Business Economics (Study Text)
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Second Edition 2020
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Business Economics (Study Text)
CONTENT
Ch.
Page No
1
ECONOMIC CONCEPTS
01
2
DEMAND AND SUPPLY ANALYSIS
47
3
ELASTICITY OF DEMAND AND SUPPLY
84
4
CONSUMER’S BEHAVIOR AND ITS ANALYSIS
124
5
PRICE INSTABILITY AND GOVERNMENT MEASURES
163
6
PRODUCTION
177
7
COST BEHAVIOUR
222
8
COMPETITION, MARKET EFFECTS AND GOVERNMENT
247
MEASURES
9
MACROECONOMIC ENVIRONMENT-I
276
10 MACROECONOMIC ENVIRONMENT-II
324
11 ECONOMICS OF PAKISTAN
359
Business Economics (Study Text)
HOW TO USE THE MATERIAL
The main body of the text is divided into a number of chapters, each of which is
organized on the following pattern:

Detailed learning outcomes. You should assimilate these before beginning
detailed work on the chapter, so that you can appreciate where your studies
are leading.

Step-by-step topic coverage. This is the heart of each chapter, containing
detailed explanatory text supported where appropriate by worked examples
and exercises. You should work carefully through this section, ensuring that
you understand the material being explained and can tackle the examples and
exercises successfully. Remember that in many cases knowledge is
cumulative; if you fail to digest earlier material thoroughly; you may struggle to
understand later chapters.

Examples. Most chapters are illustrated by more practical elements, such as
relevant practical examples together with comments and questions designed
to stimulate discussion.

Self-Test questions. The test of how well you have learned the material is
your ability to tackle standard questions. Make a serious attempt at producing
your own answers, but at this stage don’t be too concerned about attempting
the questions in exam conditions. In particular, it is more important to absorb
the material thoroughly by completing a full solution than to observe the time
limits that would apply in the actual exam.

Solutions. Avoid the temptation merely to ‘audit’ the solutions provided. It is an
illusion to think that this provides the same benefits as you would gain from a
serious attempt of your own. However, if you are struggling to get started on a
question you should read the introductory guidance provided at the beginning
of the solution, and then make your own attempt before referring back to the
full solution.
Business Economics (Study Text)
STUDY SKILLS AND REVISION GUIDANCE
Planning
To begin with, formal planning is essential to get the best return from the time
you spend studying. Estimate how much time in total you are going to need
for each subject you are studying for the Operational Level. Remember that
you need to allow time for revision as well as for initial study of the material.
This book will provide you with proven study techniques. Chapter by chapter it
covers the building blocks of successful learning and examination techniques.
This is the ultimate guide to passing your ICMA Pakistan written by a team of
developers and shows you how to earn all the marks you deserve, and
explains how to avoid the most common pitfalls.
With your study material before you, decide which chapters you are going to
study in each week, and in which week you will devote revision and final
question practice.
Prepare a written schedule summarizing the above and stick to it.
It is essential to know your syllabus. As your studies progress you will become
more familiar with how long it takes to cover topics in sufficient depth. Your
timetable may need to be adapted to allocate enough time for the whole
syllabus.
Tips for effective studying
(1)
Aim to find a quiet and undisturbed location for your study, and plan as
far as possible to use the same period of time each day. Getting into a
routine helps to avoid wasting time. Make sure that you have all the
materials you need before you begin so as to minimize interruptions.
(2)
Store all your materials in one place, so that you do not waste time
searching for items around your accommodation. If you have to pack
everything away after each study period, keep them in a box or even a
suitcase, which will not be disturbed until the next time.
(3)
Limit distractions. To make the most effective use of your study
periods you should be able to apply total concentration, so turn off all
entertainment equipment, set your phones to silent mode and put up
your ‘do not disturb’ sign.
Business Economics (Study Text)
(4)
Your timetable will tell you which topic to study. However, before
dividing in and becoming engrossed in the finer points, make sure you
have an overall picture of all the areas that need to be covered by the
end of that session. After an hour, allow yourself a short break and
move away from your study text. With experience, you will learn to
assess the pace you need to work at.
(5)
Work carefully through a chapter, note imported points as you go.
When you have covered a suitable amount of material, vary the
pattern by attempting a practice question. When you have finished
your attempt, make notes of any mistakes you make, or any areas that
you failed to cover or covered more briefly.
Business Economics (Study Text)
Business Economics (Study Text)
1
Content
1.
2.
3.
4.
5.
6.
7.
Definition of Economics
Factors of Production: Land, Labour, Capital and Enterprise
Allocation of scare resources and wants
Microeconomics VS Macroeconomics
Basic economics school of thoughts, Classical, new classical and modern
school of thought
Major economics system of the world capitalism, socialism and Islamic
Concept of Opportunity Cost and Production Possibility Curve
Business Economics (Study Text)
2
1. Definition of Economics
The field of economics, as a social science, has been shaped by the contributions of
eminent thinkers throughout history. Among them, Adam Smith, Alfred Marshall, and
Lionel Robbins stand as pillars, each offering unique perspectives on the
fundamental principles governing economic behavior and systems. Their definitions
collectively illustrate the relationship between human wants, scarce resources, and
the mechanisms driving economic activity.
1.1 Definition of economics by Adam Smith
Adam Smith (1723-1790) was British Economist. He was the founder of the Classical
School of Thought. He was the first who started writing about economic problems.
His book, “An Inquiry into the Nature and Causes of the Wealth of Nations” was
published in 1776.
This was the first-ever book on Economics. In his book, Adam Smith defined
economics in the following words:
“Economics is the Science of Wealth”
This is the first-ever definition of economics. Adam Smith discussed four aspects of
wealth in his book, which is as follows:
1. Production of wealth
In this part of the book, he discussed that how goods and services are produced with
the help of four factors of production i.e., Land, Labor, Capital and Enterprise. So
according to Adam Smith, production of goods and services is the production of
wealth.
2. Distribution of wealth
This part of the book is related with the distribution of goods and services produced.
Adam Smith discussed various theories about the determination of remunerations for
the four factors of production. He also talked about the evenness and unevenness of
distribution of wealth.
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3. Exchange of wealth
This part of the book is about exchange of goods and services. Producers produce
goods & services in excess of their needs. So, they want to exchange their excess
production with one another. Adam Smith discussed the rules of Domestic &
International Trade.
4. Consumption of wealth
This segment of the book is about consumption of wealth. Adam Smith discussed
that how an individual should spend his wealth to get maximum utility or satisfaction.
Followers of Adam Smith
Economists like Chapp Man, Franscis A. Walker, Alley, N.W. Senior, J.S.Mill,
Ricardo, Malthus, and J.B.Say etc. followed Adam Smith in his ideas about this
subject. All these economists are called the followers of Adam Smith.
So, the Classical Economists, Adam Smith and followers, defined economics more
or less in the following words:
“Economics is a science in which the Nature of Wealth and
all those laws are studied which are related to the Production,
Distribution, and Exchange & Consumption of Wealth”
Criticism
Social Reformers like Ruskin, Carlyle & Arnold criticized this definition. They called
it as a “Dismal Science” and a “Pig Philosophy”. According to these reformers this
science only discusses wealth, which creates selfishness into the man.
The main criticisms on this definition are as follows:
1. Importance to wealth
According to this definition basic importance is given to wealth rather than to man.
The fact is that man is more important than wealth.
2. Concept of economic man
According to this definition man works for self-interest while the social interest is
ignored. The fact is that Economics does not study the selfish man but a common
man.
3. Controversial
The word ‘Wealth’ did not have clear meanings, so the definition became
controversial.
4. Man’s welfare
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This definition ignores the importance of man’s welfare. Wealth cannot be the
solution of all human problems.
5. No study of means
This definition gives importance to the earning of wealth but it ignores the means
for the earning of wealth.
1.2 Definition of economics by Alfred Marshall
Professor Dr. ALFRED MARSHALL (1842-1924) was a British economist. He was
the founder of Neo-Classical School of Thought.
Alfred Marshall
His book, “Principles of Economics” was published in 1890.
economics in the following words:
He defined
“Economics is the study of that human behavior which is
related with the ordinary business of life. It deals with that part
of individual and collective human efforts which is greatly
related with the attainment and with the use of material things
for the prosperous life. So we can say that economics, on the
one hand, is the science of wealth while on the other hand, it is
the study of an aspect of human life.”
We can derive the following points from this definition of economics:
A. In this definition of economics Marshall says that wealth is sought for promoting
human welfare. So primary importance is given to human welfare and not to
wealth.
B. Economics is concerned with the ordinary business of life. It does not concern
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with Economic Man i.e., a man who only wants to get wealth only for wealth.
Economics is concerned with ordinary man who is influenced by human
considerations in the pursuit of wealth.
C. Economics does not study the wealth only for wealth but for the purpose that with
the help of wealth we can attain those material requisites, which can increase the
material welfare of human being.
D. Human efforts are of many types. Economics is concerned only that struggles
due to the result of which material requisites are attained to the human being.
Followers of Dr. Alfred Marshall
Professor Marshall’s followers like Cannon, Pareto, Pegou, Clark, Baveridge, etc.,
also defined Economics as “A study of causes of material welfare.”
Merits of definition
The merits of this definition of Economics are as follows:
1. Science of human welfare
According to Marshall, economics is a science of human welfare. This science
guides human being to get and utilize resources for the fulfillment of human
needs in a better way.
2. Comprehensive and clear definition
Unlike the definition of economics by Adam Smith, this definition is clear from all
conflicts. The struggle for the attainment of requisites in order to live a better life
is the scope of economics.
3. Study of individual and collective struggles
According to this definition economics stresses the collective struggle of human
being in order to put the society on the way of progress.
4. Man’s importance
According to Marshall, man is more important than wealth. Wealth is the source
of the fulfillment of human needs.
Criticism
Professor Lionel Robbins in his book, “Nature and Significance of Economic
Science” criticized this definition. The main points of his criticism are as follows:
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1- Does not cover whole economic problems
This definition does not cover the whole economic problems. According to this
definition only those human efforts are discussed in economics, which increase
the material welfare of man. Those human efforts that do not relate with the
material needs are not discussed in this subject. The fact is that economics is
related with all types of struggles for financial returns, whether the struggle fulfils
the material needs or non-material needs. So, this definition covers some of the
problems.
2- Concept of consumption of wealth
The part of man’s income is consumed on the fulfillment of material needs like
clothing, housing, feeding etc. and the other part is consumed on the fulfillment of
non-material needs like education, traveling etc. Marshall in Economics
discusses only those problems that are created by the use of wealth in the
fulfillment of material needs while the fact is that all the problems are discussed in
economics.
3. Immeasurable concept of welfare
In this definition of Economics Marshall uses the word WELFARE which is
ambiguous and immeasurable. Welfare is a state of mind that cannot be
measured. So the concept that cannot be measured should not be used in the
definition of any science.
4. Likes and dislikes
According to Marshall, economics is a science of material welfare. If it is true,
then we should take the steps that can increase the welfare and we should avoid
the things due to which welfare may decline. So the question of likes and dislikes
arises while the fact is that economics should be neutral among the various
objectives.
5. Economics is not a pure social science
According to this definition economics is confined only to the social science. In
this way economics only studies the behavior of that person who lives in society
and it does not discuss the behavior of the person who does not live in the
society.
1.3 Definition of Economics by Lionel Robbins
Lionel Charles Robbins was a British economist, and prominent member of the
economics department at the London School of Economics (LSE). Professor
Lionel Robbins has published his book, “An Essay on Nature and Significance of
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Economic Science” in 1932.
He defined economics in the following words:
“Economics is the science which studies human behavior as a relationship
between multiple ends (wants) and scarce means (resources) which have
alternative uses.”
This definition of Economics explains a particular aspect of human behavior i.e., the
behavior that concerns with the utilization of scarce resources to achieve unlimited
ends.
Following four basic points are mentioned explicitly in this definition.
A. Unlimited wants
Human wants are unlimited. Multiplicity of wants is the cause of unending cycle of
economic activity. If wants had been limited, they would have been adequately
satisfied and there would have been no economic problem.
B. Various importance of wants
This definition also points out implicitly that human wants are of various
importance. Due to the difference in importance, problem of choice appears. If all
human wants are of the same importance, then there will be no problem for man
because he can fulfill any of his desire with his limited resources.
C. Limited resources
Economic resources are scarce in relation to human wants. Natural, human and
artificial resources are not scarce in absolute term but they are scarce in relative
term. So according to Robbins, unlimited wants and scarce means provide a
foundation to the field of economics. Due to this relationship between wants and
means, ‘Economic Problem’ arises. If all the things were freely available to satisfy
the unlimited human wants, there would be no scarcity and there would be no
economic Problem.
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D. Various uses of resources
The limited means available to satisfy human wants may be utilized alternatively.
A particular mean is not fixed for a particular need. If particular means were fixed
for the satisfaction of particular desires, no economic problem could have
appeared.
Merits of definition
The merits of the definition of economics by Robbins are as follows:
1. Comprehensive
This definition of economics is superior to early definitions because of the fact
that no one can claim that all of his needs are fulfilled. Similarly, in any part of the
world human wants are abundant and resources are scarce. So, this reality
makes the definition comprehensive.
2. Positive science
Unlike early economists, Robbins regarded economics as a positive science. We
can say that according to Robbins, economics is not concerned with the
goodness or badness of wants i.e., it is not a normative science. In economics
facts are studied neutrally. So, economics is a science like other science subjects.
3. Wider scope
Robbins widens the scope of economics. He considers all types of human wants,
material or non-material as well as all types of persons whether living in a society
or not. So, unlike the definition of economics by Marshall, the problem of likes
and dislikes does not appear.
4. No charge of mammonism
According to this definition no charge of ‘Mammonism’ can be put against
economics. Economics takes no responsibility for selecting the wants. They may
be good or bad, economics is not concerned. Wherever the wants are unlimited
and the means are scarce, economics is directly concerned.
Demerits of definition
This definition of Economics is also not free from demerits which are as follows:
1. Positive science
Robbins wants to prove this subject as a positive science but he ignores this fact
that the purpose of all social sciences is to improve the human life. So, if
economics is assumed to be a positive science, then there will be no use of it.
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2. Men and matter
Robbins tries to prove economics as a positive science like other physical
sciences but this fact is ignored that physical sciences are related to matter. But
economics is related with man and it is his nature that he cannot follow the fixed
principles.
3. Scarcity of resources
Problems are not only created by the scarcity of resources but also by the
abundance of resources. The depression of 1930s was also the result of
abundance of resources.
4. Static nature
According to the contemporary economists, this definition of Economics is of
Static Nature while in our society changes appear in resources and wants but
Robbins did not discuss about this issue.
5. Problem of unemployment
This definition does not explain the problem of unemployment. For some
countries this is an urgent problem. There is abundance of manpower rather than
scarcity of it.
6. Economic growth
The theory of Economic Growth has become a very important branch of
economics. Robbins’ definition does not cover it.
2. Factors of Production: Land, Labour, Capital, and Enterprise
2.1 Factors of Production
By factors of Production or ‘resources’, economists mean all the human, natural and
manufactured or ‘manmade’ resources which are at our disposal and which we use
to create wealth.
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Resources or inputs include land, labor, capital and enterprise.
Land
Reward
Labor
Rent
Reward
Capital
Pre-determined
Wage
Reward
Entrepreneur
No risk
Pre-determined
Interest
Reward
Pre-determined
Profit
No risk
Not predetermined
No risk
May be
Profit
May be
Loss
Land
Land means all economic resources which are free gift of Nature to man or blessed
by Nature that can go into production process.
Land stands for all-Natural resources that have an exchange value. It represents
those Natural resources that are useful and scarce. It consists of all the free Natural
gifts i.e., arable land, forests, livestock, minerals, oil deposits, water etc. It consists of
all the material resources beneath and around the surface of land like mineral
resources and the resources above the surface of land like atmosphere and climate.
No production is possible without Natural resources. So, land is considered as the
fundamental factor of production.
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Labor
Any mental or physical exercise of human beings which is done for the sake of
material reward is called labor.’
‘Any exertion of mind or body undergone partly or wholly with a view to some good
other than the pleasure derived directly from the work is called labor.’
Any work, manual or mental, undertaken for a monetary consideration, is called
Labor. Any work done for the sake of pleasure or love does not fall under labor.
Labor is different from other factors of production. Labor is not only a means of
production but also an end of production.
So, labor is the broad term for all human physical and mental talents that can be
used in producing goods and services. (This excludes a special class of human
talent – entrepreneurial ability – which, because of its special significance in a
capitalistic economy, we consider separately). Thus, the services of builder’s laborer,
retail clerk, machinist, teacher, band member and investment banker, workers,
lawyers, police officers, waiters, actors all fall under the heading of labor.

