Economics for 2nd PUC
By Professor Vipin
This module is designed from the exam point of view. The quality of the content in this is the BEST you will
come across.
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1 Introduction to Microeconomics
Introduction
Economics is the social science that describes the factors that determine the production, distribution and
consumption of goods and services.
Scottish philosopher Adam Smith (1776) defined what was then called political economy as "an inquiry
into the nature and causes of the wealth of nations", in particular as:
‘A branch of the science of a statesman or legislator [with the twofold objectives of providing] a plentiful
revenue or subsistence for the people ... [and] to supply the state or commonwealt h with a revenue for the
public services.’
Economy
An economy is a system which tries to balance the available resources of a country (land, labor, capital and
enterprise) against the wants and needs of consumers. The basic functions of an economy are
production, consumption, distribution and exchange.
Basic Problems of an Economy
The problem of scarcity of resources which arises before an individual consumer also arises collectively
before an economy. On account of this problem and economy has to choose between the following:
1. Which goods should be produced and in how much quantity?
2. What technique should be adopted for production?
3. For whom goods should be produced?
These three problems are known as the central problems or the basic problems of an economy. This is so
because all other economic problems cluster around these problems. These problems arise in all
economics whether it is a socialist economy like that of North Korea or a capitalist economy like that of
America or a mixed economy like that of India. Similarly, they arise in developed and under- developed
economics alike.
What to produce?
There are two aspects of this problem— firstly, which goods should be produced, and secondly, what
should be the quantities of the goods that are to be produced. The first problem relates to the goods
which are to be produced. In other words, what goods should be produced? An economy wants many
things but all these cannot be produced with the available resources.
Therefore, an economy has to choose what goods should be produced and what goods should not be. In
other words, whether consumer goods should be produced or producer goods or whether general goods
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should be produced or capital goods or whether civil goods should be produced or defense goods? The
second problem is what should be the quantities of the goods that are to be produced.
Production of goods depends upon the use of resources. Hence, this problem is the problem of allocation
of resources. If we allocate more resources for the production of one commodity, the resources for the
production of other commodities would be less.
How to produce?
The second basic problem is which technique should be used for the production of given commodities.
This problem arises because there are various techniques available for the production of a commodity
such as, for the production of wheat, we may use either more of labor and less of capital or less of labor or
more of capital. With the help of both these techniques, we can produce equal amount of wheat. Such
possibilities exist relating to the production of other commodities also.
Therefore, every economy faces the problem as to how resources should be combined for the production
of a given commodity. The goods would be produced employing those methods and techniques, whereby
the output may be the maximum and cost of production be the minimum.
Organization of Economic Activities
Choice is an important tool in the organization of economic activities. Just like an individual, a nation also
has limited resources. Therefore it must decide what to produce, how to produce and for whom to
produce.
The way a nation solves this problem is by way of an Economic System.
There are 3 types of Economic Systems
Centrally Planned Economy
A planned economy is an economic system in which inputs are based on direct allocation. Economic
planning may be carried out in a decentralized, distributed or centralized manner depending on the
specific organization of economic institutions.
An economy based on economic planning (either through the state, an association of worker cooperatives
or another economic entity that has jurisdiction over the means of production) appropriates its resources
as needed, so that allocation comes in the form of internal transfers involving the purchasing of assets by
one government agency or firm by another. In a traditional model of planning, decision-making would be
carried out by workers and consumers on the enterprise-level.
Less extensive forms of planned economies include those that use indicative planning as components of a
market-based or mixed economy, in which the state employs "influence, subsidies, grants, and taxes, but
does not compel." This latter is sometimes referred to as a "planned market economy". In some instances,
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the term planned economy has been used to refer to national economic development plans and statedirected investment in market economies.
Countries like China, Russia and North Korea are examples of centrally planned economies.
Capitalist Economy or Market Economy
Capitalism is an economic system based on private ownership of the means of production and the creation
of goods and services for profit. Central characteristics of capitalism include private property, capital
accumulation, wage labor and competitive markets.
In a capitalist market economy, investments are determined by private decision and the parties to a
transaction typically determine the prices at which they exchange assets, goods, and services.
The degree of competition in markets, the role of intervention and regulation, and the scope of state
ownership vary across different models of capitalism.
Economists, political economists, and historians have adopted different perspectives in their analyses of
capitalism and have recognized various forms of it in practice. These include laissez-faire or free market
capitalism, welfare capitalism and state capitalism. Each model has employed varying degrees of
dependency on free markets, public ownership, obstacles to free competition, and inclusion of state sanctioned social policies.
Countries like America and Great Britain follow capitalism.
Mixed Economy
A mixed economy is variously defined as an economic system consisting of a mixture of either markets
and economic planning, public ownership and private ownership, or free markets and economic
interventionism. However, in most cases, "mixed economy" refers to market economies with strong
regulatory oversight and governmental provision of public goods, although some mixed economies also
feature a number of state-run enterprises.
In general the mixed economy is characterized by the private ownership of the means of production, the
dominance of markets for economic coordination, with profit-seeking enterprise and the accumulation of
capital remaining the fundamental driving force behind economic activity.
But unlike a free-market economy, the government would wield indirect macroeconomic influence over
the economy through fiscal and monetary policies designed to counteract economic downturns and
capitalism's tendency toward financial crises and unemployment, along with playing a role in interventions
that promote social welfare. Subsequently, some mixed economies have expanded in scope to include a
role for indicative economic planning and/or large public enterprise sectors.
Countries like India, Germany and France follow mixed economy system.
Positive and Normative Economics
Positive Economics
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Positive economics is a branch of economics that focuses on the description and explanation of
phenomena, as well as their casual relationships. It focuses primarily on facts and cause-and-effect
behavioral relationships, including developing and testing economic theories. As a science, positive
economics focuses on analyzing economic behavior.
It avoids economic value judgments. For example, positive economic theory would describe how mone y
supply growth impacts inflation, but it does not provide any guidance on what policy should be followed.
"The unemployment rate in France is higher than that in the United States" is a positive economic
statement. It gives an overview of an economic situation without providing any guidance for necessary
actions to address the issue.
Normative Economics
Normative economics is a branch of economics that expresses value or normative judgments about
economic fairness. It focuses on what the outcome of the economy or goals of public policy should be.
Many normative judgments are conditional. They are given up if facts or knowledge of facts change. In
this instance, a change in values is seen as being purely scientific. Welfare economist Amartya Sen
explained that basic (normative) judgments rely on knowledge of facts.
An example of a normative economic statement is "The price of milk should be $6 a gallon to give dairy
farmers a higher living standard and to save the family farm."
It is a normative statement because it reflects value judgments. It states facts, but also explains what
should be done. Normative economics has subfields that provide further scientific study including social
choice theory, cooperative game theory, and mechanism design.
Microeconomics
Microeconomics (from Greek prefix mikro- meaning "small" and economics) is a branch of economics that
studies the behavior of individuals and small impacting players in making decisions on the allocation of
limited resources.
Macroeconomics
Macroeconomics (from the Greek prefix makro- meaning "large" and economics) is a branch of economics
dealing with the performance, structure, behavior, and decision-making of an economy as a whole, rather
than individual markets. This includes national, regional, and global economies.
With microeconomics, macroeconomics is one of the two most general fields in economics.
These two terms were first coined and used by Prof Ragner Frisch, the first Nobel Laureate in Economics
in 1920.
Uses of Micro Economics
1.
Individual Behavior Analysis: Micro economics studies behavior of individual consumer or producer
in a particular situation.
2. Resource Allocation: Resources are already scare i.e. less in quantity. Micro economics helps in
proper allocation and utilization of resources to produce various types of goods and services.
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3. Price Mechanization: Micro economics decides prices of various goods and services on the basis of
'Demand-Supply Analysis'.
4. Economic Policy: Micro economics helps in formulating various economic policies and economic
plans to promote all round economic development.
5. Free Enterprise Economy: Micro economics explain operating of a free enterprise economy where
individual has freedom to take his own economic decisions.
6. Public Finance: It helps the government in fixing the tax rate and the type of tax as well as the
amount of tax to be charged to the buyer and the seller.
7. Foreign Trade: It helps in explaining and fixing international trade and tariff rules, causes of
disequilibrium in BOP, effects of factors deciding exchange rate, etc.
8. Social Welfare: It not only analyze economic conditions but also studies the social needs under
different market conditions like monopoly, oligopoly, etc.
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2 Theory of Consumer Behavior
There are two theories that explain consumer behavior, they are; Utility Theory and the Indifference
Preference Theory.
Utility Analysis
Eminent economists such as Jevons, Walras and Menger developed the utility analysis during the 19 th
century. The real credit for its present development goes to Alfred Marshall and Pigou.
The term utility should not be confused with satisfaction. A consumer gets satisfaction only after
consumption. But utility is calculation of want-satisfying power of a particular commodity before
consumption. Utility refers to ‘expected satisfaction’ whereas satisfaction denotes ‘realized satisfaction’.
Measurement of Utility
Utility is a subjective concept.
According to Alfred Marshall, it can be measured objectively in terms of price. The price a person is willing
to pay shows the utility for the consumer.
Cardinal and Ordinal Measures of Utility
Cardinal Measure of Utility
a. One util equals one unit of money
b. Utility of money remains constant
However, over a passage of time, it has been felt by economists that the exact or absolute measurement
of utility is not possible. There are a number of difficulties involved in the measurement of utility. This is
because of the fact that the utility derived by a consumer from a good depends on various factors, such as
changes in consumer’s moods, tastes, and preferences.
These factors are not possible to determine and measure. Therefore, no such technique has been devised
by economists to measure utility. Utility; thus, is not measureable in cardinal terms. However, the cardinal
utility concept has a prime importance in consumer behavior analysis.
Ordinal Utility Concept
Cardinal utility approach is based on the fact that the exact or absolute measurement of utility is not
possible. However, modern economists rejected the cardinal utility approach and introduced the concept
of ordinal utility for the analysis of consumer behavior.
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According to them, it may not be possible to measure exact utility, but it can be expressed in terms of less
or more useful good. For instance, a consumer consumes coconut oil and mustard oil. In such a case, the
consumer cannot say that coconut oil gives 10 utils and mustard oil gives 20 utils.
Instead he/she can say that mustard oil gives more utility to him/her than coconut oil. In such a case,
mustard oil would be given rank 1 and coconut oil would be given rank 2 by the consumer. This assumption
lays the foundation for the ordinal theory of consumer behavior.
Concepts of Utility
Initial Utility
It is the utility derived from consumption of the first unit of a commodity. For example having the first
glass of water to quench your thirst.
Total Utility
This is the total utility derived from consuming a given amount of goods and services over a period of
time.
If a person consumes five units of a commodity and derives U1, U2, U3, U4, and U5 utlity from the units of
a commodity then the total utility is
𝑇𝑈 = 𝑈1 + 𝑈2 + 𝑈3 + 𝑈4 + 𝑈5
This can also be the sum of marginal utility of each successive unity of consumption.
𝑇𝑈𝑥 = ∑ 𝑀𝑈𝑥
Marginal Utility
The utility derived from the consumption of additional unit of commodity is known as marginal utility. In
other words, the change in total utility due to the change in consumption of commodity is known as
marginal utility. Mathematically it can be expressed as:
𝑀𝑈 =
∆𝑇𝑈
∆𝑄
TU is the change in total utility.
Q is the change in consuming additional unit of a good.
It can also be expressed as
𝑀𝑈𝑛 = 𝑇𝑈𝑛 − 𝑇𝑈𝑛−1
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MUn is the marginal utility of n units
TUn is the total utility of n units
TUn-1 is the total utility of n-1 units
Law of Diminishing Marginal Utility
A German economist Gossen explained this law. Therefore it is also known as Gossen’s First Law. Alfred
Marshall, the founder of the neo-classical school popularized it.
The law of diminishing marginal utility is one of the important laws of utility analysis.
Statement of the Law
As consumer increases the consumption of any one commodity keeping constant consumption of all the
other commodities, the marginal utility of the variable commodity must eventually decline.
In other words, as a consumer consumes more of any commodity, the total utility increases but the
increase in total utility is not proportionate to the increase in units of consumption.
Assumptions of the Law
1.
2.
3.
4.
5.
6.
All the units of the given commodity are homogenous i.e. identical in size shape, quality, quantity
etc.
The units of consumption are of reasonable size. The consumption is normal.
The consumption is continuous. There is no unduly long time interval between the consumption of
the successive units.
The law assumes that only one type of commodity is used for consumption at a time.
Though it is psychological concept, the law assumes that the utility can be measured cardinally i.e.
it can be expressed numerically.
The consumer is rational human being and he aims at maximum of satisfaction.
Glass of Water Total Utility Marginal Utility
0
0
1
70
70
2
110
40
3
130
20
4
140
10
5
145
5
6
140
-5
Explanation of the Law
As more and more quantity of a commodity is
consumed, the intensity if desire decreases and also
the utility derived from the additional unit. Suppose
a person drinks water and 1st glass of water gives
him maximum satisfaction. When he will drink 2nd
glass of water, his total satisfaction would increase.
But the utility added by 2nd glass of water (MU) is
less than the 1st glass of water. His Total utility and marginal utility can be put in the form of a following
schedule.
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Exceptions of the Law
1.
2.
3.
4.
5.
6.
7.
The law does not hold well in the rare collections. For example, collection of ancient coins, stamps
etc.
The law is not fully applicable to money. The marginal utility of money declines with richness but
never falls to zero.
It does not apply to the knowledge, art and innovations.
The law is not applicable for precious goods such as jewelry or gems.
Law does not operate if consumer behaves in irrational manner. For example, drunkard is said to
enjoy each successive peg more than the previous one.
Man is fond of beauty and decoration. He gets more satisfaction by getting the above merits of
the commodities.
If a dress comes into fashion or a trend, its utility goes up. On the other hand its utility goes down
if it goes out of fashion.
Importance of the Law of Diminishing Marginal Utility
1.
2.
3.
4.
5.
6.
7.
Basis of Economic Laws: The Law of Diminishing Marginal Utility is the basic law of con-sumption.
The Law of Demand, the Law of Equi-marginal Utility, and the Concept of Consumer’s Surplus are
based on it.
Diversification in Consumption and Production: The changes in design, pattern and pack-ing of
commodities very often brought about by producers are in keeping with this law. We know that
the use of the same good makes us feel bored; its utility diminishes in our estimation. We want
variety in soaps, toothpastes, pens, etc. Thus, this law helps in bringing variety in consumption and
production.
Value Theory: The law helps to explain the phenomenon in value theory that the price of a
commodity falls when its supply increases. It is because with the increase in the stock of a
commodity, its marginal utility diminishes.
Diamond-Water Paradox: The famous “diamond-water paradox” of Smith can be explained with
the help of this law. Because of their relative scarcity, diamonds possess high marginal utility and
so a high price. Since water is relatively abundant, it possesses low marginal utility and hence low
price even though its total utility is high. That is why water has low price as compared to a
diamond though it is more useful than the latter.
Progressive Taxation: The principle of progression in taxation is also based on this law. As a
person’s income increases, the rate of tax rises because the marginal utility of money to him falls
with the rise in his income.
Basis of Socialism: I his law underlie the socialist plea for an equitable distribution of wealth. The
marginal utility of money to the rich is low. It is, therefore, advisable that their surplus wealth be
acquired by the state and distributed to the poor who possess high marginal utility for money.
For Producer: This law helps the producer in increasing sales. The producer reduces the price of
the product for the purpose of increasing sales. The consumers purchase more quantity of that
product to obtain maximum satisfaction given their income. As they buy more quantities the
marginal utility of the last rupee diminishes. Thus, the sale of the product increases.
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Concept of Consumer Behavior
Consumer behavior is the study of individuals, groups, or organizations and the processes they use to
select, secure, and dispose of products, services, experiences, or ideas to satisfy needs and the impacts
that these processes have on the consumer and society.
Budget Line
Consumer Budget states the real income or purchasing power of the consumer from which he can
purchase certain quantitative bundles of two goods at given price. It means, a consumer can purchase
only those combinations (bundles) of goods, which cost less than or equal to his income.
Budget line is a graphical representation of all possible combinations of two goods which can be
purchased with given income and prices, such that the cost of each of these combinations is equal to the
money income of the consumer. Alternately, Budget Line is locus of different combinations of the two
goods which the consumer consumes and which cost exactly his income.
Let us understand the concept of Budget line with the help of an example: Suppose, a consumer has an
income of Rs. 20. He wants to spend it on two commodities: X and Y and both are priced at Rs. 10 each.
Now, the consumer has three options to spend his entire income: (i) Buy 2 units of X; (ii) Buy 2 units of Y;
or (iii) Buy 1 unit of X and 1 unit of Y. It means, possible bundles can be: (2, 0); (0, 2) or (1, 1). When all these
three bundles are represented graphically, we get a downward sloping straight line, known as ‘Budget
Line’. It is also known as price line.
Budget Set
Budget set is the set of all possible combinations of the two goods which a consumer can afford, given his
income and prices in the market.
In addition to the three options, there are some
more options available to the consumer within his
income, even if entire income is not spent. Budget
set includes all the bundles with the total income of
Rs. 20, i.e. possible bundles or Consumer’s bundles
are: (0, 0); (0, 1); (0, 2); (1, 0); (2, 0); (1,1). Consumer’s
Bundle is a quantitative combination of two goods
which can be purchased by a consumer from his
given income.
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Suppose, a consumer has a budget of Rs. 20 to be spent on two commodities: apples (A) and bananas (B).
If apple is priced at Rs. 4 each and banana at Rs. 2 each, then the consumer can determine the various
combinations (bundles), which form the budget line. The possible options of spending income of Rs. 20
are given in the table.
In the figure, number of apples is taken on the X-axis and
bananas on the Y-axis. At one extreme (Point ‘E’),
consumer can buy 5 apples by spending his entire income
of Rs. 20 only on apples.
The other extreme (Point ‘j’), shows that the entire income
is spent only on bananas. Between E and J, there are other
combinations like F, G, H and I. By joining all these points,
we get a straight line ‘AB’ known as the Budget Line or
Price line.
Every point on this budget line indicates those bundles of
apples and bananas, which the consumer can purchase by
spending his entire income of 20 at the given prices of goods.
Important Points about Budget Line
1.
Budget line AB slopes downwards as more of one
good can be bought by decreasing some units of the other
good.
2.
Bundles which cost exactly equal to consumer’s
money income (like combinations E to J) lie on the budget
line.
3. Bundles which cost less than consumer’s money income (like combination D) shows under
spending. They lie inside the budget line.
4. Bundles which cost more than consumer’s money income (like combination C) are not available to
the consumer. They lie outside the budget line.
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Slope of Budget Line
We know, the slope of a curve is calculated as a change in variable on the vertical or Y-axis divided by
change in variable on the horizontal or X-axis. In the example of apples and bananas, slope of the budget
line will be number of units of bananas, that the consumer is willing to sacrifice for an additional unit of
apple.
Slope of Budget Line = Units of Bananas (B) willing to Sacrifice/ Units of Apples (A) willing to Gain
𝑆𝑙𝑜𝑝𝑒 = −
𝑃𝐵
𝑃𝐴
As seen in the figure, bananas need to be sacrificed each time to gain 1 apple.
So, Slope of Budget Line = -2/1 = **2/1 = 2
Numerator will always have negative value as it shows number of units to be sacrificed. However, for
analysis, absolute value is always considered.
This slope of budget line is equal to ‘Price Ratio’ of two goods.
What is Price Ratio?
Price Ratio is the price of the good on the horizontal or X-axis divided by the price of the good on the
vertical or Y-axis. For instance, If good X is plotted on the horizontal axis and good Y on the vertical axis,
then:
Price Ratio = Price of X (PX)/Price of Y(PY) = PX /P
Effect of change in the relative Prices (Apples and Bananas)
If there is any change in prices of the two commodities,
assuming no change in the money income of consumer, then
budget line will change. It will change the slope of budget
line, as price ratio will change, with change in prices.
(i) Change in the price of commodity on X-axis (Apples):
When the price of apples falls, then new budget line is
represented by a shift in budget line to the right from ‘AB’ to
‘A1B’. The new budget line meets the Y-axis at the same point
‘B’, because the price of bananas has not changed. But it will
touch the X-axis to the right of ‘A’ at point ‘A1, because the
consumer can now purchase more apples, with the same
income level.
Similarly, a rise in the price of apples will shift the budget line towards left from ‘AB’ to ‘A 2B’.
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(ii) Change in the price of commodity on Y-axis
(Bananas): With a fall in the price of bananas, the
new budget line will shift to the right from ‘AB’ to
A2B. The new budget line meets the X-axis at the
same point ‘A’, due to no change in the price of
apples. But it will touch the Y-axis to the right of ‘B’ at
point ‘B1‘, because the consumer can now purchase
more bananas, with the same income level.
Similarly, a rise in the price of bananas will shift the
budget line towards left from ‘AB’ to ‘A2B‘.
Indifference Curve Analysis
Meaning
When a consumer consumes various goods and services, then there are some combinations, which give
him exactly the same total satisfaction. The graphical representation of such combinations is termed as
indifference curve.
Indifference curve refers to the graphical representation of various alternative combinations of bundles of
two goods among which the consumer is indifferent. Alternately, indifference curve is a locus of points
that show such combinations of two commodities which give the consumer same satisfaction. Let us
understand this with the help of following indifference schedule, which shows all the combinations giving
equal satisfaction to the consumer.
As seen in the schedule, consumer is indifferent between five combinations of apple and banana.
Combination ‘P’ (1A + 15B) gives the same utility as (2A + 10B), (3A + 6B) and so on. When these
combinations are represented graphically and joined together, we get an indifference curve ‘IC1’ as shown
in the diagram
In the diagram, apples are measured along the X-axis and bananas on the Y-axis. All points (P, Q, R, S and
T) on the curve show different combinations of apples and bananas. These points are joined with the help
of a smooth curve, known as indifference curve (IC1). An indifference curve is the locus of all the points,
representing different combinations, that are equally satisfactory to the consumer.
Every point on IC1, represents an equal amount of satisfaction to the consumer. So, the consumer is said
to be indifferent between the combinations located on
Indifference Curve ‘IC1’. The combinations P, Q, R, S and T give
equal satisfaction to the consumer and therefore he is
indifferent among them. These combinations are together
known as ‘Indifference Set’.
