commodities and
property with others. Money has facilitated the transaction of goods in distant places.

5.5.3. Contingent

Prof. Kinley has mentioned four contingent functions of money.

These functions are as follows

5.5.3. a Basis of Credit:

In Recent days, the use of credit money like Cheque, Draft, bill of exchange,

Promissory Notes is expanding widely. The credit instruments are issued on the basis of
cash reserve. The credit instrument like Cheque is issued on the basis of money deposits.
Hence, money is a basis of credit.

5.5.3.b Distribution of National Income:

The national banks also create credit on this basis.

Income is produced by the joint efforts and coordination of different factors of production.
This national income is distributed among the factors in monetary terms.

The contribution of all factors is calculated in monetary terms. The distribution of

production among factors would be difficult in the era of modern specialized labor in the
absence of money.

5.5.3.c General Form of Capital:

Money works as a general form of capital. Now a day’s most of the wealth or capitals are
kept in the form of money. This increases the liquidity and mobility of capital.

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5.5.3.d Maximum Benefit:

People derive maximum satisfaction from own income by the help of money. According to
law of equip-marginal utility, people derive maximum satisfaction when they spend by
making marginal utility equal in all goods. People spend money to make marginal utilities
of all commodities equal and derive maximum satisfaction by the help of money.

Similarly, the producers also spend money in different factors so as to make marginal
productivity of all factors equal. This increases total output and yields maximum benefit to
the producers.

5.5.4. Liquidity Approach

This approach of defining money is based upon a conceptual framework similar to that
used in the functional approach. Generally, acceptability of money by creditors in discharge
of their claims, and by sellers as sales proceeds, means that money has a generalized
purchasing power. It is a claim upon the resources of the society and can be exercised in a
variety of ways. In other words, it can be used to acquire other goods and services.

This economic capacity of an item to be readily acceptable in the market is termed its
‘liquidity’. It is seen that acceptability and liquidity go together and convey roughly the
same meaning. An item cannot have liquidity unless it is marketable, that is unless it can be
sold or exchanged in the market. But given this precondition for the very existence of
liquidity, items differ in their liquidity because of the difference in the quality of their
marketability or acceptability. An item which is more readily acceptable by the creditors
(and has, therefore, better marketability) is more liquid than the other.

Cash or official currency, by its very nature, is the most liquid asset.

Liquidity-wise, cash is followed by non-currency financial assets while tangible assets (that
is, “commodities”) are least liquid. Additional within each asset category, liquidity differs

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from one asset to the other. Liquidity of an asset is deeply influenced by several factors
including the following: The first factor which determines the liquidity of an asset is the
rapidity with which it can be sold or exchanged. Liquidity content of an asset is inversely
related with the average time taken to convert it into cash (which is most liquid) in the
market.

Selling an asset is often accompanied with a cost in terms of both money and other
resources. A higher marketing cost reduces the liquidity of an asset. Liquidity of an asset
also depends upon the probability and extent of capital loss/gain associated with its sale.
The idea is that the market price of an asset can differ from the price at which it is
purchased.

Accordingly, the acceptability of an asset declines if its market price is liable to fluctuate. By
inference, the liquidity of an asset is inversely related to the probability and extent of its
price fluctuation. The liquidity approach emphasizes the function of money as a store of
money. It implies that money is not qualitatively different from other assets. Liquidity is the
property of all assets; only the degree of liquidity varies.

The liquidity approach includes in the measurement of money those assets that are highly
liquid, i.e., those assets that can be converted into money quickly. In other words, any asset
for which no nominal capital gain or loss is possible qualifies as a perfectly liquid asset and
is therefore identified as money. Those assets for which only slight capital gains or losses
are possible are highly liquid and are called near-money assets. Liquidity of an asset
depends upon two factors: existence of secondary market and the maturity period of the
asset. The liquidity of an asset is increased by the existence of organized secondary
markets. Shorter the term to maturity of the assets, greater the liquidity. Money has no
term to maturity, therefore it is perfectly liquid Inclusion of near-money assets in the
definition of money makes it empirically more realistic and enables it to explain the actual
economic changes in a better way. Measures of money based on the liquidity approach are
highly correlated with economic activity. Economic activity or the level of aggregate
expenditure in the country is more a function of overall liquidity rather than of total money

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stock (i.e., currency and demand deposits). The prevalence of near-money assets greatly
increases the overall level of liquidity and hence the level of economic activity. An increase
in the money supply by the monetary authority leads to an increase in the liquidity with the
public.

This increase in liquidity will cause further portfolio adjustments. Though the liquidity
approach provides a broader and better measure of money supply, its adoption in the
actual world is difficult due to following reasons: If money is theoretically defined to mean
anything that serves the liquid-store-of money function, then money will include all
medium of exchange assets.

This would be a broader definition of money. But, the empirical difficulties with this
definition are: where the list of measures of money will stop how to quantify the liquidity
content of a medium. Though the liquidity approach is superior to the transactions
approach, but the actual definition of money must take into consideration the empirical
realities, the institutional framework of the economy and the availability of data.