Capital
‘That part of a man’s wealth which is used in producing further wealth or generates
income is called Capital’.
As far the definition of capital is concerned, there are two conditions attached with
capital.
Capital is a part of wealth.

This part of wealth helps in producing further wealth or generates income.
This shows that all the capital is a part of wealth, but all the wealth is not capital.
Only that part of wealth is capital which brings income, or which is used in producing
further wealth.
‘Produced means of production are known as Capital’.
According to this definition, capital is generally used for capital goods i.e., plants,
machinery, tools, accessories, stocks of raw material, goods in process and fuel.
Capital, or investment goods, consists of those goods manufactured as aids to
production. Capital includes factory, storage, transport and distribution facilities, and
all tools, machinery and equipment used in producing goods and services and
getting them to the ultimate consumer. The process of producing and accumulating
capital goods is known as investment.
Capital goods (tools) differ from consumer goods because the consumer goods
satisfy wants directly, whereas the capital goods satisfy wants indirectly by
facilitating the production of consumable goods. Note especially that term ‘capital’ as
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here defined does not refer to money. True business people and economists often
talk of ‘money capital’ meaning money available to purchase machinery, equipment
and other productive facilities. But money as such, produces nothing; hence, it is not
considered as an economic resource.
Real capital – tools, machinery and other productive equipment’s – is an economic
resource; money or financial capital is not.
The entrepreneur – a fourth resource?








