Basic Problems of an Economy – #1 – What to Produce?

What does a society do when the resources are limited? It decides which goods/service it wants to produce. Further, it also
determines the quantity required. For example, should we produce more guns or more butter? Do we opt for capital goods like
machines, equipment, etc. or consumer goods like cell phones, etc.? While it sounds elementary, society must decide the type and
quantity of every single good/service to be produced.
Basic Problems of an Economy – #2 – How to Produce?
The production of a good is possible by various methods. For example, you can produce cotton cloth using handlooms, power
looms or automatic looms. While handlooms require more labour, automatic looms need higher power and capital investment.
Basic Problems of an Economy – #3 – For whom to Produce?
Think about it – can a society satisfy each and every human wants? Certainly not. Therefore, it has to decide on who gets what
share of the total output of goods and services produced. In other words, society decides on the distribution of the goods
and services among the members of society.
Basic Problems of an Economy – #4 – What provision should be made for economic growth?
Can a society use all its resources for current consumption? Yes, it can. However, it is not likely to do so. The reason is simple. If a
society uses all its resources for current consumption, then its production capacity would never increase.
Microeconomics Macroeconomics
Meaning
Microeconomics is the branch of Economics that is related Macroeconomics is the branch of Economics that deals with the
to the study of individual, household and firm’s behaviour in study of the behaviour and performance of the economy in total.
decision making and allocation of the resources. It comprises The most important factors studied in macroeconomics involve
markets of goods and services and deals with economic gross domestic product (GDP), unemployment, inflation and
issues. growth rate etc.
Area of study
Microeconomics studies the particular market segment of Macroeconomics studies the whole economy, that covers
the economy several market segments
Deals with
Microeconomics deals with various issues like demand,
Macroeconomics deals with various issues like national
supply, factor pricing, product pricing, economic welfare,
production, consumption, and more. income, distribution, employment, general price level,
money, and more.

Business Application
It is applied to internal issues. It is applied to environmental and external issues.

Scope
It covers several issues like demand, supply, factor pricing, It covers several issues like distribution, national income,
product pricing, economic welfare, production, employment, money, general price level, and more.
consumption, and more.
Significance

It is useful in regulating the prices of a product It perpetuates firmness in the broad price level, and
alongside the prices of factors of production (labour, solves the major issues of the economy like deflation,
land, entrepreneur, capital, and more) within the inflation, rising prices (reflation), unemployment, and
economy. poverty as a whole.

Limitations

It is based on impractical presuppositions, i.e., in
microeconomics, it is presumed that there is full
employment in the community, which is not at all
feasible.
It has been scrutinised that the misconception of
composition’ incorporates, which sometimes fails to
prove accurate because it is feasible that what is true for
aggregate (comprehensive) may not be true for
individuals as well.
What is Microeconomics?
Microeconomics is the study of decisions made by people and businesses regarding the allocation of resources and prices of goods
and services. The government decides the regulation for taxes. Microeconomics focuses on the supply that determines the price
level of the economy.
It uses the bottom-up strategy to analyse the economy. In other words, microeconomics tries to understand human’s choices and
allocation of resources. It does not decide what are the changes taking place in the market, instead, it explains why there are
changes happening in the market.
The key role of microeconomics is to examine how a company could maximise its production and capacity, so that it could lower
the prices and compete in its industry. A lot of microeconomics information can be obtained from the financial statements.
The key factors of microeconomics are as follows:
• Demand, supply, and equilibrium
• Production theory
• Costs of production
• Labour economics
Examples: Individual demand, and price of a product.
What is Macroeconomics?
Macroeconomics is a branch of economics that depicts a substantial picture. It scrutinises itself with the economy at a massive
scale, and several issues of an economy are considered. The issues confronted by an economy and the headway that it makes are
measured and apprehended as a part and parcel of macroeconomics.
Macroeconomics studies the association between various countries regarding how the policies of one nation have an upshot on
the other. It circumscribes within its scope, analysing the success and failure of the government strategies.
In macroeconomics, we normally survey the association of the nation’s total manufacture and the degree of employment with
certain features like cost prices, wage rates, rates of interest, profits, etc., by concentrating on a single imaginary good and what
happens to it.
The important concepts covered under macroeconomics are as follows:
1. Capitalist nation
2. Investment expenditure
3. Revenue
Law of Demand
The Law of Demand states that when the price of a product increases, its demand decreases and vice versa, keeping all other factors
constant. Say a buyer may get a dozen fruits at Rs.80. If the price hikes up to Rs.90, he can limit the purchase to half a dozen.
Therefore, the law of Demand in Economics pictures an inverse relationship between the Price and quantity of a particular product
or service. Now, we will get into what are the exceptions to the law of Demand?
Exceptions to the Law of Demand
Veblen Goods
The theory of Veblen goods belongs to the next category of exceptions to the law of Demand. Thorstein Veblen was the one to
highlight this concept. Veblen goods are the ones whose demand increases with their Price. They become more valuable with their
price rise. These are the goods people consider to be more useful with an increase in Price. Like a high-priced gold necklace, it's
more desirable to the customer than the one with lower costs.
Price Change Exception
Eventually, there are times when the Price of a product is about to decrease. Consumers may temporarily stop the purchase to avail
of the future benefits of price decrement. Recently, there has been a massive rise in the price of onions. People were buying it more
due to the worry of the further cost increase.
Necessary Goods
Let us understand what are the exceptions to the law of demand in the case of necessary items. The Demand for essential goods
stays intact even if there’s a price rise. People can’t stop purchasing the products of regular necessities. For example, if the cost of
salt increases, consumers won't be able to afford it. It is the complete opposite of the law of Demand in Economics.
Luxury Goods
A significant exception to the law is the Demand for luxury goods. In such cases, even if the price increases, the consumer won't
stop consumption. Cigarettes and alcohol typically come in this category.
Income Change
The change in income of a consumer or a family also determines the Demand for a particular product. If a family's income increases,
they may choose to buy a specific product in more quantity, no matter the Price. Again, if the family's income decreases, they can
select to reduce product consumption to an extent. It opposes the law of Demand.
What is demand?