Certain problems relating to the concept of liquidity creates further difficulties in adopting
the liquidity approach: It is not easy to quantify the liquidity content of an asset

Liquidity contents of an asset may not be constant. Since the central bank does not have
much control over the lending activities of the non-bank financial institutions, the existence
and growth of near-money assets may create problems in the effective implementation of
the monetary policy.

5.5.5.ADVANTAGES OF MONEY

Money plays a significant role in the whole functioning of the economy. Its advantages are
as follows:

 Money has overcome drawbacks of barter system.

 Money helps in various ways in the process of production.

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  Money can help producers to decide, plan, execute and manage the production
activities, moreover, the existence of money helps the producers to assess the
quality and quantity of demand of a consumer regarding the product produced.

 Money has a great importance in consumption.

 All the consumers consume the products by buying it from the market. The goods
are bought in consideration of the value money serves as a unit of value or unit of
account and acts as a yardstick to measures exchange value of all commodities.

 Money is accepted as medium of exchange.

 People exchange goods and services through medium of money when they buy
goods or sell goods money.

 So money helps in fulfillment of wants of the consumers.

 Money helps in maximizing consumer’s satisfaction and producer’s profit. It helps

and promotes saving.

 Money can be utilised in reviving the economy from depression. It is the institution
of money which has proved a valuable social instrument of promoting economic
welfare.

 The whole economic science is based on money; economic motives and activities are
measured by money.

 Paper money is the most convenient form of money

5.5.6. Disadvantages of Money

 Prof. J.S. Mill says, "If money gets out of order it would give rise to so many
distinctive and independent effects".

 It means that J.S. Mill wanted to control money.

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 Paper money is of no value outside the country of issue.

 Gold and silver coins are accepted even by foreigners, as they have got some
intrinsic value.

 There is a possibility of the damage to paper. Fire may burn it; if the place is flooded

 There is always a danger of its over-issue when the Government is in financial

difficulties.

 An over-issue of notes, in other words ‘inflation’, brings many disadvantages.

 A great disadvantage of money is that its value does not remain constant which
creates instability in the economy. Too much of money reduces its value and causes
inflation (i.e., rise in price level) and too little of money raises its value and results in
deflation

 Money, through its excessive use and inflationary effect, creates and widens the
inequalities in the distribution of income and wealth.

 The use of money leads to the concentration of wealth in a few hands and this gives
rise to monopolies.

 Growth of monopolies results in the exploitation of the workers brings misery and
degradation to them easy borrowing and lending facilities, made possible through
money, may lead certain industries to use more capital than is required. This over-
capitalization, in turn, results in overproduction and unemployment.

 Money, which is the basis of credit, leads to the creation of more and more credit
creation.

 Credit creation, if not matched by the increase in production, results in inflationary

rise in the prices.

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  Some people give undue importance to money and, instead of utilizing in productive
activities, may start hoarding. This would adversely affect the growth of income,
output and employment of the economy.

 Money, due to storability characteristic, is the cause of the evil of black money.

 It provides people a convenient way to evade taxes by concealing their income.

 Black money, in turn, encourages black marketing and speculative activities.

 The defects of money do not, however, indicate its elimination.

 The advantages of money far exceed its disadvantages.

 What is required is the proper regulation of money supply through a wisely

formulated monetary policy to ensure the efficient working of the economic system
and to achieve the socio-economic objectives of the economy.

5.6 Demand and Supply for Money

This is module is about demand and supply for money. The supply and demand are
determined by various factors. There are various approaches for demand and supply for
money.

5.6.1. Demand for Money

Money is demanded by individuals and Business firm for various reasons. The old theory of
economics states that money is demanded for completing transactions. The modern idea
about the demand for money was put forward by the Lord Keynes, the famous English
economist, who gave birth to what has been called the Keynesian Economics. According to
Keynes, the demand for money, or liquidity preference as he called it, means the demand
for money to hold. The demand for money is the amount of money individuals in an
economy wish to hold at a particular point in time. Bonds, treasury bills or treasury
certificates are not included in the theory of the demand for money.

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The demand for money is motivated by three main reasons. These reasons are the pillars
behind individuals desire to hold liquidity (money), and they include:

A. Transactions Motive:

(a) From the point of consumers who want income to meet the household expenditure
which may be termed the income motive, and

(b) From the point of view of the businessmen, who require money and want to hold it in
order to carry on their business, i.e., the business motive.

(a) Income Motive:

The transactions motive relates to the demand for money or the need for cash for the
current transactions of individual and business exchanges. Individuals hold cash in order
“to bridge the interval between the receipt of income and its expenditure.” This is called the
income Motive’.

Most of the people receive their incomes by the week or the month, while the expenditure
goes on day by day. A certain amount of ready money, therefore, is kept in hand to make
current payments. This amount will depend upon the size of the individual’s income, the
interval at which the income is received and the methods of payments current in the
locality.

(b) Business Motive:

The businessmen and the entrepreneurs also have to keep a proportion of their resources
in ready cash in order to meet current needs of various kinds. They need money all the time
in order to pay for raw materials and transport, to pay wages and salaries and to meet all
other current expenses incurred by any business of exchange.