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Indifference Map
Indifference Map refers to the family of indifference curves
that represent consumer preferences over all the bundles of
the two goods. An indifference curve represents all the
combinations, which provide same level of satisfaction.
However, every higher or lower level of satisfaction can be
shown on different indifference curves. It means, infinite
number of indifference curves can be drawn.
Properties of Indifference Curve
1. Indifference curves are always convex to the origin: An indifference curve is convex to the origin
because of diminishing MRS. MRS declines continuously because of the
law of diminishing marginal utility. As seen in the table, when the
consumer consumes more and more of apples, his marginal utility from
apples keeps on declining and he is willing to give up less and less of
bananas for each apple. Therefore, indifference curves are convex to
the origin. It must be noted that MRS indicates the slope of
indifference curve.
2. Indifference curve slope downwards: It implies that as a consumer
consumes more of one good, he must consume less of the other good.
It happens because if the consumer decides to have more units of one
good (say apples), he will have to reduce the number of units of another good (say bananas), so that total
utility remains the same.
3. Higher Indifference curves represent higher levels of satisfaction: Higher indifference curve represents
large bundle of goods, which means more utility because of monotonic preference. Consider point ‘A’ on
ICX and point ‘B’ on IC2 in the diagram. At ‘A’, consumer gets the combination (OR, OP) of the two
commodities X and Y. At ‘B’, consumer gets the combination (OS, OP). As OS > OR, the consumer gets
more satisfaction at IC2.
4. Indifference curves can never intersect each other:
As two indifference curves cannot represent the same level of satisfaction, they cannot intersect each
other. It means, only one indifference curve will pass through a given point on an indifference map. In the
figure below, satisfaction from point A and from B on IC1 will be the same.
Similarly, points A and C on IC2 also give the same level of satisfaction. It means, points B and C should also
give the same level of satisfaction. However, this is not possible, as B and C lie on two different
indifference curves, IC1 and IC2 respectively and represent different levels of satisfaction. Therefore, two
indifference curves cannot intersect each other.
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Marginal Rate of Substitution (MRS)
Marginal Rate of Substitution (MRS):
MRS refers to the rate at which the commodities can be substituted with each other, so that total
satisfaction of the consumer remains the same. For example, in the example of apples (A) and bananas
(B), MRS of ‘A’ for ‘B’, will be number of units of ‘B’, that the consumer is willing to sacrifice for an
additional unit of ‘A’, so as to maintain the same level of satisfaction.
MRSAB = Units of Bananas (B) willing to Sacrifice / Units of Apples (A) willing to Gain
MRSAB = ∆B/∆A
MRSAB is the rate at which a consumer is willing to give up Bananas for one more unit of Apple. It means,
MRS measures the slope of indifference curve.
It must be noted that in mathematical terms, MRS should always be negative as numerator (units to be
sacrificed) will always have negative value. However, for analysis, absolute value of MRS is always
considered.
MRS between Apple and Banana:
Combination
Apples
Banana
MRSAB
P
(A)
1
(B)
15
–
Q
2
10
5B:1 A
R
3
6
4B:1A
S
4
3
3B:1A
T
5
1
2B:1 A
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As seen in the given schedule and diagram, when consumer moves from P to Q, he sacrifices 5 bananas for
1 apple. Thus, MRS AB comes out to be 5:1. Similarly, from Q to R, MRS AB is 4:1. In combination T, the
sacrifice falls to 2 bananas for 1 apple. In other words, the MRS of apples for bananas is diminishing.
Why MRS diminishes?
MRS falls because of the law of diminishing marginal utility. In the given example of apples and bananas,
Combination ‘P’ has only 1 apple and, therefore, apple is relatively more important than bananas. Due to
this, the consumer is willing to give up more bananas for an additional apple. But as he consumes more
and more of apples, his marginal utility from apples keeps on declining. As a result, he is willing to give up
less and less of bananas for each apple.
Optimal Choice of Consumer (Utility Maximization or Consumer Equilibrium)
Assumptions
The various assumptions of indifference curve are:
1.
Two commodities: It is assumed that the consumer
has a fixed amount of money, whole of which is to be
spent on the two goods, given constant prices of both
the goods.
2.
Non Satiety: It is assumed that the consumer has
not reached the point of saturation. Consumer always
prefer more of both commodities, i.e. he always tries to
move to a higher indifference curve to get higher and
higher satisfaction.
3.
Ordinal Utility: Consumer can rank his preferences
on the basis of the satisfaction from each bundle of
goods.
4. Diminishing marginal rate of substitution: Indifference curve analysis assumes diminishing
marginal rate of substitution. Due to this assumption, an indifference curve is convex to the origin.
5. Rational Consumer: The consumer is assumed to behave in a rational manner, i.e. he aims to
maximize his total satisfaction.
Conditions of Consumer’s Equilibrium:
The consumer’s equilibrium under the indifference curve theory must meet the following two conditions:
1.
MRSXY = Ratio of prices or PX/PY
Let the two goods be X and Y. The first condition for consumer’s equilibrium is that MRSXY = PX/PY
P a g e 17 | 105
a. If MRSXY > PX/PY, it means that the consumer is willing to pay more for X than the price
prevailing in the market. As a result, the consumer buys more of X. As a result, MRS falls till
it becomes equal to the ratio of prices and the equilibrium is established.
b. If MRSXY < PX/PY, it means that the consumer is willing to pay less for X than the price
prevailing in the market. It induces the consumer to buys less of X and more of Y. As a
result, MRS rises till it becomes equal to the ratio of prices and the equilibrium is
established.
2. MRS continuously falls: The second condition for consumer’s equilibrium is that MRS must be
diminishing at the point of equilibrium, i.e. the indifference curve must be convex to the origin at
the point of equilibrium. Unless MRS continuously falls, the equilibrium cannot be established.
Thus, both the conditions need to be fulfilled for a consumer to be in equilibrium.
IC1, IC2 and IC3 are the three indifference curves and AB is the budget line. With the constraint of budget
line, the highest indifference curve, which a consumer can reach, is IC 2. The budget line is tangent to
indifference curve IC2 at point ‘E’. This is the point of consumer equilibrium, where the consumer
purchases OM quantity of commodity ‘X’ and ON quantity of commodity ‘Y.
All other points on the budget line to the left or
right of point ‘E’ will lie on lower indifference
curves and thus indicate a lower level of
satisfaction. As budget line can be tangent to
one and only one indifference curve, consumer
maximizes his satisfaction at point E, when
both the conditions of consumer’s equilibrium
are satisfied:
a. MRS = Ratio of prices or PX/PY: At tangency
point E, the absolute value of the slope of the
indifference curve (MRS between X and Y) and
that of the budget line (price ratio) are same.
Equilibrium cannot be established at any other
point as MRSXY > PX/PY at all points to the left of
point E and MRS XY < PX/PY at all points to the
right of point E. So, equilibrium is established at point E, when MRS XY = PX/PY.
b. MRS continuously falls: The second condition is also satisfied at point E as MRS is
diminishing at point E, i.e. IC2 is convex to the origin at point E.
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3 Demand Analysis
Meaning of Demand
Demand is an economic principle that describes a consumer's desire and willingness to pay a price for a
specific good or service. Holding all other factors constant, the price of a good or service increases as its
demand increases and vice versa.
Determinants of Demand
The five determinants of demand are:
1. Price of the good or service.
2. Prices of related goods or services. These are either complementary, which are things that are
usually bought along with the product in demand. They could also be substitutes for the product
in demand.
3. Income of those with the demand.
4. Tastes or preferences of those with the demand.
5. Expectations. These are usually about whether the price will go up.
Demand Function
The demand function shows the relationship between quantity demanded and its determinants. It is
expressed as:
𝑄𝑑 = 𝑓(𝑃, 𝑃𝑅, 𝑌, 𝑇 … )
P – Price
Pr – Prices of Related Goods
Y – Income
T – Tastes and Preferences
Example: If the demand equation Qd = 20 – 2p represents the market situation for a good. If the price of
tomato per kg at different points of time is Rs. 4, Rs, 5, Rs. 6, Rs. 7 and Rs. 8 then calculate the quantity of
good demanded by a consumer in the market at different prices and prepare an individual demand
schedule.
Solution: Linear demand equation is Qd = 20-2p
When p is 4; Qd = 20-2(4) = 12
When p is 5; Qd = 20-2(5) = 10
When p is 6; Qd = 20 – 2(6) = 8
When Qd = 20 – 2(7) = 6
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When Qd = 20 – 2(8) = 4
Individual Demand Schedule
Price (in Rs.)
4
5
6
7
8
Demand (in kg)
12
10
8
6
4
Law of Demand
Statement
In economics, the law states that, all else being equal, as the price of a product increases, quantity
demanded falls; likewise, as the price of a product decreases, quantity demanded increases.
In other words, the law of demand states that the quantity demanded and the price of a commodity are
inversely related, other things remaining constant. If the income of the consumer, prices of the related
goods, and preferences of the consumer remain unchanged, then the change in quantity of good
demanded by the consumer will be negatively correlated to the change in the price of the good. There are,
however, some possible exceptions to this rule.
Demand Schedule
Price in Rupees
Demand in Kg.
5
100
4
200
3
300
2
400
The table shows the demand of all the consumers in a
market. When the price decreases there is increase in
demand for goods and vice versa. When price is Rs. 5
demand is 100 kilograms. When the price is Rs. 4 demand is
200 kilograms. Thus the table shows the total amount
demanded by all consumers various price levels.
There is same price in the market. All consumers purchase
commodity according to their needs. The market demand
P a g e 20 | 105
curve is the total amount demanded by all consumers at different prices. The market demand curve slopes
from left down to the right.
Assumptions
There should not be any change in income of consumer
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
k)
—
—
—
—
—
—
—
—
—
—
—
There should not be any change in Taste , preferences, habits and fashion of consumers
There should not be any change in Price of the related commodity
Population should be constant
Should not anticipate any price change in the future
The seasons and climate should not change
No change in government policy
Commodity should be normal one
There should be no change in the population size
Distribution of income and wealth should be equal
There should be continuous demand
There should be perfect competition in the market
Exception to the Law
a) Giffen goods: Some special varieties of inferior goods are termed as Giffen goods. Cheaper
varieties of this category like bajra, cheaper vegetable like potato come under this category. Sir
Robert Giffen or Ireland first observed that people used to spend more their income on inferior
goods like potato and less of their income on meat. But potatoes constitute their staple food.
When the price of potato increased, after purchasing potato they did not have so many surpluses
to buy meat. So the rise in price of potato compelled people to buy more potato and thus raised
the demand for potato. This is against the law of demand. This is also known as Giffen paradox.
b) Conspicuous Consumption: This exception to the law of demand is associated with the doctrine
propounded by Thorsten Veblen. A few goods like diamonds etc are purchased by the rich and
wealthy sections of the society. The prices of these goods are so high that they are beyond the
reach of the common man. The higher the price of the diamond the higher the prestige value of it.
So when price of these goods falls, the consumers think that the prestige value of these goods
comes down. So quantity demanded of these goods falls with fall in their price. So the law of
demand does not hold good here.
c) Conspicuous necessities: Certain things become the necessities of modern life. So we have to
purchase them despite their high price. The demand for T.V. sets, automobiles and refrigerators
etc. has not gone down in spite of the increase in their price. These things have become the
symbol of status. So they are purchased despite their rising price. These can be termed as “U”
sector goods.
d) Ignorance: A consumer’s ignorance is another factor that at times induces him to purchase more
of the commodity at a higher price. This is especially so when the consumer is haunted by the
phobia that a high-priced commodity is better in quality than a low-priced one.
P a g e 21 | 105
e) Emergencies: Emergencies like war, famine etc. negate the operation of the law of demand. At
such times, households behave in an abnormal way. Households accentuate scarcities and induce
further price rises by making increased purchases even at higher prices during such periods.
During depression, on the other hand, no fall in price is a sufficient inducement for consumers to
demand more.
f) Future changes in prices: Households also act speculators. When the prices are rising households
tend to purchase large quantities of the commodity out of the apprehension that prices may still
go up. When prices are expected to fall further, they wait to buy goods in future at still lower
prices. So quantity demanded falls when prices are falling.
g) Change in fashion: A change in fashion and tastes affects the market for a commodity. When a
broad toe shoe replaces a narrow toe, no amount of reduction in the price of the latter is sufficient
to clear the stocks. Broad toe on the other hand, will have more customers even though its price
may be going up. The law of demand becomes ineffective.
Why Demand Curve Slopes Downwards
Marginal utility decreases: When a consumer buys more units of a commodity, the marginal utility of such
commodity continue to decline. The consumer can buy more units of commodity when its price falls and
vice versa. The demand curve falls because demand is more at lower price.
Price effect: When there is increase in price of commodity, the consumers reduce the consumption of such
commodity. The result is that there is decrease in demand for that commodity. The consumers consume
mo0re or less of a commodity due to price effect. The demand curve slopes downward.
Income effect: Real income of consumer rises due to fall in prices. The consumer can buy more quantity of
same commodity. When there is increase in price, real income of consumer falls. This is income effect that
the consumer can spend increased income on other commodities. The demand curve slopes downward
due to positive income effect.
Same price of substitutes: When the price of a commodity falls, the prices of substitutes remaining the
same, consumer can buy more of the commodity and vice versa. The demand curve slopes downward due
to substitution effect.
Demand of poor people: The income of people is not the same. The rich people have money to buy same
commodity at high prices. Large majority of people are poor. They buy more when price fall and vice versa.
The demand curve slopes due to poor people.
Different uses of goods: There are different uses of many goods. When prices of such goods increase
these goods are put into uses that are more important and their demand falls. The demand curve slopes
downward due to such goods.
Normal and Inferior Goods
In economics, an inferior good is a good that decreases in demand when consumer income rises (or rises
in demand when consumer income decreases), unlike normal goods, for which the opposite is observed.
Normal goods are those for which consumers' demand increases when their income increases.
P a g e 22 | 105
Substitutes and Complimentary Goods
A complementary good is a good whose use is related to the use of an
associated or paired good. Two goods (A and B) are complementary if
using more of good A requires the use of more of good B.
For example, the demand for one good (printers) generates demand
for the other (ink cartridges). If the price of one good falls and people
buy more of it, they will usually buy more of the complementary good
also, whether or not its price also falls. Similarly, if the price of one good rises and reduces its demand, it
may reduce the demand for the paired or complementary good as well.
In economics, you may often hear about substitute goods. These are the opposite of complementary
goods and are a whole other topic by themselves. For instance, Microsoft Windows-based personal
computers and Apple Macs are substitutes. If you buy one, you probably don't buy the other. Sprite and 7UP are another example of substitute goods.
Shifts in Demand Curve
i.
ii.
Increase in Demand is shown by rightward shift in demand curve from DD to D1D1. Demand
rises from OQ to OQ1 due to favourable change in other factors at the same price OP
Decrease in Demand is shown by leftward shift in demand curve from DD to D2D2. Demand
falls from OQ to OQ2 due to unfavourable change in other factors at the same price OP
Increase in Demand refers to a rise in the demand of a commodity caused due to any factor other than the
own price of the commodity. In this case, demand rises at the
same price or demand remains same even at higher price. For
example, suppose a research reveals that people who regularly
eat green vegetables live longer. This will raise the demand for
green vegetables even at the same price and it will shift the
demand curve of vegetables towards right.
P a g e 23 | 105
Decrease in Demand refers to a fall in the demand of a commodity
caused due to any factor other than the own price of the
commodity. In this case, demand falls at the same price or
demand remains same even at lower price. It leads to a leftward
shift in the demand curve
Market Demand Schedule
Market demand schedule refers to a tabular statement
showing various quantities of a commodity that all the
consumers are willing to buy at various levels of price, during a
given period of time. It is the sum of all individual demand
schedules at each and every price.
Where Dm is the market demand and DA + DB
+…………………. are the individual demands of Household A,
Household B and so on.
Let us assume that A and B are two consumers for commodity x in the market. Table below shows that
market demand schedule is obtained by horizontally summing the individual demands:
As seen in the table, market demand is obtained by adding demand of households A and B at different
prices. At Rs. 5 per unit, market demand is 3 units. When price falls to Rs. 4, market demand rises to 5
units. So, market demand schedule also shows the inverse relationship between price and quantity
demanded.
P a g e 24 | 105
Elasticity of Demand
Income Elasticity of Demand
The Income Elasticity of Demand measures the rate of response of quantity demand due to a raise (or
lowering) in a consumer’s income. The formula for the Income Elasticity of Demand (IEoD) is given by:
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑
)
𝐼𝐸𝑜𝐷 = (
%𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒
a) A negative income elasticity of demand is associated with inferior goods; an increase in income will
lead to a fall in the demand and may lead to changes to more luxurious substitutes.
b) A positive income elasticity of demand is associated with normal goods; an increase in income will
lead to a rise in demand. If income elasticity of demand of a commodity is less than 1, it is a
necessity good. If the elasticity of demand is greater than 1, it is a luxury good or a superior good.
c) A zero income elasticity of demand occurs when an increase in income is not associated with a
change in the demand of a good. These would be sticky goods.
Price Elasticity of Demand
Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness, or
elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives
the percentage change in quantity demanded in response to a one percent change in price (ceteris
paribus, i.e. holding constant all the other determinants of demand, such as income).
Types of Price Elasticity
The concept of price elasticity reveals that the degree of responsiveness of demand to the change in price
differs from commodity to commodity. Demand for some commodities is more elastic while that for
certain others are less elastic. Using the formula of elasticity, it possible to mention following different
types of price elasticity:
a)
b)
c)
d)
e)
Perfectly inelastic demand (ep = 0)
Inelastic (less elastic) demand (e < 1)
Unitary elasticity (e = 1)
Elastic (more elastic) demand (e > 1)
Perfectly elastic demand (e = ∞)
Factors Determining Price Elasticity of Demand
1. The number of close substitutes – the more close
substitutes there are in the market, the more elastic is demand
P a g e 25 | 105
2.
3.
4.
5.
6.
7.
8.
because consumers find it easy to switch. E.g. Air travel and train travel are weak substitutes
for inter-continental flights but closer substitutes for journeys of around 200-400km e.g.
between major cities in a large country.
The cost of switching between products – there may be costs involved in switching. In this
case, demand tends to be inelastic. For example, mobile phone service providers may insist on
a12 month contract which has the effect of locking-in some consumers once a choice has been
made
The degree of necessity or whether the good is a luxury – necessities tend to have an inelastic
demand whereas luxuries tend to have a more elastic demand. An example of a necessity is
rare-earth metals which are an essential raw material in the manufacture of solar cells,
batteries. China produces 97% of total output of rare-earth metals – giving them monopoly
power in this market
The proportion of a consumer's income allocated to spending on the good – products that
take up a high % of income will have a more elastic demand
The time period allowed following a price change – demand is more price elastic, the longer
that consumers have to respond to a price change. They have more time to search for cheaper
substitutes and switch their spending.
Whether the good is subject to habitual consumption – consumers become less sensitive to
the price of the good of they buy something out of habit (it has become the default choice).
Peak and off-peak demand - demand is price inelastic at peak times and more elastic at offpeak times – this is particularly the case for transport services.
The breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for
petrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be
more elastic following a price change.
Cross Elasticity of Demand
In economics, the cross elasticity of demand or cross-price elasticity of demand measures the
responsiveness of the demand for a good to a change in the price of another good. It is measured as the
percentage change in demand for the first good that occurs in response to a percentage change in price
of the second good.
For example, if, in response to a 10% increase in the price of fuel, the demand of new cars that are fuel
inefficient decreased by 20%, the cross elasticity of demand would be:
−20%
= −2%
10%
Measuring Cross Elasticity
𝐸𝐴,𝐵 =
%𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝐴
%𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝐵
In the example above, the two goods, fuel and cars (consists of fuel consumption), are complements; that
is, one is used with the other. In these cases the cross elasticity of demand will be negative, as shown by
P a g e 26 | 105
the decrease in demand for cars when the price for fuel will rise. In the case of perfect substitutes, the
cross elasticity of demand is equal to positive infinity (at the point when both goods can be consumed).
Where the two goods are independent, or, as described in consumer theory, if a good is independent in
demand then the demand of that good is independent of the quantity consumed of all other goods
available to the consumer, the cross elasticity of demand will be zero: as the price of one good changes,
there will be no change in demand for the other good
P a g e 27 | 105
4 Production and Cost
Production function explains the relationship between factor input and output of a given technology.
Accoriding to Watson, ‘Production function is a relationship between physical inputs and physical outputs
of a firm’.
It is written as
𝑌 = 𝑓(𝑅, 𝐿, 𝐾, 𝑂 … )
Y - Output
R – Land
L – Labor
K – Capital
O – Organization
Isoquants
An isoquant is a curve on which the various combinations of labour and capital show the same output. An
isoproduct curve is a curve along which the maximum achievable rate of production is constant. It is also
known as a production indifference curve or a constant product curve.
A number of isoquants representing different amounts of output are
known as an isoquant map. In Figure 1, curves IQ, IO1 and IQ2 show an
isoquant Units of Labour map. Starting from the curve IQ which yields
100 units Fig. 1. Of product, the curve IQ1 shows 200 units and the IQ2
curve 300 units of the product which can be produced with altogether
different combinations of the two factors.
Marginal Rate of Technical Substitution
The principle of marginal rate of technical substitution (MRTS or MRS) is based on the produc-tion
function where two factors can be substituted in variable proportions in such a way as to produce a
constant level of output.
The marginal rate of technical substitution between two factors К (capital) and L (labor), MRTSIK is the
rate at which L can be substituted for К in the production of good X without changing the quantity of
P a g e 28 | 105
output. As we move along an isoquant downward to the right, each point on it represents the substitution
of labor for capital.
𝑀𝑅𝑇𝑆𝐿𝐶 =
∆𝐾
∆𝐿
Where K is the change in units of capital used and L is the change in units of labor used.
Total Product, Average Product and Marginal Product
Total Product (TP)
Total product of a factor is the amount
of total output produced by a given
amount of the factor, other factors
held constant. As the amount of a
factor increases, the total output
increases. It will be seen from the
table that when with a fixed quantity
of capital (K), more units of labour are
employed total product is increasing in
the beginning.
