Chapter 01

Market Economy
Market economy is an economy in which the questions of what to produce, how to produce and for whom to
produce are guided solely by the invisible hand of market forces of demand and supply without any external
intervention.

Positive vs Normative Economics

Positive economics deals questions of facts which can be answered with empirical analysis without taking
sides.

On the other hand, normative economics addresses questions of fairness and ethics which are subjective.

Both positive and normative economics may be based on empirical analysis, but positive economics stops short of
prescribing any course of action while the normative economics attempts to provide recommendations to
redress the situation

Mixed Economy
A mixed economy is a type of economic organization of society which combines elements of both a market economy
and a command economy. Most of the economies today are mixed economies.

market economy is a method economic organization in which economic decisions through the interplay of demand
and supply and the government’s role is that of an onlooker who just ensures no one breaks the rules. On the other
hand, in a command economy, the government is everything i.e. the producer of all goods, the owner of all means of
production (land and capital), the employer of all people and the CEO of all enterprises.

Depression/ Trough 4th stage

Expansion (recovey)-Peak-Contraction(Recession) –Depression

Depression (also known as trough) is an economics term referring to the stage of business cycle
in which a regional or world economy operates at its lowest level. Depression is one of the four
stages of a business cycle. It is preceded by recession stage and succeeded by recovery stage.

Depression is characterized by low trade and commerce, high rate of unemployment, decline in
real GDP, low incomes and investment, sovereign debt defaults, reduced credit availability,
bankruptcies including bank failures.

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In some depressions, price deflation may also be observed.( a gradual decrease in consumer
prices for goods and services. This is often caused by the deflationary gap, also known as
demand gap, which is characterized by low demand and oversupply.)

Production Possibility Frontier

Production possibility frontier (also called production possibility curve) is a plot that shows the maximum outputs
that an economy can produce from the available inputs (i.e. factors of production).

Since resources are scarce, deciding about what to produce is of pivotal importance for individuals, firms,
governments and whole economies. Production possibility frontier is a good tool that helps decision-makers imagine
their production choices and tradeoffs and determine whether they are producing at their full potential.

Inefficient Production and Infeasible Production

If an economy’s total production falls within or below the production possibility frontier, i.e. as in Point G in the PPF
plotted above, it is producing at below their potential. It is referred to as inefficient production.(inward shift) It is
because at Point G, the country is producing 2 nukes and 2,500 megawatts of electricity while it has the potential to
produce 2 nukes and 3,300 megawatts of electricity. Many countries produce at a point inside their production
possibility fronteir due to business cycles because the market system is not able to correctly match the supply and
demand.

Similarly, an economy can’t produce a combination of products outside their production possibility frontier. Point H
in the chart above is an infeasible production (outward shift)goal because it falls outside the PPF. The country can’t
produce 2 nukes and 4,000 megawatts of electricity at the same time. However, by investing in new technology and
thereby improving productivity, a country can shift its production possibility outwards and achieve the production
goal in future.

Factors that Shift Production Possibility Frontier

As we move along the production possibility frontier i.e. from A to B or B to C and so on, the total production
remains constant and we are just substituting one product for another. This happens when the available inputs and
technology is the same. However, there are certain factors that increases or decrease an economy’s total production
potential and they cause and inward or outward shift in the PPF.

Inward Shift in production possibility frontier means that the economy is shrinking i.e. its production potential is
decreases.

 Natural disasters such as earth quakes, floods,

 Wars, terrorism, violent protests
 Outward immigration i.e. brain drain causes the skilled people to immigrate to other countries
 Spending too much on current consumption or unproductive pursuits (for example, engaging in an arms
race)

Outwards shifts in PPF causes an increase in an economy’s production potential. Factors that result in
outwards shifts include:

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  New inventions i.e. improvement in technology:.
 Population growth and inward immigration:
 Investment in education and other training opportunities:

Command Economy
A command economy (also called a planned economy) is a type of economic organization of a society in which the
government owns most of the means of productions and makes all the major decisions regarding production.

Significant red tape exists in command economies because the managers become risk averse and may prefer to
‘look busy do nothing’.

Business Cycle
Business cycle, also known as economic cycle, consists of a alternating and irregular
fluctuations in economic activity in a region. The economic activity is measured by real
GDP.

Phases
Expansion (recovey)-Peak-Contraction(Recession) –Depression

A business cycle is commonly classified into four phases:

 Expansion: The output and employment level starts to rise again and economy
continues to expand beyond the maximum level achieved in past and thus the
long-term trend of real GDP is positive.
 Peak: The expansion phase ends with economic activity at peak. In peak phase,
business activity reaches the maximum potential of an economy at which it
operates at or near full capacity. Unemployement reaches minimum level and
prices are likely to rise.
 Recession: A recession is period in which the total income, output and
employement declines. Many sectors of economy show contraction in business
activities such as buying, selling and production. Both consumers and producers
start to face hardships in this stage of business cycle.
 Depression(Trough): In this phase, the contraction in business activities which
started in recession phases reaches minimum level. The level of output and
unemployment stands still for some duration at the lowest level.

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 Chapter 02
the supply curve slopes upwards i.e. at higher price, quantity supplied is high. (MCQ)

The demand curve generally slopes downwards as a consequence of law of demand. (MCQ)

A demand function is a mathematical representation of the demand curve in that it links the price with quantity
demanded and any other variables such as consumer income,

Market equilibrium occurs when supply equals demand.(MCQ)

The market clearing price (also called equilibrium price) is the price at which quantity supplied equals
quantity demanded.(MCQ)

both price and quantity supply cannot be negative numbers.(MCQ)

The supply curve is always restricted to the first quadrant in a Cartesian coordinate system
because both price and quantity supply cannot be negative numbers.(MCQ)

A supply function is a mathematical expression of the relationship between quantity demanded of a product or
service, its price and other associated factors such as input costs, prices of related goods, etc.(MCQ)

A supply function has single dependent variable (i.e. the quantity supplied) and many independent variables
i.e. market price, price of related goods, input costs, etc. A supply equation can be formulated by studying the
relationship between supply (the dependent variable) and the independent variables and determining
whether the relationship is positively-related or negatively-related. For example, in general the supply and
market price are inversely related. The same is the case with supply and input prices i.e. at higher input prices, supply
is lower. On the other hand, supply and technological progress are inversely related, i.e. better technology means
more supply, etc.

A supply function can be used to find out the expected quantities of a product which will enter the market if we
know the market price, input costs and other variables. If we have a demand function and supply function for a
market, we can solve them to find out the equilibrium price (i.e. the market clearing price) and the equilibrium
quantity.

ceteris paribus (i.e. other things being constant).

Determinants of supply.
It is important to note that supply is affected by a number factors in addition to price. and the law of supply
applies only under the assumption that these other factors remain constant. The factors affecting supply are
called determinants of supply.

The above supply line has a positive slope thus indicating that there is direct relationship between the price of a
product and the quantity supplied. As the price increases, producers and resource owners will supply more.(MCQ)

The demand of a single consumer or producer is called individual demand whereas the combined demand of all the
consumers or producers is called market demand.

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 The result is a downward sloped demand curve showing the inverse relationship between price and quantity
demanded as stated in the law of demand. (MCQ)

Demand Function
A demand function is a mathematical equation which expresses the demand of a product or service as a function of
the its price and other factors such as the prices of the substitutes and complementary goods, income, etc.

A demand functions creates a relationship between the demand (in quantities) of a product (which is a
dependent variable) and factors that affect the demand such as the price of the product, the price of substitute
and complementary goods, average income, etc., (which are the independent variables).

Determinants of demand

Other potential factors are the determinants of demand including price of substitutes i.e. price of the public
transportation or competing cab services, whether it is a working day or a weekend, whether it is a clear or a rainy
day, etc.

multiple regression analysis

One method of creating a demand function to use multiple regression analysis to find out the relationship
between quantity demanded, the product price and all other factors. The multiple regression analysis assigns
different coefficients to each of the factor that affects the demand. The sign of the coefficient (i.e. positive or
negative) tells us whether the demand and the factor are positively-related or negatively-related.

Market Demand
Market demand is a series of various quantities of a product or service that consumers in a given market are able
and willing to purchase collectively at each of a series of potential prices per unit of the product or service,
provided other things such as number of consumers, consumer incomes and consumer tastes etc. remain
constant.

Quantity supplied is the quantity of a product which producers are willing to supply at a given price while
change in supply refers to the overall shift in supply schedule due to technological changes, input prices,
government regulations, etc.

When the whole supply curve shifts inwards or outwards i.e. it decreases or increases, it is referred to as a
change in supply or a shift in supply curve. (MCQ)

Such a change in supply (from the blue curve to the orange curve) in response to a change in external factors is
referred to as a shift in supply. Factors that bring about such shift in supply are called determinants of supply.

Quantity Demanded vs Shif in Demand

In economics, demand refers to the demand schedule i.e. the demand curve while the quantity demanded is a point
on a single demand curve which corresponds to a specific price.

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 It is important to distinguish between the two terms because they refer to totally different concepts. When we
say that demand for a product or service has changed, we mean that the whole demand curve has shifted
inwards or outwards i.e. the number of units demanded at each price has increased or decreased simultaneously.
However, when we say that there is a change quantity demanded, we mean that due to change in price of the
product, the number of units of the product which consumers are willing to buy at the new price has changed.

Shifts in Demand

When there is an increase or decrease in demand due to factors other than the product's own price, there is a
shift in demand curve inwards or outwards. In the plot above, a movement form demand curve for the first
survey to a demand curve for the survey represent an increase in demand. Change in demand results not from
change in price of the product plotted but due to other determinants of demand such as prices of substitute,
prices of complements, etc. In the example discussed above, the increase in demand for your mass transit system
increases due to increase in the price of substitute goods (i.e. ride-sharing app due to additional taxes).

Market Equilibrium
Market equilibrium is the state of product or service market at which the intentions of producers and consumers,
regarding the quantity and price of the product or service, match. At market equilibrium point, consumers collectively
purchase the exact quantity of goods or services being supplied by producers and both the parties also agree on a
single price per unit. We use the word equilibrium because the market always tends to revert back to matched price
and quantity after any price or quantity distrubances on either producers' or consumers' side.

Market equilibrium is represented by the point of intersection of supply and demand curves of a market. The
price and quantity prevailing at market equilibrium point are known as equilibrium price and equilibrium
quantity respectively. At any price above or below equilibrium price, the quantity supplied doesn't equal the
quantity demanded.

Market Clearing Price

Market clearing price is the price at which the quantity demanded of a product or service equals quantity supplied
and no surplus or shortage exists in the market. It is the price that corresponds to the point of intersection of the
demand curve and the supply curve.

A market demand curve plots the quantities of a product or service which consumers are willing and able to buy with
reference to their prices. Similarly, the supply curve shows quantities which the supplier will make available in the
market at different price levels. The demand curve is generally downward sloping which means that as the price
decreases, the quantity demanded increases. On the other hand, the supply curve is upward sloping i.e. when price
increases, the quantity supplied increases too.

If the quantity demanded exceeds the quantity supplied, it tends to increase the market price of the product which
in turn decreases the quantity demanded until it matches the quantity supplied. The opposite applies when the
quantity demanded is lower than the quantity supplied i.e. the market price falls and the quantity demanded
increases to meet the quantity supplied (through a downward movement on the demand curve).

Market surplus/shortage
This excess of quantity supplied over quantity demanded represents a market surplus. (MCQ)

This excess of quantity demanded over quantity supplied represents a market shortage. (MCQ)

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Market equilibrium occurs when the upward-sloping supply curve intersects the downward-sloping demand curve.
When there is a change in supply and/or demand, quantity bought and sold in the market changes such that
the market reached a new market clearing price.

Movement vs Shift in Demand/Supply

If there is a change in price of a good, there is a change in quantity supplied and demanded but such a change
represents a movement along the supply curve or demand curve. But when there is a change in any other
determinant of supply or demand such as cost of production, price of substitute goods or complementary
goods, etc., there is a shift in supply/demand curves i.e. there is a change in quantity at all prices.

Determinants of Supply
Determinants of supply (also known as factors affecting supply) are the factors which influence the quantity of a
product or service supplied. The price of a product is a major factor affecting the willingness and ability to supply.
Here we will discuss the determinants of supply other than price. These are the factors which are assumed to be
constant in law of supply. (MCQ)

These are the factors which are assumed to be constant in law of supply.

However when the other determinants change, the supply curve is shifted. (MCQ)

Thus increase in number of sellers will increase supply and shift the supply curve rightwards whereas decrease
in number of sellers will decrease the supply and shift the supply curve leftwards. (MCQ)

Increase in resource prices reduces the supply and the supply curve is shifted leftwards whereas decrease in
resource prices increases the supply and the supply curve is shifted rightwards. (MCQ)

Taxes reduces profits, therefore increase in taxes reduce supply whereas decrease in taxes increase supply.
Subsidies reduce the burden of production costs on suppliers, thus increasing the profits. Therefore increase in
subsidies increase supply and decrease in subsidies decrease supply.

Improvement in technology enables more efficient production of goods and services. Thus reducing the
production costs and increasing the profits. As a result supply is increased and supply curve is shifted
rightwards. Since technology in general rarely deteriorates, therefore it is needless to say that deterioration of
technology reduces supply.

Suppliers' Expectations For example when farmers suspect the future price of a crop to
increase, they will withhold their agricultural produce to benefit from higher price thus reducing the supply. In
case of manufacturers, when they expect the future price to increase, they will employ more resources to increase
their output and this may increase current supply as well.

Prices of Related Products For example a firm which produces cricket bats is usually
able to manufacture hockey sticks as well. When the price of hockey sticks increases, the firm will produce
more hockey sticks and less cricket bats. As a result, the supply of cricket bats will be reduced.

Prices of Joint Products

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 When two or more goods are produced in a joint process and the price of any of the product increases, the
supply of all the joint products will be increased and vice versa. For example, increase in price of meat will
increase the supply of leather.

Determinants of Demand
Determinants of demand (also called factors affecting demand) are the factors which cause the demand curve to
shift. A change in any of the determinants of demand will cause the demand to change even if the price remains
fixed. Major determinants of demand are:

1. When buyers increase, demand is likely to increase and if buyers decrease, it will probably
decrease. For example, increase in number of students will increase demand for books.
2. Increase in income of buyers will allow them to purchase more thus demand will be increased
and decrease in income will restrict their purchases thus demand will be decreased. However
for some goods demand usually varies inversely with change in income. For example, if the
income of consumers who could only buy used cars increases such that they are now able to buy
new ones, they will buy new cars instead of old. Thus demand for old cars will drop with increase in
income.
3. If consumer tastes change such that they now favor a product more, the will demand that product
more and if their taste changes unfavorably they will demand lower quantity of that product.
Businesses advertise their products to change consumer tastes in favor of their products.
4. Change in consumer expectations about a product may affect the quantity they demand. For
example if consumers expect that future price of a product A will increase, they will demand
more to save money. Conversely, if they expect that future price will decrease, they will
decrease demand and wait to benefit from lower future price.

5. Price of Related Goods

There are two types of related goods, substitute goods and complementary goods.

substitute goods: The price change of a substitute of a product usually affects the demand of the product
directly.

For example, price drop of solar power technology will decrease the demand for traditional electric power.

(move in same direcetion) (MCQ)

Complementary goods: The demand for a product changes inversely with a price change of a complementary
good. For example decrease in price of cars will increase the demand for cars. More cars will need more fuel
and demand for fuel will be increased.

1. (move in opposite direction) (MCQ)

Types of Elasticity of Demand

Elasticities of demand are measures of responsiveness of quantity demanded of a product to different
determinants of demand i.e. price, income, prices of substitute and complements, etc. The most popular elasticity
of demand is the price elasticity of demand.

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There are three main types of elasticities of demand:

1. the price elasticity of demand (so popular that it is generally referred to as simply elasticity of demand),
2. income elasticity of demand
3. and cross elasticity of demand.

There are a range of factors which affect quantity demanded either directly or indirectly.

1. The product’s own price is the most significant factor. Quantity demanded increases if the price of the product
decreases and vice versa. The extent of this relationship between quantity demanded and price is measured by price
elasticity of demand.

2. The income elasticity of demand measures responsive of demand to changes in income

3. while the cross elasticity of demand tells us how demand changes when the prices of substitutes or complements
changes.

Price Elasticity of Demand

Price elasticity of demand is a measurement of the change in the consumption of a product in
relation to a change in its price.

Price elasticity of demand is represented by Ed and it is calculated using the following formula:

Price Elasticity of Demand = Percentage Change in Quantity Demanded ÷ Percentage Change in

Price

Ed= ΔQΔPx PQ

Where ΔQ is the change in quantity demanded, ΔP is the change in price and Q and P stands for quantity demanded
and price respectively at the point at which elasticity is being determined.

Because quantity demanded decreases with increases in price, price elasticity of demand for normal goods is
negative. However, the negative sign is usually ignored, and price elasticity is quoted as a positive number.

(MCQ)
When the price elasticity is greater than 1, equal to 1 or lower than one, the product is said to have

1. elastic greater than 1

2. unit-elastic is equal to 1and

inelastic demand curve less than 1 (MCQ)

If the price elasticity of demand is (a) higher than 1, demand is considered elastic, (b) equal to 1, demand is
unit-elastic and (c) lower than 1, demand is inelastic.(MCQ)

Income Elasticity of Demand

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Income elasticity of demand refers to the sensitivity of the quantity demanded for a certain good to
a change in the real income of consumers who buy this good.

The formula for calculating income elasticity of demand is the percent change in quantity demanded
divided by the percent change in income. With income elasticity of demand, you can tell if a
particular good represents a necessity or a luxury.

Income elasticity of demand is calculated by dividing the percentage change in quantity divided by the percentage
change in income.

Ed= ΔQΔMxQM or = %ΔQ/%ΔM

1. Normal good :If the quantity demanded increases with increase in income, the income elasticity of demand
is positive, and the product is a normal good. (MCQ)

Inferior good:However, when the quantity demanded decreases with increase in income, the income elasticity is
negative, and the product is an inferior good. (MCQ)

Cross Elasticity of Demand

The cross elasticity of demand is an economic concept that measures the responsiveness in the
quantity demanded of one good when the price for another good changes. Also called cross-price
elasticity of demand, this measurement is calculated by taking the percentage change in the
quantity demanded of one good and dividing it by the percentage change in the price of the other
good.

Cross elasticity of demand is calculated by dividing the percentage change in quantity demanded by the
percentage change in price of a related good

Ed= %ΔQ/%ΔP of related good

1. Substitutes (positive): If the quantity demanded of a product increases with increase in price of the related
good, the cross elasticity of demand is positive, and the products are substitutes. (MCQ)

2. Complements (negative): Similarly, if the quantity demanded decreases with increases in price of the related
good, the cross elasticity of demand is negative, and the products are complements. (MCQ)

Point Elasticity of Demand

Point elasticity of demand is the ratio of percentage change in quantity demanded of a good to percentage change
in its price calculated at a specific point on the demand curve. (MCQ)

Arc elasticity of demand is the ratio of percentage change in quantity demanded of a good to percentage change in
its price calculated between two points on the demand curve. (MCQ)

Price Elasticity of Supply

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Price elasticity of supply is the measure of responsiveness of producers and resource suppliers to the change in price
of a produce or resource. The responsiveness of suppliers to price means the degree to which they change their
supply when the price of a product, service or a resource changes by a certain amount. When suppliers are more
responsive, they will change the quantity they supply by a greater amount in response to a small change in
price.

Price Elasticity of Supply Es=Percentage Change in Quantity Supplied /Percentage Change in Price

We can avoid the above problem by using a more accurate formula called the mid-point formula of price elasticity

Elasticity of Demand and Revenue (MCQ)

Total revenue of a producer equals the product of quantity demanded and price. Change in revenue due to a change
in price depends on the price elasticity of demand of the product. Following are the effect on total revenue under
different price elasticity scenarios: (MCQ)

 If demand is elastic, price elasticity of demand is greater than 1 and a one percentage increase in price
will result in more than one percentage change in quantity demanded. (MCQ)
 If demand is unit-elastic, price elasticity is equal to 1 and a one percentage increase in price will result
in exactly one percentage change in quantity demanded. (MCQ)
 If demand is inelastic, price elasticity of demand is lower than 1 and a one percentage increase in price
will result in less than one percentage change in quantity demanded. (MCQ)

Elastic vs Inelastic Demand

A product or service has elastic demand when its price elasticity of demand is greater than 1, unit-elastic when price
elasticity is 1 and inelastic when the price elasticity is less than 1. (MCQ)

1. Demand is considered elastic when the absolute value of price elasticity of demand is higher than 1. It
means that the percentage change is quantity demanded is greater than the percentage change price.
2. Demand is considered inelastic if the price elasticity is less than 1 i.e. where the percentage change in
quantity demanded is less than the associated percentage change in price.