Keynes calls it the ‘Business Motive’ for keeping money. It is clear that the amount of
money held, under this business motive, will depend to a very large extent on the turnover

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(i.e., the volume of trade of the firm in question). The larger the turnover, the larger in
general, will be the amount of money needed to cover current expenses.

B. Precautionary Motive:

Precautionary motive for holding money refers to the desire of the people to hold cash
balances for unforeseen contingencies People hold a certain amount of money to provide
tor the risk of unemployment, sickness, accidents and other more uncertain perils. The
amount of money held under this motive will depend on the nature of the individual and on
the conditions in which he lives.

C. Speculative Motive:

The speculative motive relates to the desire to hold one’s resources in liquid form in order
to take advantage of market movements regarding the future changes in the rate of interest
(or bond-prices). The notion of holding money for speculative motive is a new typically
Keynesian idea. Money held under the speculative motive serves as a store of value as
money held under the precautionary motive does. But it is a store of money meant for a
different purpose.

The cash held under this motive is used to make speculative gains by dealing in bonds
whose prices fluctuate. If bond prices are expected to rise, which in other words means that
the rate of interest is expected to fall, businessmen will buy bonds to sell when the price
actually rises

If however, bond prices are expected to fall, i.e., the rate of interest is expected to rise,
businessmen will sell bonds to avoid capital losses. Nothing being certain in this dynamic
world, where guesses about the future course of events are made on precarious bases,
businessmen keep cash to speculate on the probable further changes in bond prices (or the
rate of interest) with a view to making profits.

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Given the expectations about the changes in the rate of interest in future, less money will be
held under the speculative motive at a higher current or prevailing rate of interest and
more money will be held under this motive at a lower current rate of interest.

The reason for this inverse correlation between money held for speculative motive and the
prevailing rate of interest is that at a lower rate of interest less is lost by not lending money
or investing it, that is by holding on to money; while at a higher rate, holders of cash
balances would lose more by not lending or investing.

5.6.2. Determinants of Demand for Money

Broadly speaking, the demand for money is thought to depend on three major factors: (a)
total wealth to be held in various forms of assets; (b) relative price of and return on one
form of wealth as compared to the other forms; and (c) tastes and preferences of the
wealth-holders.

Cost of holding cash balances is influenced by (a) the rate of interest and (b) the expected
rate of change in the price level. An increase in the rate of interest or the price level causes
a decline in the cash balances and vice versa the yield on various forms of wealth as used
by Friedman in his demand function are discussed below:

1. Total Wealth:

Broadly speaking, the demand for money is thought to depend on three major factors: (a)
total wealth to be held in various forms of assets; (b) relative price of and return on one
form of wealth as compared to the other forms; and (c) tastes and preferences of the
wealth-holders.

2. Human and Non-Human Wealth:

Total wealth includes both human and non-human wealth, but there exist legal and
institutional constraints in converting human into non-human wealth. Therefore, Friedman

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introduces the ratio of non-human to human wealth (w) as a variable in the demand
function.

3. Money

The nominal return of money may be zero as on currency or positive as on savings deposits
or even negative if current account deposits are subject to net service charges But money is
demanded for the services it yields and these services arise because of money’s command
over goods and services.

Thus, the real yield on money will depend upon the price index (P) because the level of pr
ices governs the ability of money to command goods and services.

4. Bond:

Bond is considered to be a perpetual security, or consol, which yields an income stream

whose value, is fixed in nominal terms. Thus, the yield on bond (r) consists of the sum of its
coupon plus any anticipated capital gain due to an expected fall in the market interest rate
or less any anticipated capital loss due to an expected rise in the market rate.

5. Equity:

The equity is identical to the bond except that it contains a cost- of-living escalator so that
its income stream always maintains constant purchasing power. The yield on equity (r) is
composed of three elements: (a) its coupon yield, (b) any expected capital gains or losses
due to changes in interest rates, and (c) any expected changes in the general price level.

6. Commodities:

Physical goods held by wealth-owners yield income in kind (i.e., utility) which cannot be
measured by an explicit interest rate. However, their real return is affected by the changes
in the price level. Friedman uses the nominal yield on commodities (r) to consist of their
expected rate of price change per unit of time.

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7. Human Capital:

In the absence of slavery, no market price for human capital exists and thus a rate of return
on this form of wealth cannot be computed directly

8. Other Variables:

Friedman introduces a variable designated by to stand for any influence other than
income that affect taste and preferences for money.

5.6.3. MONEY SUPPLY

The money supply the money supply is the total amount of money available in an economy
at a particular point in time (a stock).

5.6.3.1. Approaches to Money Supply

There are four broad approaches of money supply. They are as follows:

1. Traditional Approach:

The traditional approach emphasises the medium of exchange function of money.

According to this approach, money supply is defined as currency with public and demand
deposits with commercial banks. Demand deposits are the current accounts of depositors
in a commercial bank.

The traditional approach is analytically superior because it provides the most liquid and
exact measure of money supply.