𝑇𝑃 = ∑𝑀𝑎𝑟𝑔𝑛𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡
Average Product (AP)
Average product of a factor is the total output produced per unit of the factor employed. Thus,
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 =
𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡
𝑁𝑜 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐹𝑎𝑐𝑡𝑜𝑟
Marginal Product (MP)
Marginal product of a factor is the addition to the total production by the employment of an extra unit of
a factor. Suppose when two workers are employed to produce wheat in an agricultural farm and they
produce 170 quintals of wheat per year.
Now, if instead of two workers, three workers are employed and as a result total product increases to 270
quintals, then the third worker has added 100 quintals of wheat to the total production. Thus 100 quintals
is the marginal product of the third worker.
𝑀𝑃 = 𝑇𝑃𝑛 − 𝑇𝑃𝑛−1
TPn is the total product of ‘n’ units
TPn-1 is the total product of ‘n-1’ units
P a g e 29 | 105
Short Run Analysis of Production / Law of Variable Proportions
The short run is a time period where at least one factor of production is in fixed supply. A business has
chosen its scale of production and must stick with this in the short run
We assume that the quantity of plant and machinery is fixed and that production can be altered by
changing variable inputs such as labor, raw materials and energy.
Law of variable proportions occupies an important place in economic theory. This law examines the
production function with one factor variable, keeping the quantities of other factors fixed. In other words,
it refers to the input-output relation when output is increased by varying the quantity of one input.
When the quantity of one factor is varied, keeping the quantity of other factors con-stant, the proportion
between the variable factor and the fixed factor is altered; the ratio of employ-ment of the variable factor
to that of the fixed factor goes on increasing as the quantity of the variable factor is increased.
Assumptions of the Law
1.
First, the state of technology is assumed to be given and unchanged. If there is improvement in
the technology, then marginal and average products may rise instead of diminishing.
2. Secondly, there must be some inputs whose quantity is kept fixed. This is one of the ways by
which we can alter the factor proportions and know its effect on output. This law does not apply
in case all factors are proportionately varied. Behavior of output as a result of the variation in all
inputs is discussed under “returns to scale”.
3. Thirdly the law is based upon the possibility of varying the proportions in which the various factors
can be combined to produce a product. The law does not apply to those cases where the factors
must be used in fixed proportions to yield a product.
P a g e 30 | 105
Three Stages of the Law
The behavior of these total, average and
marginal products of the variable factor as a
result of the increase in its amount is
generally divided into three stages which are
explained below:
Stage 1: Law of Increasing Returns
In this stage, total product curve TP increases
at an increasing rate up to a point. In the
figure. from the origin to the point F, slope of
the total product curve TP is increasing, that
is, up to the point F, the total product
increases at an increasing rate (the total
product curve TP is concave upward upto the
point F), which means that the marginal
product MP of the variable factor is rising.
Stage 2: Law of Diminishing Returns
In stage 2, the total product continues to
increase at a diminishing rate until it reaches
its maximum point H where the second stage
ends. In this stage both the marginal product
and the average product of the variable
factor are diminishing but remain positive.
At the end of the second stage, that is, at
point M marginal product of the variable
factor is zero (corresponding to the highest
point H of the total product curve TP). Stage 2
is very crucial and important because as will be explained below the firm will seek to produce in its range.
Stage 3: Law of Negative Returns:
In stage 3 with the increase in the variable factor the total product declines and therefore the total
product curve TP slopes downward. As a result, marginal product of the variable factor is negative and the
marginal product curve MP goes below the X-axis. In this stage the variable factor is too much relative to
the fixed factor. This stage is called the stage of negative returns, since the marginal product of the
variable factor is negative during this stage.
It may be noted that stage 1 and stage 3 are completely symmetrical. In stage 1 the fixed factor is too
much relative to the variable factor. Therefore, in stage 1, marginal product of the fixed factor is negative.
On the other hand, in stage 3 the variable factor is too much relative to the fixed factor. Therefore, in
stage 3, the marginal product of the variable factor is negative.
P a g e 31 | 105
Long Run Production Analysis – Returns to Scale
The laws of returns to scale are often confused with ‘returns to scale’. By “returns to scale” is meant the
behavior of production or returns when all productive factors are increased or decreased simultaneously
and in the same ratio.
When all inputs are changed in the same proportion, we call this as a change in scale of production. The
way total output changes due to change in the scale of production is known as returns to scale.
Thus, whereas in the short-run change in output is associated with the change in factor proportions, and
change in output in the long-run is associated with change in the scale of production. Thus returns to scale
is the long-run concept.
Increasing returns to Scale
This situation occurs if a percentage increases in all inputs results in a greater percentage change in
output. For e.g. a 10 % increase in all inputs causes a
20% increase in output.
By increasing its scale, the firm may be able to use
new production methods that were infeasible at the
smaller scale. For instance, the firm may utilize
sophisticated, highly efficient, large-scale factories.
It also may find it advantageous to exploit
specialization of labour at the large scale. This is
shown in the following example.
Inputs (Units) Output (Units)
2 capital + 2 Labour
4 Capital + 4 Labour
200
500
The table shows that the input is increasing by 100%, on the other hand the output is increased by 150%.
This shows the increasing returns to scale. As changes in the output is more than the change in input.
Constant returns to Scale
It occurs if a given percentage change in all inputs results in an equal percentage in output. For instance, if
all inputs are doubled, output also doubles; a 10% increase in inputs would imply a 10% increase in output;
and so on. Under constant returns, the firm’s input are equally productive whether or smaller or larger
levels of output are produced.
A common example of constant returns to scale occurs when a firm can easily replicate its production
process.
For, instance a manufacturer of electrical company finds that it can double its output by replicating its
current plant and labour force, that is, by building an identical palnt beside the old one.
P a g e 32 | 105
Inputs (Units) Output (Units)
2 capital + 2 Labour
200
4 Capital + 4 Labour
400
The above example shows that as the inputs (i.e. labour and capital) increased to 100%, output also
increased to 100%.
Decreasing Returns to scale
It occurs if a given percentage increase in all inputs results in a smaller percentage increase in output. The
most common explanation for decreasing Returns involves organization factors in very large firms. As the
scale of firms increases, the difficulties in Coordinating and monitoring the many management functions.
Coordinating production and distribution of 12 products manufactured in four separate plants typically
means incurring additional costs tor management and information systems that would be unnecessary in
a firm one-quarter size. As a result, proportional increases in output require more than proportional
increases in inputs. The following example will explain decreasing returns to scale.
Inputs (Units) Output (Units)
2 capital + 2 Labour
200
4 capital + 4 Labour
300
The above shows, that inputs ate increases to 100% but the increase output is 50%, which shows that there
is decreasing returns to scale.
P a g e 33 | 105
Cost
In production, research, retail, and accounting, a cost is the value of money that has been used up to
produce something, and hence is not available for use anymore. In business, the cost may be one of
acquisition, in which case the amount of money expended to acquire it is counted as cost. In this case,
money is the input that is gone in order to acquire the thing.
Short Run Costs
Fixed costs
Fixed costs do not change with output, firms must pay these even if they shut down
Examples include the rental costs of buildings; the costs of leasing or purchasing capital equipment; the
annual business rate charged by local authorities; the costs of employing full-time contracted salaried
staff; the costs of meeting interest payments on loans; the depreciation of fixed capital (due solely to age)
and also the costs of business insurance.
Fixed costs are the overhead costs of a business.
Total fixed costs (TFC)
Average Fixed Cost
Average fixed cost (AFC) = TFC / output
Average fixed costs must fall continuously as output increases because total fixed costs are being spread
over a higher level of production.
A change in fixed costs has no effect on marginal costs. Marginal costs relate only to variable costs.
Variable Costs
Variable costs vary directly with output – when output is zero, variable costs will be zero but as production
increases, total variable costs will rise. Examples of variable costs include the costs of raw materials and
components, packaging and distribution costs, the wages of part-time staff or employees paid by the
hour, the costs of electricity and gas and the depreciation of capital inputs due to wear and tear
Average variable cost
(AVC) = total variable costs (TVC) /output (Q)
Total Cost (TC)
Total cost = fixed costs + variable costs
Average Total Cost (ATC or AC)
P a g e 34 | 105
Average total cost is the cost per unit produced
Average total cost (ATC) = total cost (TC) / output (Q)
Marginal Cost
Marginal cost is the change in total costs from increasing output by one extra unit
The marginal cost of supplying extra units of output is linked with the marginal productivity of labor. The
law of diminishing returns implies that marginal cost will eventually rise as output increases. At some
point, rising marginal cost will lead to a rise in average total cost. This happens when the rise in AVC is
greater than the fall in AFC as output (Q) increases.
𝑀𝐶 = 𝑇𝐶𝑛 − 𝑇𝐶𝑛−1
Long Run Costs
In the short‐run, some factors of production are fixed. Corresponding to each different level of fixed
factors, there will be a different
short‐run average total cost curve
(SATC). The average total cost
curve is just one of many SATCs
that can be obtained by varying the
amount of the fixed factor, in this
case, the amount of capital.
Long‐run average total cost curve.
In the long‐run, all factors of
production are variable, and hence,
all costs are variable. The long‐run
average total cost curve (LATC) is
found by varying the amount of all
factors of production. However,
because each SATC corresponds to a different level of the fixed factors of production, the LATC can be
constructed by taking the “lower envelope” of all the SATCs, as is illustrated in Figure
The LATC is shown to be tangent to each of five different SATCs, labeled SATC 1 through SATC 5.
In general, there will be a large number of SATCs, each of which corresponds to a different level of the
fixed factors the firm can employ in the short‐run. Because there is such a large number of SATCs more
than just the five illustrated in Figure the lower envelope of all the SATCs, which makes up the LATC, can
be approximated by a smooth, U‐shaped curve.
P a g e 35 | 105
Economies of scale
The U‐shape of the LATC, depicted in Figure , reflects the changing costs of production that the firm faces
in the long‐run as it varies the level of its factors of production and hence the level of its output. At low
levels of output, a firm can usually increase its output at a rate that exceeds the rate at which it increases
its factor inputs. When this situation occurs, the firm's average total costs are falling, and the firm is said
to be experiencing economies of scale.
At higher levels of output, the firm may find that its output increases at the same rate at which it increases
its factor inputs. In this case, the firm's average total costs remain constant, and the firm is said to
experience constant returns to scale. At even higher output levels, the firm's output will tend to increase
at a rate that is below the rate at which it increases its factor inputs. In this situation, average total costs
are rising, and the firm is said to experience diseconomies of scale.
The firm's minimum efficient scale is the level of output at which economies of scale end and constant
returns to scale begin. The minimum efficient scale is indicated in Figure.
Opportunity Costs
Opportunity Cost
Opportunity cost is concerned with the cost of forgone opportunities/alternatives. In other words, it is
the return from the second best use of the firms resources which the firms forgoes in order to avail of the
return from the best use of the resources.
Sunk Cost
Sunk costs are those do not alter by varying the nature or level of business activity. Sunk costs are
generally not taken into consideration in decision making as they do not vary with the changes in the
future. Sunk costs are a part of the outlay/actual costs.
Real Cost
It was introduced by Alfred Marshall. It refers to all efforts, services and sacrifices made in production of a
commodity.
Private Cost
A producer's or supplier's cost of providing goods or services. It includes internal costs incurred for inputs,
labor, rent, and depreciation but excludes external costs incurred as environmental damage (unless the
producer or supplier is liable to pay for them).
Social Cost
It is the expense to an entire society resulting from a news event, an activity or a change in policy. When
assessing the overall impact of its commercial actions in terms of social costs, a socially responsible
business operator should take into account its own production expenses, as well as any indirect expenses
or damages borne by others.
P a g e 36 | 105
5 The Theory of Firm and Perfect Competition
Meaning of Market
In mainstream economics, the concept of a market is any structure that allows buyers and sellers to
exchange any type of goods, services and information. The exchange of goods or services for money is a
transaction.
There are 4 conditions to be met for the existence of a market:
1. Commodity which is traded
2. Existence of buyers and sellers
3. Price
4. A location for the exchange to take place; virtual or physical.
Difference between Firm and Industry
Firm
Industry
Is a business within an industry
Group of firms dealing in same business
Existence of one firm is case of monopoly is called
There can be many firms in an industry
industry
A sub sector of a type of a business
A sub sector of an economy
No separate rules and regulations are formulated
for a firm.
Rules and regulations are made for an industry.
Market Structure
Meaning
Economists assume that there are a number of different buyers and sellers in the marketplace. This means
that we have competition in the market, which allows price to change in response to changes in supply
and demand.
Furthermore, for almost every product there are substitutes, so if one product becomes too expensive, a
buyer can choose a cheaper substitute instead. In a market with many buyers and sellers, both the
consumer and the supplier have equal ability to influence price.
P a g e 37 | 105
Perfectly Competitive Market
A purely competitive (price taker) market exists when the following conditions occur:
1. Low entry and exit barriers - there are no restraints on firms entering or exiting the market
2. Homogeneity of products - buyers can purchase the good from any seller and receive the same
good.
3. Perfect knowledge about product quality, price, and cost
4. No single buyer or seller is large enough to influence the market price
5. There is absence of transport costs
6. There is free mobility for the factors of production
Sellers must take the existing market price; if they set a price above the market price, no one will buy their
product because potential buyers simply will go to other suppliers. Setting a price below the market price
does not make any sense because the firm can sell as much as it wants to at the market price; selling
below the market price will just reduce profits.
Because sellers must take the current market price a purely competitive market is also called a "price
takers" market.
Revenue
Total Revenue
Total revenue is the total sale proceeds of a firm by selling a commodity at a given price. If a ×firm sells 2
units of a commodity at Rs. 18, total revenue is 2 x 18 = Rs. 36. Thus total revenue is price per unit
multiplied by the number of units sold, i.e., R = P ×Q, where R is the total revenue, P the price and Q the
quantity.
𝑇𝑅 = 𝑝 × 𝑞
Average Revenue
Average Revenue (AR or A) is the average receipts from the sale of certain units of the commod-ity. It is
found out by dividing the total revenue by the number of units sold. In our above example, average
revenue is 36 / 2 = Rs.18. The average revenue of a firm is, in fact, the price of the commodity at each level
of output. Since = P× Q
Thus the functional relationship P = f (Q) is the average revenue curve which reflects price as a function of
quantity demanded. It is also the demand curve.
Marginal Revenue
Marginal revenue (MR or M) is the addition to total revenue as a result of a small increase in the sale of a
firm. Algebraically, M is the addition to R by selling n + 1 units instead of n units. M = dR/dO, where d
represents a change. Since we are concerned mainly with the relationship between average revenue and
marginal revenue, we ignore total revenue in our discussion.
P a g e 38 | 105
𝑀𝑅 =
∆𝑇𝑅
∆𝑄
Relationship Between TR, AR and MR under Perfect
Competiton
Under pure (or perfect) competition, a very large
number of firms are assumed to be present. The
supply of each seller is just like a drop of water in
a mighty ocean so that any increase or decrease in
production by any one firm exerts no perceptible
influence on the total supply and on the price in
the market. The collective forces of demand and supply determine the price in the market so that only
one price tends to prevail for the whole industry.
Each firm has to take the market price as given and sell its quantity at the ruling market price. In simple
terms, the firm is a ‘price-taker’ and the firm’s demand curve is infinitely elastic. As the firm sells more and
more at the given price, its total revenue will increase but the rate of increase in the total revenue will be
constant, since AR = MR. In the figure, OX – axis represents the number of units sold and OY axis
represents the price per unit. The price of the unit remains constant at P1 . Consequently AR and MR curves
coincide with each other.
P a g e 39 | 105
Supply
In economics, supply refers to the amount of a product that producers and firms are willing to sell at a
given price when all other factors being held constant. Usually, supply is plotted as a supply curve
showing the relationship of price to the amount of product businesses are willing to sell.
Short Run Supply Curve
To illustrate, consider the production and supply decision
made by Raj the rice grower, a hypothetical firm.
Because Raj is one of many of rice producers, each
producing identical products and each with a relatively
small part of the overall market, he has no market
control.
This graph displays Raj's U-shaped cost curves
representing his rice production. Note that all three
curves (average total cost, average variable cost, and
marginal cost) are U-shaped. The marginal cost curve is
U-shaped as a direct consequence of increasing, then
decreasing marginal returns.
As a profit-maximizing rice producer, Raj produces the quantity of rice that equates the going market
price with marginal cost. Raj's supply response to changing prices can be observed by... well... by
changing prices then noting Raj's supply response.
One place to begin is with a price of say Rs. 4. The quantity supplied by Raj at a $4 price is thus 7kg rice. This
price/quantity supplied combination is one point on Raj's rice supply curve. What might Raj do if he faces
different prices?
Consider a higher price. This higher price induces Raj to increase his quantity supplied from 7 to almost 8. How
about a Rs. 8 price? Once again, a higher price motivates Raj to increase his quantity supplied. Bumping the
price up to Rs. 10, results in an even greater quantity supplied 9kg of rice.
Does Raj reduce the quantity supplied if the price declines? Up to a point. That point being the minimum of
the average variable cost curve, about Rs. 2.75. If the price falls below this level, then Raj shuts down
production in the short run, incurring a lost equal to total fixed cost.
The conclusion from this analysis is that the marginal cost curve that lies above the average variable cost is
Raj's short-run supply curve. A click of the [Short-Run Supply] button highlights Raj's rice supply curve.
Here all 3 conditions of short run equilibrium must be fulfilled:
1. P = SMC
2. SMC is not decreasing
P a g e 40 | 105
3. P > SAVC
Long Run Supply Curve
The long-run adjustment undertaken by a perfect competitive industry in response to demand shockscan
result in increasing, decreasing, and constant costs, which then trace out long-run industry supply curves
that are positively-sloped, negative-sloped, or horizontal, respectively.
The path taken by an industry depends on underlying changes in resource prices and production cost. If
the expansion of an industry causes higher resource prices and production cost, then the result is an
increasing-cost industry. If expansion causes lower resource prices and production cost, then the result is a
decreasing-cost industry. If expansion has no affect on resource prices and production cost, then the result
is a constant-cost industry.
The three alternatives are:
Increasing-Cost Industry (shut down point): An industry with a positivelysloped long-run industry supply curve that results because expansion of
the industry causes higher production cost and resource prices. An
increasing-cost industry occurs because the entry of new firms,
prompted by an increase in demand, causes the long-run average supply
curve of each firm to shift upward, which increases the minimum
efficient scale of production
Decreasing-Cost Industry (Normal profit): An industry with a negatively-sloped long-run industry supply
curve that results because expansion of the industry causes lower
production cost and resource prices. A decreasing-cost industry occurs
because the entry of new firms, prompted by an increase in demand,
causes the long-run average cost curve of each firm to shift downward,
which decreases the minimum efficient scale of production.
Constant-Cost Industry (Break Even Point): An industry with a horizontal
long-run industry supply curve that results because expansion of the
industry causes no change in production cost or resource prices. A
constant-cost industry occurs because the entry of new firms, prompted
by an increase in demand, does not affect the long-run average cost
curve of individual firms, which means the minimum efficient scale of
production does not change
P a g e 41 | 105
Determinants of Supply
1. Resource Prices: The prices paid for the use of labor, capital, land, and entrepreneursh ip affect
production cost and the ability to supply a good.
2. Production Technology: The information available concerning production techniques affects the
ability to supply a good. Technology is what producers know about the ways to combine inputs into
the production of outputs.
3. Other Prices: The supply for one good is based on the prices paid for other goods that use the same
resources for production. A change in the price of a substitute good (or substitute -in- production)
induces sellers to alter the mix of goods purchased.
4. Sellers' Expectations: The decision to sell a good today depends on expectations of future prices.
Sellers seek to sell the good at the highest possible price. If sellers expect the price to decline in the
future, they are inclined to sell more now.
5. Number of Sellers: The number of sellers willing and able to sell a good affects the overall supply.
With more sellers, there is more supply. With fewer sellers, there is less supply.
Law of Supply
Meaning
The law of supply describes the practical interaction between the price of a commodity and the quantity
offered by producers for sale. The law of supply is a hypothesis, which claims that at higher prices the
willingness of sellers to make a product available for sale is more while other things being equal. When the
price of a product is high, more producers are interested in producing the products.
Supply Schedule
Supply schedule represents the relationship between
prices and the quantities that the firms are willing to
produce and supply. In other words, at what price,
how much quantity a firm wants to produce and
supply. Assuming a firm wants to supply oranges.
The supply curve is a graphical representation of
the law of supply. The supply curve has a positive
slope, and it moves upwards to the right. This
curve shows that at the price of $6, six dozens
will be supplied and at the higher price $12, a
larger quantity of 13 dozens will be supplies
P a g e 42 | 105
Market Supply Curve
The summation of supply curves of all the
firms in the industry gives us the market supply
curve.
The upward sloping function is given as
𝑄𝑆 = 𝑎 + 𝑏𝑝
a is the maximum limit of the function
b is the slope of function.
Exceptions
The law of supply states that other things
being equal; the supply of a commodity
extends with a rise in price and contracts
with a fall in price. There are however a few exceptions to the law of supply.
1. Exceptions of a fall in price: If the firms anticipate that the price of the product will fall
further in future, in order to clear their stocks they may dispose it off at a price that is even
lower than the current market price.
2. Sellers who are in need of cash: If the seller is in need of hard cash, he may sell his
product at a price which may even be below the market price.
3. When leaving the industry: If the firms want to shut down or close down their business,
they may sell their products at a price below their average cost of production.
4. Agricultural output: In agricultural production, natural and seasonal factors play a
dominant role. Due to the influence of these constraints supply may not be responsive to
price changes.
5. Backward sloping supply curve of labor: The rise in the price of a good or service
sometimes leads to a fall in its supply. The best example is the supply of labor. A higher
wage rate enables the worker to maintain his existing material standard of living with less
work, and he may prefer extra leisure to more wages. The supply curve in such a situation
will be ‘backward sloping’ SS1 as illustrated.