Demand simply means a consumer’s desire to buy goods and services without any hesitation and pay the price for it. In simple
words, demand is the number of goods that the customers are ready and willing to buy at several prices during a given time
frame. Preferences and choices are the basics of demand, and can be described in terms of the cost, benefits, profit, and other
variables.
Determinants of Demand
There are many determinants of demand, but the top five determinants of demand are as follows:
Product cost: Demand of the product changes as per the change in the price of the commodity. People deciding to buy a product
remain constant only if all the factors related to it remain unchanged.
The income of the consumers: When the income increases, the number of goods demanded also increases. Likewise, if the
income decreases, the demand also decreases.
Costs of related goods and services: For a complimentary product, an increase in the cost of one commodity will decrease the
demand for a complimentary product. Example: An increase in the rate of bread will decrease the demand for butter. Similarly, an
increase in the rate of one commodity will generate the demand for a substitute product to increase. Example: Increase in the
cost of tea will raise the demand for coffee and therefore, decrease the demand for tea.
Consumer expectation: High expectation of income or expectation in the increase in price of a good also leads to an increase in
demand. Similarly, low expectation of income or low pricing of goods will decrease the demand.
Buyers in the market: If the number of buyers for a commodity are more or less, then there will be a shift in demand.
Types of Demand
Few important different types of demand are as follows:
1. Price demand: It refers to various types of quantities of goods or services that a customer will buy at a quoted price and
given time, considering the other things remain constant.
2. Income demand: It refers to various types of quantities of goods or services that a customer will buy at different stages of
income, considering the other things remain constant.
3. Cross demand: This means that the product’s demand does not depend on its own cost but depends on the cost of the
other related commodities.
4. Direct demand: When goods or services satisfy an individual’s wants directly, it is known as direct demand.
5. Derived demand or Indirect demand: The goods or services demanded or needed for manufacturing the goods and
satisfying the consumer indirectly is known as derived demand.
6. Joint demand: To produce a product there are many things that are related to each other, for example, to produce bread,
we need services like an oven, fuel, flour mill, and more. So, the demand for other additional things to produce a product
is known as joint demand.
7. Composite demand: A composite demand can be described when goods and services are utilised for more than one
cause. Example: Coal
Types of price elasticity
Different products react differently to the price change. A price change for a essential product such as rice has little impact on
demand while the price change in other products has huge impact on demand. This gives rise to the different types of price
elasticities. Price elasticities are generally classified into the following categories.
1. Perfectly elastic demand (ep = ∞)
Here there is no need for reduction in price to cause an increase in demand, f this be the case, a firm can sell all the quantity it
wants at the prevailing price, but the firm can sell none at all at even a slightly higher price. Here the demand curve is horizontal.
2. Absolutely inelastic demand or perfectly inelastic demand (ep=0)
Absolutely inelastic demand is where a change in price howsoever large, causes no change in the quantity demanded of a product.
Here, the shape of the demand curve is vertical. Some examples of absolutely inelastic demand are the demand of essential
commodities such as rice, wheat etc. whose change is price does not affect the quantity demanded.
3. Unit elasticity of demand (ep = 1)
Unit elasticity is where a given proportionate change in price causes and equal proportionate change in the quantity demanded of
the product. The shape of the demand curve here is that of a rectangular hyperbola.
4. Relatively Elastic of Demand (ep>1)
It is where a reduction in price leads to more than proportionate change demand. Here the shape of the demand curve in flat.
5. Relatively in elastic demand (ep<1)
It is where a decline in price leads to less than proportionate increase in demand. Here the shape of the demand curve is steep.
Factors determining price elasticity of Demand:
1. Nature of the product
The demand for products that fall in the category of necessities (eg. Rice, salt, wheat etc) are usually inelastic. This is because their
demand do not change even when there is a change in price. On the other hand the demand for luxuries (TV's, washing machines
etc) are elastic where even a small change in price reflects on a huge change in the demand
2. Extent of usage:
If a product has varied usage (eg. steel, aluminums, wood etc) then it has a comparatively elastic demand. For example, if the
price of teak wood falls then its usage in many areas will be increased and the opposite happens when the price rises, the usage in
some quarters will be cut down while the usage in other and will be the same.
3. Availability of substitutes:
When a product has many substitutes then its demand will be relatively elastic. This is because if the price of one substitute goes
down then customers switch to that substitute and vice versa. Products without substitutes or has weak substitutes have
relatively inelastic demand.
4. Income level of people:
People with high income are less affected by price changes in products while people with low income, are highly affected by price
rise. People with high income will not change their buying habits because of the increase in price of either essential commodities
or luxuries while other will cut back on purchase of certain commodities to compensate for the essential commodities if there is a
price increase.
5. Proportion of income spent on the commodity:
When a person spends only a very small part of his income on certain products (match boxes, salt etc) the price change in these
products does not materially affect his demand for the product. Here the demand is inelastic.
6. Urgency of Demand:
If a person requires buying a product immediately no matter what or no other go but to-buy a product at that point of time, with
no substitutes, the demand for that product becomes inelastic. For example if one is building a lodge and is in urgent need for
completing the construction then, any price change in cement or bricks or steel etc will have little impact on the demand for those
products.
Supply
The fundamental economic concept that states the total amount of a specified product or service that is available to customers is
known as ‘supply.’ It is very closely related to and goes hand in hand with demand. When supply exceeds demand for a product or
service, the prices of said product fall.
The various types of supply are:
Short-term supply: The ability of consumers to buy products is restricted by available supplies. They cannot buy beyond the
supplied goods.
Long-term supply: The factor of availability of time when demand changes which gives the supplier a way to adjust to the quick
change in demand.
Joint supply: The supply of products produced and sold jointly.
Composite supply: The supply of a product through its different sources, where the product serves more than one purpose.
Market supply: The overall desire and capability of suppliers to supply the market with specific products regularly.

Exceptions of Law of supply

1. Closure of business
When a business is on the verge of closure, the seller may sell the goods even at low prices in order to clear the stock. Thus, in this
case, the law of supply shall not hold true.
2. Agricultural products
We know that land is a limited resource and thus the agricultural produce can also not be increased beyond a certain level. Hence,
even if the prices increase the supply cannot be increased.