The central bank can have better control over the money supply if it includes currency and
demand deposits of banks alone. But, this approach limits money supply to a very narrow
area.

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2. Monetarist Approach:

The Chicago School led by Milton Friedman includes in money supply currency plus
demand deposits plus time deposits. Time deposits are fixed deposits of the banks which
earn a fixed rate of interest depending upon the period for which the amount is deposited.

According to Friedman money is defined as “anything that serves the function of providing
a temporary abode of purchasing power.”

Money can act as a temporary abode of purchasing power if it is kept in the form of cash,
demand deposits or any other asset which is close to currency, i.e., time deposits. This
approach lays emphasis on the store of value function of money and provides a broader
measure of money.

3. Gurley and Shaw Approach:

Gurley and Shaw further widened the scope of money supply by including in its
constituents currency plus demand and time deposits of banks plus the liabilities of non-
banking intermediaries. The liabilities of non-banking intermediaries cover saving bank
deposits, shares, bonds, etc. and are close substitutes to money.

4. Radcliffe Committee Approach:

Radcliffe Committee approach or liquidity approach provides much wider view of the
concept of money supply. In this approach, the concept of money supply is viewed in terms
of general liquidity of the economy.

Money supply covers “the whole liquidity position that is relevant to spending decisions.”
The spending is not limited to the amount of money in existence. It is related to the amount
of money people think they can get hold of whether by receipts of income, by disposal of
assets or by borrowing.

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Thus, according to this approach, money supply includes cash, all kinds of bank deposits,
deposits with other institutions, near-money assets and the borrowing facilities available
to the people.

The practical difficulty with this liquidity approach is that the money supply in this wider
sense cannot be successfully measured because the degree of liquidity of different
constituents of money supply varies considerably.

Moreover, most of the constituents remain outside the control of central bank and thus
restrict the effective implementation of monetary policy.

5.6.3.2. Determinants of Money Supply

Main determinants of the supply of money are (a) monetary base and (b) the money
multiplier. These two broad determinants of money supply are, in turn, influenced by a
number of other factors. Various factors influencing the money supply are discussed below:

1. Monetary Base:

Magnitude of the monetary base (B) is the significant determinant of the size of money
supply. Money supply varies directly in relation to the changes in the monetary base.

Monetary base refers to the supply of funds available for use either as cash or reserves of
the central bank. Monetary base changes due to the policy of the government and is also
influenced by the value of money.

2. Money Multiplier:

Money multiplier (m) has positive influence upon the money supply. An increase in the size
of m will increase the money supply and vice versa.

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3. Reserve Ratio:

Reserve ratio (r) is also an important determinant of money supply. The smaller cash-
reserve ratio enables greater expansion in the credit by the banks and thus increases the
money supply and vice versa.

Reserve ratio is often broken down into its two component parts; (a) excess reserve ratio
which is the ratio of excess reserves to the total deposits of the bank (r e = ER/D); (b)
required reserve ratio which is the ratio of required reserves to the total deposits of the
bank (rr = RR/D). Thus r = re + rr. The rr ratio is legally fixed by the central bank and the
re ratio depends on the market rate of interest.

4. Currency Ratio:

Currency ratio (c) is a behavioural ratio representing the ratio of currency demand to the
demand deposits. The effect of the currency ratio on the money multiplier (m) cannot be
clearly recognised because enters both as a numerator and a denominator in the money
multiplier expression (1 + c/r(1 +t) + c). But, as long as the r ratio is less than unity, a rise
in the c ratio must reduce the multiplier.

5. Confidence in Bank Money:

General economic conditions affect the confidence of the public in bank money and,
thereby, influence the currency ratio (c) and the reserve ratio (r). During recession,
confidence in bank money is low and, as a result, c and r ratios rise. Conversely, during
prosperity, c and r ratios tend to be low when confidence in banks is high.

6. Time-Deposit Ratio:

Time-deposit ratio (t), which represents the ratio of time deposits to the demand deposits
is a behavioural parameter having negative effect on the money multiplier (m) and thus on
the money supply. A rise in t reduces m and thereby the supply of money decreases.

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7. Value of Money:

The value of money (1/P) in terms of other goods and services has positive influence on the
monetary base (B) and hence on the money stock.

8. Real Income:

Real income (Y) has a positive influence on the money multiplier and hence on the money
supply. A rise in real income will tend to increase the money multiplier and thus the money
supply and vice versa.

9. Interest Rate:

Interest rate has a positive effect on the money multiplier and hence on the money supply.
A rise in the interest rate will reduce the reserve ratio (r), which raises the money
multiplier (m) and hence increases the money supply and vice versa

10. Monetary Policy:

Monetary policy has positive or negative influence on the money multiplier and hence on
the money supply, depending upon whether reserve requirements are lowered or raised. If
reserve requirements are raised, the value of reserve ratio (r) will rise reducing the money
multiplier and thus the money supply and vice versa.

11. Seasonal Factors:

Seasonal factors have negative effect on the money multiplier, and hence on the money
stock. During holiday periods, the currency ratio (c) will tend to rise, thus, reducing the
money multiplier and, thereby, the money supply.