P a g e 43 | 105
Elasticity of Supply
Completely (Perfectly) Inelastic supply: In this case the
quantity supplied does not react to the changes in the
price. The increase or decrease in the price does not
change the quantity supplied. The diagram below shows
us the completely inelastic supply:
As seen in the diagram, the supply curve S1S1 is parallel
to Y axis and is a vertical line. The diagram below shows
that even when the price rises there is no change in the
quantity supplied. When price rises from P1 to P2 the
quantity supplied still remains the same.
Completely (Perfectly) Elastic supply: When a minuscule
change in price results in infinite change in the quantity
supplied then it is a case of completely elastic supply. For
instance when there is marginal rise in the price, then the
quantity supplied rises infinitely.
The following diagram shows us the completely elastic
supply curve represented with a horizontal line. We can
see that the supply curve S1S1 is parallel to the X axis.
Here PEs will be equal to infinity. Even the smallest price
change in this case will change the quantity by infinity. The value of price elasticity of supply here
will be infinity (∞)
Unitary Elastic supply: When the proportionate change
in quantity supplied is equal to the proportionate
change in the price of the commodity then we call it as
unitary or unit elasticity of supply. Here PEs will be 1 at
all the points
Here we can see that when price rises from 20 rupees
to 40 rupees, the quantity supplied also rises from 20
lakhs to 40 lakhs. So when we compute the Price
elasticity of supply we have :
% change in quantity supplied/% change in price
Which I (40-20)/20 Which gives us 1 as the answer.
P a g e 44 | 105
Relatively Inelastic supply: When the percentage change in
quantity supplied is less than the proportionate change in
price than it is a case of relatively inelastic supply.
Let us see this kind of supply by putting the values for price
and quantity. In this case PEs will be less than 1. Here when
the price increases from rupees 20 to rupees 40, the quantity
supplied rises from 8 lakhs to 12 lakhs. So if we compute the
PEs as per the percentage formula then we have
% change in quantity supplied/% change in price
Which is (12-8)/8 = Which gives us 0.5 as the answer.
Relatively Elastic supply: When the percentage change in quantity supplied is more than the
percentage change in the price then we can say that it is relatively elastic supply. It can be seen
in the diagram:
For such relatively elastic supply PEs will be more then 1. In
the diagram above when price rises from 20 rupees to 40
rupees, the quantity supplied rises from 2 lakhs to 6 lakhs.
Applying the percentage formula we have:
(6-2)/2
(40-20)/20
Which gives us 2 as the answer.
Thus it can be seen that the responsiveness of the quantity to price when measured gives us
different values and when these values are put in various ranges then we have the various
degrees of elasticity
P a g e 45 | 105
Equilibrium under Perfect Competition
We know that under perfect completion both buyers and sellers are price takers. Neither of them can
influence the price level. The price of a product is determined by its supply and demand forces. This
process of determination of price by supply and demand is called ‘Price Mechanism’
Adam Smith calls price mechanism as an ‘invisible hand’. Accoding to Adam Smith ‘invisible hand’ is always
at work.
Equilibrium means a state of rest. It is a position from which there will be no intention to move in either
direction. It is a point where buyers and sellers obejctives are satisfied.
Market Equilibrium
Market equilibrium is a market state where the supply in the market is equal to the demand in the market.
The equilibrium price is the price of a good or service when the supply of it is equal to the demand for it in
the market. If a market is at equilibrium, the price will not change unless an external factor changes the
supply or demand, which results in a disruption of the equilibrium.
Supply, Demand & Equilibrium
If a market is not at equilibrium, market forces tend to move it to
equilibrium. Let's break this concept down.
If the market price is above the equilibrium value, there is an
excess supply in the market (a surplus), which means there is
more supply than demand. In this situation, sellers will tend to
reduce the price of their good or service to clear their inventories.
They probably will also slow down their production or stop
ordering new inventory. The lower price entices more people to
buy, which will reduce the supply further. This process will result
in demand increasing and supply decreasing until the market price equals the equilibrium price.
If the market price is below the equilibrium value, then there is excess in demand (supply shortage). In this
case, buyers will bid up the price of the good or service in order to obtain the good or service in short
supply. As the price goes up, some buyers will quit trying because they don't want to, or can't, pay the
higher price. Additionally, sellers, more than happy to see the demand, will start to supply more of it.
Eventually, the upward pressure on price and supply will stabilize at market equilibrium.
P a g e 46 | 105
6 Imperfect Competitive Markets
Monopoly
Monopoly is the least competitive market structure of all. A pure monopoly is a market with only
one producer who produces 100% of the output. In a pure monopoly the HHI is 10,000, the highest
HHI possible. Consumers have the least choice in a monopoly market – buy from the monopolist or
don’t buy. AOTE, we would expect a monopoly market to have the highest price and the lowest
total production of any market structure.
Features of Monopoly
1.
2.
3.
4.
5.
6.
One seller: The classic monopoly has only one seller by definition. In actuality, we also use
the market structure to analyze industries that have essentially one producer controlling
almost all the output.
Unique product: Since there is only one producer, or effectively one producer, the productthey
make cannot be compared to alternatives. It is unique. This is important in understanding why
a company like Pepsi is not a monopoly even though it is the only company that can produce its
version. The product is not unique.
Good or poor information is largely irrelevant: Whether the information is good or bad is
essentially irrelevant since there is no other product to compare this one to.
Barriers to Entry: As in oligopoly, firms are not able to move resources in, and out of this
market relatively easily with little expense. The barriers to entry are higher in monopoly and
also include the same two types.
Artificial barriers: artificial barriers to entry keep new firms from entering even if they wish
to. These are generally structural features that make entry difficult or impossible. Artificial
barriers to entry include patents, government licenses, control of a raw material, network
advantage and high start-up costs
Natural barrier: there is one natural barrier – large economies of scale – that discourages
new producers from even trying to enter. There is such a cost advantage to being big that
the industry has ended up with only one producer. A new producer is reluctant to enter
because they can’t produce for as low a cost.
Market Demand Curve of Monopoly Firm
Single-seller status for Ranbaxy Pharmaceutical
means that it faces a negatively-sloped demand
curve, such as the one displayed in the exhibit to
the right. The demand curve facing any monopoly
is the market demand curve for the product.
The top curve in the exhibit is the demand curve (D) for
Coflex. This demand curve is also theaverage revenue
curve for Coflex. It shows the per unit revenue received
by Ranbaxy Pharmaceutical for the sale of Coflex. For
reference purposes, the lower curve is the marginal
revenue curve (MR). This curve displays the extra
revenue received by Ranbaxy Pharmaceutical for each extra ounce of Coflex sold.
Because a monopoly is a price maker with extensive market control, it faces a negatively-sloped
demand curve. To sell a larger quantity of output, it must lower the price. For example, the Ranbaxy
Pharmaceutical can sell 1 ounce of Coflex for Rs. 10. However, if it wants to sell 2 ounces, then it
must lower the price to Rs. 9.50. If it seeks to sell 3 ounces, then the price must be lowered to Rs. 9.
Larger quantities are only sold it the price is less.
For this reason, the marginal revenue generated from selling extra output is less than price. While
the price of the second ounce sold of Coflex is Rs. 9.50, the marginal revenue generated by selling
the second ounce is only Rs. 9. While the Rs. 9.50 price means the monopoly gains Rs. 9.50 from
selling the second ounce, it loses Rs. 0.50 due to the lower price on the first ounce (Rs. 10 to
Rs.9.50). The net gain in revenue, that is marginal revenue, is thus only Rs. 9 (= Rs. 9.50 - Rs. 0.50).
By similar reasoning, the marginal revenue generated by the third ounce of Coflex is only Rs. 8, even
though the price is Rs. 9. On the plus side, Ranbaxy Pharmaceutical receives Rs. 9 from selling the
third ounce. However, to sell the third ounce, it must lower the price on the first two ounces from
Rs. 9.50 to Rs. 9. It loses Rs. 0.50 on each of these two ounces, or a total loss of Rs. 1. As such, the
net gain in revenue, marginal revenue, is only Rs. 8 (= Rs. 9 - Rs. 1)
Short Run Equilibrium under Monopoly (TR, TC approach)
The short-run production decision for a
monopoly can be graphically illustrated
using total revenue and total cost curves,
such as those displayed in the exhibit to the
right. These total curves represent the total
revenue and cost of Coflex production by
Ranbaxy Pharmaceutical the Coflex grower.
Total Revenue: The line (TR) depicts the
total revenue Ranbaxy Pharmaceutical
receives from Coflex production. The line is hump-shaped because Ranbaxy Pharmaceutical must
lower the price to sell a larger quantity.
Total Cost: The line (TC) depicts the total cost Ranbaxy Pharmaceutical incurs in the production of
Coflex. The shape is based on increasing, then decreasing marginal returns.
Profit: The vertical difference between these two lines is economic profit. If the total revenue line is
above the total cost line, economic profit is positive. If the total revenue line is below the total cost
line at the far right and far left, economic profit is negative.
The key for Ranbaxy Pharmaceutical is to identify the production level that gives the greatest vertical
distance between the total revenue and total cost curves in the middle of the diagram. This might
not be evident by just looking at the exhibit. The output quantity identified is, once again, 6 ounces
of Coflex.
Short Run Equilibrium (MC, MR Approach)
Perhaps the most common method of identifying the
profit-maximizing level of production for a monopoly is
using marginal revenue and marginal cost curves, such as
those displayed in this exhibit.
Marginal Revenue: The negatively-sloped line,
labeled MR, is the marginal revenue Ranbaxy
Pharmaceutical receives for each extra ounce
of Coflex sold.
Marginal Cost: The U-shaped curve, labeled MC, is the
marginal cost Ranbaxy Pharmaceutical incurs in the
production of Coflex. The shape is based on
increasing, then decreasing marginal returns.
Average Revenue: The negatively-sloped light green line (AR) is the average revenue Ranbaxy
Pharmaceutical receives from selling Coflex, which is also the demand curve.
Average Cost: Two additional U-shaped curves included in the diagram (just for good measure) are
average total cost (ATC) and average variable cost (AVC). These curves are helpful when identifying
the level of economic profit or loss and the firm's short-run supply curve.
In this analysis, Ranbaxy Pharmaceutical needs to identify the quantity of output that achieves
equality between marginal revenue and marginal cost. The highlighted quantity is once again 6
ounces of Coflex. The price charged by Ranbaxy Pharmaceutical to sell this quantity is Rs. 7.50.
Long Run Equilibrium of Monopoly
In the long run monopolist would make
adjustment in the size of his plant. The long-run
average cost curve and its corresponding longrun marginal cost curve portray the alternative
plants, i.e., various plant sizes from which the
firm has to choose for operation in the longrun.
The monopolist would choose that plant size
which is most appropriate for a particular
level of demand. In the short run the
monopolist adjusts the level of output while
working with a given existing plant. His
profit- maximizing output in the short run will be where only the short-run marginal cost curve
(i.e., marginal cost curve with the existing plant) is equal to marginal revenue.
But in the long run he can further increase his profits by adjusting the size of the plant. So in the long
run he will be in equilibrium at the level of output where given marginal revenue curve cuts the long
run marginal cost curve.
Fixing output level at which marginal revenue is equal to long-run marginal cost shows that the size
of the plant has also been adjusted. That is, a plant size has been chosen which is most optimal for a
given demand for the product. It should be carefully noted that, in the long run, marginal revenue is
also equal to short-run marginal cost.
But this short-run marginal cost is of the plant which has been selected in the long run keeping in
view the given demand for the product. Thus while, in the short run, marginal revenue is equal only
to the short-run marginal cost of the given existing plant, in the long run marginal revenue is equal
to the long-run marginal cost as well as to the short-run marginal cost of that plant which is
appropriate for a given demand for the product in the long run. In the long- run equilibrium,
therefore, both the long-run marginal cost curve and short-run marginal cost curve of the relevant
plant intersect the marginal revenue curve at the same point.
Further, it is important to note that, in the long run, the firm will operate at a point on the long- run
average cost curve (LAC) at which the short-run average cost is tangent to it. This is because it is only
at such tangency point that short-run marginal cost (SMC) of a plant equals the long-run marginal
cost (LMC).
It therefore follows that for the monopolist to maximise profits in the long run, the following
conditions must be fulfilled:
1. MR = LMC = SMC
2. SAC = LAC
3. P ≥ LAC
Monopolistic Competition
Meaning
Monopolistic competition is a type of imperfect competition such that many producers sell products
that are differentiated from one another (e.g. by branding or quality) and hence are not perfect
substitutes.
Features
1.
2.
3.
4.
5.
6.
A large number of firms: The first important feature of monopolistic competition is that
under it there are a relatively large number of firms each satisfying a small share of the
market demand for the product. Because there are a large number of firms under
monopolistic competition, there exists stiff competition between them. Unlike perfect
competition these large number of firms do not produce identical products.
Product differentiation: The second important feature of monopolistic competition is that the
products produced by various firms are not identical but are slightly different from each other.
Though different firms make their products slightly different from others, they remain close
substitutes of each other.
Some influence over the price: Each firm under monopolistic competition produces a
product variety which is close substitute of others. Therefore, if a firm lowers the price of its
product variety, some customers of other product varieties will switch over to it. This means
as it lowers the price of its product variety; quantity demanded of it will increase. On the
other hand, if it raises the price of its product, some of its customers will leave it and buy the
similar products from its competing firms.
Non-price competition: Expenditure on advertisement and other selling costs: An important
feature of monopolistic competition is that firms incur a considerable expenditure on
advertisements and other selling costs to promote the sales of their products. Promoting
sales of their products through advertisement is an important example of non-price
competition
Product variation: Another form of non-price competition which a firm under monopolistic
competition has to face is the variation in products by various firms. A firm, under perfect
competition, does not confront this problem, for the product is homogeneous under perfect
competition.
Freedom of entry and exit: This is another important feature of monopolistic competition. In
a monopolistically competitive industry it is easy for the new firms to enter and the existing
firms to leave it. Free entry means that when in the industry existing firms are making supernormal profits, the new firms enter the industry which leads to the expansion of output.
Short Run Equilibrium of Monopolistic Firm
Assuming the conditions with respect to all substitutes
such as their nature and prices being constant, the demand
curve for the product of a firm will be given. We further
suppose that the product of the firm is held constant, only
variables are price and output in respect of which
equilibrium adjustment is to be made.
The individual equilibrium under monopolistic
competition is graphically shown DD is the demand
curve for the product of an individual firm, the nature
and prices of all substitutes being given. This demand
curve DD is also the average revenue (AR) curve of the
firm.
AC represents the average cost curve of the firm, while MC is the marginal cost curve corresponding
to it. It may be recalled that average cost curve first falls due to internal economies and then rises
due to internal diseconomies.
Given these demand and cost conditions a firm will adjust his price and output at the level which
gives it maximum total profits. Theory of value under monopolistic competition is also based upon
the profit maximization principle, as is the theory of value under perfect competition.
Thus a firm in order to maximize profits will equate marginal cost with marginal revenue. In Fig. 28.3,
the firm will fix its level of output at OM, for at OM output marginal cost is equal to marginal
revenue. The demand curve DD facing the firm in question indicates that output OM can be sold at
price MQ – OP. Therefore, the determined price will evidently be MQ or OP.
In this equilibrium position, by fixing its price at OP and
output at OM, the firm is making profits equal to the
area RSQP which is maximum. It may be recalled that
profits RSQP are in excess of normal profits because the
normal profits which represent the minimum profits
necessary to secure the entrepreneur’s services are
included in average cost curve AC. Thus, the area RSQP
indicates the amount of supernormal or economic
profits made by the firm.
In the short-run, the firm, in equilibrium, may make
supernormal profits, as shown above, but it may make
losses too if the demand conditions for its product are
not so favorable relative to cost conditions. The above diagram depicts the case of a firm whose
demand or average revenue curve DD for the product lies below the average cost curve throughout
indicating thereby that no output of the product can be produced at positive profits.
However, the firm is in equilibrium at output ON and setting price NK or OT, for by adjusting price at
OT and output at ON, it is rendering the losses to the minimum. In such an unfavorable situation
there is no alternative for the firm except to make the best of the bad bargain.
We thus see that a firm in equilibrium under monopolistic competition, as under pure or perfect
competition, may be making supernormal profits or losses depending upon the position of the
demand curve relative to the position of the average cost curve. Further, a firm may be making only
normal profits even in the short run if the demand curve happens to be tangent to the average cost
curve.
Oligopoly
Meaning
Oligopoly is an important form of imperfect competition. Oligopoly is said to prevail when there are
few firms or sellers in the market producing or selling a product. In other words, when there are two
or more than two, but not many, producers or sellers of a product, oligopoly is said to exist.
Oligopoly is also often referred to as “Competition among the Few”.
Features of Oligopoly
1.
Interdependence: The most important feature of oligopoly is the interdependence in
decision•-making of the few firms which comprise the industry. This is because when the
number of competitors is few, any change in price, output, product etc. by a firm will have a
direct effect on the fortune of its rivals, which will then retaliate in changing their own prices,
output or products as the case may be.
2. Importance of advertising and selling costs: A direct effect of interdependence of oligopolists
is that the various firms have to employ various aggressive and defensive marketing weapons
to gain a greater share in the market or to prevent a fall in their market share. For this various
firms have to incur a good deal of costs on advertising and on other measures of sales
promotion.
3. Group behavior: Further, another important feature of oligopoly is that for the proper solution
to the problem of determination of price and output under, it analysis of group behavior is
important. Theories of perfect competition, monopoly and monopolistic competition present
no difficult problem of making suitable assumption about human behavior.
4. Indeterminateness of demand curve facing an oligopolist: Another important feature is the
indeterminateness of the demand curve facing an oligopolist. The demand curve shows what
amounts of its product a firm will be able to sell at various prices. Now, under perfect
competition, an indi-vidual firm’s demand curve is given and definite.
Duopoly
Meaning
Duopoly is a limiting case of oligopoly, in the sense that it has all the characteristics of oligopoly except
the number of sellers which are only two increase of duopoly as against a few in oligopoly. The main
distinguishing feature of duopoly (and also of oligopoly) from other market situating is that the sellers’
decisions are not independent of each other.
Duopoly Equilibrium Conditions
1. MR = MC
2. At the last stage, supply of both firms must be equal
3. Supply of each firm at zero price should be 1/3rd of market demand
Behavior of Firms in Oligopoly
1. Collusive Oligopoly: If firms in oligopoly collude and form a cartel, then they will try and fix the
price at the level which maximizes profits for the industry. They will then set quotas to keep
output at the profit maximizing level.
2. Non Collusive Oligopoly: Where each firm aims at maximizing its own profits and how much
quantity to produce assuming that the other firms would not change their quantity supplied.
Macro
Economics
7 Introduction to Macro Economics
Concept of Macro Economics
Macroeconomics is the branch of economics that studies the behavior and performance of an economy as
a whole. It focuses on the aggregate changes in the economy such as unemployment, growth rate, gross
domestic product and inflation.
Macroeconomics analyzes all aggregate indicators and the microeconomic factors that influence the
economy. Government and corporations use macroeconomic models to help in formulating of economic
policies and strategies.
Emergence of Macro Economics
Macroeconomics, as a separate branch of economics, emerged after the British economist John Maynard
Keynes published his celebrated book, The General Theory of Employment, Interest and Money in 1936.
The dominant thinking in economics before Keynes was that all the labourers who are ready to work will
find employment and all the factories will be working at their full capacity. This school of thought is known
as the classical tradition.
However, the Great Depression of 1929 and the subsequent years saw the output and employment levels
in the countries of Europe and North America fall by huge amounts. It affected other countries of the
world as well. Demand for goods in the market was low, many factories were lying idle, workers were
thrown out of jobs. In USA, from 1929 to 1933, unemployment rate rose from 3 per cent to 25 per cent
(unemployment rate may be defined as the number of people who are not working and are looking for
jobs divided by the total number of people who are working or looking for jobs).
Over the same period aggregate output in USA fell by about 33 per cent. These events made economists
think about the functioning of the economy in a new way. The fact that the economy may have long
lasting unemployment had to be theorized about and explained. Keynes’ book was an attempt in this
direction. Unlike his predecessors, his approach was to examine the working of the economy in its entirety
and examine the interdependence of the different sectors. The subject of macroeconomics was born.
Nature and Scope of Macro Economics
Nature of Macro Economics
Macroeconomics is the study of aggregates or averages covering the entire economy, such as total
employment, national income, national output, total investment, total consumption, total savings,
aggregate supply, aggregate demand, and general price level, wage level, and cost structure.
In other words, it is aggregative economics which examines the interrelations among the various
aggregates, their determination and causes of fluctuations in them. Thus in the words of Professor Ackley,
“Macroeconomics deals with economic affairs in the large, it concerns the overall dimensions of economic
life. It looks at the total size and shape and functioning of the “elephant” of economic experience, rather
than working of articulation or dimensions of the individual parts. It studies the character of the forest,
independently of the trees which compose it.”
Macroeconomics is also known as the theory of income and employment, or simply income analysis. It is
concerned with the problems of unemployment, economic fluctuations, inflation or deflation,
international trade and economic growth. It is the study of the causes of unemployment, and the various
determinants of employment.
In the field of business cycles, it concerns itself with the effect of investment on total output, total
income, and aggregate employment. In the monetary sphere, it studies the effect of the total quantity of
money on the general price level.
In international trade, the problems of balance of payments and foreign aid fall within the purview of
macroeconomic analysis. Above all, macroeconomic theory discusses the problems of determination of
the total income of a country and causes of its fluctuations. Finally, it studies the factors that retard
growth and those which bring the economy on the path of economic development.
The obverse of macroeconomics is microeconomics. Microeconomics is the study of the economic actions
of individuals and small groups of individuals. The “study of particular firms, particular households,
individual prices, wages, incomes, individual industries, particular commodities.” But macroeconomics
“deals with aggregates of these quantities; not with individual incomes but with the national income, not
with individual prices but with the price levels, not with individual output but with the national output.”
Microeconomics, according to Ackley, “deals with the division of total output among industries, products,
and firms, and the allocation of resources among competing uses. It considers problems of income
distribution. Its interest is in relative prices of particular goods and services.”
Macroeconomics, on the other hand, “concerns itself with such variables as the aggregate volume of the
output of an economy, with the extent to which its resources are employed, with the size of the national
income, with the ‘general price level’.”