When the demand is inelastic, producers can increase their revenue by increasing price. It is because the
percentage drop in quantity demanded in response to price increase is lower. (MCQ)

3. Unit-elastic demand is where the price elasticity of demand is 1. A unit-elastic demand means that
the percentage change in quantity demand and percentage change in price are equal.

The total revenue of a unit-elastic product remains the same because any change in price is exactly offset by a
corresponding opposite change in quantity demanded.(MCQ)

Perfectly-Elastic Demand
Perfectly-elastic demand is an extreme case in which quantity demanded changes infinitely in response to an
infinitesimal (smaller) change in price. (MCQ)

It is represented by a horizontal demand curve. (MCQ)

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The concept of a perfectly-elastic demand is a theoretical extreme case. There are rarely any real-life products whose
price elasticity is infinity. However, the concept is very useful in economic analysis.

Perfectly-Inelastic Demand
Demand is perfectly-inelastic if it the quantity demanded doesn’t change regardless of any change in price. It means
that the quantity demanded of such a product will not change in response to any change in its price. (MCQ)

it is represented a vertical demand curve. (MCQ)

Perfectly-inelastic price elasticity is another extreme case and it is represented a vertical demand curve. Theoretically,
a producer with a product that has perfectly-inelastic price elasticity can increase the product price as much as he
wants without any loss in units sold.

Iso elastic Demand

A product has iso elastic demand when its price elasticity is the same at each point on the demand curve. Such a
demand curve is constant elasticity demand curve.

In case of a linear demand curve, (MCQ)

Cross Elasticity of Demand

Cross elasticity of demand is the ratio of percentage change in quantity demanded of a product to percentage change
in price of a related product.

1. Substitutes (positive): If the quantity demanded of a product increases with increase in price of the related
good, the cross elasticity of demand is positive, and the products are substitutes. (MCQ)

2. Complements (negative): Similarly, if the quantity demanded decreases with increases in price of the related
good, the cross elasticity of demand is negative, and the products are complements.(MCQ)

A Positive (Negative) cross elasticity of demand means that the products are substitutes (complements).(MCQ)

Income Elasticity of Demand

Income elasticity of demand is the ratio of percentage change in quantity of a product demanded to percentage
change in the income level of consumer. It is a measure of responsiveness of quantity demanded to changes in
consumers income.

Income elasticity of demand indicates whether a product is a normal good or an inferior good. When the quantity
demanded of a product increases with an increase in the level of income and decreases with decrease in level of
income, we get a positive value for income elasticity of demand.

A positive income elasticity of demand stands for a normal (or superior) good. (MCQ)

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When the quantity demanded of a product or service decreases in response to an increase in the income level, the
income elasticity of demand is negative and the product is an inferior good. (MCQ)

If the quantity demanded of a product increases with increase in consumer income, the product is a normal good and
if the quantity demanded decreases with increase in income, it is an inferior good.

1. A normal good has positive and an (MCQ)

2. inferior good has negative elasticity of demand. (MCQ)

Substitute vs Complements
Substitute goods (or simply substitutes) are products which all satisfy a common want and complementary goods
(simply complements) are products which are consumed together.

Demand for a product’s substitutes increases and demand for its complements decreases if the product’s price
increases. (MCQ)

Substitutes, Complements and Cross Elasticity of Demand

The extent to which two products are substitutes or complements can be measured by calculating their mutual cross
elasticity of demand. The cross elasticity of demand measures the percentage change in quantity demanded of the
product that occurs in response a percentage change in price of a substitute good

. If the cross elasticity of demand is positive, the products are substitute goods. On the other hand, if cross
elasticity is negative, the products are complements. (MCQ)

Price Floor (lower limit)

A price floor is a minimum price enforced in a market by a government or self-imposed by a group. It tends to
create a market surplus because the quantity supplied at the price floor is higher than the quantity demanded.
(MCQ)

1. Demand curve is generally downward sloping which means that the quantity demanded increase when the
price decreases and vice versa.
2. Similarly, a typical supply curve is upward sloping i.e. quantity supplied increases with increase in price and
vice versa.

Market activity converges the quantity demanded and quantity supplied and the price at which it happens is called
the market-clearing price (or equilibrium price).

Price Ceiling (price cap)(upper limit)

Price ceiling (also known as price cap) is an upper limit imposed by government or another statutory body on the
price of a product or a service. A price ceiling legally prohibits sellers from charging a price higher than the
upper limit.

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Binding price ceiling:A price ceiling is typically below equilibrium market price in which case it is known
as binding price ceiling because it restricts price below equilibrium point. Binding price ceilings interrupt
natural market equilibrium forces.

Non-binding price ceiling :Rarely, a price ceiling may be above market price in which case it is called non-
binding price ceiling because it does not affect market equilibrium.

When price ceiling is below equilibrium market price, the quantity supplied by producers is below the
equilibrium quantity, as governed by law of supply. But the quantity demanded by consumers is above the
equilibrium quantity, as governed by law of demand. This results in excess of quantity demanded over quantity
supplied thus creating shortage in the market.

Advantages and Disadvantages

Price ceilings increase the affordability of goods and services that are basic necessities allowing low-income
consumers to fulfil their needs. Price ceilings allow a government to counter practices such as price collusion in which
suppliers charge outrageously high prices.

One of the arguments against setting price ceilings is that the shortage created by price ceilings actually makes it
difficult to find and purchase sufficient quantities of the product or service. Price ceilings reduce economy's output by
discouraging suppliers thus reduces economy's growth rate.

Chapter# 03
Production Functions
A production function is an equation that establishes relationship between the factors of production (i.e. inputs) and
total product (i.e. output). There are three main types of production functions:

(a) the linear production function, (b)

(b) the Cobb-Douglas production and
(c) (c) fixed-proportions production function (also called Leontief production function).

The linear production function and the fixed-proportion production functions represent two extreme case scenarios.

1. The linear production function represents a production process in which the inputs are perfect
substitutes i.e. one, say labor, can be substituted completely with the capital.
2. The fixed-proportion production function reflects a production process in which the inputs are required
in fixed proportions because there can be no substitution of one input with another.
3. The Cobb-Douglas production function represents the typical production function in which labor and
capital can be substituted, if not perfectly.

A linear production function is represented by a straight-line isoquant. (MCQ)

A fixed-proportion production function corresponds to a right-angle isoquant.(MCQ)

It represents the typical convex isoquant (MCQ)

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Cost Elasticity (Cost-output elasticity)
Cost elasticity (also called cost-output elasticity) measures the responsiveness of total cost to changes in output.

It is calculated by dividing the percentage change in cost with percentage change in output.

A cost elasticity value of less than 1 means that economies of scale exists.(MCQ)

Economies of scale exist when increase in output is expected to result in a decrease in unit cost while keeping the
input costs constant.

Such a reduction in average cost may occur, for example, when workers are able to specialize which increases
their productivity, when the firm is able to negotiate more effectively with suppliers and receive volume
discounts, etc.

Cost Elasticity = %Change in Total Costs/% Change in Output

Minimum Efficient Scale

Minimum efficient scale (MES) is the smallest output level at which LONG RUN AVERAGE COST is at its minimum.

It provides insight about competitiveness of an industry: an industry with high MES typically has few large firms.

Long-run average cost (LRAC) curve is a graph that plots average cost of a firm in the long-run when all inputs can
be changed.

LRAC is determined by the firm’s expansion path i.e. the combination of labor and capital and other inputs which
minimize the firm’s costs at each production level.

Downward sloping: LRAC initially slopes downward due to economies of scale but as soon as diseconomies
of scale set in, it bottoms out and starts to rise. The minimum point of the LRAC represent the firm’s minimum
efficient scale.(MCQ)

Minimum efficient scale is an important indicator of an industry’s competitiveness and barriers to entry. (MCQ)

If the MES is high, it means that each firm must produce a high proportion of the industry’s output in order to
reach the minimum efficient scale.

This potentially creates barriers to entry and the industry is expected to be dominated by a few large
firms.

IMPORTANT MCQs:

One of the property of the long-run cost curves is that the average cost curve is minimum at a point at which the
marginal cost curve intersects it from below.

IMPORTANT MCQs:

15
 It means that the LRAC is minimum at a point at which LRAC and long-run marginal cost (LMC) are equal.

Since the marginal cost equals the slope i.e. the first derivative of the total cost curve, the equation for LMC can be
written as follows: MCQ

Let’s verify that the minimum efficient scale occurs at the lowest point on the LRAC by plotting the LRAC and LMC
curves. (at the point of intersection) MCQ

Expansion Path
Expansion path is a graph which shows how a firm’s cost minimizing input mix changes as it expands its
production.

It traces out the points of tangency of the isocost lines and isoquants.

An expansion path provides a long-run view of a firm’s production decision and can be used to create its long-run
cost curves. Since we define long-run as a time period in which a firm can change all its inputs including capital, the
expansion path depends on how the firm changes its input mix.

MCQS

An isocost line plots such combinations of inputs at which the firm’s total cost is constant.

An isoquant represents such combination of inputs which generate the same amount of output.

MCQS

This occurs at a
A profit-maximizing firm is interested in producing maximum output at minimum cost.
point at which its isocost line is tangent (touches) to the relevant isoquant.

IMPORTANT MCQ

As the firm increases its input budget while the unit costs of inputs remain the same, the firm’s isocost lines
shift outwards such that they touch higher and higher isoquants. If we connect all such points at which isocost
lines are tangent to the isoquants, we get the firm’s expansion path.

Normal Input vs Inferior Input

A firm’s expansion path tells us whether the firm’s inputs are normal inputs or inferior inputs.

An input is a normal input if the firm increases its proportion in its production mix as it increases production. An
inferior input, on the other hand, is an input whose proportion decreases as the firm switches to other inputs at
higher production level.

MCQ

16
The expansion path slopes away from an inferior input i.e. it has negative slope. But in case of a normal
input, the expansion path has a positive slope.

Isocost Line (ISO MEAN SAME )

(DOWNWARD SLOPING)
An isocost line is a graph of combinations of labor and capital, or any other two factors of production, such that the
total cost remains the same.

MCQ

An isocost line is to the producers what a budget line is to a consumer. While a budget line shows a consumer’s
maximum income,

an isocost line shows the maximum amount which a firm is willing to expend on production.

The interplay of a firm's isocost line and its isoquants determine the firm's production.

MCQ

The point at which the isocost line is tangent to the highest-possible isoquant is the point at which the firm
maximizes its output keeping in view its cost constraints.

Shifts in Isocost Line

A firm’s isocost line can shift if there is (a) a change in total expenditure of the firm on inputs and (b) change in
price of the inputs.

MCQ

If a firm decides to spend more money on production, its isocost line shifts outwards/rightwards
parallel to the original isocost line. It is because more budget allows the firm to simultaneously employ more
capital and labor at the same time.

MCQ

A reduction in budget would have an exactly opposite effect i.e. it would move the isocost line inwards.

A parallel shift can also happen if prices of both inputs change by equal proportion. However, where the change
in prices of inputs is not proportionate, it changes the slope of the isocost line (recall the fact that the slope of the
isocost line equals the ratio of price of one factor to the other). Such a change in slope rotates the isocost line.

Economies of Scale

17
Economies of scale are the advantages, in the form of reduced cost per unit of goods or services produced, that result
from large scale production. When more and more units are produced during a given length of time, the percentage
increase in total cost is less than the percentage increase in total units. But only up to a certain limit i.e. there is
an upper limit on production beyond which the advantages of large scale production begin to decline (known as
diseconomies of scale).

Economies of scale are sometimes classified into internal and external economies of scale.

1. Internal economies arise from factors within the firm whereas

external economies are caused by factors in the environment in which the firm operates.

Diseconomies of Scale
Diseconomies of scale are disadvantages that result from large scale production or large scale provision of services by
a single firm. Diseconomies are the result of factors such as coordination difficulties, duplication of job positions, etc.

When a small firm expands its scale of production, it initially gains cost advantages (called economies of scale), in the
form of reducing average cost per unit of goods or service produced. At a certain optimum firm size, the cost
advantages are maximized and beyond this point, the economies are overcome by the diseconomies of scale and the
average production cost starts to rise.

Economies of Scope
Economies of scope represent the production efficiency which enables a firm to produce more than one
products at a cost which is lower than the sum of stand-alone costs of each product.

Economies of scope can occur, for example, when the by-product of a firm’s main production process can be used to
produce another product cheaply, when the firm has a fixed resource such as a license which can be used to offer new
products at minimal additional cost, when the firm’s supply chain can be leveraged to introduce another product at
no additional cost, etc.

Graph (product transformation curve)( BOWED OUT CONCAVE)

Economies of scope can be represented graphically by plotting a production possibility frontier. Where the
economies of scope exist, the production possibility frontier is bowed out i.e. it is concave. This curve is also called
product transformation curve.

Economies of scope vs diseconomies of scope

There might be a situation in which the combined production of two goods escalate the costs such that the combined
cost of the two products is higher than the sum of the stand-alone costs of each product. Such a situation exhibits
diseconomies of scope.

When the value of degree of economies of scope is negative, there are diseconomies of scope i.e. it is better to
produce both products independently because the combined cost is higher than the sum of stand-alone costs. (MCQ)

18
Isoquants
Isoquants are curves that represent efficient blend of different inputs such as labor and capital which yield the same
(iso) level of output (quantity).

MCQ

Isoquants are usually downward sloping convex curves whose shape depend on the degree of substitution
between different inputs.

Isoquants are plotted with labor on one axis (generally the x-axis) and capital on the other axis i.e. the y-axis. There
are three types of isoquants depending on their shapes: (a) straight-line, (b) right-angle and (c) curved.

The straight-line and right-angle isoquants are extreme scenarios which represent inputs that perfect substitutes
and perfect complements respectively

MCQ

1. straight line: When both inputs are perfect substitutes, isoquants are straight line and have a constant
slope because one input can be replaced with the other at the same rate.
2. Right Angled:Similarly, when no substitution is possible at all, the isoquants take the shape of a right
angle which means that a fixed proportion must always be maintained between the two inputs.
3. Curved isoquants are the most typical isoquants which represent inputs which are neither perfect
substitutes nor perfect complements. They are convex in shape which means that they are steeper near the
y-axis and gets flatter as they reach x-axis.

Isoquants are to producers what indifference curves are to consumers.

While the indifference curves tell us about different combinations of two products that give a consumer same level
of satisfaction, isoquants tell us about different mixtures of inputs that generate the same level of output. Many
properties of the isoquants are like those of indifference curves, namely

MCQ

 Isoquants that are to the left represent a higher production level than isoquants which are closer to the
vertex (i.e. origin): an isoquant that represent 6 units produced is to the left of an isoquant that represent
production of 4 units.
 Isoquants do not cross each other: an isoquant representing 6 units can’t cross an isoquant representing 4
units because if they do, it would mean two production levels corresponding to a single combination of
labor and capital. We need to stick to the more efficient production point.
 Isoquants are downward sloping and their slope change as we move along the curves

 MRTS
 Marginal rate of technical substitution (MRTS) is the rate at which a firm can substitute capital with labor. It
equals the change in capital to change in labor which in turn equals the ratio of marginal product of labor to
marginal product of capital.
 MCQ
 MRTS equals the slope of an isoquant.

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  An isoquant is a curve which represents combinations of different factors of production i.e. labor and capital
that yield the same total production.
 MCQ
 The concept behind MRTS is similar to that of marginal rate of substitution (MRS). While the marginal rate of
substitution tells us the rate at which a consumer is willing to replace one product with another, the marginal
rate of technical substitution tells us the rate at which a producer is willing to switch one input (i.e. factor of
production) with another.
 MRTS is relevant to producers and MRS is relevant to consumers.

Cobb-Douglas Production Function

Cobb-Douglas production function is a model that tells us about the relationship between total product, total
factor productivity, quantities of labor and capital and their output elasticities.

The Cobb-Douglas production function is the most widely used production function because it allows
different combination of labor and capital. Other versions of the production functions such as the linear
production function and fixed-proportion (Leontief) production function represent extreme case-scenarios i.e. perfect
substitution between labor and capital and zero substitution respectively.

MCQ

The Cobb-Douglas production function was developed by Paul Douglas, an economist, and Charles Cobb, a
mathematician.

Marginal Product of Labor

Marginal product of labor (MPL) is the increase in total production that occurs when labor increases by one unit, but
all other inputs remain the same.

Firms care about marginal product of labor because their hiring decisions depend on whether the additional output
generated by the new worker i.e. MPL is higher than the cost of the worker. If firms have enough demand for their
goods, they continue hiring new workers as long as the revenue they generate i.e. their marginal product of labor is
higher than their salary.

Marginal Product of Capital

Marginal product of capital (MPK) is the incremental increase in total production that results from one unit
increase in capital while keeping all other inputs constant.

Identifying the marginal product of capital is important because firms take investment decisions by comparing their
marginal product of capital with their cost of capital. When the marginal product of capital is higher than the cost of
capital, it makes sense to increase production by increasing capital but as soon as marginal product of capital falls
below the cost of capital, adding any more capital results in a decrease in the firm’s profit.

Total Factor Productivity

20
Total factor productivity (TFP) is a measure of productivity calculated by dividing economy-wide total production
by the weighted average of inputs i.e. labor and capital. It represents growth in real output which is in excess of
the growth in inputs such as labor and capital.

Productivity is a measure of the relationship between outputs (total product) and inputs i.e. factors of production
(primarily labor and capital). It equals output divided by input. There are two measures of productivity:

(a) labor productivity, which equals total output divided by units of labor and

(b) total factor productivity, which equals total output divided by weighted average of the inputs.

Returns to Scale
Returns to scale tell us how production changes in response to an increase in all inputs in the long run. An
industry can exhibit constant returns to scale, increasing returns to scale or decreasing returns to scale.

Study of whether efficiency increases with increase in all factors of production is important for both businesses and
policy-makers. It tells businesses about their optimal production level and it lets policy-makers determine whether the
industry will consist of large number of small producers or a small number of large producers.

Law of diminishing returns tells us what happens when one input increases while other inputs stay the same. It is
most relevant in the short-run i.e. time scale in which at least one factor of production is constant. In the long run, all
factors of production can be changed, and it is then when the returns to scale become relevant.

There are three possibilities for total production function when all inputs increase:

(a) increase at increasing rate,

(b) increase at a fixed rate or

(c) increase at a decreasing rate. These three possibilities result in three forms of returns to scale.

Constant Returns to Scale

Constant returns to scale mean that total product changes proportionately with increase in all inputs. In other words,
the percentage increase in total product under the constant returns to scale is the same as the percentage increase in
all inputs.

If the sum of a and b in the Cobb-Douglas production function equals 1, it represents constant returns to
scale. (MCQ)

Increasing Returns to Scale

In industries subject to increasing returns to scale, a 1% increase in total inputs will result in a more than 1% increase
in total product i.e. total product increases at a rate higher than the rate in which all inputs increase. Increasing
returns to scale are also referred to as economies of scale.

Decreasing Returns to Scale

In case of decreasing returns to scale, total product increases at a rate lower than the rate of increase in inputs. In
other words, additional investment generates progressively less and less additional production.

21
 If the sum of a and b in the Cobb-Douglas production function is less than 1, it represents decreasing returns to
scale. Decreasing returns to scale are also referred to as diseconomies of scale.(MCQ)

Law of Diminishing Returns

Law of diminishing returns states that as we increase units of a factor of production, say labor, while keeping
all other factors, such as land and capital, constant, there will be progressively less and less increase in total
product.

The increase in total product that results from each additional unit of an input is called marginal product. Hence, law
of diminishing returns can also be defined as follows: the marginal product of a factor of production decreases as we
increase that factor while keeping the other factors constant. Mathematically speaking, the additional output that the
nth unit of an input generates is less than the additional output generated by the unit preceding it i.e. by (n-1)th unit.