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5.7 Money Market

5.7.1. Introduction

As per the Reserve Bank of India, the term ‘Money Market’ is used to define a market where
short-term financial assets with a maturity up to one year are traded.

Money market, a set of institutions, conventions, and practices, the aim of which is
to facilitate the lending and borrowing of money on a short-term basis. The money market
is, therefore, different from the capital market, which is concerned with medium- and long-
term credit. The definition of money for money market purposes is not confined to bank
notes but includes a range of assets that can be turned into cash at short notice, such as
short-term government securities, bills of exchange, and bankers’ acceptances.

Objectives of Money Market:

To cater to the requirements of borrowers for short term funds, and provide liquidity to
the lenders of these funds.

2. To provide parking place for temporary employment of surplus fund.

3. To provide facility to overcome short term deficits.

4. To enable the central bank to influence and regulate liquidity in the economy.

To help the government to implement its monetary policy through open market operation.

5.7.2. CONSTITUENTS OF INDIAN MONEY MARKET

Money market is a centre where short-term funds are supplied and demanded. Thus, the
main constituents of money market are the lenders who supply and the borrowers who
demand short-term credit.

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A. Supply of Funds

There are two main sources of supply of short-term funds in the Indian money market:

(a) Unorganised indigenous sector,

(b) Organised modern sector.

(a) Unorganized Sector:

The unorganised sector comprises numerous indigenous bankers and village money
lenders. It is unorganized because its activities are not controlled and coordinated by the
Reserve Bank of India.

(b) Organized Sector:

The organized modern sector of Indian money market comprises:

a) The Reserve Bank of India;

b) The State Bank of India and its associate banks;

c) The Indian joint stock commercial banks (scheduled and non-scheduled) of which
20 scheduled banks have been nationalised;

d) The exchange banks which mainly finance Indian foreign trade

e) Cooperative banks;

f) Other special institutions, such as, Industrial Development Bank of India, State
Finance Corporations, National Bank for Agriculture and Rural Development,
Export-Import Bank, etc., which operate in the money market indirectly through
banks; and

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 g) Quasi-government bodies and large companies also make their funds available to
the money market through banks.

B. Demand for Funds:

In the Indian money market, the main borrowers of short-term funds are: (a)
Central Government, (b) State Governments, (c) Local bodies, such as,
municipalities, village panchayats, etc., (d) traders, industrialists, farmers, exporters
and importers, and (e) general public.

Sub-Markets of Organised Money Market:

The organised sector of Indian money market can be further classified into the following
sub-markets:

 Call Money Market:

The most important component of organised money market is the call money market. It
deals in call loans or call money granted for one day. Since the participants in the call
money market are mostly banks, it is also called interbank call money market.

Call money market provides the institutional arrangement for making the temporary
surplus of some banks available to other banks which are temporary in short of funds.
Mainly the banks participate in the call money market. The State Bank of India is always on
the lenders’ side of the market. The call money market operates through brokers who
always keep in touch with banks and establish a link between the borrowing and lending
banks. The call money market is highly sensitive and competitive market. As such, it acts as
the best indicator of the liquidity position of the organised money market. The rate of
interest in the call money market is highly unstable. It quickly rises under the pressures of
excess demand for funds and quickly falls under the pressures of excess supply of funds.
The call money market plays a vital role in removing the day-to-day fluctuations in the
reserve position of the individual banks and improving the functioning of the banking
system in the country.

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  Treasury Bill Market:

The Treasury bill market deals in treasury bills which are the short-term (i.e., 91, 182 and
364 days) liability of the Government of India. Theoretically these bills are issued to meet
the short-term financial requirements of the government.

 Commercial Bill Market:

Commercial bill market deals in commercial bills issued by the firms engaged in business.
These bills are generally of three months maturity. A commercial bill is a promise to pay a
specified amount in a specified period by the buyer of goods to the seller of the goods. The
seller, who has sold his goods on credit draws the bill and sends it to the buyer for
acceptance. After the buyer or his bank writes the word ‘accepted’ on the bill, it becomes a
marketable instrument and is sent to the seller.

The seller can now sell the bill (i.e., get it discounted) to his bank for cash. In times of
financial crisis, the bank can sell the bills to other banks or get them rediscounted from the
Reserved Bank. In India, the bill market is undeveloped as compared to the same in
advanced countries like the U.K. There is absence of specialised institutions like acceptance
houses and discount houses, particularly dealing in acceptance and discounting business.

 Collateral Loan Market:

Collateral loan market deals with collateral loans i.e., loans backed by security. In the
Indian collateral loan market, the commercial banks provide short- term loans against
government securities, shares and debentures of the government, etc.

 Certificate of Deposit and Commercial Paper Markets:

Certificate of Deposit (CD) and Commercial Paper (CP) markets deal with certificates of
deposit and commercial papers. These two instruments (CD and CP) were introduced by
Reserve Bank of India in March 1989 in order to widen the range of money market

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instruments and give investors greater flexibility in the deployment of their short-term
surplus funds.