The fourth factor is the special human resource of production is enterprise1 or
entrepreneurial ability, which is supplied by the entrepreneur. We assign the
following related functions to the entrepreneur.
An entrepreneur is the person who starts work, organizes and supervises it.
The entrepreneur takes the initiative in combining the resources of land, capital
and labour in the production of a good or service. The entrepreneur is at once the
driving force behind production and the agent who combines the other resources
in the hope of profit.
The entrepreneur2 makes basic business policy decisions, that is, those non –
routine decisions that set the course of a business enterprise.
The entrepreneur is an innovator – the one who attempts to introduce, on a
commercial basis, new products, new productive techniques or even new form of
business organization.
The entrepreneur is a risk bearer. This is apparent from a close examination of
the other three functions. Entrepreneurs have no guarantee of profit. The reward
for their time, efforts and abilities may be attractive profits, or losses and eventual
bankruptcy. They risk not only time, effort and business reputation, but also their
invested funds and those of associates or shareholders.
He undertakes to remunerate all the factors of production: to pay rent to the
landlord, interest to the capital owner, wages to labor and to make efforts for his
own profit.
In the words of Harvey Leibenstein, an entrepreneur is the person who,
“Searches and discovers economic opportunities, evaluates economic
opportunities, marshals the financial resources necessary for the enterprise,
makes time-binding arrangements, takes ultimate responsibility for management,
is the ultimate risk-bearer, searches and discovers new economic information,
translates new information into new markets, techniques and goods and provides
leadership for the work groups.”
2.2 Rewards of Factors of Production
1
2
The ability to run a production process is called enterprise.
Entrepreneur is a French word which means “ one who undertakes”
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Resources are also sometimes referred to as factors of production –
the elements or factors used in the process of producing goods and services. The
returns to economic resources are wages, rent, interest and profits.
As resources or factors of production are used in the process of wealth creation, this
results in a flow of income payments to the providers of these factors. These
incomes are variously referred to as factor rewards, factor returns, factor incomes or
factor pricing.
KEY POINT
The returns to economic resources are wages, rent, interest and profits/(loss).
The terminologies used to refer to the different incomes which accrue to the factors
are as follows:
Factor
Income
Land
Rent
Labor
Wages / Salaries
Capital
Interest (the rate of interest is usually taken to represent
the price of using capital)
Enterprise
Profit/(Loss)
3. Allocation of Scare Resources and Wants
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The fundamental economic problem
Unlimited/
Multiple wants
Economic
Economic Problem
Activity
Satisfaction
wants
Scarce Resources
All human societies face a fundamental economic problem. The cumulative total of
all human wants is unlimited but the resources available to satisfy these wants are
strictly limited. Thus, the quantity of goods and services which we can produce to
satisfy our wants is limited. So, relative to our wants, resources are scarce.
Unlimited wants
Psychologists have attempted to explain the unlimited nature of human wants by
differentiating between different levels of wants. In all societies, we have basic wants
which we must satisfy. These are the need for food, clothing and shelter. Once these
basic wants have been satisfied, we then attempt to satisfy another level of wants:
comforts, e.g. wanting entertainment, holidays, a varied diet and a greater choice of
clothing. Having achieved satisfaction at this level, we now move on to another level
of wants, namely luxuries, e.g. a car, a holiday home, etc. This level of wants is
never fully satisfied because once a certain level of luxury wants is satisfied a more
sophisticated level is then desired.
Furthermore, innovation brings new products on to the market and consumers then
want to own these goods. Product modification can also increase wants. Finally,
many wants are of a recurring nature, e.g. food, clothing and holidays.
Having established that human wants are without limit, it then follows that in order to
satisfy wants it would be necessary to have an endless supply of goods and services
available. However, this is not the case because if there were an endless supply of
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goods and services, then there would be no need to economise and all goods would
be free, with everybody having as much as they want.
The reason that there is not an endless supply of goods and services available is
that there is a limited supply of the factors of production or resources which are
required to produce any goods or service. The quantity of factors available will
determine the quantity of goods and services which can be produced.
The amount of each of the factors of production can be increased over time.
However, at any one time there is a finite quantity of resources available and
therefore there is a limit to the quantity of goods and services which can be produced.
Scarcity and choice
It can be seen that society has unlimited wants but, because of a scarcity of the
factors of production, there is a scarcity of goods and services available to satisfy
these unlimited wants. It is for this very reason that we must economise. We cannot
satisfy all of our wants; therefore, we must choose which wants to satisfy and which
wants will have to remain unsatisfied. We must allocate our scarce resources
between all of the competing ends to which we would like to devote our available
resources.
This concept of choice exists at all levels in our society. The household must choose
between a new set of saucepans or a new kettle. The board of a manufacturing
company must decide upon what products to produce to maximize company profits.
Central government chooses between greater resource allocation to the health
service or improved armed forces.
We have now defined economics as the study of how societies use – scarce
resources, which have alternative uses, to satisfy unlimited wants - how we decide
what quantities of resources should be allocated to all of the competing end results
which we consider desirable or necessary.
4. Microeconomics VS Macroeconomics
There are two branches of economics (a) microeconomics and (b) macroeconomics
Microeconomics focuses on the actions of individual agents within the economy, like
households, workers, and businesses; Macroeconomics looks at the economy as a
whole. It focuses on broad issues such as growth of production, the number of
unemployed people, the inflationary increase in prices, government deficits, and
levels of exports and imports. Microeconomics and macroeconomics are not
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separate subjects, but rather complementary perspectives on the overall subject of
the economy.
Microeconomics
Microeconomics is also called ‘Price Theory’. The word MICRO is derived from the
Greek word ‘MIKROS’ which means one-millionth part i.e., very small. It does not
mean that the theory itself is very small.
‘Microeconomics is the study of some small part of the whole Economy.’
Following important problems, theories and behaviors are studied in Microeconomics.
1. Theory of consumers’ behavior
In this theory we try to understand how consumers decide about their purchases
and what factors affect their decisions. This theory studies the demand side of
the economic problem.
2. Behavior of firm
In this theory we discuss the basic problems of the firm i.e., what to produce?
How to produce? Where to produce? How much to produce? For whom to
produce? This theory examines the supply side of the economy.
3. Price theory
In this theory, keeping in view the demand and supply sides, we study how the
price of a single commodity is determined.
4. Theory of Income Distribution
In this theory we examine how the national income is distributed among various
FOP. In other words, the principle, according to which wages, rent, interest and
profit are determined, is studied under this head.
Macroeconomics
Macroeconomics is also called ‘Income Theory’. Macro means very large. John
Maynard Keynes gave clear meanings to this concept in 1936 with publication of
book, “General Theory of Employment, Interest & Money” as:
‘Macroeconomics is the study of aggregates and averages of the whole Economy’
‘Macroeconomic theory is the theory of income, employment, price and money’
‘Macro Economics deals with the functioning of Economy as a whole’
In Macroeconomics, the following theories are studied.
1. Theory of employment and income determination
In this theory we study all the problems that arise in connection with the income
and employment at national level. Here we also study how to raise the level of
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national income and employment in the country.
2. Theory of trade cycle
In this theory we study the causes of the ups and downs in business, prices and
national income under capitalistic system of production. We also study the ways
how these fluctuations can be removed.
3. Theory of money
In this theory we try to understand the problems of money and banking. We
attempt here to find out their solutions at the national level. Here we study also
the problems connected with the general price level.
4. Theory of international trade
Generally, the problem of international trade is included in Macroeconomics, but
both the Micro & Macro approaches are used to study the problem.
5. Theory of public finance
In this theory the problems relating to the sources of government revenue, the
items of expenditure of the govt. and public debts are studied.
4. Basic economics school of thoughts, classical, new classical and
modern school of thought
School of economic thought is a group of economic thinkers who share or shared a
common perspective regarding the way economies work. Systematic economic
theory has been developed mainly since the beginning of what is termed as the
modern era which started with the rise of early classical economists belonging to
the mercantilist and physiocrats schools. They were succeeded by the mainstream
classical economists such as Adam Smith, David Ricardo, JS Mill, Alfred Marshall
etc.
Classical Economics
The Classical school, which lasted until 1870 is associated with the 18th Century
Scottish economist Adam Smith, and those British economists that followed, such
as Robert Malthus and David Ricardo. The main idea of the Classical school was
that markets work best when they are left alone because the price mechanism acts
as a powerful ‘invisible hand’ to allocate resources to where they are best
employed as value of every product or service was determined mainly by scarcity
and costs of production. According to them there is nothing but the smallest role for
government as the economy would always return to the full-employment level of
real output through an automatic self-adjustment mechanism.
New Classical
New classical school of economics emerged during the 1970s and tried to explain
the global macro-economic problems and issues of the period through
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reinterpretation of concepts used by the Classical Economists. For example,
Robert Lucas used the concepts of rational behavior and rational expectations for
the 1970s crises.
Modern Economics
The modern definition, attributed to the 20th-century economist, Paul Samuelson,
builds upon the definitions of the past and defines the subject as a social science.
According to Samuelson, “Economics is the study of how people and society
choose, with or without the use of money, to employ scarce productive resources
which could have alternative uses, to produce various commodities over time and
distribute them for consumption now and in the future among various persons and
groups of society.”
6.
Major economics system of the world capitalism, socialism and
Islamic
The way in which these problems are solved varies from society to society
depending on the economic system in operation. Whilst there are many similarities
between, for example, Britain, France, West Germany and the United States, there
are also many differences. In the USA, the central government plays a much
smaller part in the provision of health care facilities than in the United Kingdom.
The German government spends more per head on health than the British
government. Basically, the way in which economic decisions are made depends on
the political and moral ideas prevailing within any given society.
Economic Systems
The free Economic System
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Capitalism
The mixed economic System
Private ownership
Co-existence of
The planned
Economic System
Socialism
Private and
Public Sector
Public / Social
ownership
6.1 The free market economic system
In many countries the system in operation is one whereby individual, in the main,
have the right to own and control the ‘means of production’ – the economic
resources – and it is not considered immoral to use these resources for the
attainment of private profit. This is achieved by using them to produce things that
other individuals want to buy. Hence private citizens decide how resources will be
used, acting as producers and consumers in the various markets for goods and
services.
An economic system of this kind is called a free enterprise, free market or
capitalist system.
There is no pure example of a free market economy in the world. Later on we will
consider the reasons why the State is likely to intervene to influence resource
allocation.
However, it is useful to begin by asking how, in the absence of government
intervention, the three basic economic problems are likely to be solved.
(1) What to produce?
The answer is that resources would be allocated according to the preferences of
consumers. Left to their own devices and free of State control, individual citizens
would make the major economic decisions about what to produce and so on, as
consumers and producers interacting in the markets for goods and services.
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CONSUMER
(motive – to
satisfy wants)
DEMAND
MARKET
SUPPLY
PRODUCER
(motive – to
make profits)
In addition to the determination of what will be produced and in what quantities, the
interaction of market forces will also result in the determination of price. Price will
depend upon the relative strength of supply and demand and will fluctuate
accordingly, acting as a signal to producers and indicating the most profitable
directions in which to allocate resources. As long as price is free to fluctuate, we can
expect, in theory, that resources will be allocated exactly according to the wishes of
consumers, and any surpluses or shortages will automatically be eliminated.
We can see the way in which this works by looking at the example below.
Situation
Suppose that the supply of holidays to celebrate the millennium exceeds the
demand of consumers to take such a holiday, at the price being asked by the
travel companies.
Tour operators will be forced to cut the price of these packages.
They will also cut back the supply of millennium breaks and devote more time
and resources to more profitable areas.
Lower prices for a millennium break will encourage more consumers to take
one, and demand will rise.
Gradually, the surplus of holidays will be eliminated.
The market mechanism, then, provides us with an automatic process whereby
consumers’ wants are satisfied as producers seek to meet demands and to
make profits. Any surpluses and shortages are ultimately automatically
eliminated as producers respond to changes in profitability brought about by
changes in market price.
(2) How and where to produce what we want?
In the market economy firms compete with one another for consumers’ attention. As
part of the quest to undercut their rivals, they will seek out production methods and
locations which minimize costs. Thus, firms will constantly try to find ways to cut
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production costs, for example, taking advantage of mass production methods or the
implementation of new technology. The location of production will be influenced by
factors like nearness to market, raw materials, and transport networks.
(3) How will the wealth created be distributed (shared out)?
How the nation’s wealth is distributed depends for most people on income. An
individual’s income depends on the relative demand for, and supply of the skill or
quality which the individual possesses. Hence, some earn much more than others.
So, the price mechanism operates in the markets for labor, as it does in the markets
for goods and services; the interaction of demand and supply determine both the
price of a job and the number of people within that occupation.
This is not, of course, the whole story. Some individuals may enjoy large shares of
the nation’s wealth as a result of inheritance. It does, however, describe the
distribution of wealth for the vast majority of the population who depend on income
from employment or self-employment.
6.2 Advantages and disadvantages of the free market system
Advantages
(i)
Consumers’ wants determine what is provided by producers. Resources will
be allocated by suppliers to those goods and services that consumers are
prepared to buy.
This power consumers possess to influence the way in which resources are
used is known as consumer sovereignty.
(ii)
By allowing the market mechanism to work without interference, for example
by government, imbalances of supply and demand will be eliminated through
fluctuations in price. Any surpluses or shortages which occur will eventually
automatically disappear.
(iii)
Competition between firms in the market economy creates a number of
important benefits for society. Firms will be encouraged to:
(iv)
(a)
be more efficient and find cheaper ways of producing.
(b)
(c)
charge lower prices to consumers.
produce better and higher quality goods to outdo their
competitors.
The principle of private ownership leads to a climate of incentive and hard
work, because individuals are free to make profits, in business for themselves
and not the government.
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Disadvantages
(i)
In the competitive market system, some will make large amounts of money
and others may not. Thus, great inequalities of wealth can occur.
(ii)
Producers seeking to make profits produce things which consumers are
willing to pay for. Some consumers may not be able to afford the price asked
in the market since they are poorly paid workers or are unemployed. In the
absence of government intervention they might have to go without things we
take for granted such as healthcare, education or housing. Healthcare and
education are examples of merit goods.
Merit goods are goods (or services) which are meritorious in that their
consumption confers benefits not only upon the consumer, but also upon the
rest of society.
For this reason, many governments take responsibility for ensuring that basic
education and healthcare are available to all, regardless of income.
Merit goods can be encouraged via a mixture of state provision, maximum
price fixing and subsidies to firms to reduce costs.
Furthermore, governments may act to discourage the provision of demerit
goods. These are goods which may have negative repercussions for both the
individual and society. The consumption of certain drugs, excessive
consumption of alcohol and smoking in public are examples. Whilst the
individual’s health may suffer, society bears the additional or external cost of
drug rehabilitation, policing of anti-social behavior and the effects of passive
smoking.
(iii) In a wholly free market system certain goods and services would not be
provided. Profit-seeking producers will only supply goods and services that
can be sold for a price that will yield a profit. Some things cannot be profitably
provided. These are called public goods.
Public goods are goods (or services) which must be provided communally
because their consumption is non-excludable and non-rivalrous.
Examples of public goods are street lighting, defense and the provision of
pavements.
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For a profit-orientated firm to provide a good or service, it must be able to
exclude from consumption anyone who is unwilling to pay the price asked.
Clearly, this is simply not possible in the case above. It would be impossible to
patrol the pavements to ensure that people had paid to use them. If someone
chose not to pay a private firm for providing defense services, they would still
be defended along with the rest of the community.
The other feature of these public goods, which renders them unsuited to
private provision, is that there is no element of rivalry in consumption. At an
art auction, buyers compete to obtain the goods on offer. However, while one
person is using street lighting or is benefiting from defense, the amount of the
good available to others is not reduced.
So, because everybody benefits equally from their provision, there is no
incentive to pay. There is therefore no reward to producers for supplying
these goods unless payment is made compulsory. Thus, government is forced
to intervene to ensure that these goods are adequately provided.
(iv) Competition may give way to monopoly and potential exploitation of the
consumer. If one firm alone controls market supply, it may be able to price its
product well above the cost of producing it. This may involve restricting output,
creating a shortage and driving up price.
In a competitive market system, some businesses will prosper but others will
not. Often the assets of those firms which fail are absorbed by the more
successful firms within an industry. The net result of this is that markets can
become less competitive and firms larger, as the survivors grow via
acquisition. The twentieth century saw a fairly consistent trend towards large
firm domination in many sectors of the economy. For example, in 1909, the
100 largest manufacturers controlled about 16% of output. By 1990, this had
risen to about 42%.
(v) Producers seeking to make profits may not consider the external cost of
their actions. Where producers manufacture chemicals using techniques that
result in environmental pollution, there is a cost to society in cleaning up the
environment. Although chemicals are not necessarily demerit goods, there is
an external cost which society has to bear. Firms which offend in this way will
often be fined or taxed to help cover the cost and discourage such techniques.
Alternatively, such products may be taxed so that the ultimate consumer pays
more to make the external costs internal. Targeting the firm and consumers in
this way is an example of ‘the polluter pays’ principle.
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Attempts to cut costs and make profits can have negative effects not only on
the environment, but also on the safety of employees and the safety of the
product itself. Automobile manufacturers might not voluntarily introduce
technology to reduce emissions or provide seat belts, and toys might be less
safe in the absence of manufacturing safety codes.
(vi) The notion that a competitive system will benefit consumers is based on
the idea that consumers know what they are buying, and can make accurate
assessments of quality when making purchasing decisions. But in reality,
many consumers are partly or wholly ignorant of products which they
purchase such as wi-fi, cars, personal computers and so on.
(vii) If profits are inadequate then producers may cease to trade, shift location
to other countries or search for new technologies that cut costs, often at the
expense of employment. The competitive nature of the free market system
makes it almost inevitable that there will be some degree of unemployment
from time to time.
6.3 The planned economic system
The problems of the free market or capitalist economy are largely responsible for
the evolution, in the second half of the twentieth century, of a different kind of
economic system, known as the planned economy.
In this kind of system, the State assumes ownership and control of economic
resources and makes decisions about their use on behalf of the population.
Individuals are not free to pursue private profits through the exploitation of privately
owned economic resources. Typically, also, the State attempts to fix or control the
prices of goods and services.
This kind of system is also known as a state-controlled command or collectivist
economic system. The best examples of the planned economy in action are the
Soviet Union and China, after the Second World War. However, the tremendous
political and social changes in these countries since the late 1980s have led to
dramatic changes in the organization of these economies, as the level of planning
has diminished and the extent of free enterprise activity has risen.
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In a planned economic system, the major economic decisions are tackled in the
following ways.
What to produce?
Using a hierarchy of planning committees, State planners decide upon priorities for
production and allocate resources accordingly to the various ends which they desire.
Targets are set for each industry to be achieved over some given time scale. Mainly
the setting of targets will be based upon experience – what had been achieved in
the past – but alterations would be made to take account of changing circumstances
such as the availability of extra resources like new capital.
How and where?
With regard to the technical aspects of production such as the choice of techniques
and resources to be used, many decisions will be part of the day-to-day running of
factories, building sites, farms and so on. In other words, detailed plans relating to
the actual organization of production will be the concern of those who actually
organise production at a factory, farm or warehouse level. There will be a
factory/works committee or agricultural cooperative which co-ordinates the efforts of
the farming community in a given area. In practice, individual enterprises play a part
in the determination of their output targets, which will be the result of a negotiation
with the ministry concerned with that particular type of production.
Who gets what?
Although the State effectively controls the distribution of incomes, this does not
mean that individuals earn similar incomes. Different skills are rewarded differently
in the State-controlled economies, and an individual’s income is dependent upon his
contribution, as seen by the State. Nor does this mean that supply and demand do
not influence income. Individuals who possess skills or qualities which are in short
supply will tend to earn more than other workers with lower degrees of skill.
So, for example, successful musicians, footballers, scientists and medical
practitioners are likely to be better rewarded than others with less skill. Workers who
offer their services to work in hostile environments are likely to be encouraged via
better pay.
6.4 Advantages and disadvantages of the planned economic system
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Advantages
(i)
The underlying idea of a planned economy is to reduce inequalities of
wealth. Some still earn more than others, but arguably the degree of
inequality is less than would prevail under a market system. The State
can try, by controlling the distribution of incomes, to prevent the serious
inequalities of wealth that characterise capitalism.
(ii)
The motivation for the use of resources in a free enterprise system is to
produce goods which yield profit to producers. This can lead to
unemployment in the absence of profitability. Where individual profit is
not the major criterion for the use of resources then, arguably, such
unemployment is less likely.
(iii)
Private monopolies, which can exploit consumers, do not exist. Of
course, there is unfortunately no guarantee that publicly owned