3. Monopoly
Monopoly is a situation where there is only a single seller of a commodity. Thus, he is the price maker and has control over the
prices.
4. Competition
When there is a cut-throat competition in the market, the sellers may sell more quantity of goods even at low prices. This is a
situation where the law of supply will not apply.
5. Perishable Goods
A seller is willing to sell more goods that are perishable in nature even at low prices because if they remain unsold they will yield
only loss.
6. Rare goods
The goods that are rare such as artistic or precious goods have a limited supply. The supply of these goods cannot be increased
according to their demand or rising prices.
Determinants of supply
1. Price of the Commodity
It is the main and the most important determinant of demand. When the price of the commodity is high, the producers or
suppliers are willing to sell more commodities.
2. Firm Goals
The supply of goods also depends on the goals of an organization. An organization may have various goals such as profit
maximization, sales maximization, employment maximization, etc.
3. Price of Inputs or Factors
The price of inputs or the factors of production such as land, labor, capital, and entrepreneurship also determine the supply of the
goods. When the price of inputs is low the cost of production is also low.
4. Technology
When a firm uses new technology it saves the inputs and also reduces the cost of production. Thus, firms produce more and
supply more goods.
5. Government Policy
The taxation policies and the subsidies given by the government also impact the supply of goods.
When the taxes are high the producers are unwilling to produce more goods and thus, the supply will decrease.
6. Expectations
When the producers or suppliers expect that the price shall increase in future they hoard the goods so that they can sell them at
higher prices later. This will result in a decrease in the supply of goods.
Determinants of Price Elasticity of Supply
• Marginal Cost- As the cost of producing one more unit is rising with output or Marginal Costs (which are the increased
costs related to each additional unit produced) are rising rapidly with output, then the rate of output production will be
limited, i.e Price Elasticity of Supply will be inelastic., which means that the percentage of quantity supplied changes less
than the change in price. However, if Marginal Cost rises slowly, then Supply will be elastic.
• Time- As the price elasticity of supply increases over time, producers would increase the quantity supplied by a greater
percentage than the price increases.
• Number of Firms- It is more likely that the supply will be elastic when there are a large number of firms. This occurs
because other firms can step in to fill the supply gap.
• Mobility of Factors of Production- When the factors of production are mobile, then the price elasticities of supply are
higher. This means that labor and other manufacturing inputs may be imported from other regions to quickly increase
production.
Equilibrium
So, is it supply or demand that determines the market price? The answer is "both." Like the two blades of a scissors, supply and
demand work together to determine price. When you combine the supply and demand curves, there is a point where they
intersect; this point is called the market equilibrium. The price at this intersection is the equilibrium price, and the quantity is the
equilibrium quantity. At the equilibrium price, there is no shortage or surplus: The quantity of the good that buyers are willing to
buy equals the quantity that sellers are willing to sell. Buyers can buy the quantity they want to buy at the market price, and
sellers can sell the quantity they want to sell at the market price.
Demand Forecasting
It is a technique for estimation of probable demand for a product or services in the future. It is based on the analysis of past
demand for that product or service in the present market condition. Demand forecasting should be done on a scientific basis and
facts and events related to forecasting should be considered.
Therefore, in simple words, we can say that after gathering information about various aspect of the market and demand based on
the past, an attempt may be made to estimate future demand. This concept is called forecasting of demand.
1. Based on Economy
There are three types of forecasting based on the economy:
i. Macro-level forecasting: It deals with the general economic environment relating to the economy as measured by the
Index of Industrial Production(IIP), national income and general level of employment, etc.
ii. Industry level forecasting: Industry level forecasting deals with the demand for the industry’s products as a whole. For
example demand for cement in India, demand for clothes in India, etc.
iii. Firm-level forecasting: It means forecasting the demand for a particular firm’s product. For example, demand for Birla
cement, demand for Raymond clothes, etc.
2. Based on the Time Period
Forecasting based on time may be short-term forecasting and long-term forecasting
i. Short-term forecasting: It covers a short period of time, depending upon the nature of the industry. It is done generally
for six months or less than one year. Short-term forecasting is generally useful in tactical decisions.
ii. Long-term forecasting casting: Long-term forecasts are for a longer period of time say, two to five years or more. It gives
information for major strategic decisions of the firm. For example, expansion of plant capacity, opening a new unit of
business, etc.
Short Run Cost Function
The cost function is a functional relationship between cost and output. It explains that the cost of production varies with the level
of output, given other things remain the same (ceteris paribus). This can be mathematically written as: C = f(X)
where C is the cost of production and X represents the level of output.
Total Fixed Cost
Fixed cost refers to the cost of fixed inputs. It does not change with the level of output (thus, fixed). Fixed inputs include building,
machinery etc. Hence the cost of such inputs such as rent or cost of machinery constitutes fixed costs. Also referred to as
overhead costs, supplementary costs or indirect costs, these costs remain the same irrespective of the level of output.
Total Variable Cost
• The cost incurred on variable factors of production is called Total Variable Cost (TVC). These costs vary with the level of
output or production. Thus, when production level is zero, TVC is also zero. Thus, the TVC curve begins from the origin.
• The shape of the TVC is peculiar. It is said to have an inverted-S shape. This is because, in the initial stages of production,
there is scope for efficient utilization of fixed factor by using more of the variable factor (eg. Workers employing
machinery).
• As the production continues to increase, more and more variable factor is employed for a given amount of fixed input.
The productive efficiency of each variable factor falls and it adds more to the cost of production. So the TVC increases but
now at an increasing rate. This is where the TVC curve is convex in shape. And so the TVC curve gets an inverted-S shape.
Total Cost
Total cost (TC) refers to the sum of fixed and variable costs incurred in the short-run. Thus, the short-run cost can be expressed as
TC = TFC + TVC
Note that in the long run, since TFC = 0, TC =TVC. Thus, we can get the shape of the TC curve by summing over TFC and TVC
curves.
The following can be noted about the TC curve:
• The TC curve is inverted-S shaped. This is because of the TVC curve. Since the TFC curve is horizontal, the difference
between the TC and TVC curve is the same at each level of output and equals TFC. This is explained as follows: TC – TVC =
TFC
• The TFC curve is parallel to the horizontal axis while the TVC curve is inverted-S shaped.