Both microeconomics and macroeconomics involve the study of aggregates. But aggregation in
microeconomics is different from that in macroeconomics. In microeconomics the interrelationships of
individual households, individual firms and individual industries to each other deal with aggregation.
“The concept of ‘industry’, for example, aggregates numerous firms or even products. Consumer demand
for shoes is an aggregate of the demands of many households, and the supply of shoes is an aggregate of
the production of many firms.
The demand and supply of labour in a locality are clearly aggregate concepts.” “However, the aggregates
of microeconomic theory,” according to Professor Bilas, “do not deal with the behaviour of the billions of
dollars of consumer expenditures, business investments, and government expenditures. These are in the
realm of microeconomics.”
Thus the scope of microeconomics to aggregates relates to the economy as a whole, “together with subaggregates which (a) cross product and industry lines (such as the total production of consumer goods, or
total production of capital goods), and which (b) add up to an aggregate for the whole economy (as total
production of consumer goods and of capital goods add up to total production of the economy; or as total
wage income and property income add up to national income).” Thus microeconomics uses aggregates
relating to individual households, firms and industries, while macroeconomics uses aggregates which
relate them to the “economy wide total”.
Scope of Macro Economics
1.
To Understand the Working of the Economy: The study of macroeconomic variables is
indispensable for understanding the working of the economy. Our main economic problems are
related to the behaviour of total income, output, employment and the general price level in the
economy. These variables are statistically measurable, thereby facilitating the possibilities of
analysing the effects on the functioning of the economy. As Tinbergen observes, macroeconomic
concepts help in “making the elimination process understandable and transparent”. For instance,
one may not agree on the best method of measuring different prices, but the general price level is
helpful in understanding the nature of the economy.
2. In Economic Policies: Macroeconomics is extremely useful from the point of view of economic
policy. Modern governments, especially of the underdeveloped economies, are confronted with
innumerable national problems. They are the problems of overpopulation, inflation, balance of
payments, general underproduction, etc.
I.
In General Unemployment: The Keynesian theory of employment is an exercise in
macroeconomics. The general level of employment in an economy depends upon effective
demand which in turn depends on aggregate demand and aggregate supply functions.
Unemployment is thus caused by deficiency of effective demand. In order to eliminate it,
effective demand should be raised by increasing total investment, total output, total income
and total consumption. Thus, macroeconomics has special significance in studying the causes,
effects and remedies of general unemployment.
II.
In National Income: The study of macroeconomics is very important for evaluating the overall
performance of the economy in terms of national income. With the advent of the Great
Depression of the 1930s, it became necessary to analyse the causes of general overproduction
and general unemployment.
III.
In Economic Growth: The economics of growth is also a study in macroeconomics. It is on the
basis of macroeconomics that the resources and capabilities of an economy are evaluated.
Plans for the overall increase in national income, output, and employment are framed and
implemented so as to raise the level of economic development of the economy as a whole.
IV.
In Monetary Problems: It is in terms of macroeconomics that monetary problems can be
analysed and understood properly. Frequent changes in the value of money, inflation or
deflation, affect the economy adversely. They can be counteracted by adopting monetary,
fiscal and direct control measures for the economy as a whole.
V.
In Business Cycles: Further macroeconomics as an approach to economic problems started
after the Great Depression. Thus its importance lies in analysing the causes of economic
fluctuations and in providing remedies.
3. For Understanding the Behaviour of Individual Units: For understanding the behaviour of
individual units, the study of macroeconomics is imperative. Demand for individual products
depends upon aggregate demand in the economy. Unless the causes of deficiency in aggregate
demand are analysed, it is not possible to understand fully the reasons for a fall in the demand of
individual products. The reasons for increase in costs of a particular firm or industry cannot be
analysed without knowing the average cost conditions of the whole economy. Thus, the study of
individual units is not possible without macroeconomics.
Limitations of Macro Economics
1.
2.
3.
4.
5.
6.
Fallacy of Composition: In Macroeconomic analysis the “fallacy of composition” is involved, i.e.,
aggregate economic behaviour is the sum total of individual activities. But what is true of
individuals is not necessarily true of the economy as a whole. For instance, savings are a private
virtue but a public vice. If total savings in the economy increase, they may initiate a depression
unless they are invested. Again, if an individual depositor withdraws his money from the bank
there is no ganger. But if all depositors do this simultaneously, there will be a run on the banks and
the banking system will be adversely affected.
To Regard the Aggregates as Homogeneous: The main defect in macro analysis is that it regards
the aggregates as homogeneous without caring about their internal composition and structure.
The average wage in a country is the sum total of wages in all occupations, i.e., wages of clerks,
typists, teachers, nurses, etc.
But the volume of aggregate employment depends on the relative structure of wages rather than
on the average wage. If, for instance, wages of nurses increase but of typists fall, the average may
remain unchanged. But if the employment of nurses falls a little and of typists rises much,
aggregate employment would increase.
Aggregate Variables may not be Important Necessarily: The aggregate variables which form the
economic system may not be of much significance. For instance, the national income of a country
is the total of all individual incomes. A rise in national income does not mean that individual
incomes have risen. The increase in national income might be the result of the increase in the
incomes of a few rich people in the country. Thus a rise in the national income of this type has little
significance from the point of view of the community.
Indiscriminate Use of Macroeconomics Misleading: An indiscriminate and uncritical use of
macroeconomics in analyzing the problems of the real world can often be misleading. For
instance, if the policy measures needed to achieve and maintain full employment in the economy
are applied to structural unemployment in individual firms and industries, they become irrelevant.
Similarly, measures aimed at controlling general prices cannot be applied with much advantage for
controlling prices of individual products.
Statistical and Conceptual Difficulties: The measurement of macroeconomic concepts involves a
number of statistical and conceptual difficulties. These problems relate to the aggregation of
microeconomic variables. If individual units are almost similar, aggregation does not present much
difficulty. But if microeconomic variables relate to dissimilar individual units, their aggregation into
one macroeconomic variable may be wrong and dangerous.
Difference between Micro and Macro Economics
Parameter
Scope
Method of study
Different Economic Agents
Equilibrium Analysis
Domain
Micro Economics
Study of individual economic
units such as firm, industry or
consumer.
Intensive study
Economic agent thinks about its
own interest and welfare.
Consumers get maximum
satisfaction by combination of
optimum goods and services at
lower prices. Producers get
maximum profit at minimum
cost of production.
Studies partial equilibrium in
the economy such as consumer
equilibrium, producer
equilibrium etc
Comprises of theories on
consumer behavior, production
and cost etc
Macro Economics
Study of large segments of
economy such as aggregate
demand and supply.
Brief study
Economic agents are different
from individual economic
agents and their aim is to get
maximum welfare of a country.
Studies general equilibrium in
the economy such as price
levels, market equilibrium etc
Comprises of
8 National Income Accounting
Introduction
National income accounting provides economists and statisticians with detailed information that can be
used to track the health of an economy and to forecast future growth and development. Although
national income accounting is not an exact science, it provides useful insight into how well an economy is
functioning, and where monies are being generated and spent.
Some of the metrics calculated by using national income accounting include gross domestic product
(GDP), gross national product (GNP) and gross national income (GNI).
Basic Concepts of National Income
1.
2.
3.
4.
5.
6.
Consumption Goods: These are goods which are also known as consumer goods. These include,
food, clothing, services such as transport and recreation.
Capital Goods: These are goods used in production by the producer. These include factories, raw
materials, machinery.
Intermediate Goods: These are goods which are produced by one producer and used by some
other producer as material input. These include petroleum and its byproducts.
Final Goods: These are goods purchased for final use. These include electronic gadgets,
automobiles and textiles.
Stock and Flow: Economics, business, accounting, and related fields often distinguish between
quantities that are stocks and those that are flows. These differ in their units of measurement. A
stock variable is measured at one specific time, and represents a quantity existing at that point in
time (say, December 31, 2004), which may have accumulated in the past. A flow variable is
measured over an interval of time. Therefore a flow would be measured per unit of time (say a
year). Flow is roughly analogous to rate or speed in this sense.
Depreciation Cost: The depreciated cost method of asset valuation is an accounting tool used by
both corporations and individuals. It allows for the books to always be carrying an asset at its
current worth, and allows cash flows based on that asset to be measured in proportion to the
value of the asset itself. It also allows for even tax treatment of large capital assets like homes,
factories and equipment.
Circular Flow of Income
National income, output, and expenditure are generated by the activities of the two most vital parts of an
economy, its households and firms, as they engage in mutually beneficial exchange.
Households
The primary economic function of households is to supply domestic firms with needed factors of
production - land, human capital, real capital and enterprise. The factors are supplied by factor owners in
return for a reward. Land is supplied by landowners, human capital by labour, real capital by capital owners
(capitalists) and enterprise is provided by entrepreneurs. Entrepreneurs combine the other three factors,
and bear the risks associated with production.
Firms
The function of firms is to supply private goods and services to domestic households and firms, and to
households and firms abroad. To do this they use factors and pay for their services.
Factor incomes
Factors of production earn an income which contributes to national income. Land receives rent, human
capital receives a wage, real capital receives a rate of return, and enterprise receives a profit.
Members of households pay for goods and services they consume with the income they receive from
selling their factor in the relevant market.
Production function
The simple production function states that output (Q) is a function (f) of: (is determined by) the factor
inputs, land (L), labour (La), and capital (K), i.e.
Q = f (L, La, K)
The Circular flow of income
Income (Y) in an economy flows from one part to
another whenever a transaction takes place. New
spending (C) generates new income (Y), which
generates further new spending (C), and further
new income (Y), and so on. Spending and income
continue to circulate around the macro economy
in what is referred to as thecircular flow of income.
The circular flow of income forms the basis for all
models of the macro-economy, and
understanding the circular flow process is key to
explaining how national income, output and expenditure is created over time.
Injections and withdrawals
The circular flow will adjust following new injections into it or new withdrawals from it. An injection of
new spending will increase the flow. A net injection relates to the overall effect of injections in relation to
withdrawals following a change in an economic variable.
Savings and investment
The simple circular flow is, therefore, adjusted to
take into account withdrawals and injections.
Households may choose to save (S) some of their
income (Y) rather than spend it (C), and this reduces
the circular flow of income. Marginal decisions to
save reduce the flow of income in the economy
because saving is a withdrawal out of the circular
flow. However, firms also purchase capital goods,
such as machinery, from other firms, and this spending is an injection into the circular flow. This process,
called investment (I), occurs because existing machinery wears out and because firms may wish to
increase their capacity to produce
The public sector
In a mixed economy with a government, the simple model must be adjusted to include the public sector.
Therefore, as well as save, households are also likely
to pay taxes (T) to the government (G), and further
income is withdrawn out of the circular flow of
income.
Government injects income back into the economy
by spending (G) on public andmerit goods like
defence and policing, education, and healthcare, and
also on support for the poor and those unable to
work.
Including international trade
Finally, the model must be adjusted to include
international trade. Countries which trade are called
‘open’ economies, the households of an open
economy will spend some of their income on goods
from abroad, called imports (M), and this is
withdrawn from the circular flow.
Foreign consumers and firms will, however, also
wish to buy domestic products, called exports (X),
and this is an injection into the circular flow.
Macro Economic Identities
GDP
The most important concept of national income is Gross Domestic Product. Gross domestic product is the
money value of all final goods and services produced within the domestic territory of a country during a
year.
Algebraic expression under product method is,
GDP=(P*Q)
where,
GDP=Gross Domestic Product
P=Price of goods and service
Q=Quantity of goods and service denotes the summation of all values.
According to expenditure approach, GDP is the sum of consumption, investment, government
expenditure, net foreign exports of a country during a year.
Algebraic expression under expenditure approach is,
GDP=C+I+G+(X-M)
Where,
C=Consumption
I=Investment
G=Government expenditure
(X-M)=Export minus import
GDP includes the following types of final goods and services. They are:




Consumer goods and services.
Gross private domestic investment in capital goods.
Government expenditure.
Exports and imports.
Gross National Product (GNP)
Gross National Product is the total market value of all final goods and services produced annually in a
country plus net factor income from abroad. Thus, GNP is the total measure of the flow of goods and
services at market value resulting from current production during a year in a country including net factor
income from abroad. The GNP can be expressed as the following equation:
GNP=GDP+NFIA (Net Factor Income from Abroad) or, GNP=C+I+G+(X-M)+NFIA
Net National Product (NNP)
Net National Product is the market value of all final goods and services after allowing for depreciation. It is
also called National Income at market price. When charges for depreciation are deducted from the gross
national product, we get it. Thus,
NNP=GNP-Depreciation or, NNP=C+I+G+(X-M)+NFIA-Depreciation
National Income (NI)
National Income is also known as National Income at factor cost. National income at factor cost means the
sum of all incomes earned by resources suppliers for their contribution of land, labor, capital and
organizational ability which go into the years net production. Hence, the sum of the income received by
factors of production in the form of rent, wages, interest and profit is called National Income.
Symbolically,
NI=NNP+Subsidies-Interest Taxes or, GNP-Depreciation+Subsidies-Indirect Taxes or,NI=C+G+I+(X-M)+NFIADepreciation-Indirect Taxes+Subsidies
Personal Income (PI)
Personal Income is the total money income received by individuals and households of a country from all
possible sources before direct taxes. Therefore, personal income can be expressed as follows:
PI=NI-Corporate Income Taxes-Undistributed Corporate Profits-Social Security Contribution+Transfer
Payments
Disposable Income (DI)
The income left after the payment of direct taxes from personal income is called Disposable Income.
Disposable income means actual income which can be spent on consumption by individuals and families.
Thus, it can be expressed as:
DI=PI-Direct Taxes
From consumption approach,
DI=Consumption Expenditure+Savings
Per Capita Income (PCI)
Per Capita Income of a country is derived by dividing the national income of the country by the total
population of a country. Thus,
PCI=Total National Income/Total National Population
Measurement of National Income
Product Method
In this method, national income is measured as a flow of goods and services. We calculate money value of
all final goods and services produced in an economy during a year. Final goods here refer to those goods
which are directly consumed and not used in further production process.
In this method, the national income is estimated by aggregating the value of all final goods and services
produced in a country during one year.
Income Method
Under this method, national income is measured as a flow of factor incomes. There are generally four
factors of production labour, capital, land and entrepreneurship. Labour gets wages and salaries, capital
gets interest, land gets rent and entrepreneurship gets profit as their remuneration.
This is calculated using:
GDP = w + r + i + π
w is wages
r is rent
i is rent and pi is profit
Expenditure Method
In this method, national income is measured as a flow of expenditure. GDP is sum-total of private
consumption expenditure. Government consumption expenditure, gross capital formation (Government
and private) and net exports (Export-Import).
This is calculated using:
GDP = C + I + G + net X
C is private final expenditure on goods and services
I is gross domestic private investment
G is governments final consumption and investment expenditure.
Net X is net value of exports.
Value Added Method
There are three main wealth-generating sectors of the economy – manufacturing and construction,
primary (including oil& gas, farming, forestry & fishing) and a wide range of service-sector industries.
This measure of GDP adds together the value of output produced by each of the productive sectors in the
economy using the concept of value added. Value added is the increase in the value of goods or services
as a result of the production process
Value added = value of production - value of intermediate goods
Difficulties in Measuring National Income
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Non Monetary Transactions: The first problem in National Income accounting relates to the
treatment of non-monetary transactions such as the services of housewives to the members of
the families. For example, if a man employees a maid servant for household work, payment to her
will appear as a positive item in the national income. But, if the man were to marry to the maid
servant, she would performing the same job as before but without any extra payments. In this
case, the national income will decrease as her services performed remains the same as before.
Problem of Double Counting: Only final goods and services should be included in the national
income accounting. But, it is very difficult to distinguish between final goods and intermediate
goods and services. An intermediate goods and service used for final consumption. The difference
between final goods and services and intermediate goods and services depends on the use of
those goods and services so there are possibilities of double counting.
The Underground Economy: The underground economy consists of illegal and uncleared
transactions where the goods and services are themselves illegal such as drugs, gambling,
smuggling, and prostitution. Since, these incomes are not included in the national income, the
national income seems to be less than the actual amount as they are not included in the
accounting.
Petty Production: There are large numbers of petty producers and it is difficult to include their
production in national income because they do not maintain any account.
Public Services: Another problem is whether the public services like general administration, police,
army services, should be included in national income or not. It is very difficult to evaluate such
services.
Transfer Payments: Individual get pension, unemployment allowance and interest on public loans,
but these payments creates difficulty in the measurement of national income. These earnings are a
part of individual income and they are also a part of government expenditures.
Capital Gains or Loss: When the market prices of capital assets change the owners make capital
gains or loss such gains or losses are not included in national income.
Price Changes: National income is the money value of goods and services. Money value depends
on market price, which often changes. The problem of changing prices is one of the major
problems of national income accounting. Due to price rises the value of national income for
particular year appends to increase even when the production is decreasing.
Wages and Salaries paid in Kind: Additional payments made in kind may not be included in national
income. But, the facilities given in kind are calculated as the supplements of wages and salaries on
the income side.
Illiteracy and Ignorance: The main problem is whether to include the income generated within the
country or even generated abroad in national income and which method should be used in the
measurement of national income.
National Income and Welfare
People get economic welfare through the consumption of goods and services. That means the greater is
the volume of consumption of goods & services, the higher is their economic welfare. The total
consumption of goods and services by the people depends on the National income of the country. That
means, the level of economic welfare of the community depends on the national income of the country &
improvement in N.I. means more goods & services and consumption of more goods & services leads to
greater economic welfare of the people of the country.
However some of the economist who differ from the opinion of economists, Alfred Marshall, A.C. Pigue,
J.R. Hicks and other. The citizens express diverse opinion about the relationship between N.I. & economic
welfare. They make a distinction between economic welfare & non-economic welfare. Economic welfare
can be measured, but non-economic welfare cannot be measured. They do not consider N.I. as the
barometer as economic welfare. To sum up we can say that the economic welfare of the community
depends upon N.I. However, N.I. is not a reliable index of economic welfare for certain reasons.
Limitations of National Income as a measure of National Welfare
1.
National Income estimate considers only those transactions which are carried through money. It
does not take into A/c the portion of output especially the farm output. If the portion of output
kept for self-consumption is also brought to the market, the national Income will increase, though
the total output in the country has not really increased. So, increase in income does not result in
increase in economic welfare.
2. The N.I. at current prices cannot be a proper indicator of the economic welfare of the community.
This is because if the prices changes, the N.I. also charges. But the actual production of the
economy does not change. So, if the income alone increases without an increase in production,
economic welfare cannot increase.
3. The per capita Income is a better index that the N.I. to measure economic welfare of a country.
4. The per capita Income also is not a foolproof index of economic welfare. This is because, if the
growth of population in the country is at a higher rating than the increase it the real national
income of the country, the per capita income and the economic welfare of the people will
decrease.
9 Money and Banking
Introduction
Money is the most important invention of modern times. It has undergone a long process of historical
evolution. In the absence of money when goods were exchanged for goods it was called barter exchange.
The inconveniences of barter, led to the invention of a medium of exchange i.e. money. Earlier commodity
money in form of shells, utensils, animal skins, etc. was prevalent. This gave way to metallic money (gold,
silver, alloy metals), then came paper money, Bank money and plastic money.
Definition
According to Crowther,
"Anything that is generally acceptable as a means of exchange and which at the same time acts as a
measure and store of value."
Functions of Money
Various functions of money can be classified into three broad groups:
(a) Primary functions, which include the medium of exchange and the measure of value;
(b) Secondary junctions which include standard of deferred payments, store of value and transfer of value;
and
(c) Contingent functions which include distribution of national income, maximization of satisfaction, basis
of credit system, etc. These functions have been explained below:
1. Medium of Exchange: The most important function of money is to serve as a medium of exchange or as
a means of payment. To be a successful medium of exchange, money must be commonly accepted by
people in exchange for goods and services. While functioning as a medium of exchange, money benefits
the society in a number of ways:
(a) It overcomes the inconvenience of baiter system (i.e., the need for double coincidence of wants) by
splitting the act of barter into two acts of exchange, i.e., sales and purchases through money.
(b) It promotes transactional efficiency in exchange by facilitating the multiple exchange of goods and
services with minimum effort and time,
(c) It promotes allocation efficiency by facilitating specialization in production and trade,
(d) It allows freedom of choice in the sense that a person can use his money to buy the things he wants
most, from the people who offer the best bargain and at a time he considers the most advantageous.
2. Measure of Value: Money serves as a common measure of value in terms of which the value of all goods
and services is measured and expressed. By acting as a common denominator or numeraire, money has
provided a language of economic communication. It has made transactions easy and simplified the
problem of measuring and comparing the prices of goods and services in the market. Prices are but values
expressed in terms of money.
Money also acts as a unit of account. As a unit of account, it helps in developing an efficient accounting
system because the values of a variety of goods and services which are physically measured in different
units (e.g, quintals, metres, litres, etc.) can be added up. This makes possible the comparisons of various
kinds, both over time and across regions. It provides a basis for keeping accounts, estimating national
income, cost of a project, sale proceeds, profit and loss of a firm, etc.
To be satisfactory measure of value, the monetary units must be invariable. In other words, it must
maintain a stable value. A fluctuating monetary unit creates a number of socio-economic problems.
Normally, the value of money, i.e., its purchasing power, does not remain constant; it rises during periods
of falling prices and falls during periods of rising prices.
3. Standard of Deferred Payments: When money is generally accepted as a medium of exchange and a unit
of value, it naturally becomes the unit in terms of which deferred or future payments are stated.
Thus, money not only helps current transactions though functions as a medium of exchange, but
facilitates credit transaction (i.e., exchanging present goods on credit) through its function as a standard
of deferred payments. But, to become a satisfactory standard of deferred payments, money must
maintain a constant value through time ; if its value increases through time (i.e., during the period of
falling price level), it will benefit the creditors at the cost of debtors; if its value falls (i.e., during the period
of rising price level), it will benefit the debtors at the cost of creditors.