5.7.2.1. Players in Money Market

Players in Money Market are as follows

 Central Government

 Public Sector Undertakings

 Insurance Companies:

 Mutual Funds

 Banks

 Corporates

5.7.3. Money Market Equilibrium

Money market is in equilibrium when at a rate of interest demand for and supplies of
money are equal.

Money Demand

According to Keynes’ Liquidity Preference theory, people demand money, that is

liquidity, and hold their wealth in a monetary form for three reasons:

1. To engage in real transactions

2. As a precaution in the event of unexpected spending

3. To engage in speculative transactions

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The demand for money as an asset, that is, for speculative purposes depends on rate of
interest on bonds, which is the opportunity cost of holding money. If rate of interest is
higher, the people would demand less money to hold for speculative purposes. This is
because at a higher rate of interest they would go in for holding more bonds or other
financial assets in their investment portfolio. On the other bond, at a lower rate of interest
on bonds, they would demand more money to hold. Thus, demand for money to hold for
speculative purposes, that is, as an asset is negatively related to rate of interest. Therefore,
demand curve for money for speculative purposes slopes downward. This indicates that at
a higher rate of interest, less money is held as an asset and at a lower interest rate, more
money is held as an asset. Demand for money to hold for speculative purposes is drawn as

Fig. 17.1. Demand for Money and Rate of Interest

Money supply

Money is an important factor which is used as a medium of exchange for undertaking

transactions and for holding as an asset. Money can perform these functions if it is kept

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scarce, that is, supply of money at a given point of time is fixed and over time it is increased
at a limited rate.

Therefore, the Central Bank of a country (in case of India, Reserve Bank of India) is given
the right to control the supply of money in the economy. The money supply is fixed by the
policy actions of the Central Bank of the country. Through open market operations changes
in cost reserve ratio (CRR) of banks Central Bank of a country can influence the creation of
bank credit which constitutes an important part of the money supply of the country

Fig. 17.3. Money supply is independent of rate of interest.

Money Market Equilibrium

Once the Central Bank of a country fixes the money supply in the economy, households and
business firms can make individual decisions regarding how much money to hold. But the
total money supply will be unaffected by their decisions to hold more or less money to fulfil
transaction and speculative purposes. Money market is in equilibrium at a rate of interest

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when demand for money is equal to the fixed money supply. Thus money market is in
equilibrium when

MS = MD

Fig. 17.4. Money Market Equilibrium.

MS is the money supply curve which is a vertical straight line showing that 200 crores of
rupees is the money supply fixed by the monetary authority. It will be seen that quantity
demanded of money equals the given money supply at 10 per cent rate of interest. So the
money market is in equilibrium at 10 per cent rate of interest. There will be disequilibrium
if rate of interest is either higher or lower than 10 per cent.

Suppose the rate of interest is 12 per cent. It will be seen from Figure that at 12 per cent
rate of interest, the given supply of money exceeds the demand for money. The excess
supply of money reflects the fact that people do not want to hold as much money in their
portfolio as the monetary authority has made it available to them. The people holding
assets in the present two-asset economy would react to this excess money supply with

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them by buying bonds and thus replace some of money in their portfolios with bonds. Since
the total money supply at a given moment remains fixed, it cannot be reduced by buying
bonds by individuals. But the bond-buying spree would lead to the rise in prices of bonds.
The rise in bond prices means the fall in the rate of interest. As will be seen from Figure
with the fall in the interest rate from 12 per cent to 10 per cent, quantity demand of money
has increased to be once again equal to the given supply of money and the excess supply of
money is entirely eliminated and money market equilibrium is restored.

On the other hand, if the rate of interest is lower than the equilibrium rate of 10 per cent,
say it is 8 per cent, and then as will be seen from Figure s there will emerge excess demand
for money. As a reaction to this excess demand for money, people would like to sell bonds
in order to obtain a greater quantity of money for holding at the lower rate of interest.

The stock of money remaining fixed, the attempt by the people to hold more money
balances at a rate of interest lower than the equilibrium level through sale of bonds will
only cause the bond prices to fall. The fall in bond prices implies the rise in the rate of
interest.

Thus, the process started as a reaction to the excess demand for money at an interest rate
below the equilibrium level will end up with the rise in the interest rate to the equilibrium
level.

5.8. Monetary Policy

Monetary policy is an important economic tool of Macro Economic policy of a country. It is

formulated and implemented by the central bank of a country through wide network of
financial institutions. It is designed with an objective to take care of economic conditions
and to avoid any policy conflicts for achieving overall efficiency in the economy. Monetary
policy includes all measures, which affect money supply, liquidity, cost and availability of
credit Monetary policy, measures employed by governments to
influence economic activity, specifically by manipulating the supplies
of money and credit and by altering rates of interest.