monopolies will behave better.
(iv)
State control of prices reduces the problem of inflation and can be used
to ensure affordable basic goods for poorer members of society.
Disadvantages
(i)
The setting of targets for industries and assessing the amount of
resources to be allocated to them to meet targets, is a very difficult
process and can result in surpluses and shortages, especially of
consumer goods. If the State also tries to fix prices, these imbalances
may be difficult to eliminate.
The USSR operated a five-year plan for many years. However, the
business of setting targets proved to be a most inaccurate exercise.
The history of the Russian plan is characterised by over and under
estimation. Targets were constantly exceeded or not achieved, and
encouraging productivity has been a recurring problem in the command
economies. In addition, even if the targets set were realized, there was
no guarantee that what was produced would be consumed. The reason
for this is that the planning authority attempted to determine production
priorities and to keep close control of prices. In order to avoid the
problem of fluctuating prices, the State attempted to fix them. However,
shortages or surpluses which emerge will not automatically be
eliminated through an adjustment in market price.
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(ii)
Since major plans are made centrally by planning committees involving
large numbers of officials, changing them may prove to be a lengthy
process. There can be a high degree of inflexibility and resistance to
change, once plans have been set in motion. For this reason,
production may fail to respond effectively to the wants of the population.
Allied to price controls, this is likely to contribute to shortage and
surplus conditions in markets.
(iii)
Since private ownership of business does not exist, there may be less
incentive for individuals to work hard. The absence of the motivating
influence of profit where workers are employed in State-run
bureaucracies, where payment does not necessarily depend on
success, may stifle enterprise and hard work. Thus, although resources
may be fully employed, they are not necessarily employed efficiently.
(iv)
The consumer is ‘relatively’ powerless in determining what is produced.
Of course, consumers still decide whether or not to buy goods, and
may boycott shoddy or poor-quality goods. However, the lack of a
competitive mechanism will inevitably lead to reduced choice and
possibly lower quality goods and services.
Moreover, it is highly probable in these circumstances that black
markets will develop, where people can buy goods which are in short
supply by paying very high prices for them.
6.5 The mixed economic system
The mixed economy, which combines elements of free enterprise and planning, is the
model adopted by most countries.
In view of these difficulties the governments of capitalist countries have been forced
to intervene to influence the allocation of resources. This intervention takes many
forms. For example, in Britain the central authorities ensure resources are allocated in
certain directions: health, education, defense, postal services and broadcasting. At
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the same time many goods and services are provided by private sector businesses
pursuing profit.
KEY POINT
The mixed economy which combines elements of free enterprise and planning is the
model adopted by most countries.
This kind of economic system is known as the mixed economy: resource allocation
undertaken partly by the State or public sector, and partly by the private or nonState sector.
In addition to directly allocating resources to specific ends, the central authorities will
intervene to influence the behavior of the private sector enterprise in many ways,
including the following.
What to produce and in what quantities?
Governments may ban certain forms of production, for example heroin or cocaine and
control the quantity of certain other goods and services like gaming, public houses
and oil exploration, through the selective granting of licenses.
How and where will production be located?
This is likely to include the imposition of controls on the type of production techniques
employed by firms, to protect employees, consumers and the environment via, for
example, health and safety, environmental pollution and product safety legislation.
Location decisions might be influenced through financial incentives, such as tax
concessions, grants or low rent premises, designed for example to encourage private
sector firms to set up in areas of unemployment.
Who gets what?
In addition to control of the pay levels of its own public sector workers, the State will
often try to influence private sector wage levels, for example, the establishment of a
minimum wage by the Labor government in the late 1990s.
Government also redistributes income via income taxation, reducing the gap between
higher and lower income earners. Furthermore, the revenue raised is partly used to
provide incomes for the unemployed, via unemployment and social security benefits.
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In addition, the State will sometimes intervene to influence who will produce. The
Office of Fair Trading and the Competition Commission (formerly the Monopolies and
Mergers Commission) exist to ensure that large powerful monopolistic firms do not
use their power to eliminate smaller competitors or to exploit consumers.
6.6 Comparison of alternative economic systems
No society fits neatly into the category of planned or free market. On one hand, USA,
Canada or UK come relatively close to the definition of the free enterprise system but
at the same time we find a limited degree of State intervention especially in the
provision of basic health, education and welfare services. On the other hand, in
countries like the former USSR where there was traditionally a strong commitment to
the system of central planning, examples of ‘free enterprise’ style arrangements for
the production of goods and services had begun to appear well before the eventual
collapse of the Soviet regime at the end of the 1980s. In fact, all countries have
systems of resource allocation which reflect both elements of free enterprise and
central planning. Even in China changes in the organisation of the economy involving
the re-introduction of private exploitation of resources, and the legal entitlement to
pursue private profit, mean it can no longer be simply labeled as a planned economy.
We could describe virtually every society today as a mixed economy.
The difference between different economic systems then, is the degree to which the
use of resources is planned or alternatively, the degree to which individuals within
society are free to make such decisions on their own behalf.
Comparison of alternative economic systems
System
Features
Ownership
of
Enterprises
Capitalism
(Private
Enterprise)
Businesses
are
owned
privately,
often
by
large
numbers of people.
Minimal
government
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Communism
Socialism
Mixed
Economy
Government owns the
means of production
with few exceptions,
such as small plots of
land.
Government owns
basic industries,
but private owners
operate
some
small enterprises.
A strong private
sector blends with
public enterprises.
30
Management
of
Enterprises
Rights
profits
ownership leaves
production
in
private hands.
Enterprises
are
managed
by
owners or their
representatives,
with
minimal
government
interference.
Centralized
management controls
all state enterprises in
line with three to fiveyear plans. Planning
now
is
being
decentralized.
to Entrepreneurs and Profits are not allowed
investors
are
entitled to all profits
(minus taxes) that
their firms earn.
under communism.
Rights of
Employees
The
rights
to
choose
one’s
occupation and to
join a labor union
have long been
recognized.
Employee rights are
limited in exchange for
promised
protection
against
unemployment.
Worker
incentives
Considerable
incentives motivate
people to perform
at their highest
levels.
Incentives
are
emerging
in
communist countries.
Significant
government
planning pervades
socialist nations.
State enterprises
are managed
directly
by
government
bureaucrats
Only the private
sector
of
a
socialist economy
generates profits.
Workers
may
choose
their
occupations and
join labor unions,
but
the
government
influences career
decisions for many
people.
Incentives usually
are
limited in state
enterprises but do
motivate workers
in
the
private
sector.
Management
of
the private sector
resembles
that
under capitalism.
Professionals may
also manage state
enterprises.
Entrepreneurs and
investors
are entitled to
private sector
profits, although
they often must
pay high taxes.
State enterprises
are also expected
to produce returns.
Workers
may
choose jobs and
labor
union
membership.
Unions
often
become
quite
strong.
Capitalist-style
incentives operate
in
the
private
sector.
More
limited incentives
influence
public
sector activities.
6.7 Islamic economic system
Islam is not a religion but it is a complete code of life. The Holy Quran and the Sunnah
of Holy Prophet, peace be upon him, are the two major sources of the Islamic
Economic System. Islam does not present the detailed sketch of the economic system
but it offers some basic principles for the solution of the economic problems and the
Muslims can solve their economic problems easily with the help of these principles.
6.7.1 Main objectives of Islamic economic system
Following are the main basic objectives of the Islamic Economic System:
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1.
Coordination between moral and material development
The first basic purpose of the Islamic individual and collective economic activities is to
co-ordinate the moral and material development. According to the teachings of Islam,
each and every Muslim should participate in the economic activity with his/her full
capacity. According to the Holy Quran;
According to the Holy Prophet, peace be upon him;
According to the above-mentioned Quranic verses and the sayings of the Holy Prophet,
peace be upon him, it is the obligation of each and every Muslim to take part in
economic activity fully but with some moral constraints and these restrictions are
imposed by the religion. Each and every Muslim should follow the two principles.
a) The Muslims should get HALAL things.
b) TAYYAB ways should be adopted by the Muslims to get HALAL things.
According to the Holy Quran;
These verses of the Holy Quran show that Muslims should participate in the economic
activities of the society subject to the moral and spiritual values.
2. Establishment of universal brotherhood
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Islam is a universal religion. According to Islam, each Muslim is the brother of every
other Muslim. There is no discrepancy of color, race, tribe, family and country in Muslim
society. According to the Holy Quran;
According to the holy prophet, peace be upon him;
According to Islam, Muslims are bound to respect each other; either they are living in
the same country or in the different regions of the world. Justice is necessary for the
establishment of universal brotherhood. Justice may be divided into to parts.
a) Social justice
According to Islam, the entire human race is one family. All the people living on
the earth are equal in the eyes of God. There is no difference between the rich
and the poor, high breed and low breed, white and black color and race. The only
yard stick for the superiority of a person is his character, ability and his services
for the humanity.
According to the Holy Prophet, peace be upon him;
During the reign of Khulafa – E – Rashideen, we find the best examples of justice
taught by Islam.
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b) Economic justice
Social justice is only possible when economic justice is implemented i.e., social
justice is conditional with the implementation of economic justice. According to
economic justice, each person should get his legitimate share from national
wealth against his services. Each person should be free to take part in national
activities according to his abilities. There should be no hoarding as it is against
the nature of economic justice. According to the Holy Quran;
Islam also urges the establishment of economic justice between the relationship
of AJIR and AJEER. It is necessary for the AJIR that he should pay wages to the
AJEERS according to their shares in the production. In the same manner, Islam
also directs AJEERS to work honestly and whole heartedly.
3. Just distribution of wealth
Just distribution of wealth and income is of great importance in Islamic economic
system. According to Islamic view point, all the productive resources are the
property of God. These resources are the gift of God for the whole human race.
So the concentration of these resources in few hands is not suitable. Islam offers
a compact system to distribute wealth more evenly. According to the holy Prophet,
peace be upon him;
Islamic program for just distribution of wealth consists of three parts:
a) To find employment for un-employed people and to arrange just wages for
those who are already employed.
b) To collect ZAKAH at the rate of 2.5% from SAHIB-E-NISAB people and to
distribute it to those who are mentioned in the Holy Quran.
c) To distribute the property of some person after his death according to the
principles of Islam.
4. Freedom of individuals under the protection of collective interest
Human freedom is of greater importance in Islam. One of the most important
beliefs of Islam is; God is the creator and each and every person is accountable
to Him for his deeds. So it is necessary that every person should be free to do
different jobs in this world according to his own free will. According to Islam, man
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is not only morally and politically free but he is also free economically because
without economic freedom, other freedoms cannot be maintained. But this
freedom must not be against the collective interest of the society. In other words,
we can say that Islam prefers collective interest of the society and gives
secondary importance to the individual freedom.
6.7.2 Basic principles of Islamic economic system
The structure of Islamic economic system is based on the following two principles:
1. Principle of earning and production
Islam allows the Muslims to participate in the economic activities subject to the
highest moral values constraints i.e., a Muslim can take part in the economic
struggle of the society but he must have to take into consideration the moral
values imposed by the Islam. According to the Holy Quran;
This verse of the holy Quran explains that all the ill-legal ways are prohibited by
Islam to earn livelihood. According to the Holy Prophet, peace be upon him;
Islam also prohibits earning wealth by the prohibited means even if its purpose is
to distribute it in the way of Allah. According to the Holy Prophet, peace be upon
him;
Islam also explains the principles of business and commerce. It is the duty of
each Muslim to fulfill business agreements. According to the Holy Quran;
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According to Islam, Muslim entrepreneur should not sell his defective commodity
without exposing its defect to the buyer. According to the Holy Prophet;
Hoarding and monopoly are also prohibited in Islam. According to the Holy
Prophet, peace be upon him;
2. Principle of consumption
As far as the consumption is concerned, Islam urges that a Muslim consumer
should spend some part of his HALAL earnings on his worldly needs and he
must not be extravagant. The other part of his HALAL earnings should be
utilized for the life hereafter. According to the Holy Quran;
These Quranic verses show that the Muslim consumer should not go beyond the
limits of extravagancy.
7.
Concept of opportunity cost and production possibility curve
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Opportunity cost measures the cost of using resources in terms of forgone
opportunities. It is important to realize at this point that choices involve sacrifices. If we
decide to use our scarce resources in one way, then other possible alternative uses
will have to be forgone. In other words, the real cost of using resources for one
purpose can be measured in terms of ‘opportunities forgone’. Opportunity cost
measures the cost of using resources in terms of foregone opportunities. Hence, if a
local authority wants to build a school and a community center but currently can only
afford to build one or the other, and decides to build the school, we would say that the
opportunity cost of building the school was the community center.
Thus, the opportunity cost of using a resource in a particular way is the benefit forgone
by not using that resource in its next best alternative use.
Looking at the cost of using resources in this way makes sense. The money cost of
resource allocation decisions is really only meaningful once we consider the
alternative uses for that money.
KEY POINT
Opportunity cost measures the cost of using resources in terms of forgone
opportunities.
7.1 The production possibility curve – illustrating opportunity cost
The production possibility curve illustrates the potential output of an economy, and
the opportunity cost of resource allocation decisions.
The production possibility curve or frontier is a useful theoretical device devised by
economists to illustrate the problems of scarcity and choice and the opportunity cost
of society’s decisions.
To understand the idea, we will simplify the economic choices facing a society. It can
produce food or capital goods. With all resources employed, producing more food can
only be achieved by some sacrifice of the production of machinery, computers and
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other items of capital. More resources for the creation of new capital will necessarily
involve less food production.
KEY POINT
The production possibility curve illustrates the potential output of an economy, and
the opportunity cost of resource allocation decisions.
We can illustrate the trade-offs facing the nation in a diagram:
Units of capital (000)
.B
20
.A
15
12
15 17
20
Units of food (million)
The economy can produce 20,000 units of capital per year if all resources are
allocated to this, or 20 million units of food if all resources are diverted into food
production. Alternatively, and more probably, a combination of both can be achieved.
For example, it can produce 15,000 units of capital and 15 million units of food.
The curve or frontier shows all the maximum possible outputs given the economy’s
existing quantity of resources. It can have any combination of goods along the line.
Point A shows a society which is failing to use all of its resources to the full, either
through inefficiency or unemployment. Point B is currently unattainable, but might be
achieved through economic growth.
The shape of the curve is bowed outwards or concave to the origin. This is based on
the notion that, as society increasingly allocates more resources to the production of
a particular good, the opportunity cost of doing so will increase.
Suppose the economy illustrated above is currently producing 15,000 units of capital
and 15 million units of food. Raising the output of food to 17 million units will have an
opportunity cost of 3,000 units of capital. However, trying to raise production of food
to 20 million units will involve the sacrifice of a massive 12,000 units of capital. The
basic idea underlying this is that as we allocate more and more resources to the
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production of a particular good, the resources allocated become less and less
suitable. To produce more food will increasingly involve the utilization of land and
labor which is less suited to this kind of production. The same argument is, of course,
true in reverse.
7.2 Contrasting opportunity cost and financial cost
Financial accounts do not usually reflect opportunity cost. Consider the following
example.
A business produces accounts for the year ended 31 December 20X4. Its
summarized profit and loss account is:
Rs.
Turnover
100,000
Cost of sales
(30,000)
––––––
Gross profit
70,000
Depreciation
(5,000)
Other costs
(30,000)
––––––
Net profit
35,000
You are given the following information. The depreciation relates to a machine that
cost Rs. 20,000 and is being depreciated over four years, straight line. The machine
is obsolete and has no disposal value. The owner draws no salary but has been
offered Rs. 40,000 to work for a company in a similar industry.
The profit based on the inclusion of opportunity cost would be as follows:
Rs.
Gross profit (as above)
Depreciation (Note 1)
Opportunity cost of owner’s time (Note 2)
Other costs
Net profit
70,000
Nil
40,000
30,000
––––––
Nil
––––––
Note 1: The machine has no value and thus costs the business nothing to use.
Note 2: This is the salary the owner is giving up to run the business (the opportunity
cost of the owner’s enterprise).
It should be clear from the above example that the accountant’s view of cost and
profit are somewhat different to that of the economist. From the economic viewpoint,
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it is just worthwhile for the entrepreneur above to continue in business. Just enough
revenue is earned to cover all costs including the opportunity cost of the
entrepreneur (Rs. 40,000).
A business in this position is said to be earning normal profits.
Normal profit is the minimum profit needed to induce an entrepreneur to remain in
his or her current employment or business. It is the opportunity cost of the services
of the entrepreneur.
Appendix-Use of Graphs and Diagrams
Graphs represent a kind of language. In economics, graphs are used frequently to
explain the laws, theories and other concepts used in economics. In economics,
generally the values used are positive therefore, first quadrant is used, however if
necessary other quadrants are also used.
In mathematics independent variable is measured on x-axis and dependent variable
is measured on y-axis. The same rule is applied in economics while constructing
graphs with the exception of price, which is always treated as an independent
variable in economic laws but is measured on y-axis. Price does not mean the price
of goods only but it also means prices of factors of production (Rent, Wage, Interest
and Profit).
y
Dependent
Variable
Except
(Price)
(Rent)
(Wage)
(Interest)
0
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Independent Variable
x
40
Graph for increasing function are upward sloping because the direction of both
variables (independent and dependent) is the same.
y
0
x
Graph for decreasing function are downward sloping from left to right top to
bottom as the direction of both the variables is opposite.
y
0
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41
Graphs and diagrams as curves
1.
All the graphs relation to consumers are convex to origin.
y
decreasing slope
decreasing opportunity cost
0
x
Examples: Demand curve, indifference curve etc.
2.
All the graphs and diagrams relating to producers and production are
concave.
y
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0
x
Example: Total product curve, marginal product curve, average product curve
etc.
Summary
The basic economic problem is how to create and distribute wealth, with resources
that are scarce and have many competing claims on them.
In the real world, we see the very different ways in which different societies have
tried to improve welfare and distribute wealth. The methods range from the highly
interventionist command economy to the free market economy. However, virtually all
societies adopt a mixed economic system with leaning towards planning or the free
market, depending on the prevailing political climate within a particular society.
Self-test questions
Definition of Economics
1
What are four aspects of wealth which Adam Smith discussed in his
book? (1.1)
2
What are the merits of definition of economics by Marshall? (1.2)
3
What are the four basic points mentioned explicitly in definition of
economics by Robbins? (1.3)
4
What is the basic economic problem? (1.3)
Factors of Production: Land, Labour, Capital and Enterprise
5
What are the four factors of production? (2.1)
6
What do you call the reward to capital? (2.2)
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Allocation of scare resources and wants
7
What are the concepts of scarcity and choice? (3)
Microeconomics VS Macroeconomics
8
What are important problems, theories and behaviors studied in
Microeconomics and Macroeconomics? (4)
Alternative economic systems
9
Define a merit good. (6.2)
10
What are the two main characteristics of a public good? (6.2)
11
Give one advantage and disadvantage of a command economy. (6.4)
Opportunity cost
12
What is the opportunity cost? (7)
Practice questions
Question 1
In economics, ‘the central economic problem’ means:
A
consumers do not have as much money as they would wish
B
there will always be a certain level of unemployment
C
resources are not always allocated in an optimum way
D
output is restricted by the limited availability of resources.
Question 2
Which of the following statements is not true?
A
Profit is the reward to the factor of production called enterprise
B
In the long run, profit will be the same in all firms that are equally
efficient
C
Profit is the reward for risk-bearing
D
Normal profit is included in average cost
Question 3
Which one of the following is not a function of profit in a market economy?
A
A signal to producers
B
A signal to consumers
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C
The return to entrepreneurship
D
A reward for risk-taking
Question 4
Arguments for allocating resources through the market mechanism rather
than through government direction include three of the following. Which one is
the exception?
A
It provides a more efficient means of communicating consumer
wants to producers
B
It ensures a fairer distribution of income
C
It gives more incentive to producers to reduce costs
D
It encourages companies to respond to consumer demand
Question 5
Which one of the following best describes the opportunity cost to society of
building a new school?
A
The increased taxation to pay for the school
B
The money that was spent on building the school
C
The other goods that could have been produced with the
resources used to build the school
D
The running cost of the school when it is opened
Question 6
In a market economy the price system provides all of the following except
which one?
A
An estimation of the value placed on goods by consumers
B
A distribution of income according to needs
C
Incentives to producers
D
A means of allocating resources between different uses
Question 7
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In a market economy, the allocation of resources between different productive
activities is determined mainly by the:
A
decision of the government
B
wealth of entrepreneurs
C
pattern of consumer expenditure
D
supply of factors of production.
Question 8
The opportunity cost of constructing a road is:
A
the money spent on the construction of the road
B
the value of goods and services that could otherwise have been
produced with the resources used to build the road
C
the cost of the traffic congestion caused during the construction
of the road
D
the value of goods that could have been produced with the labor
employed in the construction of the road.
Additional question
Allocation of resources
(a)
Explain the meaning and importance of the term ‘the allocation
of resources.
(b)
Describe the mechanisms by which resources are allocated in
mixed economies.
For the answer to this question, see the ‘Answers’ section at the end of the
book.
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Contents
1
Concept of Market
2
Concept of Demand and Law of Demand
3
Change in Demand vs Change in Quantity Demand
4
Concept of Supply and Law of Supply
5
Change in Supply vs Change in Quantity Supplied
6
Formation of Equilibrium Price
7
Short run and Lonf run Equilibrium Price
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1.
1.1
Concept of Market
What is a Market
Individual economic units can be divided into two broad groups i.e. buyers and sellers.