You must be wondering why it is so. It is because too many cooks spoil the broth. Efficient production requires a
good balance between different inputs. If one factor of production increases without proportionate increase in other
inputs, such a mismatch is bound to cause a declining marginal product. There is a lot of empirical analysis behind the
law of diminishing returns.

Law of diminishing returns explains the dilemma of stagnating economic growth in different countries of the world.
Developing countries with high population and very low capital (i.e. machinery, infrastructure, etc.) suffer from low
growth because there are too many workers for too less factories. The opposite is true in case of some developed
countries, say Japan, who have an ageing population and hence too less labor to work with the available capital.

Short Run vs Long Run

In economics, short run refers to a period during which at least one of the factors of production (in most cases
capital) is fixed. The long run, on the other hand, refers to a period in which all factors of production are
variable.

Differentiation between short run and long run is important in economics because it tells companies what to do
during different time periods. Let’s consider a company which is incurring losses. Assume that it needs at least one
year to shut down operations. Despite the net loss, the company should continue producing during the short run
(i.e. for one year) if its marginal revenue is higher than its marginal cost. It is because the company can’t move
its capital to other uses instantaneously, so it should continue producing as long as each additional unit reduces the
losses. However, if the marginal cost itself is higher than marginal revenue, it should cease to operate right
away. The difference lies in the flexibility of the company to change different inputs.

A factor of production that can be changed is called a variable factor and factor which can’t be adjusted is called a
fixed factor. Generally, labor is the variable factor and capital is the fixed factor in the short run. On the other hand,
both the labor and capital are the variable factors in the long-run.

Marginal Product
Marginal product of a factor of production, for example labor, is the increase in total production that results
from one unit increase in the factor of production i.e. labor if other factors, for example capital, are held
constant.

22
Production function shows the relationship between factors of production (also called inputs) such as labor and
capital and total production i.e. outputs. As we add more and more of an input, say labor, generally the total units
produced increase and vice versa. The marginal product of an input refers to the increase in total production
that results from the last unit of the input.

It is important to keep all factors other than the factor for which marginal product is being calculated
constant otherwise the increase in total production will represent the combined effect of changes in all
factors. For example, in finding out marginal product of labor, we need to keep land, capital, technology, etc.
constant to filter out the change in output that results from change in labor.

Mathematically, marginal product equals total production at n units of input minus total production at n -1 units of
input.

Average Product
Average product equals the units of output produced per unit of a factor of production while keeping other factors of
production constant.

The higher the average product, the more productive a factor of production is and vice versa. Average product is
different from average revenue product which equals the revenue earned per factor of production while keeping
other factors constant.

Average product
Total Output in Units
=
Units of Factor of Production

Producer Surplus
Producer surplus is the amount which a producer gains by participating in the market. It equals the excess of
the amount which a unit of a good fetches in the market over the minimum amount at which the producer is
willing to supply it.

The sum of producer surplus and consumer surplus is a measure of economic welfare. Economists study the effect of
different economic systems/interventions by comparing how they change the sum of producer surplus and consumer
surplus.

The loss of producer or consumer surplus is called deadweight loss.(MCQ)

A producer faces an upward sloping supply curve which means that he is willing to sell first unit at say P1, second
unit at say P2, third unit at P3 and so on such that P3 is greater than P2 which in turn is greater than P1. The price
which he actually receives in the market is the equilibrium price P which is determined by the intersection of the
relevant supply curve and demand curve. Producer surplus thus equals the sum of the positive differences between P
and P1, P and P2, P and P3.

Chapter # 04
Cost Curves
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Cost curves are graphs of how a firm’s costs change with change in output. Economists draw separate curves
for short-run and long-run because firms have higher flexibility in selecting their inputs in the long-run.

Differentiating between short-run and long-run cost curves is important because in the short-run at least one of the
inputs is fixed. When an input, say capital, is fixed, the marginal product of all other inputs, say labor, ultimately
exhibit the law of diminishing returns in the short-run.

Since a firm is able to vary all inputs in the long-run, the long-run cost curves depends on the firm’s returns to
scale, economies of scale and economies of scope.

Short-run Cost Curves

A firm’s total costs can be broadly categorized as either fixed or variable. Fixed costs are costs which a firm incur
regardless of the output level. These costs do not change with change in output. Variable costs, on the other hand,
are costs which vary directly with output. The relationship between a firm’s total costs (TC), fixed costs (FC) and
variable costs (VC) can be written as follows:

TC= FC + VC

If we divide both sides of the above equation with Q, we get the relationship between average costs:

TC/Q = FC/Q+ VC/Q

It shows that the average total cost (TC/Q) is the sum of average fixed cost (FC/Q) and average variable cost (VC/Q).

Marginal cost is the incremental cost of each additional unit. It equals total cost at Q units minus total cost at Q – 1
units. Alternatively, it can also be defined as total variable cost at Q units minus total variable cost at Q – 1 units.

Marginal cost equals the slope of the total cost curve and it can be calculated using the following formula (MCQ)

MC=change inTC/Change inQ

MCQs VERY IMPORTANT

 The average fixed cost (AFC) decreases continuously with increase in output. Since AFC = TFC/Q, increase
in Q decreases AFC indefinitely.
 The average variable cost (AVC) curve is U-shaped. It slopes downward as long as the marginal cost curve
is below AVC, but it starts to slope upwards when the marginal cost curve crosses it from below. It is because
the AVC is effectively the average of the cumulative marginal cost.
 The marginal cost curve is U-shaped. It initially decreases when marginal product increases, but it starts to
rise as the diminishing returns set in.
 AVC is equal to MC at the output level at which AVC intersects MC.

The average total cost (ATC) curve is the vertical sum of the average fixed cost (AFC) curve and average variable cost
(AVC) curve.

Long-run Cost Curves

Since all inputs, both labor and capital, are variable in the long-run, the long-run cost structure depends on
the firm’s expansion path, returns to scale and economies of scale, if any.

24
A firm’s expansion path traces out the combination of different inputs which it employs at different level of output.
The long-run total cost is given by the following equation:

LTC= r*K+w*L

Where LTC is the long-run total cost, r is the user cost of capital, w is the wage rate and K and L are the units of
capital and labor respectively.

MCQs VERY IMPORTANT

1. When the firm’s production process exhibit constant returns to scale, output can be doubled by doubling
all inputs. Since the cost of inputs is unchanged, it would result in a flat long-run average total cost (LAC)
curve i.e. long-run average total cost shall be same at all output levels.
2. However, if the firm has increasing returns to scale, it would be able to produce double output at a less
than double inputs. This should cause a decrease in LAC. SLOPE DOWNWARD
3. Alternatively, if the firm experiences decreasing returns to scale, doubling output would require more than
double inputs and this would cause the long-run average total cost (LAC) curve to slope upwards.

Since long-run marginal cost (LMC) is the slope of the long-run average total cost,

MCQ

LAC curve is U-shaped. It slopes downward as long as the long-run marginal cost curve lies below it but it
starts to slope upwards as soon as LMC crosses it from below.

Cost Functions
A cost function is a mathematical relationship between cost and output. It tells how costs change in response to
changes in output.

Cost functions typically have cost as a dependent variable and output i.e. quantity as an independent variable. Such
cost functions do not account for any changes in cost of inputs because they assume fixed input prices.

Types of Cost Functions

Typical cost functions are either linear, quadratic and cubic.

1. A linear cost function is such that exponent of quantity is 1. It is appropriate only for cost structures in which
marginal cost is constant.
2. A quadratic cost function, on the other hand, has 2 as exponent of output. It represents a cost structure
where average variable cost is U-shaped.
3. A cubic cost function allows for a U-shaped marginal cost curve. The cost function in the example below is
a cubic cost function.

Total cost function is the most fundamental output-cost relationship because functions for other costs such as
variable cost, average variable cost and marginal cost, etc. can be derived from the total cost function.

Average Total Cost

25
In economics, average total cost (ATC) equals total fixed and variable costs divided by total units produced.

Average total cost curve is typically U-shaped i.e. it decreases, bottoms out and then rises. (MCQ)

A firm’s total cost is the sum of its variable costs and fixed costs. Variable costs are costs which vary with change in
output level. Fixed costs, on the other hand, do not change with change in output. Whether amount spent on an input
is a variable cost or fixed cost depends on whether we are talking about short-run or long-run. In the short-run, labor
is variable cost and capital is fixed but in the long-run, all costs are variables.

Formula
We can write the following equation to express the relationship between total cost (TC), variable costs (VC) and fixed
costs (FC):

TC = VC + FC

If we divide both sides of the above equation with output Q, we get a relationship between average total cost
(ATC), average variable cost (AVC) and average fixed cost (AFC):

TC/Q= VC/Q+ FC/Q

ATC = AVC + AFC

It shows that average total cost is the sum of average variable cost and average fixed cost.

Marginal Cost
In economics, marginal cost is the incremental cost of additional unit of a good. It equals the slope of the total cost
function. The marginal cost curve is generally U-shaped.

Of all the different categories of costs discussed by economists, including total cost, total variable cost, total fixed
cost, etc., marginal cost is arguably the most important. It is because it directly affects a firm’s production
decision. Firms compare marginal revenue of a unit sold with its marginal cost and produce it only if the
marginal revenue is higher or equal to the marginal cost.

Marginal cost can be calculated directly by subtracting total cost of Q – 1 units from total cost of Q units. This can be
written mathematically as follows:

MC = TCQ − TCQ−1

Since equal amount of fixed costs is included in TCQ and TCQ – 1, if we subtract FC from both sides, we can define
marginal cost as the difference between total variable cost at Q units minus total variable cost at Q – 1 units

MC= VCQ − VCQ − 1

Marginal cost is the change in total cost (or total variable cost) (as fixed cost do not change )in response to a
one unit change in output. It equals the slope of the total cost curve/function or the total variable cost curve.
As the slope of any function can be determined by finding its first derivative, MC can also be defined as
follows:

26
  As long as the marginal cost curve lies below the average cost curve, the average cost decreases and
the average cost curve declines, but as soon as the marginal cost curve crosses the AVC curve, average
cost starts to rise. (MCQ)
 Marginal cost is equal to the average variable cost when the average variable cost is at its minimum.
It means that MC curve crosses AVC curve at its minimum point. (MCQ)

 Average Variable Cost

 In economics, average variable cost (AVC) is the variable cost per unit. Variable costs are such cost which
vary directly with change in output. AVC equals total variable cost divided by output.
 A firm’s composition of variable costs depends on the time period being considered.
 Firms can change all their inputs, both labor and capital, in the long-run; but in the short-run, at least one of
the inputs is fixed.
 It follows that in the short run, average variable cost is different from average total cost but in the
long-run average variable cost and average total cost are effectively the same.
 Average variable cost is important because it helps a firm in deciding whether it should continue operating
in the short-run. It is feasible to operate only when the marginal revenue is higher than average
variable cost.

You can see that the average variable cost curve is U-shaped. It initially declines but ultimately it starts rising. It
declines because marginal product initially rises but eventually starts rising because at least one input, typically
capital, is fixed in the short-run and in presence of a fixed input, law of diminishing returns govern the marginal
product of other factors, such as labor.

Marginal Cost and AVC

Marginal cost is the incremental cost of each additional unit of a product. The cumulative marginal cost of Q
units equals total variable cost. Hence, average variable cost effectively equals cumulative marginal cost of Q
units divided by Q.

 If the marginal cost curve is below the average variable cost curve, average variable cost should
decline. It is because AVC is the average marginal cost and a marginal cost lower than AVC causes it
to decline.(MCQ)
 On the other hand, if the marginal cost curve is above the average variable cost curve, the average
variable cost increases. (MCQ)

The marginal cost equals average variable cost when the average variable cost is at its minimum. (MCQ)

Average Fixed Cost

In economics, average fixed cost (AFC) is the fixed cost per unit of output. Fixed costs are such costs which do not vary
with change in output. AFC is calculated by dividing total fixed cost by the output level.

Whether a cost is fixed or variable depends on whether we are considering a cost in short-run or long-run. Average
fixed cost is relevant only in the short-run. Short-run is defined as a time period in which at least one of the inputs,
typically capital, is fixed. Since all inputs are variable in the long-run, no costs are fixed in the long-run.

27
CHAPTER 06
Consumption Function
Consumption function is an equation that shows how personal consumption expenditure changes in response to
changes in disposable income, wealth, interest rate, etc. Generally, consumption equals autonomous consumption
plus the product of marginal propensity to consume and disposable income.

Consumption is the largest component of a country’s gross domestic product (GDP). It includes non-commercial
expenditure which people incur on final goods and services such as food, clothing, education, entertainment,
furniture, cars, computers, etc.

The most popular consumption function is the Keynesian consumption function which shows that consumption (C)
depends on autonomous spending (c0), marginal propensity to consume (MPC) and disposable income (Y D).(MCQ)

Average Propensity to Consume (APC)

Average propensity to consume, the ratio of total consumption to total disposable income, can be worked out by
dividing consumption with total income as follows:

The life-cycle hypothesis argues that consumption is a function of both wealth and income. The permanent income
hypothesis, on the other hand, postulates that people base their consumption decision only income which they
reasonably expect to continue in future and not on any transitory one-off income.

Law of Diminishing Marginal Utility

Law of diminishing marginal utility states that as we consume more and more of a good, the contribution of each
additional unit to our total utility is less than the contribution of the unit consumed before it.

Utility is a central concept in economics that refers to the satisfaction or value that we obtain from consumption of a
product. It is an abstract quantification of benefits and its (hypothetical) unit is util. Marginal utility is the
increase in total utility that results from consumption of each additional unit. Marginal utility of the nth unit (MUn)
equals total utility derived from consumption of n units (Un) minus total utility derived from consumption of n – 1
units (Un-1) as show below:

Equimarginal Principle
The equimarginal principle states that consumers allocate their money such that the marginal utility per dollar
of each good is the same because this is how they maximize their total utility.

Marginal utility is the additional satisfaction derived by a consumer by consuming one additional unit of a good.
The law of diminishing marginal utility dictates that the marginal utility decreases with each additional unit consumed.
Because different goods have different prices, their marginal utilities can’t be compared directly. This is where the
concept of marginal utility of income becomes relevant. Marginal utility of income is the marginal utility of a
good per dollar.

28
The quimarginal principle and the law of diminishing marginal utility can explain the law of demand i.e. why
a demand curve slopes downward. Because consumers attempt to equate the marginal utility of income of all goods,
if price of a good rises, in accordance with law of diminishing marginal utility, consumers reduce the quantity
demanded to increase the marginal utilty and rebalance its MU/$ to the equilibrium MU/$.

Budget Line (Budget Constraints)

Budget line (also known as budget constraint) is a schedule or a graph that shows a series of various
combinations of two products that can be consumed at a given income and prices.

Budget line is to consumers what a production possibilities curve is to producers.(MCQ) It is a useful tool in
understanding consumer behavior and choices. Budget line depicts the consumer choices between two products.
Number of units of one product are displayed along horizontal axis while those of the other along vertical axes. Each
possible combination of the two products is then plotted to obtain a budget constraint curve.

A budget line is a constraint in that it limits the total potential consumption of a consumer. Only such combination of
two goods is attainable which falls within or on the budget line. Any combination of two goods which falls outside the
budget line is unattainable.

Together with a consumer’s indifference curves, which shows different combinations of two products which give the
consumer the same utility, we can arrive at a combination of two goods which is optimal for the consumer i.e. which
gives the consumer maximum attainable satisfaction.

Attainable combination is any combination of two products which may be purchased using the given income. All
points on or below the budget line are attainable, for example, 20 songs and 4 games.

Unttainable combination is any combination of two products which is impossible to purchase using the given
income. All points above the budget line are un-attainable, for example, 30 songs and 6 games.

Consumer Behavior
Consumer behavior is a field of study in economics which tries to explain consumer choices and their decisions in the
context of limited income and the perceived benefit they derive from various goods and services.

The perceived benefit obtained from a product or service is called utility in economics. Marginal utility is the
additional utility from each additional unit purchased.

Theories on consumer behavior state that people’s income is limited and their want are virtually unlimited which
means they are forced to make choose some things and let go others. So they spend it carefully to best satisfy their
needs and desires. Of course, their choices may not be perfect, but they are far from haphazard.

The marginal utility theory states that the ratio of marginal utility to price is same for all the products that have been
purchased by a consumer. This may happen consciously or subconsciously and the degree of effort by a consumer to
make the best decisions will increase with the importance and value of the product being purchased.

Study of consumer behavior also includes demand which is the quantity of a product demanded at various prices.
While the most important factor in determining demand of a product is its price, other factors such as the income and
tastes etc. will also affect the quantity demanded by a consumer.

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Shifts in Budget Line
A budget line shows the maximum consumption of a consumer at a given income level. It shifts parallelly
when there is a change in income but rotates when the relative prices change.

A budget line is also called a budget constraint because it limits total consumption possibility of a consumer. Total
consumption in dollars at all points on the budget line equals total income. If Product A is plotted on y-axis and
Product B on x-axis, the budge line touches y-axis at a point at which all budget is spent on Product A and it touches
x-axis at a point at which only Product B is consumed. At any point in between these two extreme cases, a
combination of Product A and B are consumed.

Change in Income: Parallel Shift

If there is a change in income of a consumer but there is no change in relative prices of the two goods, the
budget line shifts parallelly i.e. the location of the new budget line is parallel to the initial one.

In other words, if there is a change in income but no change in relative prices, the ratio of the prices i.e. slope of the
new budget line is the same as the slope of the initial budget line but its location changes.

When there is an increase in income, a consumer can buy more of both goods and this shows an outward i.e.
rightward shift in the budget line. On the other hand, when there is a decrease in income, the consumer’s
consumption possibility decreases, and the budget line shifts inwards.

Change in Relative Prices: Rotation

When there is a change in relative prices i.e. when price of only one good increase or when the price of one
good increases by a larger percentage than the other, the budget line rotates i.e. it shifts but not parallelly.
(MCQ)

The unparallel shift in budget line due to change in relative prices occurs because an unequal change in price causes a
change in the slope of the budget line i.e. the ratio of prices.

Indifference Curve
An indifference curve is a graph of different combinations of two products to which a consumer is indifferent i.e. he
likes both combinations equally likely.
Obviously, Mark would prefer to watch 4 movies and dine out 4 times because this combination is better than all of
the current combinations. It shows that a single consumer can have more than one indifference curve. Such a group
of indifference curves that show the equally likeable alternatives for a consumer at difference income level is called
a family of indifference curves. The outermost indifference curve IC2 has higher ranking because it offers more of
both movies and dine-outs in all instances.

Properties of Indifference Curves

Following are some important properties of indifference curves:

 The indifference curves do not slope upwards. It is because an indifference curve shows trade-off
between two goods i.e. one must decrease if the other increases. If we have an upward-sloping indifference
curve, it would mean that consumption of both goods can simultaneously increase.(MCQ)
 The outermost indifference curve is most preferred by a consumer and the ranking decreases as we
move inwards i.e. towards left. (MCQ)

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  Indifference curves do not intersect. It is because different indifference curves represent different
affluence level and an intersection would mean that the consumer is indifference between product
combinations represented by the two indifference curves. (MCQ)

Marginal Rate of Substitution

Marginal rate of substitution is the rate at which a consumer is willing to replace one good with another. For
small changes,

the marginal rate of substitution equals the slope of the indifference curve.(MCQ)

An indifference curve is a plot of different bundles of two goods to which a consumer is indifferent i.e. he has no
preference for one bundle over the other. If we decrease units of one good, we must compensate the consumer with
more units of the other goods in order to maintain the indifference condition. Marginal rate of substitution is the rate
at which a decrease in one good must be compensated with an increase in the other good.

Income Effect vs Substitution Effect

Income effect and substitution effect are the components of price effect (i.e. the decrease in quantity
demanded due to increase in price of a product). Income effect arises because a price change changes a
consumer’s real income and substitution effect occurs when consumers opt for the product's substitutes.

Substitution Effect
It follows from the law of demand that the quantity demanded of a product increases if the product price decreases
and vice versa. One reason for this phenomenon is substitution i.e. when consumers discontinue consumption of the
product whose price increases and switch over to other similar products. It happens when the increase in price
renders the product more expensive than its substitutes and rational consumers decide that it is not worthwhile to
continue consuming the product at its increased price.