4. Store of Value: Money, being a unit of value and a generally acceptable means of payment, provides a
liquid store of value because it is so easy to spend and so easy to store. By acting as a store of value,
money provides security to the individuals to meet unpredictable emergencies and to pay debts that are
fixed in terms of money. It also provides assurance that attractive future buying opportunities can be
exploited.
Money as a liquid store of value facilitates its possessor to purchase any other asset at any time. It was
Keynes who first fully realized the liquid store value of money function and regarded money as a link
between the present and the future. This, however, does not mean that money is the most satisfactory
liquid store of value. To become a satisfactory store of value, money must have a stable value.
5. Transfer of Value: Money also functions as a means of transferring value. Through money, value can be
easily and quickly transferred from one place to another because money is acceptable everywhere and to
all. For example, it is much easier to transfer one lakh rupees through bank draft from person A in
Amritsar to person B in Bombay than remitting the same value in commodity terms, say wheat.
6. Distribution of National Income: Money facilitates the division of national income between people.
Total output of the country is jointly produced by a number of people as workers, land owners, capitalists,
and entrepreneurs, and, in turn, will have to be distributed among them. Money helps in the distribution
of national product through the system of wage, rent, interest and profit.
7. Maximization of Satisfaction: Money helps consumers and producers to maximize their benefits. A
consumer maximizes his satisfaction by equating the prices of each commodity (expressed in terms of
money) with its marginal utility. Similarly, a producer maximizes his profit by equating the marginal
productivity of a factor unit to its price.
8. Basis of Credit System: Credit plays an important role in the modern economic system and money
constitutes the basis of credit. People deposit their money (saving) in the banks and on the basis of these
deposits, the banks create credit.
9. Liquidity to Wealth: Money imparts liquidity to various forms of wealth. When a person holds wealth in
the form of money, he makes it liquid. In fact, all forms of wealth (e.g., land, machinery, stocks, stores,
etc.) can be converted into money.
Demand for Money
The demand for money is affected by several factors, including the level of income, interest rates, and
inflation as well as uncertainty about the future. The way in which these factors affect money demand is
usually explained in terms of the three motives for demanding money: the transactions, the
precautionary, and the speculative motives.
Supply of Money
There are four measures of money supply in India which are denoted by M 1, M2, M3 and M4. This
classification was introduced by the Reserve Bank of India (RBI) in April 1977. Prior to this till March 1968,
the RBI published only one measure of the money supply, M or defined as currency and demand deposits
with the public. This was in keeping with the traditional and Keynesian views of the narrow measure of the
money supply.
M1. The first measure of money supply, M 1 consists of:
(i) Currency with the public which includes notes and coins of all denominations in circulation excluding
cash on hand with banks:
(ii) Demand deposits with commercial and cooperative banks, excluding inter-bank deposits; and
(iii) ‘Other deposits’ with RBI which include current deposits of foreign central banks, financial institutions
and quasi-financial institutions such as IDBI, IFCI, etc., other than of banks, IMF, IBRD, etc. The RBI
characterizes as narrow money.
M2. The second measure of money supply is M 2 which consists of M1 plus post office savings bank
deposits. Since savings bank deposits of commercial and cooperative banks are included in the money
supply, it is essential to include post office savings bank deposits. The majority of people in rural and urban
India have preference for post office deposits from the safety viewpoint than bank deposits.
M3. The third measure of money supply in India is M3, which consists of M1, plus time deposits with
commercial and cooperative banks, excluding interbank time deposits. The RBI calls M 3 as broad money.
M4. The fourth measure of money supply is M 4 which consists of M3 plus total post office deposits
comprising time deposits and demand deposits as well. This is the broadest measure of money supply.
Of the four inter-related measures of money supply for which the RBI publishes data, it is M 3 which is of
special significance. It is M 3 which is taken into account in formulating macroeconomic objectives of the
economy every year. Since M 1 is narrow money and includes only demand deposits of banks along-with
currency held by the public, it overlooks the importance of time deposits in policy making. That is why, the
RBI prefers M3 which includes total deposits of banks and currency with the public in credit budgeting for
its credit policy. It is on the estimates of increase in M 3 that the effects of money supply on prices and
growth of national income are estimated. In fact is an empirical measure of money supply in India, as is the
practice in developed countries. The Chakravarty Committee also recommended the use of M 3 for
monetary targeting without any reason.
New Definition of Money Supply
At present there are only 3 monetary aggregates:
NM1 = Currency with public + demand deposits in banking system + other deposits with RBI
NM2 = NM1 + short term deposits of residents (including and up to the contractual maturity of 1year)
NM3 = NM2 + long term deposits of residents + call / term funding from financial institutions
Narrow Money and Broad Money
The narrow definition of money can be given as:
Mn = C + DD + OD
C is the currency held by public
DD is the demand deposit held in banks
OD is the other deposits in RBI
Broad money can be represented as:
MB = C + DD + SD + TD
C is the currency held by public
DD is the demand deposit held in banks
SD represents savings deposits in post offices
TD represents time deposits with banks
Commercial Banks
Meaning
A commercial bank is a type of bank that provides services such as accepting deposits, making business
loans, and offering basic investment products. Commercial bank can also refer to a bank or a division of a
bank that mostly deals with deposits and loans from corporations or large businesses, as opposed to
individual members of the public (retail banking).
Functions of Commercial Banks
Primary Functions
The primary functions of the commercial banks include the following:
A. Acceptance of Deposits
1. Time Deposits: These are deposits repayable after a certain fixed period. These deposits are not
withdrawn able by cheque, draft or by other means. It includes the following.
(a) Fixed Deposits: The deposits can be withdrawn only after expiry of certain period say 3 years, 5 years
or 10 years. The banker allows a higher rate of interest depending upon the amount and period of time.
Previously the rates of interest payable on fixed deposits were determined by Reserve Bank. Presently
banks are permitted to offer interest as deter-mined by each bank. However, banks are not permitted to
offer different interest rates to different customers for deposits of same maturity period, except in the
case of deposits of Rs. 15 lakhs and above. These days the banks accept deposits even for 15 days or one
month etc. In times of urgent need for money, the bank allows premature closure of fixed deposits by
paying interest at reduced rate. Depositors can also avail of loans against Fixed Depos-its. The Fixed
Deposit Receipt cannot be transferred to other persons.
(b) Recurring Deposits: In recurring deposit, the customer opens an account and de-posit a certain sum of
money every month. After a certain period, say 1 year or 3 years or 5 years, the accumulated amount along
with interest is paid to the customer. It is very helpful to the middle and poor sections of the people. The
interest paid on such deposits is gener-ally on cumulative basis. This deposit system is a useful mechanism
for regular savers of money.
(c) Cash Certificates: Cash certificates are issued to the public for a longer period of time. It attracts the
people because its maturity value is in multiples of the sum invested. It is an attractive and high yielding
investment for those who can keep the funds for a long time. It is a very useful account for meeting future
financial requirements at the occasion of marriage, education of children etc. Cash certificates are
generally issued at discount to face value. It means a cash certificate of Rs. 1, 00,000 payable after 10 years
can be pur-chased now, say for Rs. 20,000.
2. Demand Deposits: These are the deposits which may be withdrawn by the deposi-tor at any time
without previous notice. It is withdraw able by cheque/draft. It includes the following:
(a) Savings Deposits: The savings deposit promotes thrift among people. The savings deposits can only be
held by individuals and non-profit institutions. The rate of interest paid on savings deposits is lower than
that of time deposits. The savings account holder gets the advantage of liquidity (as in current a/c) and
small income in the form of interests. But there are some restrictions on withdrawals. Corporate bodies
and business firms are not allowed to open SB Accounts. Presently interest on SB Accounts is determined
by RBI. It is 4.5 per cent per annum. Co-operative banks are allowed to pay an extra 0.5 per cent on its
savings bank deposits.
(b) Current Account Deposits: These accounts are maintained by the people who need to have a liquid
balance. Current account offers high liquidity. No interest is paid on cur-rent deposits and there are no
restrictions on withdrawals from the current account. These accounts are generally in the case of business
firms, institutions and co-operative bodies. Nowadays, banks are designing and offering various
investment schemes for deposit of money. These schemes vary from bank to bank. It may be stated that
the banks are currently working out with different innovative schemes for deposits. Such deposit
accounts offer better interest rate and at the same time withdraw able facility also. These schemes are
mostly offered by foreign banks. In USA, Current Accounts are known as 'Checking Accounts' as a cheque
is equivalent to check in America.
B. Advancing of Loans: The commercial banks provide loans and advances in various forms. They are given
below:
1. Overdraft: This facility is given to holders of current accounts only. This is an ar-rangement with the
bankers thereby the customer is allowed to draw money over and above the balance in his/her account.
This facility of overdrawing his account is generally pre-arranged with the bank up to a certain limit. It is a
short-term temporary fund facility from bank and the bank will charge interest over the amount
overdrawn. This facility is generally available to business firms and companies.
2. Cash Credit: Cash credit is a form of working capital credit given to the business firms. Under this
arrangement, the customer opens an account and the sanctioned amount is credited with that account.
The customer can operate that account within the sanctioned limit as and when required. It is made
against security of goods, personal security etc.
3. Discounting of Bills: Discounting of Bills may be another form of bank credit. The bank may purchase
inland and foreign bills before these are due for payment by the drawer debtors, at discounted values, i.e.,
values a little lower than the face values. The Banker's discount is generally the interest on the full amount
for the unexpired period of the bill. The banks reserve the right of debiting the accounts of the customers
in case the bills are ulti-mately not paid, i.e., dishonored.
4. Loans and Advances: It includes both demand and term loans, direct loans and advances given to all
type of customers mainly to businessmen and investors against per-sonal security or goods of movable or
immovable in nature. The loan amount is paid in cash or by credit to customer account which the
customer can draw at any time.
5. Housing Finance: Nowadays the commercial banks are competing among them-selves in providing
housing finance facilities to their customers. It is mainly to increase the housing facilities in the country.
State Bank of India, Indian Bank, Canara Bank, Punjab National Bank, has formed housing subsidiaries to
provide housing finance.
6. Educational Loan Scheme: The Reserve Bank of India, from August, 1999 intro-duced a new Educational
Loan Scheme for students of full time graduate/post-graduate professional courses in private professional
colleges.
7. Loans against Shares/Securities: Commercial banks provide loans against the se-curity of
shares/debentures of reputed companies. Loans are usually given only up to 50% value (Market Value) of
the shares subject to a maximum amount permissible as per RBI directives. Presently one can obtain a
loan up to Rs.10 lakhs against the physical shares and up to Rs. 20 lakhs against dematerialized shares.
8. Loans against Savings Certificates: Banks are also providing loans up to certain value of savings
certificates like National Savings Certificate, Fixed Deposit Receipt, Indira Vikas Patra, etc. The loan may be
obtained for personal or business purposes.
9. Consumer Loans and Advances: One of the important areas for bank financing in recent years is
towards purchase of consumer durables like TV sets, Washing Machines, Micro Oven, etc. Banks also
provide liberal Car finance.
10. Securitization of Loans: Banks are recently trying to securities a part of their part of loan portfolio and
sell it to another investor. Under this method, banks will convert their business loans into a security or a
document and sell it to some Investment or Fund Manager for cash to enhance their liquidity position.
Secondary Functions
The secondary functions of the banks consist of agency functions and general utility functions.
A. Agency Functions
Agency functions include the following:
(i) Collection of cheques, dividends, and interests: As an agent the bank collects cheques, drafts,
promissory notes, interest, dividends etc., on behalf of its customers and credit the amounts to their
accounts.
(ii) Payment of rent, insurance premiums: The bank makes the payments such as rent, insurance
premiums, subscriptions, on standing instructions until further notice. Till the order is revoked, the bank
will continue to make such payments regularly by debiting the customer's account.
(iii) Dealing in foreign exchange: As an agent the commercial banks purchase and sell foreign exchange as
well for customers as per RBI Exchange Control Regulations.
(iv) Purchase and sale of securities: Commercial banks undertake the purchase and sale of different
securities such as shares, debentures, bonds etc., on behalf of their customers. They run a separate
'Portfolio Management Scheme' for their big customers.
(v) Act as trustee, executor, attorney, etc: The banks act as executors of Will, trustees and attorneys. It is
safe to appoint a bank as a trustee than to appoint an individual. Acting as attorneys of their customers,
they receive payments and sign transfer deeds of the properties of their customers.
(vi) Act as correspondent: The commercial banks act as a correspondent of their customers. Small banks
even get travel tickets, book vehicles; receive letters etc. on behalf of the custom-ers.
(vii) Preparations of Income-Tax returns: They prepare income-tax returns and provide advices on tax
matters for their customers. For this purpose, they employ tax experts and make their services, available
to their customers.
B. General Utility Services
The General utility services include the following:
(i) Safety Locker facility: Safekeeping of important documents, valuables like jewels are one of the oldest
services provided by commercial banks. 'Lockers' are small receptacles which are fitted in steel racks and
kept inside strong rooms known as vaults. These lockers are available on half-yearly or annual rental basis.
(ii) Payment Mechanism or Money Transfer: Transfer of funds is one of the important functions performed
by commercial banks. Cheques and credit cards are two important payment mechanisms through banks.
Despite an increase in financial transactions, banks are managing the transfer of funds process very
efficiently.
(iii) Travelers' cheques: Travelers Cheques are used by domestic travelers as well as by international
travelers. However the use of traveler's cheques is more common by interna-tional travelers because of
their safety and convenience. These can be also termed as a modi-fied form of traveler's letter of credit.
(iv) Circular Notes or Circular Letters of Credit: Under Circular Letters of Credit, the cus-tomer/traveller
negotiates the drafts with any of the various branches to which they are addressed. Thus the traveller can
obtain funds from many of the branches of banks instead only from a particular branch. Circular Letters of
Credit are therefore a more useful method for obtaining funds while travelling to many countries.
(v) Issue "Travellers Cheques": Banks issue travellers cheques to help carry money safely while travelling
within India or abroad. Thus, the customers can travel without fear, theft or loss of money.
(vi) Letters of Credit: Letter of Credit is a payment document provided by the buyer's banker in favour of
seller. This document guarantees payment to the seller upon production of document mentioned in the
Letter of Credit evidencing dispatch of goods to the buyer.
(vii) Acting as Referees: The banks act as referees and supply information about the business transactions
and financial standing of their customers on enquiries made by third parties. This is done on the
acceptance of the customers and help to increase the business activity in general.
(viii) Provides Trade Information: The commercial banks collect information on business and financial
conditions etc., and make it available to their customers to help plan their strategy. Trade information
service is very useful for those customers going for cross-border business. It will help traders to know the
exact business conditions, payment rules and buyers' financial status in other countries.
(ix) ATM facilities: The banks today have ATM facilities. Under this system the custom-ers can withdraw
their money easily and quickly and 24 hours a day. This is also known as 'Any Time Money'. Customers
under this system can withdraw funds i.e., currency notes with a help of certain magnetic card issued by
the bank and similarly deposit cash/cheque for credit to account.
(x) Credit cards: Banks have introduced credit card system. Credit cards enable a cus-tomer to purchase
goods and services from certain specified retail and service establishments up to a limit without making
immediate payment. In other words, purchases can be made on credit basis on the strength of the credit
card.
(xi) Gift Cheques: The commercial banks offer Gift cheque facilities to the general public. These cheques
received a wider acceptance in India. Under this system by paying equivalent amount one can buy gift
cheque for presentation on occasions like Wedding, Birthday.
(xii) Accepting Bills: On behalf of their customers, the banks accept bills drawn by third parties on its
customers. This resembles the letter of credit. While banks accept bills, they provide a better security for
payment to seller of goods or drawer of bills.
(xiii) Merchant Banking: The commercial banks provide valuable services through their merchant banking
divisions or through their subsidiaries to the traders. This is the function of underwriting of securities. They
underwrite a portion of the Public issue of shares, Deben-tures and Bonds of Joint Stock Companies.
(xiv) Advice on Financial Matters: The commercial banks also give advice to their custom-ers on financial
matters particularly on investment decisions such as expansion, diversifica-tion, new ventures, rising of
funds etc.
(xv) Factoring Service: Today the commercial banks provide factoring service to their customers. It is very
much helpful in the development of trade and industry as immediate cash flow and administration of
debtors' accounts are taken care of by factors. This service is again provided only by a separate subsidiary
as per RBI regulations.
RBI and its Functions
Meaning
The Reserve Bank of India is India's Central Banking Institution, which controls the Monetary Policy of the
Indian Rupee. It commenced its operations on 1 April 1935 during the British Rule in accordance with the
provisions of the Reserve Bank of India Act, 1934. The original share capital was divided into shares of 100
each fully paid, which were initially owned entirely by private shareholders. Following India's
independence on 15 - August - 1947, the RBI was nationalized in the year of 1949.
Functions of RBI
Traditional Functions of RBI:
1.
Issue of Currency Notes: The RBI has the sole right or authority or monopoly of issuing currency
notes except one rupee note and coins of smaller denomination. These currency notes are legal
tender issued by the RBI. Currently it is in denominations of Rs. 2, 5, 10, 20, 50, 100, 500, and 1,000.
The RBI has powers not only to issue and withdraw but even to exchange these currency notes for
other denominations. It issues these notes against the security of gold bullion, foreign securities,
rupee coins, exchange bills and promissory notes and government of India bonds.
2. Banker to other Banks: The RBI being an apex monitory institution has obligatory powers to guide,
help and direct other commercial banks in the country. The RBI can control the volumes of banks
reserves and allow other banks to create credit in that proportion. Every commercial bank has to
maintain a part of their reserves with its parent's viz. the RBI. Similarly in need or in urgency these
banks approach the RBI for fund. Thus it is called as the lender of the last resort.
3. Banker to the Government: The RBI being the apex monitory body has to work as an agent of the
central and state governments. It performs various banking function such as to accept deposits,
taxes and make payments on behalf of the government. It works as a representative of the
government even at the international level. It maintains government accounts, provides financial
advice to the government. It manages government public debts and maintains foreign exchange
reserves on behalf of the government. It provides overdraft facility to the government when it
faces financial crunch.
4. Exchange Rate Management: It is an essential function of the RBI. In order to maintain stability in
the external value of rupee, it has to prepare domestic policies in that direction. Also it needs to
prepare and implement the foreign exchange rate policy which will help in attaining the exchange
rate stability. In order to maintain the exchange rate stability it has to bring demand and supply of
the foreign currency (U.S Dollar) close to each other.
5. Credit Control Function: Commercial bank in the country creates credit according to the demand in
the economy. But if this credit creation is unchecked or unregulated then it leads the economy
into inflationary cycles. On the other credit creation is below the required limit then it harms the
growth of the economy. As a central bank of the nation the RBI has to look for growth with price
stability. Thus it regulates the credit creation capacity of commercial banks by using various credit
control tools.
6. Supervisory Function: The RBI has been endowed with vast powers for supervising the banking
system in the country. It has powers to issue license for setting up new banks, to open new
branches, to decide minimum reserves, to inspect functioning of commercial banks in India and
abroad, and to guide and direct the commercial banks in India. It can have periodical inspections
an audit of the commercial banks in India.
Development Functions
1.
2.
3.
4.
5.
6.
Development of the Financial System: The financial system comprises the financial institutions,
financial markets and financial instruments. The sound and efficient financial system is a
precondition of the rapid economic development of the nation. The RBI has encouraged
establishment of main banking and non-banking institutions to cater to the credit requirements of
diverse sectors of the economy.
Development of Agriculture: In an agrarian economy like ours, the RBI has to provide special
attention for the credit need of agriculture and allied activities. It has successfully rendered service
in this direction by increasing the flow of credit to this sector. It has earlier the Agriculture
Refinance and Development Corporation (ARDC) to look after the credit, National Bank for
Agriculture and Rural Development (NABARD) and Regional Rural Banks (RRBs).
Provision of Industrial Finance: Rapid industrial growth is the key to faster economic development.
In this regard, the adequate and timely availability of credit to small, medium and large industry is
very significant. In this regard the RBI has always been instrumental in setting up special financial
institutions such as ICICI Ltd. IDBI, SIDBI and EXIM BANK etc.
Provisions of Training: The RBI has always tried to provide essential training to the staff of the
banking industry. The RBI has set up the bankers' training colleges at several places. National
Institute of Bank Management i.e. NIBM, Bankers Staff College i.e. BSC and College of Agriculture
Banking i.e. CAB is few to mention.
Collection of Data: Being the apex monetary authority of the country, the RBI collects process and
disseminates statistical data on several topics. It includes interest rate, inflation, savings and
investments etc. This data proves to be quite useful for researchers and policy makers.
Publication of the Reports: The Reserve Bank has its separate publication division. This division
collects and publishes data on several sectors of the economy. The reports and bulletins are
regularly published by the RBI. It includes RBI weekly reports, RBI Annual Report, Report on Trend
and Progress of Commercial Banks India., etc. This information is made available to the public also
at cheaper rates.
7. Promotion of Banking Habits: As an apex organization, the RBI always tries to promote the
banking habits in the country. It institutionalizes savings and takes measures for an expansion of
the banking network. It has set up many institutions such as the Deposit Insurance Corporation1962, UTI-1964, IDBI-1964, NABARD-1982, NHB-1988, etc. These organizations develop and
promote banking habits among the people. During economic reforms it has taken many initiatives
for encouraging and promoting banking in India.
8. Promotion of Export through Refinance: The RBI always tries to encourage the facilities for
providing finance for foreign trade especially exports from India. The Export-Import Bank of India
(EXIM Bank India) and the Export Credit Guarantee Corporation of India (ECGC) are supported by
refinancing their lending for export purpose.
Supervisory Functions of RBI
1.
Granting license to banks: The RBI grants license to banks for carrying its business. License is also
given for opening extension counters, new branches, even to close down existing branches.
2. Bank Inspection: The RBI grants license to banks working as per the directives and in a prudent
manner without undue risk. In addition to this it can ask for periodical information from banks on
various components of assets and liabilities.
3. Control over NBFIs: The Non-Bank Financial Institutions are not influenced by the working of a
monitory policy. However RBI has a right to issue directives to the NBFIs from time to time
regarding their functioning. Through periodic inspection, it can control the NBFIs.