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5.8.1. Objectives of Monetary Policy

The following are the specific objectives of monetary policy:

1. High level of output (or national income)

2. High rate of economic growth

3. High employment

4. Price stability (or optimal rate of inflation – inflation rate is nominal anchor for monetary
policy)

5. Low inequality in the distribution of income and wealth (equity objective)

6. External stability or healthy balance of payment position (stability of external value of

domestic currency)

Monetary policy operates through changes in the stock of money. Money stock changes will
influence the level of aggregate demand and so the level of output or income. Two
characteristics of monetary policy are noteworthy. One is that it is an aggregative policy.
Any allocation or sectorial problems are beyond its domain and these are the concerns of
credit policy. Second is that it operates on the demand side and not on the supply side of
the goods market (credit policy can affect even the supply side of goods market).

A central bank is an apex institution of a country’s monetary and financial system. Since the
monetary system (which includes commercial banks) is a dominant part of the financial
system of a country; the central bank is the apex system to the country’s financial system
also. As such it plays a leading role in organizing, running, supervising, regulating and
developing the monetary financial system.

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5.8.2. Tools of Monetary Policy

1. Bank Rate or Discount Rate:

Bank rate refers to that rate at which a central bank is ready to lend money to commercial
banks or to discount bills of specified types. Thus by changing the bank rate, the credit and
further money supply can be affected. In other words, rise in bank rate increases rate of
interest and fall in bank rate lowers rate of interest. During the course of inflation,
monetary authority raises the bank rate to curb inflation. Higher bank rate will check the
expansion of credit of commercial banks. They will be left with fewer reserves, which
would restrict the credit creating capacity of the bank. On the contrary, during depression,
bank rate is lowered; business community will prefer to have more and more loans to pull
the economy out of depression. Therefore, bank rate or discount rate can be used in both
type of situation is inflation and depression.

2. Open Market Operations:

By open market operations, we mean the sale or purchase of securities. It is known that the
credit creating capacity of the commercial banks depend on the cash reserves of the bank.
In this way, the monetary authority (Central Bank) controls the credit by affecting the base
of the credit-creation by the commercial banks. If the credit is to be decreased in the
country, the Central Bank begins to sell securities in the open market. This will result to
reduce money supply with the public as they will withdraw their money with the
commercial banks to purchase the securities. The cash reserves will tend to diminish. This
happens in the period of inflation. During depression, when prices are falling, the central
bank purchases securities resulting expansion of credit and aggregate demand also
increases and prices also rise.

3. Reserve Ratio:

The commercial banks have to keep given percentage as cash-reserve with the central
bank. In lieu of that cash ratio, it allows commercial bank to contract or expand its credit
facility. If the central bank wants to contract credit (during inflation period) it raises the

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cash reserve ratio. As a result, commercial banks are left with fewer amounts of deposits.
Their power to credit is curtailed. If there is depression in the economy, the reserve ratio is
reduced to raise the credit creating capacity of commercial banks. Therefore, variable
reserve ratio can be used to affect commercial banks to raise or reduce their credit creation
capacity.

4.Statutory Liquidity Ratio: refers to the percentage of total deposits of the commercial
banks that the commercial banks are required to maintain with themselves in form of
liquid assets viz.-cash,goldorapprovedgovernment securities

5. Change in Liquidity: According to this method, every bank is required to keep a certain
proportion of its deposits as cash with it. When the central bank wants to contract credit, it
raises its liquidity ratio and vice-versa.

5.8.3. TYPES OF MONETARY POLICY

There two kinds of Monetary Policy the government takes to regulate the Economy .They
are as follows

A. Expansionary Monetary Policy to Cure Recession or Depression:

When the economy is faced with recession or involuntary cyclical unemployment, which
comes about due to fall in aggregate demand, the central bank intervenes to cure such a
situation. Central Bank takes steps to expand the money supply in the economy and/or
lower the rate of interest with a view to increase the aggregate demand which will help in
stimulating the economy.

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The measures that are adopted as a part of an expansionary monetary policy to cure
recession and to establish the equilibrium of national income at full-employment level of
output are as follows:

1. The central bank undertakes open market operations and buys securities in the open
market. Buying of securities by the central bank from the from commercial banks will lead
to an increase in reserves of the banks or amount of currency with the general public.

With greater reserves, commercial banks can issue more credit to the investors and
businessmen for undertaking more investment. More private investment will cause
aggregate demand curve to shift upward. Thus’ buying of securities will have an
expansionary effect.

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2. The Central Bank may lower the bank rate or (what is also called discount rate,) which
are the rate of interest charged by the central bank a of country on its loans to commercial
banks Bank rate is the interest rate at which Reserve Bank of India lends funds to the
commercial banks for a short period of time. At a lower bank rate, the commercial banks
will be induced to borrow more from the central bank and will be able to issue more credit
at the lower rate of interest to businessmen and investors.

This will not only make credit cheaper but also increase the availability of credit or money
supply in the economy. The expansion in credit or money supply will increase the
investment demand which will tend to raise aggregate output and income.

3. Thirdly, the central bank may reduce the Cash Reserve Ratio (CRR) to be kept by the
commercial banks. This is a more effective and direct way of expanding credit and
increasing money supply in the economy by the central bank. With lower reserve
requirements, a large amount of funds is released for providing loans to businessmen and
investors.

As a result, credit expands and investment increases in the economy which has an
expansionary effect on output and employment. Thus it regulates recession and
unemployment.