Income Effect
Substitution effect explains only half of the mechanism that results in downward-sloping demand curve. Another way
in which a change in price results in change in quantity demanded is by resulting in a change in purchasing power
of the consumer i.e. the income effect.

The income effect equals the difference between quantity demanded of movies at Point S and Point N. The income
effect arises because at the increased price of movies, the consumer feels less rich.

Price-Consumption Curve
Price-consumption curve is a graph that shows how a consumer’s consumption choices change when price of
one of the goods changes. It is plotted by connecting the points at which budget line touches the relevant
maximum-utility indifference curve.

Since consumers have limited income, they must choose their consumption basket keeping in view their budget
constraint. A consumer’s budget line plots all such combinations of two goods which he can afford. There are two
causes of a budget line shift: change in income or change in the relative price of goods in the consumption basket.
When price of one good changes relative to others, it causes a rotation in the budget line.

31
Income-Consumption Curve
Income-consumption curve is a graph of combinations of two goods that maximize a consumer’s satisfaction at
different income levels. It is plotted by connecting the points at which budget line corresponding to each income
level touches the relevant highest indifference curve.

The interplay of a consumer’s budget constraint and his indifference curves determine his utility-maximizing
combination of goods. The point at which his budget constraint (which is derived from his income and prices of
the relevant goods) is tangent to the highest indifference curve is the point at which a consumer’s utility is
maximized.

Consumer Surplus
Consumer surplus represents the difference between total utility of a good and its market cost. It equals the
cumulative difference between the amount consumers are willing to pay for a good and the amount they pay in the
market.

Consumer surplus can be worked out by adding up the price consumers are willing to pay for first, second, third and
nth unit of a good and subtracting the n times the market price of the good. It can be mathematically expressed as
follows:

Engel Curve
An Engel curve is a graph which shows the relationship between demand for a good (on x-axis) and income
level (on y-axis). If the slope of curve is positive, the good is a normal good but if it is negative, the good is an
inferior good. (MCQ)

One of the determinants of demand is consumer income. A change in income can cause a shift in demand curve. In
case of a normal good, an increase in income increases demand and causes an outwards (right-ward) shift in the
demand curve. But in case of an inferior good, an increase in income decreases demand and shifts the demand curve
inwards (left-ward). This is how an Engel curve shows whether a good is a normal good or inferior good.

Engel curve and income elasticity of demand

Since in case of a normal good, quantity demand increases with increase in income, it causes the Engel curve to have
a positive slope. On the other hand, in case of an inferior good, the Engel curve has negative slope. (MCQ)

Engel curves are also related to the income elasticity of demand: where the income elasticity of demand is positive,
Engel curves slope upwards and where the income elasticity of demand is negative, Engel curve slopes downwards.
(MCQ)

Externalities
There are two types of externalities: positive and negative. Positive externalities refer to the benefits enjoyed by
people outside the marketplace due to a firm’s actions but for which they do not pay any amount. On the other hand,
negative externalities are the negative consequences faced by outsiders due a firm’s actions for which it is not
charged anything by the market.

32
Externalities are a type of market failure, i.e. market’s inability to appropriately price all the consequences of
economic actions. It arises because it is impossible or unfeasible to determine the price of the externality and/or no
mechanism exists to collect it.
Positive Externalities
Positive externalities cause the social benefits of an economic transaction (enjoyed both by private users who do pay
a price for it and free-riders who do not pay anything) to exceed the private benefits that accrue to the market
participants.

There are two types of positive externalities:

(a) positive production externalities i.e. the positive unpriced benefits that arise from production process and

(b) positive consumption externalities, i.e. the positive external benefits that arise from the consumption activities.

 Appreciation in property values that result from construction of new roads, mass transit systems, etc. and
travel time savings due to higher accessibility.
 Development of new technologies by companies become freely available to other people after mandatory
expiry of the patent.
 Vaccination has an associated positive benefit for others because it reduces the risk of contraction.
 Finding your location more accurately as your phone uses location of nearby Wi-Fi hot spots.
Negative Externalities
Negative externalities cause the social costs of an economic activity (those borne by the whole society) to exceed the
private costs borne by the market participants.

There are two forms of negative externalities: (a) negative production externalities and (b) negative consumption
externalities.

1. Negative production externalities arise from production activities and

negative consumption externalities are negative unpriced consequences of consumption process.

CHAPTER 07
Market Structure
Market structure refers to structural variables such as number of firms, barriers to entry and exit, product
differentiation, etc. which determine the level of competition in a market.

Basic market structures are

1. monopoly,
2. oligopoly,
3. monopolistic competition and
4. perfect competition.
a. Monopoly has only one firm,
b. duopoly only two,
c. oligopoly is characterized by a few firms,
d. monopolistic competition has significant number of firms and

33
 e. perfect competition has the largest number of firms each of which is so small that it can’t affect the market
in any way.

Degree of Concentration
Degree of concentration refers to the extent of the market share held by top firms.

1. A monopoly has highest degree of concentration, followed by an oligopoly.

2. Monopolistic competition and perfect competition both have low degree of concentration
3. but in perfect competition, a single firm's market share is negligible.

Nature of Product and its Substitutes

Whether a firm sells a differentiated product is very important in determining the firm’s ability to charge a price
higher than the market price. If the product is standardized, it has multiple substitutes which eliminates a firm’s ability
to charge premium for it. However, if the product is differentiated i.e. there is something such as brand value,
features, advertising, etc. to which the consumers attach some additional value, the firm may be able to charge a little
more for it.

1. Firms in perfect competition have completely standardized product with multiple substitutes,
2. a firm which has a monopoly has a product with few substitutes
3. but firms in oligopoly and monopolistic competition are characterized by differentiated products.

Entry and Exit Barriers

The extent to which existing firms in a market can restrict new firms from entering the market is an indicator of
market power. The barriers to entry may arise either from patents, copyrights, economies of scale, etc.

1. The entry barriers are the highest in case of a monopoly and to some extent in oligopoly.
2. Monopolistic competition and perfect competition, on the other hand, have very low barriers to entry.

Demand Curves
One of the most important factor affecting market power of a firm is the elasticity of demand of its product and the
nature of its demand curve.

1. A firm which has a monopoly in a product faces a down-ward sloping demand curve and the product
typically has very low elasticity of demand. (MCQ)
2. In case of an oligopoly, even though the industry demand curve slopes downward and the market
elasticity of demand is low, each individual firm has a demand curve and elasticity of demand which are less
steep than the overall market. (MCQ)
3. Firms in perfect competition, on the other hand, face a horizontal demand curve and hence theoretically
infinite price elasticity of demand. (MCQ)

Cost Curves
The existence of economies of scale and increasing returns to scale gravitate a market towards monopoly and/or
oligopoly. It is because when average cost of production is low, larger firms are able to produce a product at a lower
price which give them considerable advantage in pricing smaller firms out of the market.

34
When the minimum efficient scale, the minimum output level at which average total cost is minimum, is high,
barriers to entry are also high because each entrant must bring heavy investment to install the feasible capacity.

Comparison
The following table summarizes key characteristics of the popular types of market structure:

Monopolistic Perfect
Characteristic Monopoly Oligopoly
Competition competition
Number of firms One Few Large Very large
Typical firm size Very large Large Medium Small
Four-firm Near zero or very
1 Close to 1 Low
concentration ratio low
Steep downward-
Demand curve Downward-sloping Downward-sloping Horizontal
sloping
Elasticity of demand Very low Low Low High
Nature of product No substitutes Differentiated Differentiated Standardized
Barriers to entry Very high Very high Low Nonexistent
Minimum efficient
Very high Very high Medium Low
scale
Positive economic Both in short-run and Both in short-run and
Only in short-run Only in short-run
profit long-rum long-run
Deadweight loss High High Low No

Perfect Competition
Market= downward sloping (MCQ)

Firm= horizontal demand curve(MCQ)

Marginal Revenue = Current Market price (maximum profit) (MCQ)

Perfect competition (also called pure competition) is a market structure characterized by no barriers to entry or exit,
large number of price-taking market participants and a homogeneous product.

Even though exactly perfectly-competitive markets are rare, markets for agricultural commodities, financial services,
housing services, etc. closely resemble perfect competition. Perfect competition is theoretically a very important
construct because Adam Smith’s invisible hand operates only in perfect competition. It is a model which maximizes
the sum of consumer surplus and producer surplus.

Characteristics of Perfect Competition

Price-taking
The most fundamental characteristic of perfect competition is that all market participants (both producers and
consumers) are price-takers. It means that they take the market price as given. If a producer attempts to sell its
product at a price higher than the market price, it won’t be able to sell anything. In other words, in perfect
competition, no firm can influence the market price on its own. It doesn’t mean that the market price can’t change. It

35
can change but through the collective movement of the market as a whole and not due to action of any one producer
or consumer.

It follows that even though the market demand curve is downward-sloping, the demand curve faced by each
individual firm is a horizontal.

For each firm, marginal revenue, the additional revenue obtained from selling one additional unit, is equal to the
current market price.

marginal revenue= current market price

Homogeneous Product
Second most important determinant of perfect competition is the nature of the product. Perfect competition occurs
only where the product traded in the market is homogenous i.e. it is standardized such that a buyer can’t tell the
difference between the products of Firm A and Firm B. This assumption is important because due to standardized
nature of the product, units produced by Firm A and Firm B are perfect substitutes.

If there is a difference between quality or even perception of a difference, consumers might be willing to pay a
premium to the firm whose quality they consider to be superior. If a perfectly-competitive market introduces
differentiated products, it is more like a monopolistic competition.

Barriers to Entry or Exit

The third critical assumption in perfect competition is that the existing firms can’t stop any new firms from entering
the market or existing firms from leaving the market. It means that there are no patents, copyrights or other legal
hurdles or even economic hurdles such as economies of scale, increasing returns to scale, etc.

This assumption is important because it ensures that no firm earns positive economic profit in the long-run. If
the market is profitable in the short-run, new firms will enter the market, and this would return the market to
zero economic profit. Similarly, if existing firms are incurring loses, some of them will exit the market and the
remaining firms would start earning zero economic profit.

it ensures that no firm earns positive economic profit but to earn zero economic profit.

Monopolistic Competition(Imperfect
Competition)
Monopolistic competition is a type of imperfect competition market structure in which a large number of
firms produce differentiated products and there are no barriers to entry.

Monopolistic competition is monopolistic in the sense that due to product differentiation each firm has some
market power because due to its differentiated products even if it increases its price, its competitors can’t
capture all of its market share.

36
 But monopolistic competition is also competitive because there are no barriers to entry and if the existing
firms earn positive economic profits, new firms can enter the market easily thereby decreasing the market power of
existing firms.

Markets which exhibit monopolistic competition include restaurants, hospitals, small retail
outlets, etc.

Profit Maximization in Monopolistic Competition

Market= downward sloping(MCQ)

Firm= faltter demand curve(MCQ)

Marginal Revenue = Marginal cost (maximum profit) (MCQ)

The demand curve facing a individual firm in monopolistic competition is downward-sloping. It is because due
to the differentiated nature of products, they are not perfect substitutes for each other. This gives each firm some
ability to set its own price.

The demand curve relevant to each firm in a monopolistic competition is called residual demand curve, a demand
curve which shows the demand for product of one particular firm. A residual demand curve is flatter than the market
demand curve because individual firm demand is more elastic than market demand. Residual demand curve is
also to the left of market demand curve because individual demand is lower than the market demand.(MCQ)

A firm in monopolistic competition can maximize its profit by producing an output at which its marginal
revenue is equal to its marginal cost.

Monopolistic Competition vs Oligopoly

Monopolistic competition differs from oligopoly in that there is very weak interdependence between output levels of
different firms.

1. An oligopoly can have a homogeneous product or a differentiated product, but a monopolistic

competition always has a differentiated product. (MCQ)

Further, there are no barriers to entry in monopolistic competition but strong barriers in case of an oligopoly.
(MCQ)

Monopolistic Competition vs Perfect Competition

The difference between perfect competition and monopolistic competition lies in the nature of demand curve and the
nature of product.

1. While a perfectly-competitive market has a homogeneous product, monopolistic competition applies in

case of differentiated product. (MCQ)

37
Further, a firm in monopolistic competition faces a downward-sloping demand curve but a perfectly-competitive
firm faces a horizontal demand curve.(MCQ)

Monopolistic Competition vs Monopoly

Perfect competition differs from monopoly on account of barriers to entry, nature of product and market power.

1. First, there are no barriers to entry in monopolistic competition but high barriers in a monopoly. (MCQ)
2. Second, there are many differentiated products in a monopolistic competition but only a single product in
a monopoly. (MCQ)

Third, even though firms in monopolistic competition have certain market power, it is very low when compared to
monopoly power. (MCQ)

Oligopoly
An oligopoly is a market structure in which a few firms have each such a large market share that any change in
output by one firm changes market price and profit of other firms. A member of an oligopoly is called an
oligopolist.

Real life examples of oligopolies include microprocessors, personal computers, airlines, tobacco,
pharmaceuticals, soft drinks, operating systems, etc.

1. An oligopoly of only two firm is called a duopoly, for example Intel and AMD in case of microprocessors.
2. Similarly, an oligopoly of three firm is called a triopoly, for example Microsoft, Nintendo and Sony in case of
game consoles.

Characteristics
 Significant barriers to entry exist such as high investment requirement because of a high minimum
efficient scale (due to increasing returns to scale), control of critical natural resource (such as oil, mercury),
etc.
 The product they sell might be differentiated (for example in automobiles) or standardized (such as steel,
crude oil, copper).
 There is an incentive for firms to because they know that a price war is zero-sum game and that
cartelization can increase the oligopoly profits to monopoly level.
 There is price-rigidity because firms fear that any price change will trigger price war.

Concentration Ratio and HHI

An oligopoly is sometimes defined as a market with a small number of firms. But this definition assumes that many
niche producers are not part of the market. For example, Rogers, Bell and Telus are the major mobile network
operators in Canada but there are many smaller regional firms too. This is why instead of looking at the number of
firm in a market, it is better to find out what proportion of the market is controlled by the top few firms. Measures
such as four-firm concentration ratio and Herfindahl-Hirschman Index (HHI) are important indicators of oligopolistic
tendency of a market. HHI of 2,500 or higher indicates that the industry is an oligopoly.

Oligopoly Competition
38
Since every firm in an oligopoly can influence market price, each firm must take into consideration the likely
response of other firms while setting its price and output level. For example, an attempt by one firm to capture
market share by reducing its price and thus increasing its output can result in a fierce price war eliminating any
positive economic profit. D1 in the graph below shows a firm’s demand curve if its demand is it rivals do not match its
price and output changes while D2 is the demand curve if its price changes are matched. You can see that D2 is
steeper which means that a firm’s quantity demand falls more drastically in response to change in its price.

Pure/Perfect Oligopoly vs Differentiated/Imperfect Oligopoly

1. A pure oligopoly (perfect) is one in which there is a homogeneous product, for example OPEC is a
pure/perfect oligopoly. Same is the case of oligopolies of other commodities such as mercury, copper, etc.
2. A differentiated oligopoly (imperfect), on the other hand, is one in which the product of different firms
is perceived to be different, for example automobile and smartphone industries are differentiated
oligopolies.

Collusive Oligopoly vs Non-Collusive Oligopoly

1. A collusive oligopoly is one in which the member firms engage in price-fixing and cartelization, for
example OPEC.
2. A non-collusive oligopoly in one in which there is no tacit understanding between the member firms
regarding pricing and output. Since price-fixing and cartelization is illegal in most developed countries,
most of oligopolies in US and Europe, etc. are non-collusive oligopolies.

Partial Oligopoly vs Full Oligopoly

1. A partial oligopoly is characterized by one large producer which leads other firms in the oligopoly in
pricing and output decision. It is called partial oligopoly because the output and pricing decisions are
sequential.
2. A full oligopoly, on the other hand, is a market in which firms have to decide about their pricing and
output decisions simultaneously.

Tight Oligopoly vs Loose Oligopoly

1. A tight oligopoly occurs when the four-firm concentration ration is higher than 60.
2. A loose oligopoly, on the other hand, is one in which the four-firm concentration is in the range of 40-
60

Oligopoly Models
An oligopoly is a market structure characterized by significant interdependence. Common models that explain
oligopoly output and pricing decisions include cartel model, Cournot model, Stackelberg model, Bertrand model
and contestable market theory.

The reason there are more than one model of oligopoly is that the interaction between firms is very complex. It
depends on whether the product is homogeneous or differentiated, whether there is a dominant firm, whether firms
compete based on output or price, etc.

Cartelization

39
An oligopoly can maximize its profits by colluding and forming a cartel. When they do so, they are effectively
a monopoly and they can maximize the industry profits by producing at an output level at which the
industry marginal revenue is equal to industry marginal cost.

Despite the significant advantage of cartelization, cartels are rarely successful. First, because collusion and price-fixing
are illegal in most jurisdictions. Second, individual firms have an incentive to cheat the cartel. Since every individual
firm can be better off if they cheat the cartel, a cartel is inherently unstable.

Cournot Model
The Cournot model of oligopoly applies where

1. the firms produce homogeneous goods

2. they compete simultaneously on output and market share, and
3. they expect their rivals to not change their output in response to any change that they make.

Cournot equilibrium is the output level at which each firm in the oligopoly maximizes its profit given the
output level of all other firms. No firm can gain from changing its output level away from Cournot equilibrium
because the response of other firms will wipe out any additional profit. Cournot equilibrium is the point of
intersection of the best-response curves (also called reaction curves) of the firms. If there are two firms, Reach
and Dorne, the reaction curve of Dorne plots Dorne’s profit-maximizing output given different output levels of Reach
and vice versa. As shown in the graph below, the Cournot equilibrium is the point of intersection of both reaction
curves.

Stackelberg Model
A Stackelberg oligopoly is one in which one firm is a leader and other firms are followers. This model applies
where: (a) the firms sell homogeneous products, (b) competition is based on output, and (c) firms choose their
output sequentially and not simultaneously.

The leader is typically a first-mover who chooses its output before other firms can do it. Since other firms must set
their output decision given the leader’s output decision, the leader in a Stackelberg oligopoly typically has a bigger
market share and higher profit than other firms in the oligopoly.

Bertrand Model
There are two versions of Bertrand model depending on whether the products are homogeneous or differentiated.

1. The homogeneous-products Bertrand model of oligopoly applies when firms in the oligopoly produce
standardized products at same marginal cost. When the marginal cost is same, it is in the best interest of
each firm in oligopoly to undercut its rival (i.e. beat its price), because the other firms are also trying to beat
it. This price war leads to a situation at which market price is equal to the marginal cost. The output and
price level in a Bertrand oligopoly is the same as in perfect competition.

2. The differentiated-products Bertrand model contends that when an oligopoly produces differentiated
products, price competition doesn’t necessarily lead to a competitive outcome. It is because when each firm
produces a differentiated product, its demand doesn’t become zero when it raises its price. In fact, the
Bertrand model concludes that if one firm increases it price, the other firms in a differentiated oligopoly
should also increase theirs because this will increase its profit.

40
Contestable Market Theory
Contestable market theory posits that when the initial investment required in an oligopoly is not a sunk cost i.e.
where most of the investment can be recovered if a firm decides to leave the market, the industry functions
more like a perfect competition. It is because the recoverability of the investment encourages new firms to get a go
at the industry and this eliminates any positive economic profit.

Bertrand Bertrand
Cartel Cournot Stackelberg (homogeneous (differentiated
products) products)
Nature of
competition
Output-setting Output-setting Output-setting Price-setting Price-setting
(output vs
price)
Nature of
Homogeneous Homogeneous Homogeneous Homogeneous Differentiated
product
Economic
Maximum >0 >0 0 >0
profit
Output Minimum Medium Maximum Medium
Sequential or
Simultaneous Simultaneous Sequential Simultaneous Simultaneous
simultaneous

Kinked Demand Curve Model

The kinked-demand curve model (also called Sweezy model) posits that price rigidity exists in an oligopoly
because an oligopolistic firm faces a kinked demand curve, a demand curve in which the segment above the
market price is relatively more elastic than the segment below it.

An oligopoly is a market structure in which there are a small number of large firms and high barriers to entry. In such
an environment, each firm has significant market power. Hence, firms must consider possible actions of their
competitors in taking their pricing decisions.