• Thus, the TC curve is the same shape as TVC but begins from the point of TFC rather than the origin.
• The law that explains the shape of TVC and subsequently TC is called the law of variable proportions.
Long run cost function
The long-run is a spell of time in which all factors of manufacturing and costs are variable. In the long run, enterprises are capable
of modifying all cost prices, whereas, in the short run, enterprises are only capable of impacting cost prices through modifications
made to production degrees.
There is no difference between the LTC or LRTC (long-run total costs) and long-run variable costs as there are no fixed costs. It
denotes the capability of an establishment of changing inputs and sanctions it to manufacture at less price in the long run.
The main difference between long run costs and short run costs is the time horizon considered in each case.
• In the short run, at least one factor of production is fixed, meaning that the firm cannot easily adjust its production
capacity. This could be due to constraints on capital or labour, for example. Therefore, the firm can only change its output
by adjusting its variable inputs, such as materials, energy, or overtime work. The short run cost of production includes
both fixed and variable costs.
• In the long run, all factors of production become variable, meaning that the firm can adjust its production capacity and
change the quantity of all inputs used in production. This allows the firm to optimize its production process and adjust its
scale of operations in response to changes in demand or input prices. The long run cost of production includes only
variable costs, as fixed costs become variable in the long run.
The long run marginal cost (LMC) and long run average cost (LAC) are U shaped
curves. The reason behind them being U-shaped is due to the law of returns to
scale. It is argued that a firm generally experiences IRS during the initial period of
production followed by CRS, and lastly by DRS. Consequently, both LAC and LMC
are U-shaped curves. Due to IRS, as the output increases, LAC falls due to
economies of scale. Then falling LAC experiences CRS at Q1 level of output which is
also called the optimum capacity. Beyond Q1 level of output, the firm experiences
diseconomies of scale and if the firm continues to produce beyond Q1 level, the
cost of production will rise.

Relationship Between Short-Run and Long-Run Average Total Cost Curves

Short-run and long-run average total cost curves differ because, in the short run, fixed assets are held fixed, whereas, in the long
run, all costs are variable. It implies that each point on the long-run average total cost curve would minimize the average total cost
for reach level of output.
Introduction
Market is a place where people can buy and sell commodities. It may be vegetables market, fish market, financial markets or foreign
exchange markets. In economic language market is a study about the demand for and supply of a particular item and its consequent
fixing of prices, example bullion on market and foreign exchange market or a commodity market like food grains market etc. Market
is classified into various types based on the characteristic features. They are classified on the basis of:
Area: family market, local, regional, national and international
Time: very short period, short period, long period, very long period
Commodity: produce exchange, bullion market, capital market, stock market
Nature of Transaction: spot market, forward market and futures market
Volume of business: whole sale market, retail market
Importance: primary market, secondary market, territory market
Regulation: regulated market, unregulated market
Economics: Perfect market and imperfect market
Market In Economic Sense Implies:
1. Presence of buyers and sellers of the commodity
2. Establishment of contact between the buyer and seller
3. Similarity of the product
4. Exchange of commodity for a price
Classification Of Market Structure Based On The Nature Of Competitor:
1. Perfect market
2. Imperfect market
The imperfect market in turn can be classified as
a. Monopoly market
b. Duopoly market
c. Oligopoly market
d. Monopolistic market/ competition
Perfect Market
Perfect competition is a market structure characterized by a complete absence of rivalry among the individual firms. A perfectly
competitive firm is one whose output is so small in relation to market volume that its output decisions have no perceptible impact
on price. No single producer or consumer can have control over the price or quantity of the product.
Characteristic features of perfect market:
1. Large number of buyers and sellers
2. Homogeneous product
3. Perfect knowledge about the market
4. Ruling prices
5.Profit maximization
Pricing Under Perfect Competition
Demand and supply curves can be used to analyze the equilibrium market price and the optimum output.
1. If quantity demanded is equal to quantity supplied at a particular price then the market is in equilibrium
2. If quantity demanded is more than the quantity supplied then market price may not be stable. i.e., it will rise.
3. If quantity demanded is less than quantity supplied then market price is fixed not in a equilibrium position.
Monopoly Market
Mono means single, poly means seller and hence monopoly is a market structure where only one sells the goods and many buyers
buy the same. Monopoly lies at the opposite extreme from perfect competition on the market structure continuum. A firm
produces the entire supply of a particular good or service that has no close substitute.
Characteristic Features:
1. A single seller in the market
2. There are no close substitutes
3. There is a restriction for the entry and exit for the firms in the market
4. Imperfect dissemination of information
Profit maximization under Monopoly Competition
For monopolist there are two options for maximizing the profit i.e. maximize the output and the limit the price or limit the
production of the goods and services and fix a higher price (market driven price). In monopoly competition, the demand curve of
the firm is identical to the market demand curve of that product. In monopoly the MR is always less than the price of the
commodity.
Oligopoly Market
This is a market consisting of a few firms relatively large firms, each with a substantial share of the market and all recognizing their
interdependence. It is a common form of market structure. The products may be identical or differentiated. The price
determination and profit maximization is based on how the competitors will respond to price or output changes.
There Are Different Types Of Oligopoly:
1.Pure and perfect oligopoly: if the firm produced homogeneous products it is perfect oligopoly. If there is product differentiation
then it is called as imperfect or differentiated oligopoly.
2.Open and closed oligopoly: entry is not possible. When it is closed to the new entrants then it is closed oligopoly. On the other
hand entry is accepted in open oligopoly.
3.Partial and full oligopoly: under partial oligopoly industry is dominated by one large firm who is a price leader and others follow.
In full oligopoly no price leadership.
4.Syndicated and organized oligopoly: where the firms sell their products through a centralized syndicate. On the other hand firms
organize themselves into a central association for fixing prices, output and quotas.
Monopolistic competition:
Monopolistic competition portrays an industry where many firms offer their services and products that are comparative (however
somewhat flawed) substitutes. Obstructions or barriers to exit and entry in monopolistic competitive industries are low, and the
choices made of any firm don’t explicitly influence those of its rivals. The monopolistic competition is firmly identified with the
business technique of brand separation and differentiation. For example, hairdressers, restaurant businesses, hotels, and pubs.