Buyers include consumers, who purchase goods and services, and firms,
which buy labor, capital, and raw materials that they use to produce goods and
services.

Sellers include firms, which sell their goods and services; workers, who sell
their labor services; and resource owners, who rent land or sell mineral
resources to firms.
Clearly, most people and most firms act as both buyers and sellers, but we will find it
helpful to think of them as simply buyers when they are buying something and sellers
when they are selling something. Together, buyers and sellers interact to form markets.
A market is the collection of buyers and sellers that, through their actual or
potential interactions, determine the price of a product or set of products.
Market is a mechanism or arrangement that brings buyers (demanders) and
sellers (suppliers) of good and service in contact with one another.
Buyers and sellers may contact each other personally or indirectly through telephone,
telegraph, fax, e-mail, etc. This personal or impersonal contact ultimately leads to price
uniformity. So the economic market is free from geographical bondage and boundaries.
The market may extend to a city, country or to the whole world.
When defining a market, potential interactions between buyers and sellers can be as
crucial as actual transactions. Take the gold market, for instance. A Pakistani looking
to buy gold is unlikely to travel to India for it. Typically, gold buyers in Pakistan will deal
exclusively with local sellers. However, since the transportation cost of gold is minimal
compared to its value, Pakistani buyers might opt to purchase gold from India if the
prices there are substantially lower.
The definition of a market determines which buyers and sellers are included based on
the extent of a market, outlining its boundaries both geographically and in terms of the
range of products.
The definition of market identifies which buyers and sellers should be included in a
given market dependes on the extent of a market which shows its boundaries, both
geographically and in terms of the range of products to be included in it.
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Note that a market includes more than an industry. An industry is a collection of firms
that sell the same or closely related products. Basically, an industry is the supply side
of the market.
2. Concept of Demand and Law of Demand
Commonly demand is taken as the desire, the need and the want etc. But in
economics demand has its particular meanings i.e.
“Demand is a desire which is supported by purchasing power”
So we can say that following two conditions must be fulfilled for perfect meanings of
demand.
 Willingness to Purchase (Desire to purchase a commodity)