The kinked demand model postulates that when a firm increases it price, its competitors do not change their prices.
This causes the demand for goods produced by the firm attempting the price increase to fall. In other words, the firm
faces a very flat demand curve above the market price. On the other hand, when the firm decreases its price, its
competitors follow suit. Since all firms reduce their prices, there is no gain in market share for any firm. The increase in
sales is restricted only to the increase in quantity demanded due to lower market price. This is illustrated by a steeper
demand curve below the market price.

Kinked Demand Curve and Price Rigidity

A kinked demand curve is composed effectively of two demand curves which meet at the prevailing market price. At a
price higher than the prevailing market price, a firm faces a more elastic demand curve but at a price below the
prevailing market price, the demand curve is relatively less elastic. This introduces the disconnect i.e. a kink in the
demand curve at the current market price.

41
As explained by the kinked demand model, any increase in price is bound to result in drop in market share of
the firm and any decrease in price is not going to result in any gain in market share. Further, firms fear that
any downward revision in price may trigger a price war. This results in significant price rigidity in an oligopoly.

Due to the kinked nature of the demand curve, an output range exists in the marginal revenue curve is vertical such
that any change in marginal cost do not impact the profit-maximizing output level and consequently the price level.

Concentration Ratio
Concentration ratio (also called n-firm concentration ratio) measures the market share of top n firms in an industry.
Four-firm concentration ratio which is the sum of market share of top four firms, is the most common
concentration ratio. It is close to 0 in case of perfect competition and close to 1 in monopoly or oligopoly.

The degree of concentration in an industry is a source of market power, the ability of firms in a market to set
their prices above their marginal cost. For example, in a monopoly where there is only one producer, a firm can
charge whatever price it deems fit without worrying about any competition. Similarly, in an oligopoly where there are
only a few firms, the equilibrium output is lower and the price is higher than in perfect competition.

Interpretation
The four-firm concentration ratio stays in the range of 0-1. It is zero when the market share held by top four firms is
negligible. It is possible only in perfect competition, a market structure in which there are so many producers that no
firm can individually influence the market price.

If the four-firm concentration is 1, it means that that whole market is controlled by four or less firms. It could be just
one firm (as in monopoly), two firms (as in duopoly), or three or four firms (as in oligopoly). The four-firm
concentration ratio can’t help us tell whether an industry is a monopoly or an oligopoly. However, it can tell whether
an industry is a loose oligopoly (when 4CR is 0.4 to 0.6) or a tight oligopoly (when 4CR is greater than 60).

Cournot Model
Cournot model is an oligopoly model in which firms producing identical products compete by setting their output
under the assumption that its competitors do not change their output in response.

Unlike a monopoly in which there is only one producer, an oligopoly in a market structure in which there are more
than one producer, and each is large enough to affect the profit of other firms through its actions.

Reaction Curve or Best-Response Curve

A reaction curve (or best-response curve) is a graph which shows profit-maximizing output of one firm in a duopoly
given the output of the other firm.

Cournot Equilibrium
Cournot equilibrium is the output level at which all firms in an oligopoly have no incentive to change their output. It is
the point of intersection of the best-response curves of the rivals in a duopoly.

42
Since both firms need to take the output decision simultaneously, we can find the equilibrium by solving reaction
curves of both firms.

Comparison: Cournot vs Bertrand vs Collusion

Cournot equilibrium tells us that an oligopoly which produces identical products, and which compete based on
output will produce a higher output than a monopoly but lower output than a Bertrand oligopoly. It will charge a
lower price than a monopoly but a higher price than a Bertrand oligopoly.

Cournot model also tells us that a firm in an oligopoly with lower marginal cost will produce a higher output and will
have a higher market share. This is evident from the example above: Reach has lower marginal cost and higher share
of the output in Cournot equilibrium.

by Obaidullah Jan, ACA, CFA and last modified on Feb 25, 2019

Profit Maximization
Profit maximization rule (also called optimal output rule) specifies that a firm can maximize its economic
profit by producing at an output level at which its marginal revenue is equal to its marginal cost.

Marginal revenue is the change in revenue that results from a change in a change in output. For example, if a firm
sells 99 units for $198 and 100 units for $200, marginal revenue of the 100th unit is $2. If ∆TR is the change in total
revenue and ∆q is the change in output, MR equals ∆TR/∆q.

Marginal cost, on the other hand, is the incremental cost of additional units of output. For example, if total cost of 99
units is $148.5 and total cost of 100 units is $150, the marginal cost of the 100th units is $1.5. If ∆TC is change in total

Why MR = MC is Profit-Maximizing?
It means that the rate of change of profit equals the difference between the rate of change of revenue and
rate of change of cost.

Now, at the profit-maximizing output, rate of change of profit should be 0 because we have reached the
peak of the profit curve. The rate of change in profit was positive till we reached the peak and it would turn negative if
we move over it. Hence, it follows that profit maximization is possible if ∆π/∆q is 0.cost and ∆q is
the change in output, MC equals ∆TC/∆q.

Shutdown Point
In short-run, a firm should shut down immediately if the market price of its product is lower than its average
variable cost at its profit-maximizing output level. In long-run, it should shut down if the price of its product is
less than its average total cost.

Short run is defined as a time period in which at least one of a firm’s inputs, say capital, is fixed. It means that at least
some of the firm’s costs will be fixed which will be incurred even if it shuts down.

Long run, on the other hand, is a period in which a firm can change all its inputs. In other words, the firm has no fixed
costs to worry about in the long-run. If it shuts down in the long-run, all its costs go away too.

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Short-run Shutdown Decision
Because fixed costs are costs which a firm continue to incur even if production falls to zero, a firm should continue
production if its revenue covers its variable cost. It is because when its revenue is higher than its variable cost, at least
there is something left behind to cover a part of the fixed costs which will be incurred anyway.

This is why the short-run shutdown point occurs when price P is less than or equal to the average variable cost
at the profit-maximizing point.

Shut-down Price
The price at which a firm should shut down even in the short-run is called the firm’s shutdown price. Shutdown price
is equal to a firm’s minimum possible average variable cost. It is because the firm will never be able to achieve an
average variable cost lower than this and if the market price is less than even the lowest-possible average variable
cost, there is no output level at which the firm will earn positive contribution margin. It doesn’t make sense for a
firm to keep producing if the sales revenue will not cover even the variable costs at a firm’s optimal output.

Long-run Shutdown Decision

Shutdown decision in the long-run is different because all costs can be avoided in the long-run. In the long-run, a
firm should shut down if its revenues do not cover its total costs.

Barriers to Entry
In economics, barriers to entry refers to obstacles that make it difficult for new firms to enter into a specific market or
industry. Barriers to entry are strongest in pure monopolistic markets where entry is virtually blocked for new firms.
Barriers to entry gradually weaken as markets become competitive. There are no entry barriers in markets that have
pure competition. In real world though, all new firms face at least some obstacles when entering a market.

Economies of Scale:
Old firms in a market are typically much larger than new startups. Large firms can produce a given product or service
at a much lower cost per unit than new firms due to economies of scale. New firms cannot beat the price of larger
firms without incurring loss. This makes it difficult for newer firms to enter and stay profitable.

Government Regulations:
In some industries government regulations are an obstacle in the way of new firms. Sometimes there is simply a limit
on the number of firms allowed to operate in a given industry e.g. limited number of 4G communication licenses.
Even when there is no limit on number of licenses, some firms may find it hard to obtain license to run a particular
type of business due to huge costs or other difficulties.

International Restrictions:
International trade restrictions exist in various forms. These are enforced by governments to protect domestic
producers from fierce international competition.

Patents:
Patents on technology owned by existing firms make it difficult for new firms to compete because either they need
to pay high licensing costs or invest in research trying to invent alternate technology.

44
Restricting Trade Practices:
Existing firms sometimes engage in restricting trade practices such as collusion or limit pricing thus making it difficult
for new firms to enter in the industry.

Profit Function
A profit function is a mathematical relationship between a firm’s total profit and output. It equals total revenue minus
total costs, and it is maximum when the firm’s marginal revenue equals its marginal cost.

Marginal Revenue
Marginal revenue is the incremental revenue generated from each additional unit. It is the rate at which total revenue
changes. It equals the slope of the revenue curve and first derivative of the revenue function.

Economists are interested in finding a firm’s marginal revenue because its profit maximization output occurs at a
point at which its marginal revenue equals its marginal cost. It is because when the marginal revenue is more than the
marginal cost, the firm has a potential to increase profit because an additional unit will fetch net profit because MR
minus MC is positive. On the other hand, if the marginal revenue is less than the marginal cost, the firm is making
loss on the marginal units and it can cut losses by reducing its output until the marginal revenue covers its marginal
cost.

Marginal Revenue of a Monopolist

In case of a monopolist, the marginal revenue is not necessarily equal to the price because he faces a
downward sloping demand function which results in a downward-facing marginal revenue curve. Total revenue
of a monopolist increases with decreasing rate because in order to increase its total revenue, the monopolist must
reduce its price. The change in revenue is the combined result of the quantity effect and the price effect. The revenue
increases due to increase in quantity but decreases due to decrease in price.

CHAPTER 05
Monopoly
In economics, a monopoly is a market structure where only a single firm supplies a product which has no close
substitutes. A firm which has a monopoly is called a monopolist.

Perfect competition and monopoly are two extreme cases of market structure.

While perfect competition is characterized by price-taking behavior.

monopolies have significant market power which enables them to dictate a price which is significantly higher than
their marginal cost. Due to extensive barriers to entry, a monopolist can earn positive economic profit even in the
long-run

Characteristics
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 1. only one seller (and downward-sloping demand curve),
2. non-existence of close substitutes (and low elasticity of demand)
3. and very high barriers to entry.

Monopolist’s Demand Curve and Marginal Revenue

Since a monopolist is the sole producer, its demand curve is the market demand curve i.e. a downward-sloping
demand curve. As shown in the graph below, a monopolist’s marginal revenue is less than its price.

No Close Substitutes

High Barriers to Entry

Monopolists typically earn positive economic profit which motivates other firms to enter the market and have a chunk
of the pie too. This is why high barriers to entry are important for a monopoly to exist and survive. Barriers might exist
due to laws and regulations (such as patents, copyrights, etc.), access to critical natural resource or due to economic
phenomena such as economies of scale, etc.

Segment Monopolist
Word processors and spreadsheets Microsoft
Movie streaming Netflix
Utilities Duke Energy (US), Eskom (South Africa)
Social networking Facebook
Video streaming YouTube
Search Google
Football FIFA
Online retail Amazon
Beer ABInBev
by Obaidullah Jan, ACA, CFA and last modified on Feb 19

Natural Monopoly
Natural monopoly is a monopoly that exists as a result of a market situation in which a single monopolistic firm can
supply a particular product or service to the entire market at a lower unit cost than what could be achieved by a
number of competing firms. Natural monopolies typically exist when production of a product or service requires
large and extremely costly infrastructure. Pure cases of natural monopoly are rare in real world but they do exit in
markets of public utilities such as power, water, telephone, railways etc.

In naturally monopolistic markets, competition is uneconomical because multiple producers are unable to completely
utilize economies of scale and this results in unit costs above the lowest possible values and thus higher prices. In
other words, a natural monopoly uses the economy's limited resources more productively than multiple competing
firms. By this logic, it is preferable for a government to allow monopolization of the market.

However monopolies have the negative feature that they tend to unfairly exploit their monopolistic power if allowed
to. Monopolies tend to restrict supply thus inflating prices. In such a situation the government may adopt one of the
following two alternative approaches in order to retain the possibility of unit cost advantage of a natural monopoly as
well as avoid the negatives of a monopoly:

a. Public ownership

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 b. Public regulation

Public ownership typically involves direct governemt control of the natural monopoly producing a specific public
good or service. For example a railroad company, owned and managed by government, which is the sole owner of
railways infrastructure in the country is a publically owned natural monopoly. By directly operating the monopoly,
government bars unfair exploitation of monopoly power by the firm.

Public regulation may involve government control of the price at which a specific utility must be sold by the
monopolistic firm. Public regulation is used in naturally monopolistic markets where public ownership is not a feasible
option.

Monopoly Price and Output

A monopolist can maximize its profit by producing at an output level at which its marginal revenue is equal to its
marginal cost.

A monopolist faces a downward-sloping demand curve which means that he must reduce its price in order to sell
more units. Marginal cost curve of the monopolist is typically U-shaped, i.e. it decreases initially but ultimately starts
rising due to diminishing returns to scale. The profit-maximizing quantity and price correspond to the point at which
the marginal revenue and marginal cost curves of the monopolist intersects.

Profit-Maximizing Output and Price

Monopoly profit is maximized at a point at which the monopoly’s marginal revenue is equal to its marginal
cost. There are two ways to find the optimal output and price: graphical and mathematical.

Monopoly Pricing
A monopolist should set its price such that the difference between the price and marginal cost as a percentage of
price equals the inverse of the elasticity of demand of its product.

The profit-maximizing output and price of a monopolist occur at output level at which its marginal revenue is
equal to its marginal cost. Marginal revenue is the incremental revenue from each additional unit of sales and
marginal cost is the incremental cost of the additional unit.

Monopoly Price and Elasticity of Demand

(Price) elasticity of demand is defined as the responsiveness of quantity demanded to change in price. It equals
percentage change in quantity divided by percentage change in price. It can be calculated using the following
equation:

Monopoly Power
Monopoly power (also called market power) refers to a firm’s ability to charge a price higher than its marginal
cost. Monopoly power typically exists where the there is low elasticity of demand and significant barriers to
entry.

47
Why is it that a firm in perfect competition is a price-taker while a monopoly can set any price it deems fit? The
answer lies in the nature of the demand curve facing each firm. In a perfect competition, no firm has any market
power because they face a horizontal demand curve. They must supply at the prevailing market price or sell
nothing.

A monopoly, on the other hand, need not worry about any competition. Since a monopolist is the only firm in the
market, if the elasticity of demand for its product is low, he determines the market price. In other words, a
monopolist has infinite monopoly power.

Sources of Monopoly Power

Important determinants/sources of monopoly power include elasticity of demand of the product, existence of
economies of scale, control of a key resource, existence of legal barriers, etc.

Elasticity of Demand
If the elasticity of demand is low, a firm is in a better position to charge a price higher than its marginal cost. If
close substitutes exist and hence the elasticity of demand is high, even a single firm can’t increase price beyond some
reasonable range. For example, if people could switch to other word processors easily, elasticity of demand for
Microsoft Word would be low and Microsoft wouldn’t enjoy a near-monopoly in the market.

Economies of Scale
A firm’s production function and cost structure are also important determinants of whether positive economic profit is
possible in the long-run.

If the cost structure of an industry is such that economies of scale matter a lot, a single large firm might be able to
produce at a significantly lower cost than other small and medium-sized firms. This enables the largest player to price
other firms out of the market. Many utility companies are able to monopolize a market owing to economies of scale.
Such a monopoly is called a natural monopoly. Similarly, existence of increasing returns to scale means that as the
size of a firm gets larger, its productivity (i.e. output per unit) increases and he can supply the product at increasingly
lower prices.

Existence of economies of scale and increasing returns to scale means that the industry’s minimum efficient scale is
high, and this restricts entry by new firms because they must start big to stand a change and not many firms may
have the capital needed to start at such a scale.

Legal Barriers
Third source of monopoly power is the existence of legal entry barriers including patents, copyrights, licenses, etc.

In many instances, a monopoly is created and enforced by a government through its intellectual property rights laws.
For example, Microsoft has monopoly in Windows-based operating systems because no one else can copy and sell
Windows. Similarly, many pharmaceutical companies have monopoly in specific drugs due to existence of patents.

Access to Critical Natural Resource

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Monopolies also arise when one firm has control over certain important physical and natural resource. The firm
controlling the resource can restrict supply of the resource to other firms thereby controlling the ultimate market
price.

Lerner Index
Lerner Index is a measure of monopoly power which equals the markup over marginal cost as percentage of
price. Its value ranges from 0, in case of a perfect competition, to 1, in case of a pure monopoly.

One of the most important difference between perfect competition and monopoly lies in the relationship between
price and marginal cost.

A perfectly-competitive firm can’t afford to set its price higher than its marginal cost. It is because it faces a
horizontal demand curve which means that if it attempts to charge a price higher than its marginal cost, it will have
zero revenue because all its customers will switch to its competitors.

A monopolist on the other hand faces a downward-sloping demand curve which means that it can charge a price
higher than its marginal cost. One way of finding out the extent of monopoly power is to work out the difference
between price and marginal cost of the monopolist. This is exactly what the Lerner Index does.

Lerner Index and Elasticity of Demand

The higher the price elasticity of demand of a firm’s product, the lower its Lerner Index.

It is because a high elasticity of demand means that any increase in the price of the product will cause customers to
switch to substitute goods. This reduces the monopolist’s ability to sell its products at a higher markup.

There is an inverse relationship between Lerner Index and elasticity of demand as given by the equation
below:

Price Discrimination
Price discrimination is the practice of charging different prices for the same product or service to different customers
instead of selling it at a uniform price to all of them. Monopolistic businesses widely use price discrimination to
maximize their sales.

Price discrimination allows a seller to divide consumers on the basis of their price elasticity of demand. By charging
higher price to consumers having low price elasticity of demand and lower price to consumer having higher
price elasticity of demand, the seller achieves total sales higher than what could be achieved with uniform price for
all customers.

Types
Price discrimination has following types:

49
  First degree price discrimination, in which the seller charges the maximum price a consumer is willing to
pay.
 Second degree price discrimination, in which the seller charges higher price for the first unit and reduces
price for each successive unit sold (commonly known as bulk discounts).
 Third degree price discrimination, in which the seller segregates customers into different classes by
location, age etc. and charges different price to each class of consumers. A firm's pricing strategy may
combine multiple types of price discrimination.

Conditions
Not all sellers have the ability to exercise price discrimination. The conditions required to use price discrimination are:

 The seller must have some degree of monopolistic powers to be able to control price and thus exercise
price discrimination.
 The seller must have the ability to divide buyers into multiple classes at low cost on the basis of their
price elasticity of demand.
 The seller must be able to stop resale of the product or service by the buyers. Businesses that exercise price
discrimination usually employ licensing restrictions to prohibit buyers from reselling.

First-Degree Price Discrimination

 First degree price discrimination, in which the seller charges the maximum price a consumer is willing to
pay.

First-degree price discrimination (also called perfect price discrimination) occurs when a producer charges each
consumer his reservation price, the maximum amount that he is willing to pay, for each unit.

In order to understand (perfect) first-degree price discrimination, let’s see what happens when there is no price
discrimination i.e. each customer is charged the same price. When a firm has a single price and it faces a
downward-sloping demand curve, it must reduce its price for all units in order to sell one more unit. The marginal
revenue of such a firm equals price adjusted for the reduction in revenue for all units due to reduction in price as
shown in the equation below:

Optimal Output under Price Discrimination

When there is no price discrimination and a single price is charged from each customer, the profit-maximizing
output for a firm facing a downward-sloping demand curve occurs at a point at which its marginal revenue is
equal to its marginal cost. But when there is price discrimination, each customer is charged a price that corresponds
to the demand function, So the optimal output level occurs when the marginal cost curve intersects the demand
curve (instead of the marginal revenue curve).

Imperfect First-Degree Price Discrimination

perfect price discrimination

In order to be able to charge each customer the maximum amount, firms must have complete information about its
customers and the customers mustn't be able to sell the product to each other. In most cases, perfect information
about customer reservation prices is not available. This is why perfect price discrimination is very rare. In reality,

50
reservation price information about different groups of customers may be available and imperfect first-degree price
discrimination can be applied to maximize profit.

Second-Degree Price Discrimination

 Second degree price discrimination, in which the seller charges higher price for the first unit and
reduces price for each successive unit sold (commonly known as bulk discounts).

Second-degree price discrimination (also called non linear price discrimination) occurs when a firm charges different
prices for different quantities of the product.

One of the conditions of (perfect) first-degree price discrimination is that the firm knows the reservation price of each
unit that each of its customers consume. In most cases, firms do not have such detailed information about their
customers, and they must infer reservation prices using some other measure. The law of diminishing marginal
utility provides a useful insight: it tells us that the reservation price for the first unit must be higher than the
second unit and so on because marginal utility decreases with increase in consumption. Second-degree price
discrimination uses this insight in that it charges different prices for different number of units that a consumer buys.