Shut Down Point:
If the market price for the product is below minimum average variable cost, the firm will cease to produce, if this appears to be
not just a temporary phenomenon. When the price is less than average variable cost it will neither cover fixed cost nor a part of
the variable costs. Then the firm can minimize losses up to total fixed costs only by not producing. It is therefore regarded as the
shut down point.
 Basis Perfect Competition Monopoly
Meaning It is a market situation where a large number of buyers It is a market situation where there is only one
and sellers deal in a homogeneous product at a fixed seller in the market selling a product with no
price set by the market. close substitutes.
Number of This market has a very large number of sellers. This market has a single seller.
Sellers
Number of This market has homogeneous products. There are no close substitutes in this market.
Product
Entry and Exit There is freedom of entry and exit in this market. There is a restriction on the entry of new firms
of Firms and exit of old firms.
Demand Curve This market has a perfectly elastic demand curve. This market is less elastic and has a downward-
sloping demand curve.
Price As each of the firms in this market is a price-taker, the As the firms in this market are price-maker, there
price is uniform. is a possibility of price discrimination.
Selling Costs In this market, no selling costs are incurred. In this market, only informative selling costs are
incurred.
Level of There is perfect knowledge of the market. There is imperfect knowledge of the market.
Knowledge
A firm’s Long-run equilibrium under Perfect Competition
• Long-term is the period in which the firm can vary all of its inputs. There are no fixed costs and therefore, the AFC or
Average Fixed Cost curve vanishes. Also, the Average Cost (AC) curve represents the Average Total Cost (ATC) curve.
Further, since the firm can vary all its inputs, it can close own and leave the industry.
• We know that in the long-run, the AC curve which is formed by its short-run AC curves is also U-shaped. This means that
up to a certain limit, the firm experiences increasing returns and the AC curve slopes downwards.
In the long-run, new firms can also enter the industry. This is the free entry and exit feature which has two implications:
1. There is no compulsion on the firm to operate under losses and it can leave the industry.
2. No firm can earn super-normal profits. This is because when a firm earns super-normal profits, it attracts new firms to the
industry. This leads to an increase in the supply which results in lowering the prices and normalizing of profits.
Price #1
• The price in the market is below the optimum cost of the firm (OP0). From this cost, we get a corresponding average
revenue of AR0 and Marginal Revenue of MR0. As you can see in the figure, MR0 cuts the LMC curve at two points – E and
E0.
• However, none of these points is the long-run equilibrium of the firm. At point ‘E’, the LMC curve cuts the MR0 curve from
above while at point E0, it cuts the curve from below. But, since AR0 < LAC, the firm incurs losses.
Price #2
• The price of the firm’s product is more than the optimum cost or the least possible average cost of the firm. In such cases,
the firm is not in a state of stable equilibrium. If this price is OP2 with the average revenue curve AR2 and the marginal
revenue curve MR2, then we can see that
• The LMC curve intersects the MR2 curve from below at point E2
• AR2 > LAC
Break Even Analysis
• Break even analysis helps to identify the level of output and
sales volume at which the firm ‘breaks even’. It means the
revenues are sufficient to cover all costs of production.
Various managerial decisions of firms are taken by the
managers based on the break- even point.
• It is a study of cost, revenues and sales of a firm and finding
out the volume of sales where the firm’s costs and revenues
will be equal. There is no profit and no loss. The total revenue
is equal to the total cost of production. The amount of money
which the firm receives by the sale of its output in the market
is known as revenue.
TFC
Break even quantity = ------------------------
Selling Price – AVC TFC + targeted profit
To decide a quantity to achieve a targeted profit = -------------------------
Sales - BEP Selling price – AVC
Safety margin = ---------------------- X 100
Sales
Managerial Uses Of Break-Even Analysis:
1. Product planning: it helps the firm in planning its new product development. Decisions regarding removal or addition of new
products in their product line.
2. Activity planning: the firm decides the expansion of production capacity.
3. Profit planning: this helps the firm to plan about their profit well in advance and at the same time it helps to identify the
quantity to be sold to achieve the targeted profit.
4. Target capacity: the targeted sales quantity helps to decide the purchase, inventory and management.
5. Price and cost decision: Decision regarding how much the price of the commodity should be reduced or increased to cover their
cost of production.
6. Safety margin: it helps to understand the extent to which the firm can withstand their fall in sales.
7. Price decision: the selling price can be fixed based on its expected revenue or profit.
8. Promotional decision: the firm can decide the kind of promotion required and how much amount could be spent.
What Is the Time Value of Money (TVM)?
The time value of money (TVM) is the concept that a sum of money is worth more now than the same sum will be at a future date
due to its earnings potential in the interim. The time value of money is a core principle of finance. A sum of money in the hand has
greater value than the same sum to be paid in the future. The time value of money is also referred to as the present discounted
value.
What Is Depreciation?
The term depreciation refers to an accounting method used to allocate the cost of a tangible or physical asset over its useful life.
Depreciation represents how much of an asset's value has been used. It allows companies to earn revenue from the assets they
own by paying for them over a certain period of time.
Straight-Line
Using the straight-line method is the most basic way to record depreciation. It reports an equal depreciation expense each year
throughout the entire useful life of the asset until the entire asset is depreciated to its salvage value.
Declining Balance
The declining balance method is an accelerated depreciation method. This method depreciates the machine at its straight-line
depreciation percentage times its remaining depreciable amount each year. Because an asset's carrying value is higher in earlier
years, the same percentage causes a larger depreciation expense amount in earlier years, declining each year.
Declining Balance Depreciation = (Net Book Value - Salvage Value) x (1 / Useful Life) x Depreciation Rate
Double-Declining Balance (DDB)
The double-declining balance (DDB) method is another accelerated depreciation method. After taking the reciprocal of the useful
life of the asset and doubling it, this rate is applied to the depreciable base—its book value—for the remainder of the asset’s
expected life. DDB = (Net Book Value - Salvage Value) x (2 / Useful Life ) x Depreciation Rate
Sum-of-the-Years' Digits (SYD)
The sum-of-the-years' digits (SYD) method also allows for accelerated depreciation. Start by combining all the digits of the
expected life of the asset.