Power to Purchase (Purchasing Power)
“The demand for anything at a given price is the amount of it, which will be bought per
unit of time at that price.” Or by demand we mean various quantities of a given
commodity or service which consumer would buy in one market in a given period of
time at various prices or at various income. Or at various prices of related good. It is
not merely a wish of the households.
2.1 Law of demand
The Law of Demand was articulated by early economists, most notably Alfred Marshall,
a British economist, in his influential work “Principles of Economics”, published in 1890.
“Other things remain the same, if the price of a commodity increases, quantity
demanded for that commodity contracts. If the price of a commodity decreases,
quantity demanded for that commodity extends”.
OR
“Ceteris paribus, quantity demanded for a commodity varies inversely with its price,
not necessarily proportionately.”
The statement of the law indicates that there is an inverse or negative relationship
between the price and the quantity demanded of a commodity. This means that the
price of any commodity and the demand for that commodity change in opposite
directions. It is also clear from the statement that an equal proportionate change in
price and quantity demanded is not necessary. We can show the functional
relationship between price and quantity demanded in the following way:
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Qd = f (P)
Quantity demanded is a function of Price.
P ↑ → Qd ↓
P ↓ → Qd ↑
It means that both variables (Price and Quantity demand) are changing
inversely. So, quantity demanded is a decreasing function of price.
Law of demand can be explained with the help of a schedule and diagram:
200
100
160
200
Increase
Decrease
120
80
400
40
500
300
Extension
Quantity Demand in Kg.
Contraction
Price Rs/Kg
It is clear from the schedule as the price of the commodity decreases, demand is
extending. Price has decreased from Rs. 200 per kg, to Rs. 40 per kg and demand
has extended from 100 kg to 500 kg. Moreover, as the price of the commodity
increases, demand is contracting. Price has increased from Rs. 40 per kg, to Rs. 200
per kg and demand has contracted from 500 kg to 100 kg.
M ovem ent along the demand curve
D
20
Ex
a
b
16
Price
R s. 12
t en
tio
n
c
d
Co
8
4
O
100
n tr
act
200
e
io n
300
D
400
500
Quantity Demanded (kg.)
A demand curve is a graphical representation of a demand schedule. Demand curve
slopes downward from left to right i.e., it has negative slope, which shows that with a
decrease in price demand for that commodity extends and with an increase in price
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demand for that commodity contracts.
Key Point
The price mechanism works as follows: Prices respond to shortages and surpluses.
Shortages cause prices to rise. Surpluses cause prices to fall. If consumers decide
they want more of a good (or if producers decide to cut back supply), demand will
exceed supply. The resulting shortage will cause the price of the goods to rise. On the
one hand, an increased price will act as an incentive to producers to supply more,
since production will now be more profitable. On the other hand, it will discourage
consumers from buying. Price will continue to rise until the shortage has been
eliminated.
If, contrarily, consumers decide they want less of a good (or if producers decide to
produce more), supply will exceed demand. The resulting surplus will cause the price
of the good to fall. This will act as a disincentive to producers, who will supply less,
since production will now be less profitable. It will encourage consumers to buy more.
Price will continue falling until the surplus has been eliminated.
2.2
Assumptions
Assumptions mean those variables which we hold them constant in order to prove the
law. Assumptions are also called conditions, parameters, Ceteris paribus (other things
remain the same). The law of demand proves true under the conditions. The
assumptions of law of demand are as follows:
1. Homogenous Units
It is assumed that units of a commodity are homogenous because if the
quality of the later units purchased is superior then with an increase in price
demand may not contract.
2. Income of the Consumers
If the income of the consumers changes, their purchasing power will change
and with a change in price of the commodities purchased the use of those
commodities will not change.
3. Taste and Fashion
If a commodity is used as a fashion or the taste of the consumers change, the
law does not hold.
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4. No New Substitutes are Discovered
If new substitutes are discovered the demand for original commodity is
subdivided and it is the psychology of the people that they like new substitutes,
so the demand for original commodity decreases without the increase in price.
5. Prices of the Substitutes
It is assumed that the prices of the substitutes do not change. If the price of
the substitute changes the demand for original commodity will change.
6. No Change in the Expectations
Sometimes the demand for a commodity change due to expectations. If it is
expected that price of a commodity will change in next few days the demand
for that commodity change without change in price.
7. Climatic or Weather Conditions
The law does not hold good when weather changes. In summer season
demand for ice increases, although price is higher and in winter season even
a lower price does not bring raise the demand.
8. No Change in Population Growth Rate
It is assumed that the population growth rate does not change because with
an increase in population, quantity demanded increases although price has
increased.
2.3 Exceptions or Limitations
Exceptions mean those cases where any law does not work or does not hold or fails.
The exceptions of law of demand are as follows where law of demand can not prove
true:
1. Danger of being Scarce
If there is a danger that a commodity will become scarce or it will not be
available in future, law of demand will not hold.
2. Use Confers Distinction
If the use of commodity confers distinction and brings superiority, the rich
people will demand more instead of increase in price.
3. Inferior/Superior Goods
If a good is inferior a fall in price will bring further fall in demand and if a
commodity is superior a rise in price will bring further rise in demand.
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4.
Necessities of Life
If the price of one of the necessities of life rises the expenditure on other
goods decreases without increase in their prices.
5.
Giffen Goods
An exception of this law, is also the classic case of Giffen goods and named
after a British economist Sir Robert Giffen, (1837-1910). A Giffen good does
not mean any specific commodity. It may be any essential commodity much
cheaper than its substitutes, consumed mostly by the poor households and
claiming a large part of their income. If price of such goods increase (price of
its substitute remaining constant), its demand increases instead of decreasing.
Due to above mentioned reasons, the demand curve become positively
sloped (left to right upward). This demand curve is based on limitations or
exceptions of law of demand thus it is called exceptional demand curve. Other
names are:
 Positively sloped demand curve
 Giffen demand curve
In this diagram, price is shown on the y-axis and quantity demanded is plotted
on x-axis. By joining the price and quantity demanded, we have made a
demand curve which is labeled by DD. The trend of the demand curve is from
left to right upward i.e., the slope of the demand curve is positive. This trend
of the demand curve shows the direct or positive relationship between price
and quantity demanded.
Key Point
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Demand curve, being the graphical representation of the demand schedule, slopes
downward. These graphs always have price on the vertical axis and quantity
demanded or supplied) on the horizontal axis, but common, mistake to reverse the
variables.
The graphical representation of the above demand schedule is smooth. But beware
that this is not essential. What is essential is that the curve has retained a general
downward slope: the lower the price, the more you are likely to buy.
Key Point
Possible explanations for the two stories can be as follows:
1. A rise in the population is shifting the demand curve for rice to the right as
more rice is demanded at each price. This in turn raises the price of rice.
2. The rising price of rice is causing each individual household to cut back on its
purchase. This causes an upward movement to the left along any particular
demand curve.
2.4 Usual shape of the demand curve
The demand curve is usually negatively sloped explaining the inverse relationship
between price and quantity demanded of a commodity. The reasons for negative
slope of the demand curve include the following:
(i)
Substitution effect
When price of a good falls whereas its substitute still commands the original
price, consumers switch from the expansive to the cheaper good.
(ii)
Purchasing power effect
When price of a good falls, consumer’s purchasing power in terms of this
good is increased, therefore, he purchases more of it.
(iii) Law of diminishing marginal utility
Law of diminishing marginal utility states that marginal utility diminishes with
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every increase in quantity of a commodity consumed. Since marginal utility of
each unit tends to decline, the consumer will buy the additional units only if its
price also falls.
2.5 Concept of market demand
Market demand for a commodity is the horizontal sum of all individual demands for
the commodity at a given price, per unit of time. Suppose, three are only three
consumers (A, B and C) of Pepsi and their weekly individual demand for Pepsi at its
different prices is given in the following schedule. The last column of the schedule
shows the market demand, i.e. the aggregate of individual demands for Pepsi.
We can explain the concept of market demand with the help of following schedule:
Price
(Rs)
12
10
8
6
4
2
0
No. of Pepsi cans
demanded by
A
B
C
0
0
0
0
0
4
0
4
8
3
8
12
5
12
16
8
16
20
11
20
24
market demand = A + B + C
0
4
12
23
33
44
55
The last column of schedule shows weekly market demand for Pepsi. The market
demand curve can be obtained by plotting the data in the last column of the schedule.
Alternatively, market demand curve can be derived graphically by horizontal
summation of the individual demand curves at each price of Pepsi. Graphical
derivation of the market demand curve is illustrated in the following diagram.
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The individual demand curves of buyers A, B and C are shown by the demand curves
DA, DB and DC, respectively. Horizontal summation of these demand curves
produces weekly market demand curve for Pepsi as shown by the curve DM. Thus, a
market curve is horizontal summation of individual demand curves at different prices.
2.6 Causes of the changes in demand or shift factors of demand
According to the law of demand, the demand for any commodity changes due to the
change in the price of that commodity. But there are some other reasons due to which
demand can also change. These reasons are as follows:
1. Change in fashion
Demand for a commodity is affected by the change in fashion whether the
price changes or not.
2. Change in population
Demand changes with the change in population in the same direction in spite
of the constant prices.
3. Change in the distribution of income
When the change in the distribution of income is such as it comes into the
hands of the poor, demand increases whether price decreases or not.
4. Change in weather
Weather can also change the demand. For example demand for wool clothes
decreases in the summer season and increases in the winter season.
5. Change in quantity of money
Due to an increase in quantity of money, people would have more money and
they would be in a position to increase the demand for goods and vice versa.
6. Change in consumer’s income
Consumer’s income is the basic determinant of the quantity demanded of a
product. It is a common knowledge that the people with higher income spend
a larger amount on goods and services than those with lower income. If the
income i.e., the purchasing power of the consumers changes, they change
the demand in the same direction whether price changes or not.
7. Change in the prices of related goods
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The demand for a commodity depends also on the prices of its substitutes
and complementary goods. Two commodities are considered to be substitutes
for one another, if change in price of one affects the demand for the other in
the same direction. For instance, commodities X and Y are substitutes for one
another if a rise in the price of X increases the demand for Y, and vice versa.
Tea and coffee, wheat and rice, alcohol and drugs are some common
examples of substitutes. By definition, the relation between demand for a
product and price of its substitute is of positive. When price of a product (say,
tea) falls (or increases), then demand for its substitute (coffee) falls (or
increases).
A commodity is considered to be complement of another when it
complements the use of the other. For example, petrol is a complement to
motor vehicles; butter and jam are complements to bread; milk and sugar are
complement to tea and coffee and so on. Two goods are complements for
one another, if an increase in the price of one causes a decrease in the
demand for another. By definition, there is an inverse relationship between the
demand for a good and the price of its complement. For example, an increase
(or a decrease) in the price of petrol causes a decrease (or an increase) in the
demand for car.
8. change in trade circumstances
When there are better circumstances for trade in the country, demand for
goods increases whether prices fall or not and vice versa.
9. Advertisement
Advertisement is also an important factor which can affect the demand for
goods. Due to an effective advertisement, the demand for goods increases or
vice versa.
Key Point
A word of warning: be careful about the meaning of the words ‘quantity demanded.
They refer to the amount consumers are willing and able to purchase at a given price
over a given time period (for example, a week, or a month, or a year). They do not
refer to what people would simply like to consume. You might like to own a Rolls
Royce, but your demand for Rolls Royce will almost certainly be zero.
2.7 Direct Demand and Derived Demand
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Direct Demand refers to the demand for goods and services that are directly
consumed by individuals or households to satisfy their needs and wants. These are
end products used for personal satisfaction and consumption. For example, the
demand for food, clothing, and electronics by consumers is considered direct demand.
Derived Demand refers to the demand for goods and services that are not desired for
their own sake but for their role in producing other goods and services. It arises
because of the demand for another good. For example, the demand for steel is
derived from the demand for cars and buildings, as steel is required to produce these
items.
2.8 Substitutes and compliments
1.
Substitute goods are those goods which can be used alternatively for
example chicken and beef, mutton and fish, tea and coffee.
2.
Complements are those goods which tend to be bought and used together,
examples cups and saucer, petrol and motor car etc.
(a)
Suppose that goods A and B are complements. If price of good
‘B’ goes up, the demand for good A decrease, under the
assumption that price of good A doesn’t change.
(b)
Suppose that goods A and B are substitutes. If price of good ‘B’
goes up, the demand for good A increase, under the
assumption that price of good A doesn’t change.
3 Change in demand vs changes in quantity demand
‘Change in Demand’ means Rise and Fall in demand (Shifting of demand
curve) and ‘Change in Quantity Demand’ means Extension or Contraction of
demand (Movement along the demand curve).
Extension and contraction of demand
If the demand for a commodity changes due to a change in the price of that
commodity, it is called the Extension or Contraction of demand.
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Extension of demand
If price of commodity decreases and demand for a commodity increases, it is
called the extension of demand.
P ↓ → Qd ↑
Contraction of demand
If price of commodity increases and demand for a commodity decreases, it is
called the Contraction of Demand.
P ↑ → Qd ↓
Extension and Contraction of Demand can also be explained with the help of
following diagram.
By joining the price and quantity demanded, we have made a curve which is
labeled by DD. DD is the demand curve. If we move Left to right (downward)
on the demand curve DD, it shows the Extension of Demand. If we move
Right to left (upward) on the demand curve DD, it shows the Contraction of
Demand.
Rise and fall in demand
If the demand for a commodity changes due to the other factors (excluding
price), it is called the Rise or Fall in Demand.
Rise in demand
If the demand for a commodity increases due to the other factors (excluding
its own price), it is called the Rise in Demand.
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Due to Other Factors → Qd ↑
This diagram shows that the demand curve shifts rightward from DD to
D1D1.This shift shows that the demand for a commodity increases at the same
prices i.e., the reason for this increase in demand is not the price. So this type
of increase in demand is known as Rise in Demand.
Fall in demand
If the demand for a commodity decreases due to the other factors (excluding
its own price), it is called the Fall in Demand.
Due to Other Factors → Qd ↓
This diagram shows that the demand curve shifts leftward from DD to
D1D1.This shift Shows that the demand for a commodity decreases at the
same prices i.e., the reason for this decrease in demand is not the price. So
this type of decrease in demand is known as Fall in Demand.
4 Supply
4.1 Supply, Stock and Hoarding
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Supply: Supply refers to the quantity of a good or service that producers are
willing and able to offer for sale at various prices during a particular period.
Stock: Stock refers to the quantity of a particular good or asset that is stored
or available for use or sale at any given point in time. It can include finished
goods ready for sale, raw materials, or other inventory items held by firms,
retailers, or individuals.
Hoarding: Hoarding refers to the practice of accumulating or stockpiling
goods, often in large quantities, with the intention of withholding them from the
market in anticipation of future price increases. Hoarding is a stock held for
earning super normal profits or to exploit the consumers.
4.2
Reserve Price
Reserve price is the minimum price below which a supplier would not be
supplying the goods in the market.
4.3 Market Period, Short Run and Long Run
1. Market Period
In economics, the market period refers to just one day. During twenty four
hours, the supply of goods and services is fixed, meaning that producers are
unable to adjust their output levels in response to changes in demand. This
scenario often applies to goods that are perishable or have immediate
consumption, where production cannot be increased or decreased within the
timeframe.
2. Short Run
The short run is a time frame in which at least one factor of production is fixed.
In the short run, firms can adjust their output levels by varying the variable
factors of production but cannot change their fixed inputs. As a result, firms
can partially adapt to changes in market conditions, but they may not be able
to achieve their optimal production levels. In the short run, some costs, like
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fixed costs, remain constant, while others, like variable costs, change with
output levels.
3. Long Run
The long run is the time frame in which ALL factors of production are variable,
and firms can adjust their production levels and inputs fully. In the long run,
firms can alter their capital equipment, expand or reduce their production
capacities, and enter or exit industries. As a result, all costs, including fixed
costs, become variable in the long run. The long run is characterized by the
ability of firms to achieve their optimal production levels and adjust to changes
in market conditions over time.
4.4
Law of Supply
Law of supply was articulated by early economists, most notably Alfred
Marshall, a British economist, in his influential work “Principles of Economics”,
published in 1890.
“Other things remain the same, if the price of a commodity increases, quantity
supplied for that commodity extends. If the price of a commodity decreases,
quantity supplied for that commodity contracts”.
OR
“Ceteris paribus, quantity supplied for a commodity varies directly with its
price, not necessarily proportionately.”
The statement of the law indicates that there is an direct or positive
relationship between the price and the quantity supplied of a commodity. This
means that the price of any commodity and the supply for that commodity
change in same directions. It is also clear from the statement that an equal
proportionate change in price and quantity supplied is not necessary.We can
show the functional relationship between price and quantity supplied in the
following way:
Qs = f (P)
Quantity supplied is a function of Price.
P ↑ → Qs ↑
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P ↓ → Qs ↓
It means that both variables (Price and Quantity supplied) are changing in the
same direction. So, quantity supplied is an increasing function of price.
The law of supply can be explained with the help of a schedule and a diagram.
4
100
500
Price
It
is
clear
from
the
20
schedule that there is a
8
direct or positive relation
12
between
price
of
the
product
and
quantity
supplied.
movement along
the Supply Curve
e
S
d
n
20
c
rac
ti o
400
Co
nt
16
300
n
12Increase
200
tio
Decrease
Ex
ten
8
Contraction
Quantity Supplied in Kg.
Extension
Price Rs/Kg
b
8
4
a
S
100
200
300
400
500
Quantity Supplied (kg.)
4.5 Assumptions of Law
The assumptions of law of supply are as follows:
1. cost of production or technology does not change
If a commodity is being produced under the law of diminishing costs i.e., the cost
of production decreases with the increase in production, it is possible that its
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supply may increase even with a fall in price. So also it is possible that as a result
of research, experiments and inventions or due to better combination of factors of
production, the quantity supplied of a commodity may increase in spite of a fall in
price.
2. No discovery of sources of raw material or substitutes
If new sources of raw material are discovered or their substitutes are found, the
cost of production of goods is reduced and it becomes possible to supply such
goods in greater quantities even at lower prices.
3. No restriction by government for increasing output
If government restricts the increase in output of a commodity, the quantity
supplied cannot be increased in spite of rise in its price.
4. No expected change in price in near future
If price of a commodity decreases a little but the sellers expect the prices to go
further down, they might increase the quantity even at a lower price to save
themselves of additional loss. On the contrary, if there is a possibility of a further
rise in prices in the near future, the sellers might not increase the quantity
supplied at a raised price to benefit by further rise in prices.
5. No increase in prices of factors of production
If the price of factors of production goes up, the quantity supplied of a commodity
might not be increased in spite of a rise in price because it might not be possible
for certain producers to earn profit because of more expensive factors of
production.
6. Prices of substitutes should not change
If the price of a commodity increases but the prices of those goods that can be
produced in place of this commodity increases more, the producers will shift the
production from this commodity to other commodities and the supply of this
commodity will come down in spite of a rise in its price.
7. No problems or obstacles to production
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It becomes impossible to increase the quantity supplied in spite of a rise in price,
due to unfavorable natural circumstances in case of agricultural produce or due to
industrial disputes. If the climatic conditions are congenial for the production
purposes, the quantity supplied increases in spite of a fall in prices of such goods.
8. Seller’s attitude should not change
The sellers sell their goods to maximize their profits. But if they once make it their
objective to maximize their sale in the market, then they will sell more quantity in
the market even at a lower price.
4.6 Exceptions of the law
Exceptions of Law of Supply are as follows where law of supply cannot prove true:
1. Need for cash
Law of supply would not hold in the case of need for cash. If a seller is in need of
cash, he would not follow the law of supply and sells his commodities at low
prices.
2. Migration
Migration is another limitation or exception of law of supply. If people are migrating
from one place to another place, they would not care what the price level is. They
would sell out the commodities even they are getting low prices.
3. Natural disasters
In the case of natural disasters (earth quake, floods etc), people would not follow
the law of supply and sells his commodities at low prices.
4. Speculation and expectations
In some cases, sellers may hold back supply in anticipation of even higher prices
in the future. This behavior, known as speculation, can lead to reduced supply in
the short term despite rising prices. Sellers may believe that delaying sales will
allow them to capture greater profits later, leading them to deviate from the typical
response to price increases dictated by the law of supply.
5. Government intervention
Government policies such as price controls or export restrictions can distort the
relationship between price and supply. For example, in situations where the
government imposes price ceilings below market equilibrium levels, sellers may
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choose to reduce supply or withhold goods rather than selling at lower prices.
Similarly, export restrictions imposed during times of domestic scarcity can limit
the quantity of goods available domestically, even if prices are rising locally.
6. Monopoly or Cartel Behavior
In markets dominated by monopolies or cartels, sellers may have significant
market power, allowing them to manipulate supply to maximize profits. In these
situations, sellers may restrict supply even in the face of rising prices to maintain
scarcity and keep prices high. This behavior runs counter to the typical response
predicted by the law of supply, as sellers prioritize profit maximization over
increasing output in response to price increases.
7. Supply Chain Disruptions
Disruptions in the supply chain, such as transportation bottlenecks, logistical
challenges, or labor strikes, can prevent sellers from increasing supply even when
prices rise. These disruptions may limit the ability of producers to bring goods to
market, leading to temporary shortages or reduced availability despite higher
prices.
8. Technology and Innovation Constraints
In industries where production processes are highly specialized or dependent on
specific technologies, rapid increases in supply may be challenging even with
higher prices. For example, the production of certain advanced electronics or
pharmaceuticals may be limited by the availability of specialized equipment or
skilled labor, constraining the ability of producers to respond quickly to price
increases.
Key Point
You might naturally associate ‘rise’ and ‘fall’ with a vertical shift. This causes no
problems in the case of demand. Supply, however, is counterintuitive in this way.
4.7 Influences on Supply
As indicated before, supply depends on several factors other than a good’s own
price. Changes in these other factors are sources of shifts in market supply
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curves, just as happens with the market demand curves discussed above.
Price of Inputs (Changes in Costs of Production)
All things that a firm uses to produce its outputs, such as materials, labor, and
machines, are called the firm’s inputs. Other things being equal, the higher the
price of any input used to make a product, the less will be the profit from making
that product. We expect, therefore, that the higher the price of any input used by a
firm, the lower will be the amount that the firm will produce and offer for sale at
any given price of the product. A rise in the price of inputs therefore shifts the
supply curve to the left, indicating that less will be supplied at any given price; a
fall in the cost of inputs shifts the supply curve to the fight.
Technology
At any time, what is produced and how it is produced depends on what is known.
Overtime, knowledge changes; so do the quantities of individual products
supplied. The technological improvements in the computer industry over the past
two decades have led to a rightward shift in the supply curve.
Number of Firms
If firms that produce for a particular market are earning high profits, other firms
may be tempted to go into that business. When the technology to produce
computers for home use became available, literally hundreds of new firms got into
the act. The popularity and profitability of the Internet has led t the formation of
new service providers. When new firms enter an industry, the supply curve shifts
to the right. When firms go out of business or exit the market, the supply curve
shifts to the left.
Suppose that the price of sugar rises. How does this affect the demand for ice
cream? Sugar is an input into ice cream production. An increase in the price of an
input tends to raise the cost of production and hence to lower profitability. In
response to this increased cost, the ice cream producers will cut back on their
supply of ice cream. At any given price of ice cream, the suppliers are now less
inclined to continue the same amount. As they produce less, the supply curve for
ice cream shifts to the left.
Key Point
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When you are told to imagine that income or some other variable has changed,
imagine enormous change. This will help you work out the effects. If a can of
Coke has risen in price, imagine that it has doubled in price. This way it is easier
to see what will happen to the quantity demanded or supplied for Coke and its
substitutes.
MCQs
If the farmers producing wheat must obtain a higher price than they did
previously to produce the same level of output as before, then we can say that
there has beenA. an increase in quantity supplied.
B. an increase in supply.
C. a decrease in supply.
D. a decrease in quantity supplied.
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Answer: C. Draw the supply curve. At the same output level and at a higher
price, place a point. Draw a line parallel to the first supply curve
through this point. The new line (curve) will to the left and above the
initial supply curve – a decrease in supply.
Supply and Demand Together
Having analyzed supply and demand separately, we now combine them to
see how they determine the quantity of a good sold in a market and its price.
5. Change in supply vs changes in quantity supply
Change in Supply means Rise and Fall of Supply (Shifting of Supply curve) and
Change in Quantity Supply means Extension or Contraction of Supply (Movement
along the Supply curve).
Extension and contraction of supply
If the supply for a commodity changes due to a change in the price of that
commodity, it is called the Extension or Contraction of Supply.
Extension of supply
If price of commodity increases and Supply for a commodity also increases, it is
called the Extension of Supply.
P ↑ → Qs ↑
Contraction of supply
If price of commodity decreases and Supply for a commodity also decreases, it is
called the Contraction of Supply.
P ↓ → Qs ↓
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This diagram shows that the supply curve remains the same in either case. The
quantity supplied moves from one point to the other at the same supply curve.
This is known as the ‘Movement along the Supply Curve’.
Rise and fall in supply
If the Supply for a commodity changes due to the other factors (excluding price), it
is called the Rise or Fall in Supply.
Rise in supply
If the Supply for a commodity increases due to the other factors (excluding price),
it is called the Rise of Supply.
Due to Other Factors → Qs ↑
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This diagram shows that when the price does not change but the supply
increases due to some other reason, the supply curve SS shifts to the right i.e.,
S1S1. This type of shift shows the rising trend of supply.
Fall in supply
If the Supply for a commodity decreases due to the other factors (excluding price),
it is called the Fall of Supply.
Due to Other Factors → Qs ↓
This diagram shows that when the price does not change but the supply of a
commodity declines due to some other reasons, the supply curve SS shifts to the
left i.e., S1S1. This type of shift shows the falling trend of supply.
6
Market Equilibrium
6.1
Equilibrium
Equilibrium means a state of balance. When forces acting in opposite
directions are exactly equal, the object on which they are acting is said to be
in a state of equilibrium.
6.2
Equilibrium Price and Equilibrium Quantity
Equilibrium price under perfect competition is determined through the forces of
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demand and supply. Both quantities demanded and quantity supplied varies
with price. Equilibrium price is determined by the interaction of demand and
supply. By demand we mean the demand of all the buyers and by supply we
mean supply of all the firms. The price at which quantity demanded is equal to
quantity supplied is called the equilibrium price. Since forces of demand and
supply are balanced at this price, the quantity bought and sold is known as
equilibrium quantity.
Assume that demand and supply of a product at different prices are given
below:
Price
Rs. Per Kg.
200
160
Quantity
Quantity
Demanded Supplied
(Kg)
(Kg)
50
250
100
200
120
150
150
80
40
200
250
100
50
Market Situation
Surplus
(Excess Supply)
Qs > Qd
Qd = Qs
No Surplus and Shortage
Equilibrium
Shortage
(Excess Demand)
Qd > Qs
It is clear from the schedule that quantity demanded is equal to quantity
supplied at price Rs. 120 per kg., therefore price of Rs. 120 will persist in the
market, because at this level there is no tendency for it to rise or fall.
So at, equilibrium price
the whole quantity of
product offered for
sale, will be purchased
by the buyers. Thus
price Rs. 120 per kg.
is the equilibrium price
and 150 quintals is the
equilibrium quantity.
This can be shown
with the help
of aText)
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(Study
diagram.
73
6.3 Market Price Determination
Market price is determined through the quantity of demand and supply in the
market period or very short period. The market period is a period in which the
maximum that can be supplied is limited by the existing stock. The market
period depends upon the nature of the product. Market price is determined
daily by the forces of demand and supply. If demand is greater than the
supply, price increases and vice versa.
6.4 Market Price Determination for Perishable Goods
In case of perishable goods like fish, vegetables, milk etc., the supply cannot
be increased or decreased in a day. Therefore, whole of the commodity must
be sold on the same day, whatever the price may be.
Suppose that the supply of fish in a day is 150 quintals in the market.
Because fish is perishable commodity and cannot be stored for longer time by
ordinary means therefore fish sellers will try to sell all the fish because it cannot
be kept back for the next day. Price determination of fish can be explained with
the help of a schedule and diagram.
Price of Fish
Rs. Per kg
140
120
100
80
60
Quantity Demand
kg
50
100
150
200
250
Quantity Supplied
Kg
150
150
150
150
150
It is clear from the schedule that market price is 100 and equilibrium quantity
is 150 Quintals.
Demand curve DD and
Business Economics
(Study
supply
curveText)
MPS both
intersect at point E.
Therefore equilibrium
74
6.5 Market Price Determination-Durable Goods
Market price for perishable goods is that where all the quantity offered for
sale is purchased. But if the market price of durable goods falls from a certain
price its supply is stopped and is kept back for the next day. It can be
explained with the help of a schedule and a diagram.
Price Per Chair
Quantity
Quantity Supplied
Demanded
400
50
10
500
40
20
600
30
30
700
20
30
800
10
30
It is clear from the schedule that demand contracts from 50 chairs to 10 chairs
and quantity supplied 30 chairs but after that supply remained unchanged.
Total number of chairs is 30. As chairs are durable so if the sellers do not get
the reserve price they will stop the supply. In the schedule Rs. 600 per chair is
the equilibrium price.
Quantity demanded and market
quantity supplied is equal at
price Rs. 600 as shown by
Businesspoint
Economics
(Study Text)
E, therefore,
Rs. 600 is
the equilibrium price.
75
The forces of demand and supply which push to a market to its equilibrium
price and quantity
(a)
There is generally market equilibrium i.e., equilibrium price and
quantity will rule if demand and supply conditions do not change.
(b)
If the market is in disequilibrium the demand and supply forces
will push prices towards the equilibrium price.
(c)
The market will be in disequilibrium when demand and supply
curves change.
6.6
Short Run and Long Run Equilibrium Price
Market prices and quantities don’t adjust immediately to changes. Price adjustments
happen in three stages: momentary (right after the change), short-run (a transition
period), and long-run (when the market finally stabilizes).
It's important to differentiate between short-run and long-run responses for both
supply and demand. In the short-run, supply and demand don’t react much to price
changes, but in the long-run, they are more responsive.
For supply, increasing or decreasing the quantity of a good often involves hiring or
laying off workers, or installing new machinery. These changes take time to
implement due to management decisions.
For demand, consumers need time to change their buying habits, but demand
usually reacts faster to price changes than supply does.
In some markets, responses to price changes are quick. For example, in stock
markets, supply and demand for shares adjust rapidly. However, in markets for fuel
oils or agricultural chemicals, responses take much longer.
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The figure below shows the impact of a change in demand.
This describes the market for an imported exotic vegetable used in cooking. Initially,
the market is balanced at price P1 with quantity Q1 bought and sold each day,
represented by point A. When a popular TV cooking show features recipes using this
vegetable, demand increases from D0 to D1.
In the short term, supply remains fixed at Q1 per day, shown by the short-term
supply curve Sm. This causes the price to rise to Pm, creating a new short-term
balance at point B. The higher price prompts importers to order more of the
vegetable, and within a few days, the supply increases. This shifts the short-term
supply curve to Ss, resulting in a new short-term price Ps at point C.
In the long run, importers fully respond to the increased demand, and the long-term
supply curve SL is established. This brings the market price down to P2 at point D.
This demonstrates that markets gradually adjust to changes in demand and supply
conditions over time, rather than jumping directly from one long-term equilibrium
price to another. This adjustment process can take years, especially in markets
where increasing production or decreasing consumption takes time.
Key Point
Be careful not to confuse the rise in supply with a leftward shift in the supply curve.
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While the rise in the demand also implies a rightward (upward) shift in the demand
curve, that is not the case in the case of the supply curve. A rise in supply implies a
rightward (downward) shift in the supply curve. And a fall in supply implies a leftward
(upward) shift in the supply curve.
6.7 Shifts in demand and supply and effects on equilibrium price
Shifts in demand and supply may affect equilibrium price in number of ways
for example:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
Rise and fall in demand, supply remains unchanged.
Rise and fall in supply, demand remains unchanged.
Equal rise in demand and supply.
Equal fall in demand and supply.
Equal rise in demand and fall in supply.
Equal fall in demand and rise in supply.
Rise in demand is greater than rise in supply.
Rise in supply is greater than rise in demand.
Fall in demand is greater than fall in supply.
Fall in supply is greater than fall in demand.
Rise in demand is greater than fall in supply.
Fall in demand is greater than rise in supply.
Rise in supply is greater than fall in demand.
Fall in supply is greater than rise in demand.
Illustration Diagram No. 1:
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In the diagram equilibrium price is OP
and equilibrium quantity is OQ. Demand
has increased to D´D´ and equilibrium
price has also increased to OP´, with a
fall in demand to D´´D´´, price has fallen
to OP´´ because new demand line
D´´D´´ intersects SS line at point E´´.
D´
Y
D
D创
S
E´
P´
Price
P
E
E´
P创
D´
D
S
D创
O
X
Q创 Q Q´
Quantity
(1)
Illustration Diagram No. 2:
In the diagram equilibrium price is OP
if supply increases to S´S´ then new
equilibrium point is E´ and equilibrium
price falls to OP´ if supply falls to
S´´S´´ then new equilibrium point is at
E´´ and equilibrium price increases to
OP´´.
Y
S
S´
Price
P´
E创
P
E
E´
P创
S创
D
S
S´
O
Illustration Diagram No. 3:
In the diagram demand and supply curves
intersect at E therefore, equilibrium price
is OP and equilibrium quantity is OQ. If
demand increases to D´D´ and supply
increases to S´S´ equilibrium price is
unchanged but equilibrium quantity has
extended to OQ´.
X
Q
Quantity
(2)
Y
D´
S
D
S´
E
Price P
E´
D´
S
O
Business Economics (Study Text)
S创
D
D
S´
Q
Quantity
(3)
Q´
X
79
Y
D´
S´
S
D
Illustration Diagram No. 4:
In the diagram equilibrium price is OP,
demand & supply curves intersect at E,
therefore equilibrium quantity is OQ. S´S´
curve shows decrease in supply and D´D´
shows increase in demand both the
curves intersect each other at E´ so the
equilibrium price increases from OP to
OP´.
Illustration Diagram No. 6:
In the diagram equilibrium price is OP,
demand & supply curves intersect at E,
therefore equilibrium quantity is OQ. S´S´
curve shows increase in supply and D´D´
shows decrease in demand, both the
curves intersect each other at E´
equilibrium price decreases from OP to
OP´.
P´
E´
P
E
Price
S´
D´
D
S
O
Y
D
S
D´
S´
Price P
E
P´
E´
D´
O
Illustration Diagram No. 5:
In the diagram equilibrium price is OP
demand and supply curves intersect at E,
therefore, equilibrium quantity is OQ. S´S´
curve shows decrease in supply and D´D´
shown decrease in demand, both the
curves are intersecting at E´ which is
parallel to earlier equilibrium price OP i.e.,
equilibrium price is unchanged.
D
X
Q
Quantity
(6)
Y
Business Economics (Study Text)
X
Q
Quantity
(5)
D
S´
D´
Price
E´
P
E
D
S´
O
S
D´
S
Q1 Q
Quantity
(4)
X
80
Illustration Diagram No. 7:
In the diagram equilibrium price prior to
changes in demand and supply is OP
and equilibrium quantity is OQ but after
increase in demand D´D´ which is
greater than increase in supply S´S´
equilibrium price increases to OP´.
D´
Y
S
D
S´
P´
Price P
E´
E
D´
S
D
S´
O
Illustration Diagram No. 8:
In the diagram equilibrium price and
quantity before shifts in demand and
supply are OP and OQ respectively. After
an increase in supply S´S´ which is
greater than increase in demand D´D´
and new equilibrium price is below the
previous equilibrium price.
Y
D
D´
E
P
Price P´
E´
S´
D
Q
Quantity
(8)
Y
D´
S´
O
Business Economics (Study Text)
S
S´
S
Illustration Diagram No. 9:
In the diagram original DD demand.
Curve and SS supply curve intersect at E
and equilibrium price is OP and quantity
is OQ. New demand curve D´D´ shows
greater decrease in demand than smaller
decrease in supply S´S´ but both the new
curves intersect at E´ and equilibrium
price falls from OP to OP´ and quantity
from OQ to OQ´. (Please show the curve
OQ´ in the diagram).
X
Q´
Q
Quantity
(7)
X
Q´
S´
D
S
D´
Price
P
E
P´
E´
S´
D
S
O
S´
Q´
D´
Q
Quantity
(9)
X
81
Illustration Diagram No. 10:
If a fall in supply is greater than fall in
demand equilibrium price will increase
from OP to OP´.
Y
S´
D
D´
S
P´
Price P
E´
E
S´
D´ D
S
O
Y
D´
D
E
P´
Price P
S´
S
E
D´
S´
D
S
O
Illustration Diagram No. 12:
If the fall in demand is greater than the
rise in supply equilibrium price will fall
from OP to OP´.
X
Q Q´
Quantity
(11)
Y
D
S
D´
Price
P
E
S
O
S´
E
P´
Business Economics (Study Text)
X
Q
Quantity
(10)
S´