Third-Degree Price Discrimination

 Third degree price discrimination, in which the seller segregates customers into different classes by location,
age etc. and charges different price to each class of consumers. A firm's pricing strategy may combine
multiple types of price discrimination.

Third-degree price discrimination (also called group price discrimination) occurs when a firm divides its customers
into two or more groups based on their price elasticity of demand and charges them different prices.

Third-degree price discrimination is the most common type of price discrimination because classifying customers into
a few groups is easier for a firm than knowing the reservation price, the maximum amount that consumers are willing
to pay, of each unit of its output.

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 Chapter 09
National Income Accounting
National income accounting represents the process of working out measures of a country’s income and production
such as gross domestic product (GDP), gross national income (GNI), net national product (NNP), disposable
personal income, etc.

National Income Accounting Identity

National income accounting identity is an equation that shows relationship between an economy’s total
income/expense and its different categories i.e. personal consumption expenditure (C), private investment (I),
government spending (G) and net exports i.e. exports (X) minus imports (M).

The relationship can be written as follows:

Y = C- I- G- X+ M

It is to national income accounting what assets (A) = liabilities (L) + equity (E) is to business accounting.

The national income accounting identity is effectively the definition of gross domestic product (using
the expenditure approach).

Gross Domestic Product

The most important number produced by the national income accounting is the gross domestic product (GDP), which
is the market value of all final goods and services produced within geographical boundaries of a country. GDP is
a measure of total production that takes place inside the border of a country. It also a measure of total expenses
incurred on final goods and services and also a measure of total income. This is due to the circular flow of
income i.e. total income in an economy equals total expense.

There are two variants of GDP:

1. nominal GDP which is value of production based on current prices and

2. Real GDP is the inflation-adjusted measure of GDP.

All other indicators of national income are derived from GDP.

GDP per capita

GDP per capita means the average income earned by a person in a country. It is calculated by dividing total GDP by
the country’s population.

Total gross domestic product is not comparable across economies because their size differ depending on the
resources available to them such as land, population, etc. but the GDP per capita is a standardized measure which
enables comparison of standard of life across countries possible.

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Gross National Product
Gross national product (also called gross national income) is the total income earned by the residents of a country.
It equals gross domestic product (GDP) plus income earned by a country’s residents abroad (R) minus income
earned by foreigners in a country (P):

GNP = GDP+ R- P

While GDP measures the income earned within geographical boundaries of a country, GNP calculates the
income earned by a country’s residents/nationals.

Net National Product

Income generated by a country is achieved on the back of significant investment in infrastructure i.e. roads,
bridges, etc. which must be maintained. If we are interested in finding out the income generated net of such charge
for periodic maintenance of such infrastructure, we calculate net national product (NNP) which equals gross
national product (GDP) minus depreciation D.

NNP= GNP- D

National income (NI) is most comprehensive measure of total income earned by residents of a country. It is
approximately equal to net national product (NNP) except for an adjustment for statistical discreprency.

Personal Income
Personal income is the gross amount attributable to residents of a country. It is the sum of all incomes in the
hand of individuals.

Measures of aggregate income such as GDP, GNI, NNP and NI are broad economy-level measures of income and
production which do not segregate transfer payments, taxes, etc. But if we are interested in finding out how much
money ultimately accrues to people, we need to calculate personal income.

Personal income (PI) equals national income minus indirect taxes (IDT) such as sales tax, VAT minus corporate
profits (CP) minus net interest (NETI) plus income from assets (such as dividends, interest payments, etc. (IA)
plus transfer payments i.e. amount paid by government to people with low incomes (TP) minus social security
contribution made by people (SS)

PI=NI- IDT-CP-NETI+IA+TP- SS

Disposable Income
Disposable income is the income that is at the disposal of residents of the country i.e. it is the income which
they can consume or save.

Disposable income equals personal income (PI) minus personal income taxes (PIT):

Disposable Income= PI – PIT

Gross domestic product (GDP) is a measure of national income which equals the market value of all final goods and
services produced in the geographical boundaries of a country in a given time period.

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GDP is the single most important number in economics which is sliced and diced to measure a whole range of
economic statistics such as GDP per capita (i.e. total GDP divided by population), gross national product (also called
gross national income), growth rate (i.e. percentage change in real GDP), labor productivity, total factor
productivity, income per capita, etc. The process used to work out GDP and other macroeconomic output-related
statistics is called national income accounting.

There are three key words in the above definition: market value, final, geographical boundaries.

 The GDP is a measure of market values of goods and services produced. If something is not traded in
market such as leisure, self-service, etc. it is not counted as part of GDP. An important exception is the
government services which even though not tradeable are included in GDP. Since there is no market and
hence no market value, such items are included at costs.
 The GDP is a measure of all final goods and services. Final goods are goods which are ready for their
intended consumption. It means that intermediate goods, i.e. goods which are themselves an input in some
other production process, are not included. It is because including both intermediate goods and final goods
would double-count production and income.
 The GDP measures income generated within the geographical boundaries of a country. GDP includes
income earned and expenditure made by all people residing or visiting a country regardless of their
nationality. This is how GDP differs from gross national product (also called gross national income).
 Other considerations in calculating and interpreting GDP includes: (a) GDP ignores financial/paper
transactions that do not involve any production i.e. purchase of a share of common stock by an
investor from another investor is not counted in GDP; (b) GDP ignores transfer payments i.e. social
security benefits, etc.; (c) GDP ignores second-hand purchases and sales: (d) GDP ignores work people
do for themselves.

Approaches to GDP Estimation

GDP can be calculated in three different ways and each gives us the same answer. These three methods are (a) the
product approach, (b) the expenditure approach, and (c) the income approach.

The mutual comparability of the three approach can be expressed mathematically as follows:

Total Production=Total Expenditure=Total Income

The formula for calculation of GDP using expenditure approach is as follows:

Y=C+I+G+X-M

Where C is personal consumption, I is private investment, G is government spending, X is exports and M is

imports.

The convergence at a single GDP number using either approach results from the circular flow nature of production in
income. The circular flow means that if properly accounted for, an economy’s total production must equal its total
expenditure and total income. It is so because what consumers spend in product market (i.e. total expenditure) they
earn in factor markets (i.e. through wages, interest, dividends, etc.). Hence, whether we start counting expenditure or
income, we must arrive at the same figure.

Nominal GDP vs Real GDP

The GDP compiled by statistical agencies is based on the prices prevailing in the market during the period. This
number is called nominal GDP. In order to compare GDP number across time, it is important to remove the effect of

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changes in purchasing power from historical time series. The real GDP is the gross domestic product which is worked
using current year quantities and the base year prices. In a time series of real GDP, GDP numbers for all
periods are restated based on the prices that prevailed in the base year.

The relationship between nominal and real GDP is given by GDP deflator.

When we talk about an economy’s growth rate in a given period, we measure it by percentage change in its real
GDP.

Shortcomings in GDP
Even though GDP is quite useful, it does not give a complete picture of an economy because:

 GDP and GDP per capita does not provide any information about distribution of income in an economy.
In the increasing disparity of income and wealth, this drawback is a serious one.
 GDP does not count self-service and leisure and a number of other categories of productive activities.
 GDP does not count the underground economy (also called informal sector). Since the size of the
underground economy is quite large in developing countries, GDP understates total production.
 GDP ignores the physical depreciation of capital goods i.e. roads, buildings, factories, etc. which are
consumed in generating the income/expenditure. Hence, it overstates the net production of an economy.
 Gross national income (GNI) is a measure of income earned by a country’s nationals/residents anywhere
in the world. It equals gross domestic product (GDP) plus net factor income from abroad.

 GNI is also sometimes referred to as gross national product (GNP) but GNI is the term used by major
international agencies such as World Bank, OECD, etc.

 World Bank defines GNI as: “GNI measures the total domestic and foreign value added claimed by
residents, and comprises GDP plus net receipts of primary income (compensation of employees and
property income) from nonresident sources.”

 In an increasingly more integrated world economy, many businesses that operate in a country are owned
by foreigners and the income they earn accrues to foreigners. Similarly, its own nationals also hold
stakes in businesses that operate in foreign countries and they repatriate the income they earn abroad. If we
are interested in finding out the income of a country’s nationals regardless of its geographical source, we
need to work out GNP.

 GNI is derived from gross domestic product i.e. it is calculated by subtracting the income earned by
foreigners from GDP and adding income earned by a country’s nationals abroad using the following
formula:

 GNI = GDP + R − P

 Where GDP refers to the gross domestic product, R stands for receipts from abroad i.e. income earned by
nationals abroad, and P is the payments to foreign countries on account of factors of product.

 GNI vs GDP
 Gross domestic product (GDP) is an indicator of income generated without geographical boundaries of a
country. It equals the sum of personal consumption expenditure (C), private investment (I), government
spending (G), and net exports (which equals exports (X) minus imports (M)).

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  Y=C+I+G+X–M

 GNI is calculated by adjusting GDP as follows:

 Y=C+I+G+X–M+R−P

 GDP measures total production within geographical boundaries of a country achieved during a period
while GNI is a measure of income generated by residents of a country regardless of their geographical
location. GDP is certainly a more popular measure of income, but GNP is useful if we are interested in
finding out a country’s tax potential, its residents’ affluence i.e. disposable income, etc.

 Example

 Many developing countries with large populations, such as India, Pakistan, Philippines, have GNP which is
higher than their GDP. It is because a significant portion of their nationals work abroad and send remittances
to their home country.

GDP: Expenditure Approach

Gross domestic product (GDP) represents the value of all final goods produced and services delivered within the
geographical boundaries of a region (city, state, country) in a period (most commonly a year).

There are two commonly used approaches to calculate GDP: the expenditures approach and the income approach.
The production approach is also another possible alternative.

The GDP under the expenditures approach is calculated by adding up all the expenditures made on final goods
and services produced within the geographical boundaries of a region. These include consumption expenditure (by
households), investment expenditures (by businesses), government expenditures (on purchase of goods and services)
and net expenditures by foreigners (i.e. net exports which in turn equals total exports minus total imports).

Formula
The GDP under the expenditures approach is calculated using the following formula:

GDP = C + I + G + (X − M)

C stands for personal consumption expenditures and it represents the spending by individuals on goods and
services for personal use. Examples of expenditures that fall under this heading includes: spending on purchase of
durable goods (such as cars, computers, etc.), non-durable goods (such as bread, milk, etc.) and on purchase of
services (such health, entertainment, haircuts, etc.)

I stands for gross private investment and it represents the spending by entrepreneurs to sustain and grow their
business. Examples of expenditures falling under gross private investment includes: fixed investment (purchase of final
plant and machinery, business tools, etc.), construction for assets (residential and others) and changes in inventory
levels, etc. However, it excludes a mere transfer of existing assets from one party to another (such as purchase of
securities on the stock exchange, purchase of a resold asset, etc.)

G stands for government expenditures and gross investment and it represents the spending by government on
consumption and on investment in new infrastructure, etc. Examples of expenditures falling under this heading

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include: salaries of government officers, expenditure on stationery and equipment used by government, expenditure
on training of government officials, expenditure on construction of new high ways, parks, etc.

(X − M) equals net exports. X stands for exports and represents the purchase of goods produced in a region that are
consumed by foreigners. M stands for imports and represents the purchase of foreign goods and services.

Since GDP sums up all production within geographical boundaries of a region, it must include the output that is
purchased by foreigners and exclude the portion of C, I and G that is expended on foreign goods and services.

Nominal GDP vs Real GDP

Nominal GDP tells about the current market value of final goods and services produced in an economy. Real GDP,
on the other hand, is a measure of total production at constant prices. Change in real GDP over the period is a
measure of growth.

Nominal GDP data series represents the combined effect of changes in quantities of goods and services and their
associated price changes,

but the real GDP keeps the prices constant and measure only changes in quantities of goods and services. Since
the real GDP removes the effect of price changes, it is a better measure of an economy’s growth rate.

Nominal GDP is sometimes referred to just as gross domestic product (GDP).

The following approximate relationship can be established between change in nominal GDP ($Y) and change in real
GDP (Y):

Change in Nominal GDP = Change in Average Prices+Change in Real GDP

The ratio of nominal GDP to real GDP is called GDP deflator which is a measure of price level:

GDP Deflator=Nominal GDP/ Real GDP

This relation is also useful is converting nominal GDP to real GDP:

Real GDP=Nominal GDP/ GDP Deflator

Following are the main differences between nominal GDP and real GDP:

 Nominal GDP is higher than real GDP when inflation is positive and lower than real GDP when there is
deflation i.e. when average prices fall.
 Nominal GDP includes the effect of both changes in prices and changes in total production while real
GDP accounts only for changes in quantities produced.
 Nominal GDP must be dissected to work out growth rate while real GDP values can be used directly to
calculate growth rate.
 Nominal GDP is lower GDP than real GDP in periods that fall before the base year and higher than real
GDP in periods that fall after the base year.

Inventory Investment

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The difference between goods produced (production) and goods sold (sales) in a given year is called inventory
investment. The concept can be applied to the economy as a whole or to an individual firm, however this concept is
generally applied in macroeconomics (economy as a whole).

Inventory investment, also referred to as change in private inventories (CIPI) by the BEA, is a component of gross
private investment of GDP that represents the difference between production and sales during the period.

Gross domestic product (GDP) tells us about the level of production in an economy. There are two popular
approaches to calculating GDP: the expenditure approach and the income approach. The expenditure approach works
out GDP as the sum of private consumption (C), private investment (I), government spending (G) and net exports (i.e.
exports (X) – imports (I)). On the hand, the income approach measures GDP as the sum of all factor incomes i.e.
wages, rents, interest and dividends.

When the expenditure approach is used, GDP is calculated using the following equation (called the national income
accounts identity):

GDP = C + I+ G+ X- M

GDP Deflator
GDP deflator (also called implicit price deflator for GDP) is a measure of price level of domestically-produced
goods and services in an economy. It is calculated by dividing nominal GDP by real GDP multiplied by 100.

Nominal GDP for period t is the value of all final goods and services produced in an economy determined at the
prices that prevail in period t. Real GDP for period t, on the other hand, is the value of total final production for
period t determined at the prices of the base year b. The base year is a pivot that is arbitrarily selected as a
common denominator. In the base year, nominal GDP and real GDP are equal and GDP deflator is equal to 1. In other
words, GDP deflator can also be defined as the ratio of GDP calculated at current year prices to GDP calculated at
base year prices.

GDP deflator is an index number, just like consumer price index, which means that its value changes with reference to
the base year. The farther it moves from the base year, the more pronounced is it difference from 1.

Formula
GDP deflator (Pt) is calculated by dividing nominal GDP by the real GDP:

Pt=Nominal GDP/ Real GDP

Difference between CPI and GDP Deflator

Consumer price index (CPI) and GDP deflator are both indicators of price level in an economy and they have a very
high correlation coefficient.

Despite these similarities, they differ in important ways:

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  CPI measures prices on a basket of goods consumed by urban consumers but GPD deflator measures
price level for the whole GDP i.e. for personal consumption, private investment and government spending,
etc.
 CPI includes effect of imported goods and services while GDP deflator only includes domestically
produced goods and services.
 In US, CPI is calculated using Laspeyres formula while GDP deflator is calculated using Fischer
formula.

Absolute Advantage
An entity has absolute advantage over another when it is more efficient than the other in the production of all
the goods or services which both produce. It means that the entity yielding absolute advantage has higher output
per unit of resource in all the products and services.

The principle of absolute advantage is applied to countries in the study of international trade, though it also relevant
to individuals and businesses.

Circular Flow Diagram

Circular flow diagram shows how income flows in an economy between households, firms and government in product
markets, factors of production markets and financial markets.

An economy is all about satisfying the coincidence of wants of different people. Because we aren’t self-sufficient, we
specialize in activities in which we are best at. We sell our goods and services at which we excel to others for money
which we use buy theirs in return. We pay taxes to government out of our income which it uses to provide us with
public goods and services, etc. The circular flow diagram lets us visualize all these transactions between different
market participants.

Factor Markets
Production by firms requires inputs i.e. factors of production, primarily labor and capital, which is provided by
households in the factor (of production) market. Labor is compensated through wages and capital is paid in the
form of interest (if it’s a debt capital) and profit/dividends (if it is equity capital). The factors of production market
involves flow of income/money from firms to households.

Goods and Services Market

The products and services produced using those inputs are bought by households in the market for goods and
services (also called products market). Firms supply goods and services which consumers pay for with the income
they earn in the factor market. The product market shows flow of income from households to firm.

Financial Market
The financial market is the market in which households invest their savings and firms raise money for their long-term
investments. The financial market has a very important supporting role for products market. Without mobilization of
private and public savings, firms may not be able to improve their productive capacity or improve productivity.

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The financial market involves transfer of money initially from households to firms which pay it back in the form of
interest and principal and dividends.

Comparative Advantage
An entity has comparative advantage in a product or service when it produces that product or service at a
lower opportunity cost than another entity. In means that the entity with a comparative advantage in Product A
has to forgo less of another product, say product B, to produce more of Product A.

The principle of comparative advantage is the basis on which international trade is encouraged. It proposes that
countries should specialize in producing products and services in which they have comparative advantage because
this will increase the total world production of all goods and services and increase the standard of life.

The concept of comparative advantage can also be applied to businesses and individuals.

Determinants of Economic Growth

Determinants of economic growth are inter-related factors that directly influence the rate of economic growth
i.e. increase in real GDP of an economy. There are six major determinants of growth. Four of these are typically
grouped under supply factors which include natural resources, human resources, capital goods and technology. The
other two are demand and efficiency factors.

Supply Factors
These factors affect the value of goods and services supplied in an economy.

Natural Resources
Natural resources include anything that exists in nature and which has exploitable economic value. Rate of economic
growth increases on increase in quantity and quality of natural resources. Examples of natural resources which can
have major effect on rate of economic growth include fossil fuels, valuable metals, oceans, and wild life.

Human Resources
Human resources include both skilled and unskilled workforce. Increase in the quantity and quality of the workforce
increases rate of economic growth. Here, increase in quality refers to improvement of skills the workers possess.
When more people work, more goods and services are produced and when more skilled workers do a job, they
produce high value goods and services.

Capital Goods
Capital goods are tangible assets such as plant and machinery that can carry out processes which result in the
production of other goods and services. Capital goods require big investments initially but they increase production
and growth rate in future periods.

Technology

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Technology includes methods and procedures used to produce various goods and services. New technology may be
invented or current technology may be improved gradually by investing in research. Better techniques once devised,
allow faster production and increase rate of economic growth.

Demand Factor
The increased supply of goods and services caused by the supply factors must be sustained by increased demand for
goods and services in the economy.

Efficiency Factor
Achieving high output to input ratio is the result of efficiency. Efficiency includes both productive and allocative
efficiency. High efficiency increases growth rate when it is coupled with full employment. To achieve maximum
growth rate, an economy must use its available resources in the least costly way to produce the optimum mix of
goods and services and it must use its resources to the maximum extent possible.

CHAPTER 10
Growth Accounting
Growth accounting is the process used to attribute economic growth to growth in labor, capital accumulation
and technological progress.

Growth Accounting Equation

For the High Garden, the following equation explains the increase in production (∆Y) from Period 1 to Period 2 as the
sum of (a) product of change in capital (∆K) and marginal product of capital, (b) product of change in labor (∆L)
and marginal product of labor and (c) change in total factor productivity (∆A).

Growth of GDP per Capita

Economic growth is generally defined as the percentage increase in real gross domestic product of an economy.
Growth rate of GDP per capita differs from growth rate (of GDP) because GDP per capita also depends on the growth
rate of population.

Capital-Labor Ratio
The expression ∆k/k in the growth accounting equation for GDP per capita represent the percentage increase in
capital to labor ratio. The capital to labor ratio is the ratio of capital to workers i.e. K/L. It shows the extent of capital-
intensiveness of an economy

GDP Growth Rate

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GDP growth rate or simply growth rate of an economy is the percentage by which the real GDP of an economy
increases in a period. If the growth rate of an economy is g, its output doubles in 70/g periods.