For example, an asset with a five-year life would have a base of the sum of the digits one through five, or 1 + 2 + 3 + 4 + 5 = 15. In
the first depreciation year, 5/15 of the depreciable base would be depreciated. In the second year, only 4/15 of the depreciable
base would be depreciated. This continues until year five depreciates the remaining 1/15 of the base.
Cost Benefit Analysis
The main objective of any public alternative is to provide goods/services to the public at the minimum cost. In this process, one
should see whether the benefits of the public activity are at least equal to its costs. If yes, then the public activity can be
undertaken for implementation. Otherwise, it can be cancelled.
BP - present worth of the total benefits
BF = future worth of the total benefits
BA = annual equivalent of the total benefits
P = initial investment
PF = future worth of the initial investment
PA = annual equivalent of the initial investment
C = yearly cost of operation and maintenance
CP = present worth of yearly cost of operation and maintenance
CF - future worth of yearly cost of operation and maintenance
EXAMPLE-1 In a particular locality of a state, the vehicle users take a roundabout route to reach certain places because of the
presence of a river. This results in excessive travel time and increased fuel cost. So, the state government is planning to construct
a bridge across the river. The estimated initial investment for constructing the bridge is Rs. 40,00,000. The estimated life of the
bridge is 15 years. The annual operation and maintenance cost is Rs. 1,50,000. The value of fuel savings due to the construction of
the bridge is Rs. 6,00,000 in the first year and it increases by Rs. 50,000 every year thereafter till the end of the life of the bridge.
Check whether the project is justified based on BC ratio by assuming an interest rate of 12%, compounded annually.
Solution
Initial investment = Rs. 40,00,000
Annual operation and maintenance = Rs. 1,50,000
Annual fuel savings during the first year = Rs. 6,00,000
Equal increment in fuel savings in the following years = Rs. 50,000
Life of the project = 15 years
Interest rate = 12%
6,00,000 + 7,00,000
Total present worth of costs = Initial investment (P) + Present worth of annual operating and maintenance cost (CP) = P + CP
= Rs. 40,00,000 + 1,50,000 x (P/A, 12%, 15)
= Rs. 40,00,000 + 1,50,000 x 6.8109
= Rs. 50,21,635
Total present worth of fuel savings (BP):
A1 = Rs. 6,00,000
G = Rs. 50,000
n - 15 years
i = 12%
Annual equivalent fuel savings (A) = A1 + G(A/G, 12%, 15)
= 6,00,000 + 50,000 (4.9803)
= Rs. 8,49,015
Present worth of the fuel savings (BP) = A(P/A, 12%, 15)
= 8,49,015 (6.8109)
= Rs. 57,82,556
BC ratio= BP/P+Cp = 57,82,556/50,21,635 = 1.1515
Since the BC ratio is more than 1, the construction of the bridge across the river is justified.
What is Inflation? In economics, inflation (or less frequently, price inflation) is a general rise in the price level of 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.
What is causing India’s inflation to persist?
• The initial shock of rising food and fuel prices gradually spread and became more widespread in the following months,
resulting in persistent core inflation that remained high.
• Despite weak demand and limited pricing power, input cost pressures were unprecedented and resulted in higher output
prices, particularly for goods.
• As the direct impact of the conflict diminished and global commodity prices eased, the domestic economy began to
recover and demand increased, leading to the pass-through of pent-up input costs. And this resulted in the persistence of
elevated inflationary pressures.
• Core goods inflation increased to 7.6% year on year in January from 7.5% in December.
• It is not just India, the US and many other EuroZone countries are also affected by the sticky inflation.
Types of Inflation
The different types of inflation in an economy can be explained as follows:
Demand-Pull Inflation
This type of inflation is caused due to an increase in aggregate demand in the economy.
Causes of Demand-Pull Inflation:
• A growing economy or increase in the supply of money – When consumers feel confident, they spend more and take on
more debt. This leads to a steady increase in demand, which means higher prices.
• Asset inflation or Increase in Forex reserves– A sudden rise in exports forces a depreciation of the currencies involved.
• Government spending or Deficit financing by the government – When the government spends more freely, prices go up.
• Due to fiscal stimulus.
• Increased borrowing.
• Depreciation of rupee.
• Low unemployment rate.
Effects of Demand-Pull Inflation:
• Shortage in supply
• Increase in the prices of the goods (inflation).
• The overall increase in the cost of living.
Cost-Push Inflation
This type of inflation is caused due to various reasons such as:
• Increase in price of inputs
• Hoarding and Speculation of commodities
• Defective Supply chain
• Increase in indirect taxes
• Depreciation of Currency
• Crude oil price fluctuation
• Defective food supply chain
• Low growth of Agricultural sector
• Food Inflation
• Interest rates increased by RBI
Cost pull inflation is considered bad among the two types of inflation. Because the National Income is reduced along with the
reduction in supply in the Cost-push type of inflation.
Built-in Inflation
This type of inflation involves a high demand for wages by the workers which the firms address by increasing the cost of goods and
services for the customers.
Measurement of Inflation
1. Wholesale Price Index (WPI) – It is estimated by the Ministry of Commerce & Industry and measured on a monthly basis.
2. Consumer Price Index (CPI) – It is calculated by taking price changes for each item in the predetermined lot of goods and
averaging them.
3. Producer Price Index – It is a measure of the average change in the selling prices over time received by domestic
producers for their output.
4. Commodity Price Indices – It is a fixed-weight index or (weighted) average of selected commodity prices, which may be
based on spot or futures price
5. Core Price Index – It measures the prices paid by consumers for goods and services without the volatility caused by
movements in food and energy prices. It is a way to measure the underlying inflation trends.
6. GDP deflator – It is a measure of general price inflation.
Remedies to Inflation
The different remedies to solve issues related to inflation can be stated as:
• Monetary Policy (Contractionary policy)
The monetary policy of the Reserve Bank of India is aimed at managing the quantity of money in order to meet the requirements
of different sectors of the economy and to boost economic growth.
This contractionary policy is manifested by decreasing bond prices and increasing interest rates. This helps in reducing expenses
during inflation which ultimately helps halt economic growth and, in turn, the rate of inflation.