Illustration Diagram No. 11:
If the rise in demand is greater than the
fall in supply, there will be a in
equilibrium price from OP to OP´ rise. In
the diagram equilibrium price is OP and
quantity is OQ before shifts in demand
and supply. After greater decrease in
supply to S´S´ than demand D´D´ new
equilibrium price increases to OP´.
Q´
D´
Q´ Q
Quantity
(12)
D
X
82
Illustration Diagram No. 13:
If a rise in supply is greater than fall in
demand equilibrium price will fall from
OP to OP´.
Y
D´
Price
D
S
P
S´
E
P´
S
O
S´ 
Q Q´
Quantity
(13)
D´
D
X
Illustration Diagram No. 14:
If fall in supply is greater than rise in demand, equilibrium price will rise i.e.,
from OP to OP´.
S´
Y
D´
D
S
P´
Price
E´
P
E
S´
O
D
S
Q´ Q
Quantity
(14)
D´
X
The forces of demand and supply which push to a market to its equilibrium
price and quantity:
(a)
There is generally market equilibrium i.e., equilibrium price and
quantity will rule if demand and supply conditions do not change.
(b)
If the market is in disequilibrium the demand and supply forces
will push prices towards the equilibrium price.
(c)
The market will be in disequilibrium when demand and supply
curves change.
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Contents
1. Price Elasticity of Demand
2. Income Elasticity of Demand
3. Cross Price Elasticity of Demand
4. Factors Influencing Elasticity of Demand
5. Importance of Elasticity of Demand
6. Price Elasticity of Supply
7. Determinants of Elasticity of Supply
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1. Price elasticity of demand
Law of demand tells the negative relationship between price and quantity demand. It
means that the law of demand shows just shows the direction of change which is
negative but it ignores the extent of change (how much change). This law does not
tell in what proportion the demand would change with the change in price.
In certain goods, a small change in price will bring about a very significant change in
the quantity demanded while in certain other goods; a very large change in price
produces a very small change in the quantity demanded.
So, Dr. Marshall has to give the concept of elasticity of demand. Elasticity of demand
includes both aspects: i) Direction of change and ii) Extent of change.
The elasticity of demand tells us how much change has occurred in the demand for a
good in response to a change in its price.
Elasticity
“The degree of responsiveness, sensitivity or proportionate change in one variable
due to the proportionate change in another variable is called Elasticity”
Elasticity of demand
“The degree of responsiveness, sensitivity or proportionate change in demand due to
the proportionate change in different variables is called Elasticity of Demand”
1.1 Degrees of price elasticity

If there is a large proportionate change in quantity demanded due to a small
proportionate change in price, it is called ‘More Elastic Demand’ or ‘elastic
demand’.

If there is a small proportionate change in quantity demanded due to a large
proportionate change in price, it is called ‘Less Elastic Demand’ or ‘Inelastic
demand’.
If there is equal proportionate change between quantity demanded and price,
it is called ‘Equal Elastic Demand’ or ‘Unit elastic demand’.