4. Implementation of the Deposit Insurance Scheme: The RBI has set up the Deposit Insurance
Guarantee Corporation in order to protect the deposits of small depositors. All bank deposits
below Rs. One lakh are insured with this corporation. The RBI work to implement the Deposit
Insurance Scheme in case of a bank failure.
Monetary Policy of RBI
Meaning
The term monetary policy is also known as the 'credit policy' or called 'RBI's money management policy' in
India. How much should be the supply of money in the economy? How much should be the ratio of
interest? How much should be the viability of money? etc. Such questions are considered in the monetary
policy. From the name itself it is understood that it is related to the demand and the supply of money.
Objectives of Monetary Policy
1.
Rapid Economic Growth: It is the most important objective of a monetary policy. The monetary
policy can influence economic growth by controlling real interest rate and its resultant impact on
the investment. If the RBI opts for a cheap or easy credit policy by reducing interest rates, the
investment level in the economy can be encouraged.
2. Price Stability: All the economics suffer from inflation and deflation. It can also be called as Price
Instability. Both inflation and deflation are harmful to the economy. Thus, the monetary policy
having an objective of price stability tries to keep the value of money stable.
3. Exchange Rate Stability: Exchange rate is the price of a home currency expressed in terms of any
foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the
exchange rate, the international community might lose confidence in our economy. The monetary
policy aims at maintaining the relative stability in the exchange rate. The RBI by altering the
foreign exchange reserves tries to influence the demand for foreign exchange and tries to
maintain the exchange rate stability.
4. Balance of Payments (BOP) Equilibrium: Many developing countries like India suffer from the
Disequilibrium in the BOP. The Reserve Bank of India through its monetary policy tries to maintain
equilibrium in the balance of payments.
5. Full Employment: The concept of full employment was much discussed after Keynes's publication
of the "General Theory" in 1936. It refers to absence of involuntary unemployment. In simple
words 'Full Employment' stands for a situation in which everybody who wants jobs get jobs.
However it does not mean that there is Zero unemployment.
6. Neutrality of Money: Economist such as Wicksted, Robertson has always considered money as a
passive factor. According to them, money should play only a role of medium of exchange and not
more than that. Therefore, the monetary policy should regulate the supply of money. The change
in money supply creates monetary disequilibrium.
7. Equal Income Distribution: Many economists used to justify the role of the fiscal policy are
maintaining economic equality. However in recent years economists have given the opinion that
the monetary policy can help and play a supplementary role in attainting an economic equality.
Instruments of Monetary Policy
Quantitative Instruments or General Tools
The Quantitative Instruments are also known as the General Tools of monetary policy. These tools are
related to the Quantity or Volume of the money. The Quantitative Tools of credit control are also called as
General Tools for credit control.
1.
Bank Rate Policy (BRP): The Bank Rate Policy (BRP) is a very important technique used in the
monetary policy for influencing the volume or the quantity of the credit in a country. The bank rate
refers to rate at which the central bank (i.e. RBI) rediscounts bills and prepares of commercial
banks or provides advance to commercial banks against approved securities.
2. Open Market Operation (OMO): The open market operation refers to the purchase and/or sale of
short term and long term securities by the RBI in the open market. This is very effective and
popular instrument of the monetary policy. The OMO is used to wipe out shortage of money in the
money market, to influence the term and structure of the interest rate and to stabilize the market
for government securities, etc. It is important to understand the working of the OMO. If the RBI
sells securities in an open market, commercial banks and private individuals buy it.
This reduces the existing money supply as money gets transferred from commercial banks to the
RBI. Contrary to this when the RBI buys the securities from commercial banks in the open market,
commercial banks sell it and gets back the money they had invested in them.
3. Variation in the Reserve Ratios (VRR): The Commercial Banks have to keep a certain proportion of
their total assets in the form of Cash Reserves. Some part of these cash reserves are their total
assets in the form of cash. Apart of these cash reserves are also to be kept with the RBI for the
purpose of maintaining liquidity and controlling credit in an economy.
These reserve ratios are named as Cash Reserve Ratio (CRR) and a Statutory Liquidity Ratio (SLR).
The CRR refers to some percentage of commercial bank's net demand and time liabilities which
commercial banks have to maintain with the central bank and SLR refers to some percent of
reserves to be maintained in the form of gold or foreign securities.
In India the CRR by law remains in between 3-15 percent while the SLR remains in between 25-40
percent of bank reserves. Any change in the VRR (i.e. CRR + SLR) brings out a change in
commercial banks reserves positions.
Qualitative Instruments or Selective Tools
The Qualitative Instruments are also known as the Selective Tools of monetary policy. These tools are not
directed towards the quality of credit or the use of the credit.
1.
2.
3.
4.
5.
6.
7.
Fixing Margin Requirements: The margin refers to the "proportion of the loan amount which is not
financed by the bank". Or in other words, it is that part of a loan which a borrower has to raise in
order to get finance for his purpose.
Consumer Credit Regulation: Under this method, consumer credit supply is regulated through hirepurchase and installment sale of consumer goods. Under this method the down payment,
installment amount, loan duration, etc is fixed in advance. This can help in checking the credit use
and then inflation in a country.
Publicity: This is yet another method of selective credit control. Through it Central Bank (RBI)
publishes various reports stating what is good and what is bad in the system. This published
information can help commercial banks to direct credit supply in the desired sectors. Through its
weekly and monthly bulletins, the information is made public and banks can use it for attaining
goals of monetary policy.
Credit Rationing: Central Bank fixes credit amount to be granted. Credit is rationed by limiting the
amount available for each commercial bank. This method controls even bill rediscounting.
Moral Suasion: It implies to pressure exerted by the RBI on the Indian banking system without any
strict action for compliance of the rules. It is a suggestion to banks. It helps in restraining credit
during inflationary periods. Commercial banks are informed about the expectations of the central
bank through a monetary policy
Control through Directives: Under this method the central bank issue frequent directives to
commercial banks. These directives guide commercial banks in framing their lending policy.
Through a directive the central bank can influence credit structures, supply of credit to certain
limit for a specific purpose. The RBI issues directives to commercial banks for not lending loans to
speculative sector such as securities, etc beyond a certain limit.
Direct Action: Under this method the RBI can impose an action against a bank. If certain banks are
not adhering to the RBI's directives, the RBI may refuse to rediscount their bills and securities.
Credit Creation by Commercial Banks
To explain the process of credit creation, we make the following assumptions:
1. There are many banks, say А, В, C, etc., in the banking system.
2. Each bank has to keep 10 percent of its deposits in reserves. In other word 10 per cent is the
required ratio fixed by law.
3. The first bank has Rs. 1000 as deposits.
4. The loan amount drawn by the customer of one bank is deposited in full in the second bank,
and that of the second bank into the third bank, and so on.
5. Each bank starts with the initial deposit which is deposited by the debtor of the other bank.
Given these assumptions suppose that Bank A receives cash deposits of Rs. 1000 to begin with. This is the
cash in hand with the bank which is its asset and this amount is also the liability of the bank by way of
deposits it holds. Given the reserve ratio of 10 per cent, the bank keeps Rs. 100 in reserves and lends Rs
900 to one of its customers who, in turn, give a cheque to some person from whom he borrows or buys
something. The net changes in Bank A’ is balance sheet are +Rs 100 in reserves and +Rs 900 in loans on the
assets side and Rs 1000 in demand deposits on the liabilities side as shown in Table 73.1. Before these
changes Bank A had zero excess reserves.
This loan of Rs. 900 is deposited by the customer in Bank B whose balance sheet is shown in Table 73.2.
Bank B starts with a deposit of Rs. 900, Keeps 10 per cent of it or Rs. 90 as cash in reserve. Bank B has Rs
810 as excess reserves which it lends thereby creating new deposits.
This loan of Rs. 810 is deposited by the customer of Bank B into Bank C. The balance sheet of Bank C is
shown in Table 73.3. Bank C keeps Rs 81 or 10 per cent of Rs 810 in cash reserves and lends Rs. 729.
This Process goes on to other banks. Each bank in the sequence gets excess reserves, lends and creates
new demand deposits equal to 90% of the preceding bank’s. In this way, new deposits are created to the
tune of Rs. 10000 in the banking system, as shown in Table 73.4.
The multiple credit creation shown in the last column of the above Table can also be worked out
algebraically as:
Rs 1000[1+ (9/10)+(9/10)2+(9/10)3+…+(9/10)”]
=Rs 1000(1/1-9/10) = Rs 1000(1/1/10)= Rs 1000×10 = Rs 10000.
10 Consumption and Investment Function
Concepts of Consumption, Income, Savings and Investment
1.
Consumption is a major concept in economics and is also studied by many other social sciences.
Economists are particularly interested in the relationship between consumption and income, and
therefore in economics the consumption function plays a major role
Different schools of economists define production and consumption differently. According to
mainstream economists, only the final purchase of goods and services by individuals constitutes
consumption, while other types of expenditure — in particular, fixed investment, intermediate
consumption, and government spending — are placed in separate categories. Other economists
define consumption much more broadly, as the aggregate of all economic activity that does not
entail the design, production and marketing of goods and services.
𝐶 = 𝑓(𝑌)
C refers to consumption
f is the functional relationship
Y is income
2. Income is the consumption and savings opportunity gained by an entity within a specified
timeframe, which is generally expressed in monetary terms. However, for households and
individuals, "income is the sum of all the wages, salaries, profits, interests payments, rents and
other forms of earnings received... in a given period of time."
In the field of public economics, the term may refer to the accumulation of both monetary and
non-monetary consumption ability, with the former (monetary) being used as a proxy for total
income.
𝑌 = 𝐶 +𝐼
I is the investment expenditure
3. Saving is income not spent, or deferred consumption. Methods of saving include putting money
aside in, for example, a deposit account, a pension account, an investment fund, or as cash. Saving
also involves reducing expenditures, such as recurring costs. In terms of personal finance, saving
generally specifies low-risk preservation of money, as in a deposit account, versus investment,
wherein risk is higher; in economics more broadly, it refers to any income not used for immediate
consumption.
"Saving" differs from "savings." The former refers to an increase in one's assets, an increase in net
worth, whereas the latter refers to one part of one's assets, usually deposits in savings accounts,
or to all of one's assets. Saving refers to an activity occurring over time, a flow variable, whereas
savings refers to something that exists at any one time, a stock variable.
𝑌 = 𝐶 +𝑆
S refers to saving
4. In economics, investment is the accumulation of newly produced physical entities, such as
factories, machinery, houses, and goods inventories. In finance, investment is putting money into
an asset with the expectation of capital appreciation, dividends, and/or interest earnings. This may
or may not be backed by research and analysis. Most or all forms of investment involve some form
of risk, such as investment in equities, property, and even fixed interest securities which are
subject, among other things, to inflation risk. It is indispensable for project investors to identify
and manage the risks related to the investment.
𝑌 = 𝐶 +𝐼
Equality between Savings and Investment
A variation of the Keynesian injections-leakages model includes the two private sectors, the household
sector and the business sector. This variation, more formally termed the two-sector injections-leakages
model, captures the interaction between induced saving (and indirectly induced consumption
expenditures) and autonomous investment expenditures. This model provides an alternative to the twosector aggregate expenditures (Keynesian cross) analysis of the macro economy, including equilibrium,
disequilibrium, and the multiplier.
Equilibrium is identified as the intersection between the saving line and the investment line. Two related
variations are the three-sector injections-leakages model and the four-sector injections-leakages model.
The saving-investment model provides an alternative to the more common two-sector Keynesian model;
the Keynesian cross, aggregate expenditures-aggregate production model of the macro economy. Both
models provide essentially the same analysis and are essentially "two sides of the same coin." The key
difference between the two models is that consumption is explicitly eliminated from the injectionsleakages variation. Whereas the Keynesian cross builds on the consumption function, the injectionsleakages model builds on the saving function.
Consumption Function
Keynes Consumption Function
In economics, the consumption function, or better, the consumption expenditure function, is a single
mathematical function used to express consumer spending. It was first mentioned by John Maynard
Keynes who tried to detail it in his most famous book The General Theory of Employment, Interest, and
Money. The function is used to calculate the amount of total consumption in an economy. Due to the lack
of mathematic tools when it was first draft, a very simplistic presentation was created. It was made up of
autonomous consumption that is not influenced by current income and induced consumption that is
influenced by the economy’s income level.
𝐶 = 𝑐0 + 𝑐1 𝑌𝑑
C is total consumption
c0 is autonomous consumption
c1 is the marginal propensity to consume
Yd is disposable income
Properties of Consumption Function
1.
Average Propensity to Consume (APC): The average propensity to consume (APC) indicates what
the household sector does with income. The APC indicates the portion of income that is used for
consumption expenditures. If, for example, the APC is 0.9, then 90 percent of income goes for
consumption.
The standard formula for calculating average propensity to consume (APC) is
𝐴𝑃𝐶 =
𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
𝐼𝑛𝑐𝑜𝑚𝑒
2. The marginal propensity to consume (MPC) indicates what the household sector does with extra
income. The MPC indicates the portion of additional income that is used for consumption
expenditures. If, for example, the MPC is 0.75, then 75 percent of extra income goes for
consumption
𝑀𝑃𝐶 =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
Importance of Consumption Function
We briefly discuss below the importance of consumption from various points of view:
1.
2.
3.
4.
5.
6.
7.
Consumption function depends on income. As income rises, consumption increases but less than
the rise in income. It is essential to increase investment.
There may be general over production which may force the government to intervene in the
economy through public policy.
It explains the turning point of trade cycles.
Explains the danger of over saving.
It brings out the unique feature of income generation.
There may be existence of under employment equilibrium.
It explains the declining marginal efficiency of capital.
Determinants of Consumption Function
1.
Psychological characteristics of human nature: The subjective factors affecting propensity to
consume are internal to the economic system. The subjective factors include characteristics of
human nature, social practices which lead households to refrain or activate to spending out of
their incomes. For example, religious belief of the people towards spending, their foresight,
attitude towards life, level of education, etc. Etc., directly affect propensity to consume or
determine the slope and position of the consumptions curve. The subjective factors do not
undergo a material change over a short period of time. These remain constant in the short run.
2. Objective Factors: The objective factors are external to economic system. They undergo rapid
changes and bring market shifts in the consumption function.
Investment Function
Investment is the second component of aggregate expenditure. Investment function plays an important
role in the determination of equilibrium level of national income and corresponding level of employment.
Types of Investment
1.
Planned Investment: Planned Investment can also be called as Intended Investment because an
investor while making investment make a concrete plan of his investment.
2. Gross Investment: Gross Investment means the total amount of money spent for creation of new
capital assets like Plant and Machinery, Factory Building, etc. It is the total expenditure made on
new capital assets in a period.
3. Induced Investment: Induced Investment is positively related to the income level. That is, at high
levels of income entrepreneurs are induced to invest more and vice-versa. At a high level of
income, Consumption expenditure increases this leads to an increase in investment of capital
goods, in order to produce more consumer goods.
4. Net Investment: Net Investment is Gross Investment less (minus) Capital Consumption
(Depreciation) during a period of time, usually a year. It must be noted that a part of the
investment is meant for depreciation of the capital asset or for replacing a worn-out capital asset.
Hence it must be deducted to arrive at net investment.
Determinants of Investment
The marginal efficiency of capital displays the expected rate of return from investment, at a particular
given time. The marginal efficiency of capital is compared to the rate of interest.
Keynes described the marginal efficiency of capital as:
“The marginal efficiency of capital is equal to that rate of discount which would make the present value of
the series of annuities given by the returns expected from the capital asset during its life just equal to its
supply price.” – J.M.Keynes, General Theory, Chapter 11
This theory suggests investment will be influenced by:
1. The marginal efficiency of capital
2. The interest rates
Generally, a lower interest rate makes investment relatively more attractive. If interest rates, were 3%,
then firms would need an expected rate of return of at least 3% from their investment to justify
investment. If the marginal efficiency of capital was lower than the interest rate, the firm would be better
off not investing, but saving the money.
Multiplier
The concept of ‘Investment Multiplier’ is an important contribution of Prof. J.M. Keynes. Keynes believed
that an initial increment in investment increases the final income by many times. Multiplier expresses the
relationship between an initial increment in investment and the resulting increase in aggregate income.
In practice, it is observed that when investment is increased by a certain amount, then the change in
income is not restricted to the extent of the initial investment, but it changes several times the change in
investment. In other words, change in income is a multiple of the change in investment. Multiplier explains
how many times the income increases as a result of an increase in the investment.
Multiplier (k) is the ratio of increase in national income (∆Y) due to an increase in investment (∆I).
K= ∆Y/∆I
Suppose an additional investment (∆I) of RS 4,000 crores in an economy generates an additional income
(∆Y) of Rs 16,000 crores. The value of multiplier (k), in this case will be:
k =16,000/4,000 = 4
It means, income increased 4 times with a single increase in investment.
Marginal Propensity to Consume / Save
MPC is the proportion of additional income that an individual consumes. For example, if a household earns
one extra dollar of disposable income, and the marginal propensity to consume is 0.65, then of that dollar,
the household will spend 65 cents and save 35 cents
𝐾=
1
1 − 𝑀𝑃𝐶
The marginal propensity to save (MPS) is the fraction of an increase in income that is not spent on an
increase in consumption. That is, the marginal propensity to save is the proportion of each additional
dollar of household income that is used for saving.
𝐾=
1
𝑀𝑃𝑆
Working of Multiplier
Let us understand this with the help of an example.
1. Suppose, an additional investment of Rs 100 crores (AI)
is made to construct a flyover. This extra investment will
generate an extra income of Rs100 crores in the first
round. But this is not the end of the story
2. If MPC is assumed to be 0.90, then recipients of this
additional income will spend 90% of Rs 100 crores, i.e. Rs
90 crores as consumption expenditure and the remaining
amount will be saved. It will increase the income by Rs 90
crores in the second round.
3. In the next round, 90% of the additional income of Rs 90
crores, i.e. Rs 81 crores will be spent on consumption and
the remaining amount will be saved.
4. This multiplier process will go on and the consumption
expenditure in every round will be 0.90 times of the
additional income received from the previous round. The
multiplier process is shown in Table 8.4.
Thus, an initial investment of Rs 100 crores leads to a total increase of Rs 1,000 crores in the income. As a
result, Multiplier (K) = ∆Y/∆I= 1,000/100 = 10
Diagrammatic Presentation of Multiplier:
The multiplier can also be shown graphically using the AD
and AS approach. In Fig. 8.7, income is taken on the X-axis
and aggregate demand on the Y-axis. Suppose, the initial
equilibrium is determined at point E where AD curve
intersects the AS curve. The equilibrium level of income is
OY. Now, suppose that the investment increases by ∆I / so
that the new aggregate demand curve (AD 1) intersects the
aggregate supply curve (AS) at point ‘F’.
Thus, the new equilibrium level of income is OY1. The income
rises from OY to OY1, in response to an initial increase in
investment (∆I ). It is clear from the figure that the increase
in income (YY1 or ∆Y) is greater than increase in investment
(∆I ). The value of multiplier is given by
K=∆Y/∆I
11 Government Budget and Economy
Budget
A budget is a quantitative expression of a plan for a defined period of time. It may include planned sales
volumes and revenues, resource quantities, costs and expenses, assets, liabilities and cash flows. It
expresses strategic plans of business units, organizations, activities or events in measurable terms.
Types of Budget
Balanced Budget
Balanced budget is a situation, in which estimated revenue of the government during the year is equal to
its anticipated expenditure.
Government's estimated Revenue = Government's proposed Expenditure.
For individuals and families, it is always advisable to have a balanced budget.
Most of the classical economists advocated balanced budget, which was based on the policy of 'Live
within means'. According to them, government's revenue should not fall short of expenditure. They also
favoured balanced budget because they believed that government should not interfere in economic
activities and should just concentrate on the maintenance of internal and external security and provision
of basic economic and social overheads. To achieve this, government has to have enough fiscal discipline
so that its expenditures are equal to revenue.
Unbalanced Budget
The budget in which income & expenditure are not equal to each other is known as Unbalanced Budget.
Unbalanced budget is of two types :1.
Surplus Budget The budget is a surplus budget when the estimated revenues of the year are
greater than anticipated expenditures.
Government expected revenue > Government proposed Expenditure.
Surplus budget shows the financial soundness of the government. When there is too much
inflation, the government can adopt the policy of surplus budget as it will reduce aggregate
demand.
2. Deficit Budget: Deficit budget is one where the estimated government expenditure is more than
expected revenue.
Government's estimated Revenue < Government's proposed Expenditure.
Such deficit amount is generally covered through public borrowings or withdrawing resources
from the accumulated reserve surplus. In a way a deficit budget is a liability of the government as
it creates a burden of debt or it reduces the stock of reserves of the government.
In developing countries like India, where huge resources are needed for the purpose of economic
growth & development it is not possible to raise such resources through taxation, deficit
budgeting is the only optio
Components of Budget
Revenue Account
This financial statement includes the revenue receipts of the government i.e. revenue collected by way of
taxes & other receipts. It also contains the items of expenditure met from such revenue.
a) Revenue Receipts: These are the incomes which are received by the government from all sources
in its ordinary course of governance. These receipts do not create a liability or lead to a reduction
in assets. Revenue receipts are further classified as tax revenue and non-tax revenue.
I.
Tax Revenue: Tax revenue consists of the income received from different taxes and
other duties levied by the government. It is a major source of public revenue. Every
citizen, by law is bound to pay them and non-payment is punishable. Taxes are of two
types, viz., Direct Taxes and Indirect Taxes. Direct taxes are those taxes which have to be
paid by the person on whom they are levied. Its burden cannot be shifted to someone
else. E.g. Income tax, property tax, corporation tax, estate duty, etc. are direct taxes.
There is no direct benefit to the tax payer. Direct taxes are progressive which means the
amount increases with respect to increase in income.
Indirect taxes are those taxes which are levied on commodities and services and affect
the income of a person through their consumption expenditure. Here the burden can be
shifted to some other person. E.g. Custom duties, sales tax, services tax, excise duties,
etc. are indirect taxes.
II.
Non-Tax Revenue: Apart from taxes, governments also receive revenue from other nontax sources. These include revenue from public sector companies, fines, grants from
foreign aid and interest receipts.
b) Revenue Expenditure: Revenue expenditure is the expenditure incurred for the routine, usual and
normal day to day running of government departments and provision of various services to
citizens. It includes both development and non-development expenditure of the Central
government. Usually expenditures that do not result in the creations of assets are considered
revenue expenditure.