• Fiscal Policy
• Monetary policy is often seen separate from fiscal policy which deals with taxation, spending by government and
borrowing. Monetary policy is either contractionary or expansionary.
• When the total money supply is increased rapidly than normal, it is called an expansionary policy while a slower
increase or even a decrease of the same refers to a contractionary policy.
• It deals with the Revenue and Expenditure policy of the government.
Effect of Inflation on the Economy
The effect of inflation on the economy can be stated as:
• The effect of inflation is not distributed evenly in the economy. There are chances of hidden costs for different goods and
services in the economy.
• Sudden or unpredictable inflation rates are harmful to an overall economy. They lead to market instability and thereby
make it difficult for companies to plan a budget for the long-term.
• Inflation can act as a drag on productivity as companies are forced to mobilize resources away from products and services
to handle the situations of profit and losses from inflation.
• Moderate inflation enables labour markets to reach equilibrium at a faster pace.
What is National Income?
The total value of final goods and services produced by the normal residents during an accounting year, after adjusting
depreciation.
• It is Net National Product (NNP) at Factor Cost (FC)
• It does not include taxes, depreciation and non-factor inputs (raw materials)
Domestic Income – Total value of final goods and services produced within a domestic territory during an accounting year, after
adjusting depreciation.
• It is NDP at FC
• Both NNP and NDP can be measured at constant prices (real income) or market prices (nominal income)
• Domestic Income + NFIA = National Income
Measurement of National Income – Income Method
Estimated by adding all the factors of production (rent, wages, interest, profit) and the mixed-income of self-employed.
1. In India, one-third of people are self-employed.
2. This is the ‘domestic’ income, related to the production within the borders of the country
Measurement of National Income – Production Method
Estimated by adding the value added by all the firms.
Value-added = Value of Output – Value of (non-factor) inputs
1. This gives GDP at Market Price (MP) – because it includes depreciation (therefore ‘gross’) and taxes (therefore ‘market
price’)
2. To reach National Income (that is, NNP at FC)
 • Add Net Factor Income from Abroad: GNP at MP = GDP at MP + NFIA
• Subtract Depreciation: NNP at MP = GNP at MP – Dep
• Subtract Net Indirect Taxes: NNP at FC = NNP at MP – NIT
Measurement of National Income – Expenditure Method
The expenditure method to measure national income can be understood by the equation given below:
Y = C + I + G + (X-M),
where Y = GDP at MP, C = Private Sector’s Expenditure on final consumer goods, G = Govt’s expenditure on final consumer goods, I
= Investment or Capital Formation, X = Exports, I = Imports, X-M = Net Exports
Any of these methods can be used in any of the sectors – the choice of the method depends on the convenience of using that
method in a particular sector.
National Income
The purpose of national income accounting is to obtain some measure of the performance of the aggregate economy. The major
concepts used in the national income calculation are Gross Domestic Product (GDP), Gross National Product (GNP), Net National
Product (NNP), personal income and Disposable income.
Gross Domestic Product is the total market value of all final goods and services currently produced within the domestic territory
of a country in a year. It measures the market value of annual output of goods and services currently produced and counted only
once to avoid double counting. It includes only final goods and services. It includes the value of goods and services produced
within the domestic territory of a country by nationals and non nationals.
Gross National Product is the market value of all final goods and services produced in a year. GNP includes net factor income from
abroad.
GNP = GDP + Net factor income from abroad (income received by Indian abroad – income paid to foreign nationals working in
India)
Net National Product at market price is the market value of all final goods and services after providing for depreciation.
NNP = GNP – Depreciation
Depreciation means fall in the value of fixed capital due to wear and tear. NNP at factor cost is called as National Income:
National income is the sum of the wages, rent, interest and profits paid to factors for their contribution to the production of
goods and services in a year. Nnp = Nnp (Market Price) – Indirect Tax + Subsidies
Personal income (PI) is the sum of all incomes earned by all individuals / households during a given year. Certain incomes are
received but not earned such as old age pension etc., Pi = Ni – Social Security Contribution – Corporate Income Tax –
Undistributed Corporate Profits + Transfer Payments.
Disposable income is calculated by deducting the personal taxes like income tax, personal property tax from the personal income
Disposable Income = Personal Income – Personal Taxes = Consumption + Saving
Supernumerary income: the expenditure to meet necessary living costs deducted from disposable consumer income is called as
supernumerary income.
The economy is divided into different sectors such as agriculture, fisheries, mining, construction, manufacturing, trade, transport,
communication and other services. The gross production is found out by adding up the net values of all the production that has
taken place inthese sectors during a given year. This method helps to understand the
importance of various sectors of the economy.
Approaches To Calculate National Income:
The Income Approach:
The income of individuals from employment and business, the profits of the firms and public sector earnings are taken into
consideration. National Income is the income of individuals + self employment + profits of firms and public corporate bodies + rent
+ interest (transfer payments, scholarships, pensions are not included) this includes the sum of the income earned by individuals
from various input factors such as rent of land, wages and salaries of employees, interest on capital, profits of entrepreneurs and
income of self employed people. This method indicates the income distribution among various income groups of people.
The Expenditure Approach:
In this approach national income is calculated by using the expenditure of individuals, private, government and foreign sectors. i.e.
the sum of all the expenditure made on goods and services during a year. National Income = Expenditure Of Individuals + Govt. +
Private Firms + Foreigners GDP = C + I + G + (X-M)
Where, C = expenditure on consumer goods and services by individuals and households
I = expenditure by private business enterprises on capital goods
G = government expenditure on goods and services (government purchase) X-M = exports – imports
Factors Determining National Income:
1. Quantity of goods and services produced by the country. Higher the quantity of production, higher shall be the national income.
2. Quality of products and services produced in the country will also determine the national income of a country.
3. Innovation of more technical skills will improve the productivity which will reflect on national income of the country.