Similar to the Cash Reserve Ratio (CRR), in India there is another monetary instrument,
namely, Statutory Liquidity Ratio (SLR) used by the Reserve Bank to change the lending
capacity and therefore credit availability in the economy. According to Statutory Liquidity
Ratio, in addition to the Cash Reserve Ratio (CRR) banks have to keep a certain minimum
proportion of their deposits in the form of some specified liquid assets such as Government
securities.

To increase the lendable resources of the banks, Reserve Bank can lower this Statutory
Liquidity Ratio (SLR). Thus, when Reserve Bank of India lowers statutory liquidity ratio
(SLR), the credit availability for the private sector will increase.

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It may be noted that the use of all the above tools of monetary policy leads to an increase in
reserves or liquid resources with the banks. Such reserves are the basis on which banks
expand their credit by lending; the increase in reserves raises the money supply in the
economy. Thus, appropriate monetary policy at times of recession or depression can
increase the availability of credit and also lower the cost of credit. This leads to more
private investment spending which has an expansionary effect on the economy.

B. Tight Monetary Policy to Control Inflation:

When aggregate demand rises sharply due to large consumption and investment
expenditure or more importantly, due to the large increase in Government expenditure
relative to its revenue resulting in huge budget deficits, a demand-pull inflation occurs in
the economy. Besides, when there is too much creation of money for one reason or the
other, it generates inflationary pressures in the economy.

To check the demand-pull inflation which has been a major problem in several other
countries in recent years, the adoption of contractionary monetary policy which is
popularly called tight monetary policy is called for. Note that tight or restrictive money
policy is one which reduces the availability of credit and also raises its cost.

The following monetary measures which constitute tight money policy are generally
adopted to control inflation:

1. The Central Bank sells the Government securities to the banks, other depository
institutions and the general public through open market operations. This action will reduce
the reserves with the banks and liquid funds with the general public.

With less reserve with the banks, their lending capacity will be reduced. Therefore, they
will have to reduce their demand deposits by refraining from giving new loans as old loans
are paid back. As a result, money supply in the economy will shrink.

2. The bank rate may also be raised which will discourage the banks to take loans from the
central bank. This will tend to reduce their liquidity and also induce them to raise their

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own lending rates. Thus this will reduce the availability of credit and also raise its cost. This
will lead to the reduction in investment spending and help in reducing inflationary
pressures.

The instruments of bank rate and reverse rate changes that have often used to fight
inflation and recessionary situation.

To control inflation Bank rate is raised. Hike in this rate raises the cost of funds for the
banks which, if they do not have excess reserves or enough liquidity, would raise their
lending rates.

The rise in lending rates of banks which will raise the borrowing costs for businessmen will
lead to the reduction in demand for bank credit and thus lower investment and
consumption demand. The opposite happens when to fight recession the RBI lowers rate
and thus reducing lending rate for the banks.

3. The most important anti-inflationary measure is the raising of statutory Cash Reserve
Ratio (CRR). Rise in cash reserve ratio (CRR) reduces cash reserves of banks. To meet the
new higher reserve requirements, banks will reduce their lending, that is, credit
availability.

This will have a direct effect on the contraction of money supply in the economy and help in
controlling demand pull inflation. Besides Cash Reserve Ratio (CRR), the Statutory
Liquidity Ratio (SLR) can also be increased through which excess reserves of the banks are
mopped up resulting in contraction in credit.

4. Fourthly, an important anti-inflationary measure is the use of qualitative credit control,

namely, rising of minimum margins for obtaining loans from banks against the stocks of
sensitive commodities such as food-grains, oilseeds, cotton, sugar, vegetable oil.

As a result of this measure, businessmen themselves will have to finance to a greater extent
the holding of inventories of goods and will be able to get less credit from banks. This
selective credit control has been extensively used in India to control inflationary pressures.

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The monetary policy is implemented by the RBI through a reserve system, bank rate policy,
moral persuasion, credit control policy and other tools. No matter which instrument is
used, it brings changes to the money supply and interest rate.

Learning Outcomes

1. To know about the kinds, causes and effects of Unemployment.

2. To know about types and causes of Inflation
3. To the concept of money
4. To learn the concept of money demand and supply.
5. To learn the Money Market Equilibrium
6. To will learn the types of Monetary Policy

Short Answer Questions

1. Define Unemployment.
2. State Okun’s Law
3. Define Inflation
4. What is Cost Push Inflation?
5. What is Philip curve?
6. What is Stagflation?
7. What is Liquidity?
8. What is supply of Money?
9. What is Demand for Money?
10. What is Treasury Bill?
11. What is CRR?

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Long Answer Questions

1. Give note on the causes of unemployment

2. Explain the kinds of Inflation
3. Enumerate on effects of Inflation
4. Enumerate on Philip Curve with illustrations
5. Enumerate on the types of Money.
6. Explain the demand and supply of Money in an Economy?
7. Enumerate on Supply of Money.
8. Explain the Money Market Equilibrium.
9. Discuss the types of Monetary Policy.

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