When an economy’s growth rate is positive, the economy’s output is increasing, and it is said to be in recovery
or in economic boom. But when the growth rate is negative, the economy is in a recession i.e. output is
contracting.

The growth rate of GDP differs from the growth rate of GDP per capita simply because GDP per capita also
depends on the population of the country which grows independently of the output. Growth rate of GDP per
capita is a better measure of improvement in standard of life of an average person in the economy.

You must be wondering why we use the rate of change in real GDP as a measure of an economy’s growth rate instead
of the rate of change of nominal GDP. It is because we are interested in finding out the increase in productive
capacity of the economy. It means that we need to exclude the increase in GDP solely due to increase in price
level.

The percentage change in nominal GDP broadly equals the growth rate (g) plus inflation rate (π).

Solow Growth Model

Solow growth model is a model that explains the relationship between economic growth and capital accumulation and
concludes that economies gravitate towards a steady state of capital and output in the long-run.

Solow growth model is a neoclassical model of growth theory developed by MIT economist Robert Solow. It implies
that it is possible for economies to grow in the short run by increasing capital per worker but not in the long
run because in the long-run the level of capital is restricted by the income level and savings rate. The model
shows that in the long run continuous technological progress is the only engine of growth because it increases total
income and eventually the capital and output level.

Steady State
Output per worker y grows less and less with increase in capital per worker k till it reaches a point when the
net change in capital approaches zero. Such a state of zero net change in capital and zero growth in output per
worker is called the steady state of capital. It is the level of capital per worker at which the economy has maximized its
output per worker.

Solow Diagram
If we plot data from the above table, we get a Solow diagram which is a plot with capital per worker on x-axis and
output, investment and depreciation on y-axis. It shows the diminishing return to capital and steady state of capital.

Rule of 70
Rule of 70 is a short-cut method of an economy’s growth accounting which tells us that if an economy’s annual
growth rate is g, its output/GDP will double in 70/g years.

CHAPTER 11

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Fiscal Policy
Fiscal policy is a form of economic policy that involves changing government spending and taxes in order to achieve
growth while keeping inflation in check. It is also termed as discretionary fiscal policy.

Together with monetary policy, fiscal policy tools are used to keep the economy steady and save it, as much as
possible, from ups and downs. While monetary policy is implemented by the central bank, fiscal policy is
implemented by the government. Since fiscal policy is based on legislation, it typically takes lot more time in
affecting the economy as compared to monetary policy.

If the economy is facing inflationary pressures, the government attempts to reduce inflation by either increasing
taxes or decreasing its expenditures or doing both.

When the economy is in facing recessionary pressures, the government provides stimulus to the economy by either
decreasing taxes or increasing its expenditures or taking both the steps simultaneously.

IS Curve
IS curve is a schedule/curve that shows the equilibrium output level that occurs in the market for goods and services
at different levels of interest. The IS curve is one part of the IS-LM model and it is plotted with interest on y-axis
and output on x-axis.

The equilibrium in the goods market depends on the interplay of aggregate demand (expenditure) and
income.

In a closed economy, aggregate demand is the sum of personal consumption expenditures (C), investment (I) and
government spending (G):

Consumption (C) depends on disposable income which equals autonomous spending (c 0), spending that occurs even
at zero income, plus the product of marginal propensity to consume (c) and disposable income. Disposable income
equals total income (Y) minus taxes (t). The consumption function can be written as follows:

Investment (I) depends on income level and interest rate. When the income level is high in the economy, firms
invest more in order to meet the increased demand and vice versa. Similarly, if the interest rate is low,
investing in new capital is cheaper and hence investment spending is higher.

Keynesian Cross
Equilibrium in the goods market occurs when expenditure equals production. It is graphically represented by the
Keynesian cross which is the graph of expenditure and output level.

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E1 is the initial equilibrium of the goods market. It is the point of intersection of the aggregate expenditure curve AD1
and the 45-degree line (which shows points where aggregate expenditure equals production) is the market-clearing
output level of goods.

Since the investment spending is a function of interest rate, the aggregate demand curve shifts when there is a
change in interest rate which in turn results in a change in total output corresponding to the new equilibrium E2.

The IS curve is a graph of different level of equilibrium aggregate expenditure at different interest rate levels. The IS
curve plots the equilibrium output at different interest levels.

The IS curve slopes downward. It is because when the interest rate is high, output is low because investment is low
and vice versa.

Together with LM curve, the IS curve completes the IS-LM model.

IS-LM Model
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IS-LM model is a macroeconomic model that links the output level of an economy in the short-run with interest rate
determined by the interplay of fiscal policy and monetary policy in the goods market and financial market.

IS-LM model combines the equilibrium in the goods market with equilibrium in the financial market to reach the
mutual equilibrium of both markets.

The IS part of the model which stands for ‘investment-saving’ relates to the relationship between demand for goods
and interest rate. The LM part of the model which stands for ‘liquidity-money’ represents the relationship between
output and interest rate.

IS-LM model applies to short-run because it assumes prices are sticky. It means that the IS-LM model assumes that
prices, wages and money supply are given and do not change. The model offers a very useful explanation of the
short-run fluctuations because stickiness of prices and wages is indeed the case in the short-run.

IS-LM model was initially developed in 1937 by John Hicks based on works of John Maynard Keynes. An extension
of the IS-LM model which integrates the net exports part of aggregate demand with domestic goods market and
financial market is called Mundell-Fleming Model or IS-LM-BoP model.

The IS curve slopes downward because an economy’s output is higher at lower interest rate and vice versa.

The LM curve slopes upwards because when output level is higher there is higher demand for money which causes
interest rates to be higher.

Fiscal Policy and Monetary Policy

Changes in fiscal policy such as changes in government spending and changes in taxes shift the IS curve by
changing the level of consumption, investment and government spending. If the changes are such that it increases
any component of the aggregate expenditure, the IS curve shifts outwards and vice versa.

Monetary policy changes such as purchase or sale of bonds by the central bank or changes in discount rate, etc. also
shift the LM curve. If there is a monetary expansion i.e. increase in money supply, the LM curve shifts outwards and
it increases output.

The new short-run equilibrium occurs at the point of intersection of the new IS and LM curves.

Marginal Propensity to Consume

Marginal propensity to consume (MPC) is the proportion of an individual’s additional income which he spends. It is the
ratio of change in consumption to change income. It can also be defined as the slope of the consumption function.

You either spend what you earn or save it. What you spend equals what you earn minus what you save. In taking
stock of what you consume, it is natural to work out the ratio of your consumption to income. This equals
your average propensity to consume. But economists are mostly interested in the marginal analysis i.e. change in your
consumption when there is a change in your income. In other words, they want to know if there is any increase in

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your income how much of it will you spend and how much will you consume. This is estimated by calculating the ratio
of increase in consumption to increase in income which equals your marginal propensity to consume.

Why is MPC important?

Marginal propensity to consume (MPC) is an important number in economist because it tells us about the strength of
the multiplier effect. Since what you spend becomes some else’s income, if the marginal propensity to consume is
high, any fiscal stimulus i.e. increase in government expenditure or decrease in taxes will have a more pronounced
effect of total income.

Automatic Stabilizers
Automatic stabilizers are economic phenomena which moderate the effect of economic expansions and slow
downs. In periods of economic booms, such factors restrict the growth and in periods of slowdown they partially
mitigate the drop in aggregate output.

In economics, the most basic measure of an economy’s income level is the gross domestic product (GDP). GDP
comprises of private consumption, business investments, government expenditures and net exports (i.e. exports
minus imports). The real GDP changes over time due to a range of factors which are hard to predict and prevent. The
cycle of economic booms followed by slowdowns is called a business cycle and it involves distinct phases: expansion,
peak, recession, trough and recovery. In economic booms, at least one of the components of productions increase
and in periods of economic recession, at least one decreases. Automatic stabilizers are such factors which either
reduce the net increase or decrease in a single GDP component or offset a change in one component with an
opposite change in another component.

As the name suggests, an automatic stabilizer comes into play on its own and no action by any policymakers is
needed to activate an automatic stabilizer. This makes it extremely effective in moderating the impact of economic
swings because there is no implementation lag.

Taxes
Personal and business taxes are typically progressive in nature i.e. the rate of tax increases as the income level
increases. This feature of the tax system comes handy when there is an economic expansion or recession. In an
economic expansion, the tax rate increases due to increase in overall income level which in turn reduces the
disposable income. A drop in disposable income reduces the multiplying effect of consumption and business
spending. The opposite occurs in an economic recession. When the income level drops, tax obligations drop by a
greater degree such that the net drop in income is lower.

Transfer payments
Transfer payments i.e. social security expenses such as unemployment insurance or any other such benefits which are
payable to unemployed people comes into play in economic recessions. When there is an economic slowdown,
companies lay off people thereby reducing the overall employment level. High unemployment rate means more
and more people are eligible for government’s social security benefits which in turn increases the government
expenditure component of the GDP and partially reduces the magnitude of decline in GDP due to slowdown.

Tax Multiplier
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

66
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.

Flat Tax
A flat tax (also called proportional tax) is a tax structure in which the tax rate stays constant regardless of the level
of income. It means the rich and the poor pay the same or nearly same proportion of their total income as taxes.

Under a flat tax regime, the rich tax payers pay a higher amount of tax. However, as he moves up the tax slab
structure, the tax rate applicable neither increases nor decreases. Such a tax structure results in constant
effective tax rate.

A flat tax regime needs simple legislation; is more efficient because less resources are expended in assessing tax
payable; and relatively more equitable than regressive tax regime. However, it does not help raise as much revenue as
a progressive tax regime.

A flat tax is either (a) true flat tax or (b) marginal flat tax. In a true flat tax, no deductions are allowed; while in
marginal flat tax, some deductions are allowed such as on account of charitable donations, etc. A marginal flat tax
is progressive at lower level of income and turns flat as income increases.(MCQ)

Regressive Tax
A regressive tax is a tax structure in which the effective tax rate decreases as the total income of the tax payer
increases. The rich might pay a higher amount of tax, they pay less relative to their total income.

Regressive taxes are criticized because they do not follow the ability to pay principle and potentially result in
increased income disparity. However, regressive taxes such as sales tax, result in consistent revenue for
governments.(MCQ)

Regressive taxes are different than flat (or proportional taxes) and progressive taxes.

Progressive Tax
A progressive tax regime is a tax structure in which the tax rate increases with an increase in taxable income. It means
that the tax rate applied to a higher slab of income is higher than the tax rate applied to a lower slab of income.

Many countries have progressive tax regimes because it generates highest revenues for the government. Proponents
of progressive tax claim that it results in the highest transfer of wealth from the rich to the poor.

Progressive tax regime is different from flat (or proportional) tax regime and regressive tax regime.

Spending Multiplier
Spending multiplier (also known as fiscal multiplier or simply the multiplier) represents the multiple by
which GDP increases or decreases in response to an increase and decrease in government

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expenditures and investment. It is the reciprocal of the marginal propensity to save (MPS). Higher
the MPS, lower the multiplier, and lower the MPS, higher the multiplier.(MCQ)

Tax Incidence
Tax incidence is the degree to which a given tax is paid or borne by a particular economic unit such as consumers,
producers, employers, employees etc. When we say that the tax incidence of a given tax falls on A, it means A
ultimately pays or bears the burden of tax in greater proportion.

Tax incidence is of two types: statutory incidence and economic incidence.

Statutory incidence or nominal incidence of a given tax is the degree to which the tax is actually paid by an
economic unit in the form of cash, check etc. (Tax may be collected and deposited in government's treasury by
someone else). Statutory incidence is stated in tax law. For example, at the time or writing, US tax laws require
that tax on salary income of an employee must be borne 50% by employer and 50% by employee. In this case,
statutory incidence of tax equally falls on employer and employee. (MCQ)

Economic incidence of a given tax is the degree to which the burden of the tax is borne by an economic unit in
the form of reduced resources. Economic incidence of a tax does not necessarily fall on the same economic unit on
which its statutory incidence falls. Rather it depends on the elasticity of demand and supply. When demand is
inelastic and supply elastic, tax burden is mainly on the consumer; in case of inelastic supply and elastic demand, tax
incidence falls mainly on producer. When both demand and supply are moderately elastic the tax incidence is
distributed between producers and consumers.(MCQ)

Average Propensity to Consume

Average propensity to consume (APC) is the percentage of total disposable income which households
spend on goods and services. It is the ratio of total consumption to total disposable income.

Economists are interested in estimating the average propensity to consume because it tells them what
proportion of their income households consume and how much they save. Since consumption rate
determines the personal consumption expenditure component of the GDP and savings rate is the driver of
private investments and eventually future growth in consumption, finding out where current income is
utilized is important.

How APC differs from MPC?

Average propensity to consume differs from marginal propensity to consume in that the marginal
propensity to consume represents the change in total consumption in response to change in total income
while the average propensity to consume shows the cumulative measure of the relationship between
consumption and income. MPC is the slope of the consumption function while APC is the slope of the
straight-line connecting origin to the point on consumption function on which the APC is
calculated.

Ability-to-Pay Principle
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Ability-to-Pay principle is principle of taxation which asserts that the amount of tax levied on an economic entity
should be directly proportional to the ability of the entity to pay taxes. Therefore, a person having high income and
wealth should be taxed more and less tax should be levied on those having low income and wealth provided other
things remain constant.

Budget Deficit
Budget deficit is the amount by which a government's expenditures such as defense, social security, science, energy
and expenditure on infrastructure, etc. exceed its total income which comes principally from taxes, duties, etc.

Budget deficit is an important phenomena in fiscal policy. When an economy is in recession, the government usually
runs a budget deficit in order to boost the economy. Budget surplus is a situation opposite to a budget deficit i.e. in a
budget surplus, a government's income exceeds its total expenditures. We normally see budget surpluses when
economy is suffering from excessive inflation.

Budget Deficit = Government's Total Expenditures − Government's Total Income

Benefits-Received Principle
A principle of taxation which states that the burden of tax on an economic entity should be directly
proportional to amount of benefits it receives from the use of public goods or services provided by
government. In other words, consumers and businesses should pay to the government, the value of the public goods
and services they have benefited from as if they were buying those goods and services. This means, for example, that
people who travel by road more should pay more of the taxes used to construct and repair those roads and those
who use roads less should pay small portion of the taxes to be spent on the roads.

Expansionary Fiscal Policy

Expansionary fiscal policy is a form of fiscal policy that involves decreasing taxes, increasing government
expenditures or both, in order to fight recessionary pressures.(MCQ)

A decrease in taxes means that households have more disposal income to spend. Higher disposal income increases
consumption which increases the gross domestic product (GDP). Further, a decrease in taxes communicates to the
businesses that the government is interested in reviving the economy. It increases their confidence which in turn
increases the private investment component of GDP.

Since government expenditures form a component of GDP, an increase in government expenditures increases
GDP directly. Further, such an increase also results in indirect increase in consumption and other components of
GDP.

The bottom line is that increase in GDP resulting from a decrease in taxes and increase in government expenditures is
much more than the initial decrease in taxes or increase in government expenditures due to the multiplier effect.

Multiplier Effect
Multiplier effect is a macro-economic phenomenon in which an initial change in spending results in a greater
ultimate change in real GDP. The initial change is usually a change in investment but other components of GDP

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such as government spending, net exports and a change in consumption which is not caused by change in income
can also have multiplier effect on the GDP.

Contractionary Fiscal Policy

Contractionary fiscal policy is a form of fiscal policy that involves increasing taxes, decreasing government
expenditures or both in order to fight inflationary pressures.(MCQ)

Due to an increase in taxes, households have less disposal income to spend. Lower disposal income decreases
consumption. An increase in taxes also reduces profits available to businesses and they cut down their investment
expenditures. Consumption and private investment are part of the Gross Domestic Product (GDP), which falls as a
result. However, this fall is magnified by the multiplier effect.

A decrease in government expenditures decreases GDP directly because government expenditures is a part of
GDP (i.e. GDP = consumption + private investment + government expenditures + net exports). But, such a decrease is
worsened as a result of indirect decrease in consumption and other components of GDP.

Budget Surplus
Budget surplus is the amount by which a government's income which primarily comes from taxes and duties exceeds
its total expenditures such as defense, social security, science, energy and expenditure on infrastructure, etc.

Budget surplus is a phenomena that is opposite of budget deficit. It is an important tool of fiscal policy. A
government runs a budget surplus when the economy is under inflationary pressure. A budget surplus means either
an increase in government income through increase in taxes or decrease in government expenditures or both.
This decreases aggregate demand, brings down price level and cools off the economy.

Formula
Budget Surplus = Government's Total Income − Government's Total Expenditures

Balanced Budget
Balanced budget is a rare situation when a government's income which primarily comes from taxes and duties, etc.,
equals its total expenditures, such as defense, social security, science, energy and expenditure on infrastructure, etc.

Balanced budget is a situation which is in-between budget deficit and budget surplus. Budget deficit is when a
government's expenditures exceeds its total income while budget surplus is a situation when a government's total
income exceeds its total expenditures.

A government runs a balanced budget when it does not want to mess with the economy. While a budget deficit
expands an economy and a budget surplus contracts it, a balanced budget on the other hand leaves the
economy alone. Balanced budget means nuetral fiscal policy.(MCQ)

Government's Expenditures − Government's Income = 0

CHAPTER 12
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Monetary Policy
Monetary policy is a form of economic policy that involves changing money supply in order to change cost of
borrowing which in turn changes inflation rate, growth rate and unemployment rate. Together with fiscal policy,
monetary policy is used to save the economy from severe ups and downs.

Monetary policy is implemented by the central banks (in US, the Federal Reserve). It is relatively more responsive
than the fiscal policy because central banks can react to economic changes more quickly than the government and
the legislature.

When the economy is under recessionary pressures, the central bank increases the money supply which in turn
decreases the cost of borrowing. Low cost of borrowing stimulates consumption and investment which increases GDP.
Higher investment by businesses reduces unemployment rate and all this helps the economy move out of recession.
On the other hand, when the economy is under inflationary pressures, the central bank decreases money supply
which increases cost of borrowing. Higher cost of borrowing dampens consumption and investment which reduces
inflation.

Most common tools used by central banks in implementing the monetary policy include:

 Changing discount rate: discount rate is decreased to fight recessionary pressures and increased to
fight inflationary pressures.
 Carrying out open market operations: government securities are bought to fight recession and sold to
fight inflation.
 Changing the required reserve ratio: the reserve ratio is decreased to fight recession and increased to fight
inflation.

Central banks widely use the Taylor's rule to set a target interest rate.

Liquidity Trap
Liquidity trap (also called zero lower bound) is a situation in which nominal interest rates is already close to
zero and any further increase in money supply does not have any expansionary effect.(MCQ)

Liquidity trap limits the monetary expansion and reduces the effectiveness of monetary policy in combating
recessions. It is called liquidity trap because any increase in money supply does not result in any decrease in the
interest rate and the economy is trapped in liquidity (i.e. excess money). It is called zero lower bound because the
zero nominal interest rate acts as a floor on the interest rate. The nominal interest rate can’t be negative.

In response to a recession, central banks (such as US Federal Reserve) decreases the nominal interest rate. It does so
by carrying open market operations in which its traders buy treasury bonds from banks. The purchase of bonds
involves transfer of money to banks which increase their reserves and increases money supply. This process works
effectively when the nominal interest rates are sufficiently high. But as soon as the interest rates gets close to zero,
any further increase in money supply does not result in any associated decrease in interest rates. Since interest rates
are stuck at the lower bound, expansionary monetary policy doesn’t work.

Overcoming Liquidity Trap

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The key to overcoming the liquidity trap is to create inflationary expectations so that the nominal interest rates rise.
This can be achieved through expansionary fiscal policy and unconventional monetary policy. In an expansionary fiscal
policy, governments either increase their spending or decrease taxes or both in order to increase aggregate demand
which induces an increase in consumption and investment.

Unconventional monetary policy advocates using forward guidance and quantitative easing. Forward guidance is
when the central banks commit to keeping the interest rates low well into future. Promise of sustained lower interest
rate gives business more confidence in undertaking new investments which stimulates consumption. Quantitative
easing occurs when central banks purchase long-term bonds in an attempt to reduce the long-term interest rates.
Both these tools show that monetary policy is not entirely useless in fighting liquidity trap.

Money Supply and Monetary Base

Money supply is the quantity of money available in an economy for immediate use. It equals the currency held by
public plus demand deposits at banks and monetary base is the sum of total currency in circulation and the amount
held by banks as reserves.