4. Political stability strengthens the national income of an economy.
Difficulties In The Calculation Of National Income:
1. Any income earned abroad have to be included
2. To avoid double counting, value added method should be considered
3. Services rendered free of charges are not to be included
4. Capital gains, transfer payments are not to be included
5. Changes in price level will also affect the calculation
6. Value of military services will not be taken into consideration.
Meaning of Bank
A bank is an institution which deals with money and credit. It accepts deposits from the public, makes the funds available to those
who need them, and helps in the remittance of money from one place to another. In fact, a modem bank performs such a variety
of functions that it is difficult to give a precise and general definition of it. It is because of this reason that different economists
give different definitions of the bank.
Functions of Commercial Banks or Modern Banks
In the modern world, banks perform such a variety of functions that it is not possible to make an all-inclusive list of their functions
and services. However, some basic functions performed by the banks are discussed below.
1. Accepting Deposits. The first important function of a bank is to accept deposits from those who can save but cannot profitably
utilise this saving themselves. People consider it more rational to deposit their savings in a bank because by doing so they, on the
one hand, earn interest, and on the other, avoid the danger of theft. To attract savings from all sorts of individuals, the banks
maintain different types of accounts :
(i) Fixed Deposit Account. Money in these accounts is deposited for fixed period of time (say one, two, or five years) and cannot
be withdrawn before the expiry of that period. The rate of interest on this account is higher than that on other types of deposits.
The longer the period, the higher will be the rate of interest. Fixed deposits are also called time deposits or time liabilities.
(ii) Current Deposit Account. These accounts are generally maintained by the traders and businessmen who have to make a
number of payments every day. Money from these accounts can be withdrawn in as many times and in as much amount as
desired by the depositors. Normally, no interest is paid on these accounts. Rather, the depositors have to pay certain incidental
charges to the bank for the services rendered by it. Currerft deposits are also called demand deposits or demand liabilities.
(iii) Saving Deposit Account. The aim of these accounts is to encourage and mobilise small savings of the public. Certain
restrictions are imposed on the depositors regarding the number of withdrawals and the amount to be with drawn in a given
period. Cheque facility is provided to the depositors. Rate of interest paid on these deposits is low as compared to that on fixed
deposits.
(iv) Recurring Deposit Account. The purpose of these accounts is to encourage regular savings by the public, particularly by the
fixed income group. Generally money in these accounts is deposited in monthly instalments for a fixed period and is repaid to the
depositors along with
interest on maturity. The rate of interest on these deposits is nearly the same as on fixed deposits.
(v) Home Safe Account. Home safe account is another scheme aiming at promoting saving habits among the people. Under this
scheme a safe is supplied to the depositor to keep it at home and to put his small savings in it. Periodical, the safe is taken to the
bank where the amount of safe is credited to his account.
Central Bank
The Reserve Bank of India is the central bank of our country. Each country has a central bank that regulates all the other banks in
that particular country.
The main function of the central bank is to act as the Government’s Bank and guide and regulate the other banking institutions in
the country. Given below are the functions of the central bank of a country:
• Guiding other banks
• Issuing currency
• Implementing the monetary policies
• Supervisor of the financial system
In other words, the central bank of the country may also be known as the banker’s bank as it provides assistance to the other
banks of the country and manages the financial system of the country, under the supervision of the Government.
Cooperative Banks
These banks are organised under the state government’s act. They give short term loans to the agriculture sector and other allied
activities.
The main goal of Cooperative Banks is to promote social welfare by providing concessional loans
They are organised in the 3 tier structure
• Tier 1 (State Level) – State Cooperative Banks (regulated by RBI, State Govt, NABARD)
• Funded by RBI, government, NABARD. Money is then distributed to the public
• Concessional CRR, SLR applies to these banks. (CRR- 3%, SLR- 25%)
• Owned by the state government and top management is elected by members
• Tier 2 (District Level) – Central/District Cooperative Banks
• Tier 3 (Village Level) – Primary Agriculture Cooperative Banks
Commercial Banks
• Organised under the Banking Companies Act, 1956
• They operate on a commercial basis and its main objective is profit.
• They have a unified structure and are owned by the government, state, or any private entity.
• They tend to all sectors ranging from rural to urban
• These banks do not charge concessional interest rates unless instructed by the RBI
• Public deposits are the main source of funds for these banks
The commercial banks can be further divided into three categories:
1. Public sector Banks – A bank where the majority stakes are owned by the Government or the central bank of the country.
2. Private sector Banks – A bank where the majority stakes are owned by a private organization or an individual or a group
of people
3. Foreign Banks – The banks with their headquarters in foreign countries and branches in our country, fall under this type of
bank
Functions of the Central Bank
Currency regulator or bank of issue: Central banks possess the exclusive right to manufacture notes in an economy. All the central
banks across the world are involved in issuing notes to the economy.
This is one of the most important functions of the central bank in an economy and due to this the central bank is also known as
the bank of issue.
Bank to the government: One of the important functions of the central bank is to act as the bank to the government. The central
bank accepts deposits and issues funds to the government. It is also involved in making and receiving payments for the
government. Central banks also offer short term loans to the government in order to recover from bad phases in the economy.
Custodian of Cash reserves: It is a practice of the commercial banks of a country to keep a part of their cash balances in the form
of deposits with the central bank. The commercial banks can draw that balance when the requirement for cash is high and pay
back the same when there is less requirement of cash.
Custodian of International currency: An important function of the central bank is to maintain a minimum balance of foreign
currency. The purpose of maintaining such a balance is to manage sudden or emergency requirements of foreign reserves and also
to overcome any adverse deficits of balance of payments.
Lender of last resort: The central bank acts as a lender of last resort by providing money to its member banks in times of cash
crunch. It performs this function by providing loans against securities, treasury bills and also by rediscounting bills.
This is regarded as one of the most crucial functions of the central bank wherein it helps in protecting the financial structure of the
economy from collapsing.
Clearing house for transfer and settlement: Central bank acts as a clearing house of the commercial banks and helps in settling of
mutual indebtedness of the commercial banks. In a clearing house, the representatives of different banks meet and settle the
inter bank payments.
Controller of credit: Central banks also function as the controller of credit in the economy. It happens that commercial banks
create a lot of credit in the economy that increases the inflation. The central bank controls the way credit creation by commercial
banks is done by engaging in open market operations.
Protecting depositors interests: Central bank also needs to keep an eye on the functioning of the commercial banks in order to
protect the interests of depositors.