I.
In general revenue expenditure includes following :II.
Expenditure by the government on consumption of goods and services.
III.
Expenditure on agricultural and industrial development, scientific research,
education, health and social services.
IV.
Expenditure on defence and civil administration.
V.
Expenditure on exports and external affairs.
VI.
Grants given to State governments even if some of them may be used for creation
of assets.
VII.
Payment of interest on loans taken in the previous year.
VIII.
Expenditure on subsidies.
Capital Account
This part of the budget includes receipts & expenditure on capital account projected for the next financial
year. Capital budget consists of capital receipts & Capital expenditure.
a) Capital Receipts: Receipts which create a liability or result in a reduction in assets are called capital
receipts. They are obtained by the government by raising funds through borrowings, recovery of
loans and disposing of assets. Items included in Capital Receipts are
I.
Loans raised by the government from the public through the sale of bonds and
securities. They are called market loans.
II.
Borrowings by government from RBI and other financial institutions through the
sale of Treasury bills.
III.
Loans and aids received from foreign countries and other international
Organisations like International Monetary Fund (IMF), World Bank, etc.
IV.
Receipts from small saving schemes like the National saving scheme, Provident
fund, etc.
V.
Recoveries of loans granted to state and union territory governments and other
parties.
b) Capital Expenditure: Any projected expenditure which is incurred for creating asset with a long
life is capital expenditure. Thus, expenditure on land, machines, equipment, irrigation projects, oil
exploration and expenditure by way of investment in long term physical or financial assets are
capital expenditure.
Planned and Unplanned Capital Expenditure
India has adopted economic planning as a strategy for economic development. For stepping up the rate of
economic development five-year plans have been formulated. So far ten five-year plans have been
completed. The expenditure incurred on the items relating to five year plans is termed as plan
expenditure. Such expen-diture is incurred by the Central Government.
A provision is made for such expenditure in the budget of the Central Government. Assistance given by
the Central Government to the State Governments and Union Territories for plan purposes also forms part
of the plan expenditure. Plan expenditure is sub-divided into Revenue Expenditure and Capital
Expenditure.
The expenditure provided in the budget for routine normal activities of the government is called non-plan
expenditure. Its examples are expenditure incurred on administrative services, salaries and pension etc.
There is no provision in the plan for such expenditure. Non-plan expenditure is also sub-divided into
revenue expenditure and capital expenditure.
Fiscal Policy
Arthur Smithies defines fiscal policy as “a policy under which the government uses its expenditure and
revenue programmes to produce desirable effects and avoid undesirable effects on the national income,
production and employment.”
Objectives of Fiscal Policy
1.
2.
3.
4.
5.
Development by effective Mobilisation of Resources: The principal objective of fiscal policy is to
ensure rapid economic growth and development. This objective of economic growth and
development can be achieved by Mobilisation of Financial Resources.
Efficient allocation of Financial Resources: The central and state governments have tried to make
efficient allocation of financial resources. These resources are allocated for Development Activities
which includes expenditure on railways, infrastructure, etc. While Non-development Activities
includes expenditure on defence, interest payments, subsidies, etc.
Reduction in inequalities of Income and Wealth: Fiscal policy aims at achieving equity or social
justice by reducing income inequalities among different sections of the society. The direct taxes
such as income tax are charged more on the rich people as compared to lower income groups.
Indirect taxes are also more in the case of semi-luxury and luxury items, which are mostly
consumed by the upper middle class and the upper class.
Price Stability and Control of Inflation: One of the main objective of fiscal policy is to control
inflation and stabilize price. Therefore, the government always aims to control the inflation by
Reducing fiscal deficits, introducing tax savings schemes, Productive use of financial resources,
etc.
Employment Generation: The government is making every possible effort to increase employment
in the country through effective fiscal measure. Investment in infrastructure has resulted in direct
and indirect employment. Lower taxes and duties on small-scale industrial (SSI) units encourage
more investment and consequently generate more employment.
6. Balanced Regional Development: Another main objective of the fiscal policy is to bring about a
balanced regional development. There are various incentives from the government for setting up
projects in backward areas such as Cash subsidy, Concession in taxes and duties in the form of tax
holidays, Finance at concessional interest rates, etc.
7. Reducing the Deficit in the Balance of Payment: Fiscal policy attempts to encourage more exports
by way of fiscal measures like Exemption of income tax on export earnings, Exemption of central
excise duties and customs, Exemption of sales tax and octroi, etc.
8. Capital Formation: The objective of fiscal policy in India is also to increase the rate of capital
formation so as to accelerate the rate of economic growth. An underdeveloped country is trapped
in vicious (danger) circle of poverty mainly on account of capital deficiency.
9. Increasing National Income: The fiscal policy aims to increase the national income of a country.
This is because fiscal policy facilitates the capital formation. This results in economic growth, which
in turn increases the GDP, per capita income and national income of the country.
10. Development of Infrastructure: Government has placed emphasis on the infrastructure
development for the purpose of achieving economic growth. The fiscal policy measure such as
taxation generates revenue to the government. A part of the government's revenue is invested in
the infrastructure development. Due to this, all sectors of the economy get a boost.
11. Foreign Exchange Earnings: Fiscal policy attempts to encourage more exports by way of Fiscal
Measures like, exemption of income tax on export earnings, exemption of sales tax and octroi,
etc. Foreign exchange provides fiscal benefits to import substitute industries. The foreign
exchange earned by way of exports and saved by way of import substitutes helps to solve balance
of payments problem.
Instruments of Fiscal Policy
The instruments of fiscal policy are:
Public Expenditure
This is the expenditure incurred by the government for promotion of social and economic welfare of the
people. This has a significant effect on income, output and employment. Hence it can have a big impact on
the growth of the country.
Deflationary gap is the excess of output over planned expenditure at base price. The government restores
full employment when there is less investment by the private sector. According to Wagner’s law of
increasing state activities there exists a causal relationship between government expenditure and
economic development. He said that there is a tendency of increasing public expenditure in India due to:
1. Participation in material production
2. Provision of social services.
3. Maintenance and enforcement of law and order.
Public Revenue
This is the revenue made from tax and non tax sources. A suitable tax policy results in economic stability.
Changes in the rates of taxes will cause changes in level of income and consumption of people. In India tax
revenue comes from income tax, service tax, customs duties etc. Non tax revenue comprises of interest
receipts obtained by the government for loans and advances from local governments and public sector
undertakings.
The tax system in India is an important instrument in fiscal policy. It is used for:
1. To mobilize revenue and check for unwanted expenditure.
2. To affect changes in the pattern of distribution of income and wealth.
3. To use a weapon to control inflation and deflation.
Progressive direct tax system affects the income of people and changes their purchasing power which
regulates inflation and deflation.
Public Debt
Public debt refers to the borrowings of the government to meet the budget deficits. It is used to control
inflation and deflation. It is often argued that internal or market debt does not matter much because we
owe money to ourselves. This is because transfer of money happens between people, purchasing power
remains within the country.
External debt on the other hand is to be taken seriously because purchasing power is transferred from
one country to another through debt repayment and interest payments.
Prof Raja Chellaiah has suggested following techniques to reduce debt:
a) Accounts of RBI should be integrated with those of the government
b) A substantial part of gold reserves created by gold seized from smuggling and other illegal
activities must be auctioned.
c) Utilization of resources generated through disinvestment.
d) Utilization of resources generated through sale of a part of vast real estate.
Deficit Financing
Fiscal deficit presents a more comprehensive view of budgetary imbalances. It is widely used as a
budgetary tool for explaining and understanding the budgetary developments in India. Fiscal deficit refers
to the excess of total expenditure over total receipts (excluding borrowings) during the given fiscal year.
Deficit financing refers to the borrowing undertaken by the government to make up for the revenue
shortfall. It is the best stimulant for the economy in short term. However, in the long term it becomes a
drag on the economy and becomes the reason for rise in interest rate. There is no precise definition of the
term deficit financing.
Deficit financing is an important source of capital formation in the developed and under developed
countries of the world. In advanced countries, the newly created money is used to finance public
investments which increase economic growth.
Budget Deficits
When the government expenditure exceeds revenues, the government is having a budget deficit. Thus
the budget deficit is the excess of government expenditures over government receipts (income). When
the government is running a deficit, it is spending more than it's receipts.
The government finances its deficit mainly by borrowing from the public, through selling bonds; it is also
financed by borrowing from the Central Bank.
Revenue Deficit
Revenue Deficit takes place when the revenue expenditure is more than revenue receipts. The revenue
receipts come from direct & indirect taxes and also by way of non-tax revenue.
Revenue Deficit = Revenue Expenditure – Revenue Receipts
Fiscal Deficit
Fiscal Deficit is a difference between total expenditure (both revenue and capital) and revenue receipts
plus certain non-debt capital receipts like recovery of loans, proceeds from disinvestment.
In other words, fiscal deficit is equal to budgetary deficit plus governments market borrowings and
liabilities.
Fiscal Deficit = Total Expenditure – Revenue Receipts + Non Debt Receipts
Primary Deficit
The fiscal deficit may be decomposed into primary deficit and interest payment. The primary deficit is
obtained by deducting interest payments from the fiscal deficit. Thus, primary deficit is equal to fiscal
deficit less interest payments. It indicates the real position of the government finances as it excludes the
interest burden of the loans taken in the past.
Primary Deficit = Fiscal Deficit – Interest Payments
12 Open Economy
Meaning of Open Economy
An open economy is an economy in which there are economic activities between the domestic community
and outside (people, and even businesses, can trade in goods and services with other people and
businesses in the international community, and funds can flow as investments across the border). Trade
can take the form of managerial exchange, of technology transfers, and of all kinds of goods and services.
Linkage of Open Economy
1.
Product Market Linkage: Consumers and firms can buy both domestic and foregn goods. This is
called product market linkage which can occur through foreign trade.
2. Financial Market Linkage: Investors can choose to invest in domestic and foregin assets. This is
financial market linkage.
3. Factor Market Linkage: It involves free movement of factors of production. Firms can choose
where to produce and workers can choose where to work.
Closed Economy
Autarky is the quality of being self-sufficient. Usually the term is applied to political states or their
economic systems. Autarky exists whenever an entity can survive or continue its activities without
external assistance or international trade. If a self-sufficient economy also refuses all trade with the
outside world then it is called a closed economy
Difference Between Closed and Open Economy
Open Economy
An open economy is one, which is not only
involved in the process of production within its
domestic territory but also can participate in
production anywhere in the rest of the world.
It buys shares, debentures, bonds etc. from
foreign countries and sells shares, debentures,
bonds etc. to foreign countries.
Closed Economy
Closed economy is an economy, which does
not have any sort of economic relation with
rest of the world but is confined to itself only.
It borrows from foreign countries and lends to
foreign countries.
It neither borrows from the foreign countries
nor lends to the foreign countries.
It can send gifts and remittances to foreigners
and can receive the same from them.
Normal residents of an open economy can
move or be employed and are allowed to work
in the domestic territory of other economies.
It neither receives gifts from foreigners nor
sends gifts to foreigners.
Normal residents of a closed economy cannot
go to other countries to work in their domestic
territory. No foreigner is allowed to work in the
domestic territory of a closed economy.
It neither buys shares, debentures, bonds etc.
from foreign countries nor sells shares,
debentures, bonds etc. to foreign countries.
Basic Concepts of Trade
Domestic Trade
The trade conducted within the national boundaries of a country is known as internal trade. Internal trade
can also be termed as Home trade or Domestic trade.
Foreign Trade
1.
Unilateral Trade: A trade agreement joins two or more states in a joint commitment to expand
their trade. Normally, this includes domestic structural reforms such as lowering tariffs and
reducing bureaucratic regulations. A unilateral trade agreement is technically not an agreement,
but the actions of one country to expand its market and reform its economy.
2. Bilateral Trade: Bilateral trade or clearing trade is trade exclusively between two states,
particularly, barter trade based on bilateral deals between governments, and without using hard
currency for payment. Bilateral trade agreements often aim to keep trade deficits at minimum by
keeping a clearing account where deficit would accumulate.
3. Multilateral Trade: Multilateral trade agreements are between many nations at one time. This
makes them extremely complicated to negotiate, but very powerful once all parties sign.
Balance of Trade and Balance of Payments
Balance of Trade
Balance of payments should be distinguished from balance of trade. Balance of trade refers to the export
and import of visible items, i.e., material goods. It is the difference between the value of visible exports
and imports.
Visible items are those items which are recorded in the customs returns; for example, material goods
exported and imported. If the value of visible exports is greater than that of visible imports, the balance of
trade is favourable.
If the value of visible imports is greater than that of visible exports the balance of trade is unfavourable; if
the value of visible exports is equal to that of visible imports, the balance of trade is in equilibrium.
Balance of trade is also known as merchandise account of exports and imports.
Balance of Payments
Balance of payments, on the other hand, is a more comprehensive concept because it covers (a) visible
items (i.e., balance of trade or merchandise account) and (b) invisible items.
Invisible items are those items which are not recorded in the customs returns; for example, services (such
as transpiration, banking, insurance, etc.), capital flows, purchase and sale of gold, etc.
Thus, balance of payments is a broader term than balance of trade; balance of payments includes both
visible as well as invisible items, whereas balance of trade includes only visible items.
Structure of Balance of Payments
The balance of payments account
of a country is constructed on the
principle of double-entry bookkeeping. Each transaction is
entered on the credit and debit side
of the balance sheet. But balance of
payments accounting differs from
business accounting in one respect.
These credit and debit items are
shown vertically in the balance of
payments account of a country
according to the principle of
double-entry book-keeping. Horizontally, they are divided into three categories: the current account, the
capital account and the official settlements account or the official reserve assets account.
Current Account
The current account of a country consists of all transactions relating to trade in goods and services and
unilateral (or unrequited) transfers. Service transactions include costs of travel and transportation,
insurance, income and payments of foreign investments, etc. Transfer payments relate to gifts, foreign
aid, pensions, private remittances, charitable donations, etc. received from foreign individuals and
governments to foreigners.
In the current account, merchandise exports and imports are the most important items. Exports are
shown as a positive item and are calculated f.o.b. (free on board) which means that costs of
transportation, insurance, etc. are excluded. On the other side, imports are shown as a negative item and
are calculated c.i.f. (costs, insurance and freight) and included.
The difference between exports and imports of a country is its balance of visible trade or merchandise
trade or simply balance of trade. If visible exports exceed visible imports, the balance of trade is
favourable. In the opposite case when imports exceed exports, it is unfavourable.
It is, however, services and transfer payments or invisible items of the current account that reflect the true
picture of the balance of payments account. The balance of exports and imports of services and transfer
payments is called the balance of invisible trade.
The invisible items along with the visible items determine the actual current account position. If ex ports of
goods and services exceed imports of goods and services, the balance of payments is said to be
favourable. In the opposite case, it is unfavourable.
In the current account, the exports of goods and services arid the receipts of transfer payments
(unrequited receipts) are entered as credits (+) because they represent receipts from foreigners. On the
other hand, the imports of goods and services and grant of transfer payments to foreigners are entered as
debits (-) because they represent payments to foreigners. The net value of these visible and invisible trade
balances is the balance on current account.
Capital Account
The capital account of a country consists of its transactions in financial assets in the form of short-term
and long-term lending’s and borrowings and private and official investments. In other words, the capital
account shows international flows of loans and investments, and represents a change in the country’s
foreign assets and liabilities.
Long-term capital transactions relate to international capital movements with maturity of one year or
more and include direct investments like building of a foreign plant, portfolio investment like the purchase
of foreign bonds and stocks and international loans. On the other hand, short- term international capital
transactions are for a period ranging between three months and less than one year.
There are two types of transactions in the capital account—private and government. Private transactions
include all types of investment: direct, portfolio and short-term. Government transactions consist of loans
to and from foreign official agencies.
In the capital account, borrowings from foreign countries and direct investment by foreign countries
represent capital inflows. They are positive items or credits because these are receipts from foreigners. On
the other hand, lending to foreign countries and direct investments in foreign countries represent capital
outflows.
They are negative items or debits because they are payments to foreigners. The net value of the balances
of short-term and long-term direct and portfolio investments is the balance on capital account. The sum of
current account and capital account is known as the basic balance.
Official Reserve / Official Statement Account
The official settlements account or official reserve assets account is, in fact, a part of the capital account.
But the U.K. and U.S. balance of payments accounts show it as a separate account. “The official
settlements account measures the change in nations’ liquidity and non-liquid liabilities to foreign official
holders and the change in a nation’s official reserve assets during the year.
The official reserve assets of a country include its gold stock, holdings of its convertible foreign currencies
and SDRs, and its net position in the IMF”. It shows transactions in a country’s net official reserve assets.
Foreign Exchange Market
In India the value of transactions involving balance of payments is measured either in rupee terms or in
terms of US dollars. Given the volume of these transactions, their value in rupees or dollars would depend
on the rate of exchange of rupee with US dollar.
Nominal and Real Exchange Rate
While the nominal exchange rate tells how much foreign currency can be exchanged for a unit of domestic
currency, the real exchange rate tells how much the goods and services in the domestic country can be
exchanged for the goods and services in a foreign country.
Real exchange rate is the ration of foreign prices to domestic prices measured in the same currency. In
other words the relative price of foreign goods in terms of domestic goods is real exchange rate.
𝑅=
𝑒𝑃𝑓
𝑃
P is domestic price level
Pf is price level abroad
e is the nominal exchange rate
Determination of Exchange Rate
Purchasing Power Parity Theory
The purchasing power parity theory was propounded by Professor Gustav Cassel of Sweden. According to
this theory, rate of exchange between two countries depends upon the relative pur-chasing power of
their respective currencies.
Such will be the rate which equates the two purchasing powers. For example, if a certain assortment of
goods can be had for £1 in Britain and a similar assortment with Rs. 80 in India, then it is clear that the
purchasing power of £1 is equal to the purchasing power of Rs. 80. Thus, the rate of exchange, according
to purchasing power parity theory, will be £1 =Rs. 80.
Let us take another example. Suppose in the USA one $ purchases a given collection of com-modities. In
India, same collection of goods cost 45 rupees.
Then rate of exchange will tend to be:
$1 = 45 rupees.
Now, suppose the price levels in the two countries remain the same but somehow exchange rate moves
to
$1 = 46 rupees.
This means that one US$ can purchase commodities worth more than 45 rupees. It will pay people to
convert dollars into rupees at the rate ($1 = Rs. 46), purchase the given collection of commodities in India
for 45 rupees and sell them in U.S.A. for one dollar again, making a profit of 1 rupee per dollar worth of
transactions.
This will create a large demand for rupees in the USA while supply thereof will be less because very few
people would export commodities from USA to India. The value of the rupee in terms of the dollar will
move up until it will reach $1 = 45 rupees. At that point, imports from India will not give abnormal profits.
$ 1 = 45 rupees is called the purchasing power parity between the two countries.
Balance of Payments Theory
There is a close relation between the balance of payments and the demand and supply of foreign
exchange. Balance of payments is a record of international payments made due to various international
transactions, such as, imports, exports, investments and other commercial, financial and speculative
transactions.
The balance of payments includes all payments made by the foreigners to the nationals as well as all
payments made by the nationals to the foreigners. The incoming payments are credits and outgoing
payments are debits.
The credits in balance of payments or the export items constitute the supply of foreign ex change; the
supply of foreign exchange is made by the exporting countries.
On the other hand, the debits in the balance of payments or the import items constitute the demand for
foreign exchange; the demand for foreign exchange arises from the importing countries.
Any deficit or surplus in the balance of payments causes changes in the demand and supply of foreign
exchange and thus leads to fluctuations in the exchange rate. When there is deficit in the balance of
payments the debits (or the demand for foreign exchange) will exceed the credits (or the demand for
foreign exchange).
As a result, the rate of exchange will rise (or the exchange value of domestic currency in terms of foreign
currency will fall).
On the other hand, a surplus in the balance of payments means credits (or the supply of foreign
exchange), exceeding debits (or the demand for foreign exchange), which in turn, will lead to a fall in the
rate of exchange (or a rise in the external value of domestic currency).
Exchange Rate Systems
Fixed Exchange Rate
Fixed exchange rate system refers to a system in which exchange rate for a currency is fixed by the
government.
1.
2.
3.
4.
5.
6.
7.
The basic purpose of adopting this system is to ensure stability in foreign trade and capital
movements.
To achieve stability, government undertakes to buy foreign currency when the exchange rate
becomes weaker and sell foreign currency when the rate of exchange gets stronger.
For this, government has to maintain large reserves of foreign currencies to maintain the
exchange rate at the level fixed by it.
Under this system, each country keeps value of its currency fixed in terms of some ‘External
Standard’.
This external standard can be gold, silver, other precious metal, another country’s currency or
even some internationally agreed unit of account.
When value of domestic currency is tied to the value of another currency, it is known as ‘Pegging’.
When value of a currency is fixed in terms of some other currency or in terms of gold, it is known
as ‘Parity value’ of currency.
Floating Exchange Rate
Flexible exchange rate system refers to a system in which exchange rate is determined by forces of
demand and supply of different currencies in the foreign exchange market.
1.
The value of currency is allowed to fluctuate freely according to changes in demand and supply of
foreign exchange.
2. There is no official (Government) intervention in the foreign exchange market.
3. Flexible exchange rate is also known as ‘Floating Exchange Rate’.
4. The exchange rate is determined by the market, i.e. through interactions of thousands of banks,
firms and other institutions seeking to buy and sell currency for purposes of making transactions in
foreign exchange.
Managed Floating Rate
It refers to a system in which foreign exchange rate is determined by market forces and central bank
influences the exchange rate through intervention in the foreign exchange market.
1. It is a hybrid of a fixed exchange rate and a flexible exchange rate system.
2. In this system, central bank intervenes in the foreign exchange market to restrict the fluctuations
in the exchange rate within certain limits. The aim is to keep exchange rate close to desired target
values.
3. For this, central bank maintains reserves of foreign exchange to ensure that the exchange rate
stays within the targeted value.
4. It is also known as ‘Dirty Floating.