The difference between money supply and monetary base arises because a $1 injected into the economy by the
central bank results in a much larger increase in overall money through the process of credit creation.

Money Multiplier
You can see that the increase in money supply M (i.e. C + D) is far larger than monetary base B (i.e. C + R).

The ratio of money supply to monetary base is called the money multiplier.

LM Curve
LM curve is a graph that plots equilibrium output dictated by the financial market at different interest levels. It slopes
upward because high output/GDP is associated with high interest rate due to high demand for money and vice versa.

IS curve and LM curve are the two components of IS-LM model, a model of combined equilibrium in the goods
market and the financial market.

LM curve is derived from a schedule of equilibrium output/GDP that correspond to different interest levels. It
represents the snapshot of the financial market i.e. the prevailing interest rate at different output levels.

LM Curve & Monetary Policy

The LM curve shifts when there is a change in monetary policy. Central banks, such as US Federal Reserve Bank,
change money supply mainly through open market operations, changes in reserve ratio, discount rate, etc. In reality,
central banks actually attempt to take the financial market to a specific equilibrium interest rate.

A monetary expansion is when a central bank purchases bonds from banks, decreases reserve ratio, etc. When money
supply curve shifts outward, market interest rate falls and the LM curve shifts outward. It is because due to
higher supply of money, a higher output is possible at the same interest rate. The opposite occurs in a monetary
contraction.

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Similarly, fiscal policy changes such as changes in government spending and taxes shift the IS curve. The interplay of
the shifts in IS and LM curves explain the short-run economic fluctuations.

Quantity Theory of Money

The quantity theory of money states that the price level that prevails in an economy is the direct consequence of
the money supply. If the velocity of money is constant, any increase in money supply causes a proportionate
increase in price level.

The quantity theory of money is the classical interpretation of what causes inflation. It states that if the number of
times a dollar is used for a transaction, i.e. the money’s velocity is constant, any increase in quantity of money
changes only prices and not the real output.

Velocity of Money
The quantity theory of money assumes that the circulation of money in an economy is constant. The circulation of
money in measured by its velocity. Velocity of money is the average turnover of a dollar i.e. it is the number of times
a dollar is used in a transaction over a period of time.

The quantity theory of money can be defined using the definition of velocity i.e. velocity must equal the value of
economy’s output measured in today’s dollars divided by number of dollars in the economy:

Expansionary Monetary Policy

Expansionary monetary policy is a form of economic policy that involves increasing the money supply so as to
decrease the cost of borrowing which in turn increases growth rate and reduces unemployment rate. Expansionary
monetary policy is used to fight off recessionary pressures.

Expansionary monetary policy is implemented by the central banks (in US, the Fed). When the economy is in
recession, the central bank increases the money supply by a combination of decrease in discount rate,
purchase of government bonds and reduction in the required reserve ratio. The increase in money supply
relative to demand decreases the cost of borrowing and increases consumption and investment which in turn
increases GDP.

Contractionary Monetary Policy

Contractionary monetary policy is a form of economic policy used to fight inflation which involves decreasing the
money supply in order to increase the cost of borrowing which in turn decreases GDP and dampens inflation.

When the economy is under inflationary pressures, the central bank (in US, the Federal Reserve) decreases the money
supply by either increase in the discount rate or sale of government bonds or increase in the required reserve ratio or
by carrying out all the changes simultaneously.

Contractionary monetary policy has some side effects too. It results in an increase in the unemployment rate and a
decrease in the growth rate of the GDP

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Fisher Effect
Fisher effect is the concept that the real interest rate equals nominal interest rate minus expected inflation rate.
It is based on the premise that the real interest rate in an economy is constant and any changes in nominal
interest rates stem from changes in expected inflation rate.

The assumption that the real interest rate in an economy should stay constant in the long-run is based on the notion
that changes in money supply affects only nominal values such as prices, exchange rates and have no bearing on real
indicators such as employment, real GDP, etc.

Money Multiplier
Money multiplier (also known as monetary multiplier) represents the maximum extent to which the money supply is
affected by any change in the amount of deposits. It equals ratio of increase or decrease in money supply to the
corresponding increase and decrease in deposits.

Money multiplier effect

The money multiplier effect arises due to the phenomenon of credit creation. When a commercial bank receives an
amount A, its total reserves are increased. The bank is required by the central bank to hold only an amount equal to r
× A in hand to meet the demand for withdrawals, where r is the required reserve ratio. The bank is allowed to extend
the excess reserves i.e. (A − r × A) as loans. When the borrower keeps the whole amount of loan in bank (it is
assumed), it increases its total reserves by an amount equal to (A − r × A). Again, the bank is required to hold only a
fraction of this second round of deposits and it can lend out the rest. This cycle continues such the ultimate increase
in money supply due to an initial increase in checking deposits of amount A is equal to m × A, where m is the money
multiplier. The opposite happens in case of a decrease in deposits through the same mechanism.

Formula
1
Money Multiplier
=
Required Reserve Ratio

Required reserve ratio is the fraction of deposits which a bank is required to hold in hand. It can lend out an amount
equals to excess reserves which equals (1 − required reserves).

Higher the required reserve ratio, lesser the excess reserves, lesser the banks can lend as loans, and lower the money
multiplier. Lower the required reserve ratio, higher the excess reserves, more the banks can lend, and higher is the
money multiplier.

In the above relationship it is assumed that there is no currency drainage, i.e. the borrowers keep 100% of the amount
received in banks.

Currency drainage
In reality, borrowers do keep a fraction of loans received in cash. This reduces the money multiplier. When there is
some currency drainage, money multiplier is calculated as per following formula:

Money multiplier when there is currency drainage= 1 + drainage ratio

required reserve ratio + drainage ratio

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Open Market Operation
Open market operation is a monetary policy tool used by central banks to increase or decrease money supply by
buying and selling government bonds in the open market.

When a central bank (in US the Federal Reserve) is interested in providing stimulus to the economy by increasing the
money supply, it purchases government bonds from commercial banks and the public. In consideration for the bonds,
the central bank pays the bondholders who keep the money in banks thereby increasing the commercial banks'
excess reserves. Higher excess reserves means commercial banks can lend more money leading to increase in money
supply and decrease in interest rates.

When the central bank is interested in controlling inflation, it sells government bonds to commercial banks and the
public. Banks and the public pay the central bank in return of the bonds and this reduces excess reserves which in turn
reduces the banks' ability to lend money, thereby decreasing money supply and increasing interest rates.

The volume of central bank sale and purchase of government bonds depends on the target federal funds rate. The
higher the change needed in federal funds rate, the bigger the sale or purchase. There are circumstance when sale
and purchase of government bonds is not enough to move the economy to its target state. In such situations central
banks engage in quantitative easing which involves sale and purchase of other financial assets (in addition to
government bonds).

Bank Reserves
Bank reserves is the amount of cash which a bank has not yet advanced as loans or invested elsewhere. It equals the
cash physically available with the bank plus the amount it has deposited with the central bank.

The amount of bank reserves relative to total deposits is a measure used to assess a bank's risk. The higher the bank
reserves are, the less risk-taking a bank is and vice versa. Central banks (such as the Federal Reserve or the Fed in the
US) requires banks to maintain a certain percentage of their total bank deposits as required reserves. The amount by
which bank reserves exceeds required reserves is called excess reserves.

Bank Reserves = Bank's Deposit at Central Bank + Vault Cash

Bank Reserves = Required Reserves + Excess Reserves

Taylor’s Rule
Taylor’s rule is a tool used by central banks to estimate the target short-term interest rate when expected inflation
rate differs from target inflation rate and expected growth rate of GDP differs from long-term growth rate of GDP. The
central banks attempt to achieve the new target rate by using the tools of monetary policy, mainly the open market
operations.

Taylor’s rule was developed by economist John Taylor. Studies have shown that actions of the Federal Reserve and
other central banks in developed countries can be predicted by the rule.

In accordance with the rule, the central banks are expected to increase short-term interest rates when
expected inflation rate is higher than target inflation rate, expected GDP growth rate is higher than long-

75
term GDP growth rate or both. Similarly, short-term interest rates are decreased when expected inflation rate is below
target, expected GDP growth rate is below long-term trend or both.

Target rate is the short-term interest rate which the central bank should target;
Neutral rate is the short-term interest rate that prevails when the difference between the actual rate of inflation and
target rate of inflation and difference between expected GDP growth rate and long-term growth rate in GDP are both
zero;

CHAPTER 13
Inflation Rate
Inflation rate is the percentage increase in general level of prices over a period. It represents the rate at which the
purchasing power of money has eroded over a period.

Central banks and governments keep track of inflation rate and change monetary and fiscal policies accordingly.
Together with unemployment rate, interest rate and growth rate, inflation rate communicates a lot about health of an
economy.

Inflation Rate Current Period CPI − Prior Period CPI

= Prior Period CPI

Limitations of CPI
Even though the consumer price index is the most common measure of inflation, it is generally believed that CPI
overstated inflation by roughly 1 percentage point. This upward bias exists because:

 CPI doesn't incorporate the substitution effect into composition of the basket of goods. For example,
when price of a good increases, consumer substitute away from it but the CPI doesn't include any
mechanism to specifically reflect this.
 Even though the BLS attempts to address changes in quality, some quality changes such as improvement in
safety, etc. are not quantifiable. Hence, CPI doesn't take into consideration such quality changes.
 Although new products generally have better quality, these goods are not included in the CPI basket
of goods immediately but are included only when they are consumed by people fairly consistently. Another
measure of inflation, the GDP deflator includes the effect of price changes of all person consumption
expenditures (excluding imports).
 Many components of CPI such as food and energy are highly volatile which makes CPI a not so good
measure of long-term inflation. Core inflation addresses this problem by considering only non-volatile
items.

Core Inflation
Core inflation is a measure of changes in prices of goods and services that offer a long-run view of purchasing power
by excluding volatile commodities such as food and energy items.

The inflation measure for the whole basket of goods and services that form part of the consumer price
index is called the headline inflation. While the headline inflation gives us a complete picture of price level, it

76
is prone to short-run price shocks. Prices of food and energy items are relatively more volatile because (a)
their supplies are subject to weather (in case of food) and politics (in case of energy), and they have a
low elasticity of demand and very steep demand curve. This is what makes core inflation more useful when we
are interested in finding out the overall trend of prices.

There are two measures of core inflation: core CPI inflation and core personal consumption expenditures (PCE)
inflation.

Core CPI Inflation

Consumer price index (CPI) is the most widely used measure of inflation for consumers. It is calculated using prices of
a fixed basket of goods and services which a typical urban consumer buy. CPI employs the Laspeyres formula in
aggregating different goods and services which means that the weights of different items in the basket are not
revised each year. Core CPI inflation is calculated using price and weights data for items other than food and energy.

Even though CPI is a very popular measure, it tends to overstate inflation. Even core inflation measure calculated
based on CPI has an upward bias. It is because it doesn’t factor in the substitution effect i.e. it doesn’t reduce the
weight of goods and services whose prices rise and eventually their quantities fall. This is where the personal
consumption expenditure (PCE) deflator is more useful.

Core PCE Index Inflation

The PCE deflator index is calculated by dividing the nominal personal consumption expenditure (PCE) component of
GDP by the real PCE multiplied by 100. Core PCE deflator equals nominal personal consumption expenditure minus
nominal food and energy expenditures divided by real PCE multiplied by 100.

The inflation measure that uses personal consumption expenditure (PCE) deflation is the preferred measure of price
level because it (a) allows for substitution of goods and (b) provides a broader basket of goods and services than CPI.

Phillips Curve
Phillips curve refers to the trade-off between inflation and unemployment. It shows that in the short-run, low
unemployment rate results in high inflation and vice versa.(MCQ)

The inverse relationship between inflation rate and unemployment rate is named after AWH Phillips, a New Zealand-
born economist who initially discovered that there is a negative relationship between unemployment rate and
changes in nominal wages in the UK. Soon other economists observed that this relationship holds between
unemployment and the general price level.

The original Phillips curve is plotted with inflation rate on the y-axis and unemployment rate on the x-axis as shown in
the graph below. It clearly shows that unemployment rate tends to increase when the inflation rate is low.

The graph below shows the relationship between inflation and unemployment in US since 1970s. It doesn’t look like a
curve, which shows that in the long-run there is no trade-off between inflation and unemployment.

Modified Phillips Curve

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In order to address this weakness of the original Phillips curve, economists have come up with the modified Phillips
curve, which plots relationship between changes in inflation rate and unemployment rate.

The modified Phillips curve is more likely candidate of a plausible relationship. It is based on the concept that actual
inflation rate depends on what people expect inflation rate to be in future adjusted for the effect of any cyclical
unemployment or supply shocks.

Producer Price Index

Producer price index (PPI) is a measure of average prices received by producers of domestically produced goods and
services. It is calculated by dividing the current prices received by the sellers of a representative basket of goods by
their prices in some base year multiplied by 100.

PPI vs CPI
Producer Price Index summarizes price level from the perspective of sellers while the Consumer Price Index
(CPI) summarizes prices from the perspective of buyers. PPI is considered a good economic indicator because it
provides early information about consumer demand and consumption. This is because prices received by producers
are an indication of the demand that exist at retail level.

Despite the PPI’s ability to foretell the consumer demand and spending level, there are reasons that may cause PPI
and CPI to diverge. First, PPI excludes imports while CPI includes imports. Further, PPI includes prices
regardless whether they are paid for the consumers or not while CPI includes only such prices which are paid
by the consumer directly.

Cost-Push Inflation
Cost-push inflation is a form of inflation which arises from increase in the cost of production or decrease in the
volume of production. In cost-push inflation, the aggregate supply curve shifts leftwards thereby pushing the
prices up, and hence, the cost-push.(MCQ)

Cost-push inflation most commonly arises due to supply shocks. For example, an increase in the price of oil increases
the cost of production for almost all goods and services and results in immediate increase in inflation. Such an
inflation is cost-push inflation. Similarly labor strikes, wars, floods, etc. reduce supply and increase prices.

Cost-push inflation is different from demand-pull inflation which arises due to increase in demand for goods and
services.

Demand-Pull Inflation
Demand-pull inflation is a form of inflation that arises when the demand for goods and services is greater than their
supply.

Demand depends on households' income, level of private investments and government expenditures. Supply of
goods and services, on the other hand, depends on the economy's production capacity, which is limited at least in the
short-run. Demand-pull inflation occurs when the excess money available with consumers increases demand beyond

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the maximum capacity of the producers. Expansionary monetary policy is the main reason for demand-pull
inflation.

CHAPTER 14
Structural Unemployment
Structural unemployment is the unemployment that exists when wages do not adjust to equilibrium such that the
number of job-seekers exceed the number of available jobs even in an economic boom.

Structural unemployment results from inability of labor market to arrive at the market-clearing wage at which the
number of workers are just equal to the number of jobs. Major factors that cause wages to stay above the equilibrium
level include (a) minimum wage, (b) collective bargaining, (c) efficiency wages, etc.

Let’s evaluate what causes the structural unemployment using the demand and supply analysis.

As shown in the graph below, the labor demand curve slopes downward. It means that as the wages fall, firms are
willing to hire more workers and vice versa. It is due to diminishing marginal product of labor. As we add more and
more workers while keeping capital constant, they are increasing less and less productive. The labor supply curve is
upward sloping. It means that more workers are willing to work at higher wages.

The interplay of demand and supply determines the wage that prevails in the market and the number of people hired.
If at a certain wage level, the number of workers needed by firms is higher than the number of workers willing to
work, the market wage will rise resulting in an increase in number of workers willing to work and a decrease in the
number of workers firms are willing to hire. If at a certain wage level, the number of workers willing to work exceed
the number of workers needed, market wage will fall coupled causing a decrease in number of job-seekers and an
increase in number of jobs available. But there are factors that do not let this automatic adjustment to work.

Causes of structural unemployment

Minimum wage
A minimum wage is a price floor created by governments. It is the wage below which no employer is allowed to hire
workers. Since the equilibrium wage for many skilled workers is above the minimum wage, it affects employment of
only the least-skilled workers.

Collective bargaining
Collective bargaining is when workers form a union and negotiate collectively. Since the negotiating power of a union
is higher than that of an individual worker, they tend to succeed in securing above-market benefits for their members
and this restricts the number of jobs and hence causes structural unemployment.

Efficiency wages
Efficiency wages refer to wages paid by employers to their workers which exceed the market clearing wage in an
attempt to retain the best talent and to provide them with incentive to perform better.

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Cyclical Unemployment
Cyclical unemployment refers to the increase in total unemployment that occurs when an economy is in recession. It
is represented by difference between the unemployment rate and the natural rate of unemployment.

Unemployment rate is never zero, not even at the peak of economic booms. It is because some sources of
unemployment such as the mismatch between available jobs and workers, exist during all phases of business cycle.
The actual unemployment rate (ua) fluctuates around the natural rate i.e. it increases when the economy enters
recession and decreases when it makes a recovery.

Actual rate of unemployment (ua) can be defined as the sum of natural rate of unemployment (un) and the rate of
cyclical unemployment (uc):

u a = un + uc

Natural Rate of Unemployment

Natural rate of unemployment is the long-run unemployment rate around which the actual employment rate
oscillates. It is the combined effect of frictional unemployment and structural unemployment.

Unemployment rate increases during recessions and decreases during expansions but is never zero. It is because
some level of frictional unemployment and structural unemployment exists during all stages of a business cycle.
Frictional unemployment arises due to the time it takes in matching workers to jobs and the structural unemployment
is the unemployment that exists due to factors such as minimum wage, unionization and efficiency wages which keep
the market from reaching equilibrium.

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Natural rate of unemployment (un) equals the sum of rate of frictional unemployment (uf) and rate
of structural unemployment (us):

Cyclical unemployment is positive and actual unemployment is higher than the natural unemployment rate
during recessions. On the other hand, during economic booms the cyclical unemployment rate is negative and
actual unemployment rate is lower than the natural rate of unemployment as shown the graph below:

Changes in Natural Rate of Unemployment

It is true that the natural rate of unemployment is the long-run measure of unemployment, it doesn’t mean that is a
constant. Natural rate of unemployment changes in response to changes in factors that affect frictional
unemployment and structural unemployment, such as demographic changes, minimum wage, unionization, efficiency
wages, etc.

Demographic Changes
Since frictional unemployment depends on the age and experience level of workers, a change in overall composition
of work force changes its frictional unemployment rate and hence its natural rate of unemployment. An economy will
high proportion of young worker will tend to have higher natural unemployment rate. It is because younger workers
are more likely to switch jobs or being laid-off.

Government Policies such as Minimum Wage

A minimum wage tends to increase natural rate of unemployment because it creates a price floor in the labor market
which stops the market from reaching market-clearing wage level. This causes firms to hire less workers and results in
an increase in structural unemployment which in turn increases natural rate of unemployment.

Some government policies such as job training, etc. tend to reduce natural rate of unemployment because they
reduce frictional and structural unemployment by allowing workers to obtain skills that are in demand and increasing
their productivity which makes it attractive for firms to hire them at the high minimum wage.

Unionization
Collective bargaining tends to increase natural rate of unemployment. It is because unionized work force can succeed
in locking-in above-equilibrium wages and other benefits. This reduces the number of workers hired by firms. Such a
below-equilibrium availability of jobs causes structural unemployment which is a component of natural
unemployment.

Frictional Unemployment
Frictional unemployment is the unemployment that results from the time it takes workers in finding jobs. The
level of frictional unemployment depends on the rate of job separations and the average time of job finding.

Since labor is not a commodity i.e. their skills and interests vary, and different jobs require different skills, it is natural
that it takes employees some time in finding a job that matches their qualifications, experience and career aspirations.

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The rate of frictional unemployment is the proportion of unemployed people who are unemployed because they are
searching for jobs.

Frictional unemployment structural unemployment both determine the natural rate of unemployment, the long-run
unemployment rate around which the actual unemployment rate moves.

Labor Force Participation Rate

Labor force participation rate is the percentage of working age population that is part of the labor force. It is a
measure of what proportion of a country's population is employed or actively looking for employment. Higher the
labor force participation rate, more of the country's population is interested in working.

Formula
Unemployed
Unemployment Rate = Employed +
Unemployed

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