1.2 Kinds of elasticity of demand
Price elasticity of demand
“The degree of responsiveness, sensitivity or proportionate change in quantity
demand due to the proportionate change in price is called Price Elasticity of
Demand”
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Income elasticity of demand
“The degree of responsiveness, sensitivity or proportionate change in demand due to
the proportionate change in income is called Income Elasticity of Demand”
Cross price elasticity of demand
“The degree of responsiveness, sensitivity or proportionate change in demand of one
commodity due to proportionate change in price of other commodities is called Cross
Price Elasticity of Demand”
1.3 Formulas of Price elasticity of demand
“The degree of responsiveness, sensitivity or proportionate change in quantity
demand due to the proportionate change in price is called Price Elasticity of
Demand”
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1.4 Measurement of price elasticity of demand
According to Alfred Marshall, we can measure the elasticity of demand with the help
of ‘UNITARY SCALE’. Demand elasticity may be Greater than Unity, Equal to Unity
or Less than Unity. There can be three ways to measure the price elasticity of
demand that are as follows:
1. Percentage method
2. Total outlay method
3. Graphic method
Now we explain these methods in turn:
1. Percentage method
FLUX presented this method. According to this method, we find out the percentage
change in the quantity demanded due to the percentage change in price. We
compare these changes to determine whether the elasticity of demand is greater
than, Equal to or less than unity. This method is also called FLUX METHOD.
Greater Than Unity
If the percentage change in quantity demanded is greater than percentage change in
price, elasticity of demand will be more than unity.
Equal To Unity
If the percentage change in quantity demanded is equal to the percentage change in
price, elasticity of demand will be equal to unity.
Less than unity
If the percentage change in quantity demanded is less than the percentage change
in price, elasticity of demand will be less than unity.
2. Total outlay method
Total outlay means total expenditure. This method has been presented by Dr. Alfred
Marshall. According to this method, we would analyses the relationship between
change in price of a commodity and the change in total expenditure on that
commodity to determine the degree of elasticity of demand whether it is greater than,
equal to or less than unity.
This method is also called Total Outlay (Total Expenditure) or Total Revenue method.
Total Outlay (Total expenditure) or Total Revenue is calculated as:
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TR =TE = P x Q
Greater than unity
Elasticity of demand will be more than unity, when there is a negative or inverse
relationship between price and total expenditure. It means that if price decreases
and total expenditure increases and if price increases and total expenditure
decreases, elasticity of demand will be more than unity.
PRICE (P)
DEMAND (Q)
TE= P x Q
Rs.20
2 Units
Rs.40
Rs.10
6 Units
Rs.60
This schedule shows that when price falls from Rs.20 to Rs.10, total expenditures
rise from Rs.40 to Rs.60, and inversely when the price rises from Rs.10 to Rs.20,
total expenditure falls from Rs.60 to Rs.40 i.e., there is an inverse relationship
between price and total outlay. So, the elasticity of demand is greater than unity.
Equal to unity
If price of the commodity changes (increase or decrease) but the total expenditure
on the commodity remains the same, elasticity of demand will be equal to unity.
PRICE (P)
DEMAND (Q)
TE= P x Q
Rs.20
2 Units
Rs.40
Rs.10
4 Units
Rs.40
This schedule shows that when the price falls from Rs.20 to Rs.10, total expenditure
remains unchanged, and inversely when the price rises from Rs.10 to Rs.20, total
expenditure also remains unchanged. So elasticity of demand is equal to unity.
Less than unity
PRICE
(P)
DEMAND (Q)
TE= P x Q
Rs.20
2 Units
Rs.40
Rs.10
3 Units
Rs.30
Elasticity of demand will be less than unity, when there is a positive or direct
relationship between price and total expenditure. It means that if price decreases
and total expenditure decreases and if price increases and total expenditure
increases, elasticity of demand will be less than unity.
This schedule shows that when price falls from Rs.20 to Rs.10, total expenditure falls
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from Rs.40 to Rs.30, and inversely when the price rises from Rs.10 to Rs.20, total
expenditure rises from Rs.30 to Rs.40 i.e., there is a direct or positive relationship
between price and total outlay. So the elasticity of demand is less than unity.
Summary schedule
The relationship between price and total expenditure is summarized in the following
schedule:
3. Graphic method
Graphically/geometrically the elasticity of demand is equal to the lower segment of
the demand curve divided by the upper segment of the demand curve.
Suppose ‘RS’ is the demand curve. Price elasticity of demand at the mid point ‘M’,
where the lower and upper segments are equal, is equal to unity. To the right of the
middle point, price elasticity of demand is less than unity while to the left of the
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middle point; price elasticity of demand is greater than unity. At point ‘R’ price
elasticity of demand tends to infinity while at point ‘S’ it is equal to zero. Price
elasticity of demand at point:
Key Point
The formula for determining elasticity utilizes the percentage change, not the
absolute change, in quantity demanded relative to price. In the upper half of the price
range (the lower half of the range of quantity), any decrease in price is bound to be
relatively small in percentage terms because the base price is relatively high. By the
same token, the corresponding increase in quantity must be relatively high in
percentage terms because the base quantities from which the percentage is
calculated are relatively low. This is illustrated in Figure, which shows that the upper
half of the demand line is elastic, whereas the lower half is inelastic. At the half point,
the demand is unitary elastic. In fact, as long as the demand is a straight line, as in
Figure, we can state that it will have an elastic half and an inelastic half with unitary
elasticity occurring right in the middle. If the demand curve is not linear, then the
relationship between range of prices and elasticity does not hold.
1.5 Measurement of point and arc elasticity of demand
1. Point elasticity of demand
The concept of Point elasticity has been given by Dr. Alfred Marshall. “The price
elasticity of Demand at a particular point on the demand curve is called Point
Elasticity of Demand.” We use the following formula to measure the Point Elasticity
of Demand.
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Point Elasticity of Demand can also be obtained by geometrically by dividing the
price of the commodity (P) at the point on the demand curve at which we want to find
the elasticity by P – A, where A is the price at which the quantity demanded is zero
(i.e. the price at which the demand curve crosses the vertical axis).
εd = P/ P - A
For a curvilinear demand curve, we draw a tangent to the demand curve at the point
at which we want to measure elasticity and then proceed as if we are dealing with a
linear demand curve.
2. Arc elasticity of demand (mid-point formula)
The concept of Arc elasticity has been given by R.G.D.Allen. “The price elasticity of
Demand between the two points on the demand curve is called Arc Elasticity of
Demand.” We use the following formula to measure the Arc Elasticity of Demand.
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Why the concept of Arc elasticity of demand is better than Point Elasticity of demand?
If we use Point Elasticity formula to measure the elasticity of demand, we get
different results depending on whether the price is rising or falling. For example,
using Point Elasticity formula to measure the elasticity of demand from point C to
point D (i.e. for price decrease) on the demand curve, we obtain:
On the other hand, using Point Elasticity formula to measure the elasticity of demand
from point D to point C (i.e. for price increase) on the demand curve, we obtain:
To avoid this problem, we use the average of the two prices and the average of the
two quantities in the calculations. Thus, the formula of point elasticity can be
converted to the formula of Arc elasticity as:
Where, the subscripts 1 and 2 refer to the original and to the new values of price and
quantity respectively. For example, using Arc Elasticity formula to measure the
elasticity of demand from point D to point C (i.e. for price increase) on the demand
curve, or from point D to point C (i.e. for price increase) on the demand curve, we
obtain the same results i.e. εd = -1.4.
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Note: Point elasticity of demand is measured on a single point on a demand curve
while arc elasticity of demand is measured between two points on a demand
curve.
EXAMPLE
The example below demonstrates how the equation works and how it relates to the
equation.
Q 2 - Q1
PED =
Q1
x100
P2 - P1
x100
P1
A firm faces the following demand curve.
Price (£)
5
4
3
2
1
(1)
(2)
2
4
6
8
10
Quantity
Demand
Work out the price elasticity of demand at point 1.
Solution
The first step is to select any other point on the line to act as a reference point,
point 2. Here point 2 is one step down the line from point 1 but, on a straight
line demand curve, any other point would give the same result.
The price and quantity at point 1 are P1 and Q1 respectively. So P1 = 4 and
Q1 = 2. Similarly, price and quantity at point 2 are P2 and Q2 respectively. So
P2 = 3 and Q2 = 4.
Applying the equation above:
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PED
=
x 100
x 100
So price elasticity of demand at point 1 is −4.
Notes on PED
(a)
As mentioned above, PED for most goods is negative, so the minus
sign is often ignored when talking about PED. For example, we could
say that the price elasticity of demand at point 1 is 4, when strictly
speaking it is −4.
(b)
PED is different at different points of a demand curve, even if that
‘curve’ is a straight line. The next section will go into this in more depth.
KEY POINT
When PED>1, demand is relatively elastic and the quantity demanded
is very responsive to price changes; when PED<1, demand is relatively
inelastic and the quantity demanded is not very responsive to price
changes.
When PED>1, demand is relatively elastic and the quantity demanded is very
responsive to price changes; when PED<1, demand is relatively inelastic and
the quantity demanded is not very responsive to price changes.
Note that, if demand is said to be inelastic, this does not mean that there will
be no change in quantity demanded when the price changes; it means that
the consequent demand change will be proportionately smaller than the price
change. If demand does not change at all after a price change, demand is
said to be perfectly inelastic, and this is a special case as will be seen belo
Mathematically we can measure elasticity of demand. If price of a commodity
increases from Rs. 10 to Rs. 12 and demand contracts from 96 to 80 units.
The elasticity of demand with the help of formula, elasticity method can be
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measured as follows:
PED =
Q
P
ΔQ P
.
ΔP Q
= –16
=2
–16
10
x
2
96
PED =
P
Qd
= 10
= 96
=
– 0.83 or inelastic
Note: The elasticity of demand is always negative, although by convention it
is taken as positive. It is negative because price and quantity
demanded are negatively related. Elasticity is always less than zero,
unless the demand curve is abnormal i.e., it slopes upward from right
to left.
1.6 Unusual demand curves (Special values of price elasticity of demand)
There are three types of demand curve that merit special attention – those of
zero elasticity, infinite elasticity and unitary elasticity. These are the only
demand curves for which elasticity is the same at every point on the curve.
(a)
Perfectly Inelastic
Such a curve is called ‘perfectly inelastic’. Given that elasticity is a measure
of the sensitivity of demand to price changes, a zero elasticity implies that
demand is completely unaffected by price; the same quantity will be
demanded, regardless of the price.
P
D
0
Q
Figure: A perfectly inelastic demand curve
(b)
Infinite elasticity
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Such a curve is called ‘perfectly elastic’. A small change in price results
in an infinitely large change in demand. So a minuscule rise in price will
result in demand falling to zero; while a minuscule fall in price will
cause demand to rise to infinity.
P
D
0
Q
Figure: A perfectly elastic demand curve
(c)
Unitary elasticity
Such a curve has a PED of 1 at every point on the curve. It is a
‘rectangular hyperbola’. The name comes from the fact that the area of
any rectangle drawn touching the curve is the same.
P
Rs.10
Rs.5
D
0
4
8
Q
Figure: A demand curve of unitary elasticity
The two rectangles drawn in Figure 6.7 have the same area. In fact, the area
of the rectangle actually represents the total sales revenue (P × Q) that
suppliers can expect to earn at different prices. If a firm makes a good with
this type of demand curve, total revenue will remain the same regardless of
the price charged and the quantity sold. Each price reduction will be exactly
matched by a rise in sales, so that total revenue will not change; and vice
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versa. In the above example, total revenue is Rs. 40,000 whether price is Rs.
10,000 or Rs. 5,000.
2. Income elasticity of demand
“The degree of responsiveness, sensitivity or proportionate change in demand due to
the proportionate change in income is called Income Elasticity of Demand”
OR
“The ratio between the proportionate change in quantity demanded of a commodity
and the proportionate change in consumer’s income is called the Income Elasticity of
Demand.”
We use the following formula in order to measure the income elasticity of demand.
Income elasticity of demand for superior and inferior goods
Income elasticity of demand can be studied in case of two types of goods i.e. Normal
goods and inferior goods. In case of normal goods, the income effect is positive i.e. if
consumer’s income increases, demand for normal goods also increases and if
consumer’s income decreases, demand for normal goods also decreases. So,
income elasticity will be positive for the normal goods.
Income ↑ → Qd ↑
Income ↓ → Qd ↓
In case of inferior goods, the income effect is negative i.e. if consumer’s income
increases, demand for inferior goods decreases and if consumer’s income
decreases, demand for inferior goods increases. So, income elasticity will be
negative for the inferior goods.
Income ↑ → Qd ↓
Income ↓ → Qd ↑
Measurement in case of normal goods
Income Elasticity of Demand in case of normal goods is positive i.e., with the
increase in income; demand for superior goods increases and vice versa.
Income elasticity of demand in case of normal goods varies from zero to infinity.
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If Ey > 1, the commodity would be Normal Luxury or superior goods
If income elasticity is between (0 < Ey <1), the commodity would be Normal
Necessity.
Measurement in case of inferior goods
Income Elasticity of Demand in case of inferior goods is negative (Ey < 0) i.e., with
the increase in income; demand for inferior goods decline and vice versa. Income
Elasticity of Demand in case of inferior goods varies from less than zero to negative
infinity.
Degrees of income elasticity of demand
1. Greater than unity
If the proportionate change in quantity demanded is greater than proportionate
change in consumer’s income, Income elasticity of demand will be greater than unity.
2. Equal to unity
If the proportionate change in quantity demanded is equal to the proportionate
change in consumer’s income, Income elasticity of demand will be equal to unity.
3. Less than unity
If the proportionate change in quantity demanded is less than proportionate change
in consumer’s income, Income elasticity of demand will be less than unity
4. Equal to zero
If there is no proportionate change in quantity demanded of a commodity due to the
proportionate change in consumer’s income. Income Elasticity of Demand will be
equal to zero.
5. Infinity case
If a minute proportionate change in consumer’s income leads to infinite proportionate
change in quantity demanded of a commodity, Income Elasticity of Demand will tend
to infinity.
Key Point
No good is automatically inferior, normal, or a luxury. For a poor person gaining
income in a distant neighborhood, a bus ride may be a luxury, while that same bus
ride might be inferior for a millionaire. You should also realize that a luxury – e.g.
bubblegum-need not be equated with high-priced, nor necessity (dental care) with
low-priced. Clearly, there may be a link between income elasticity and price elasticity.
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Whether a good has many substitutes may be linked with whether it is considered a
luxury or a necessity.
3. Cross price elasticity of demand
Normally quantity demand of a commodity (QA) depends on its own price (PA). It is
called Own Price Effect.
QA = f (PA)
The demand for a commodity (QA) also depends on prices of the related
commodities. It is called Cross Price Effect.
QA = f (PB)
“The ratio between the proportionate change in quantity demanded of a commodity
and the proportionate change in the price of a related commodity is known as Cross
Price Elasticity of Demand”
We use the following formula to measure the Cross Price Elasticity of Demand
between goods A and B.
Cross Price Elasticity of Demand measures the relative change in the quantity of
commodity ‘A’ purchased as a result of a relative change in the price of a related
commodity ‘B’, while the price of commodity ‘A’ remains the same.
We can find the Cross-Price Elasticity of Demand for Related and Unrelated goods.
Related Goods
Related goods mean those goods which have a relationship with one another. There
are two types of related goods, Substitutes & Complementary Goods.
Unrelated Goods
Unrelated goods mean those goods which do not have any relationship with one
another. Unrelated goods are also called independent goods.
Cross price elasticity for substitute goods (related goods)
Substitute goods are those goods which can be used in place of one another. For
example, Pepsi or Coke, Butter or Margarine, Pen or Ballpoint, Tea or coffee etc. In
case of substitutes Cross Price Elasticity is positive (the quantity demand of A varies
directly with the change in price of B). If the price of Pepsi rises, the demand for
Coke also rises. Similarly a fall in the price of Pepsi will cause a decrease in the
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demand for Coke. So, the price of one commodity and the demand for the other
commodity are directly related. The larger the positive coefficient, the greater is the
substitutability between the two products.
Cross elasticity of complementary goods (related goods)
Complementary or joint goods are those goods which can be used jointly. For
example, Car and petrol, Cell phone and Sim card, Pen and ink etc. In case of
complementary goods, Cross elasticity is negative (the quantity demand of A varies
inversely with the change in price of B). If the price of Sim card rises, the demand
for Cell phone falls. Similarly, a fall in the price of Sim card will cause an increase in
the demand for Cell phone. So, the price of one commodity and the demand for the
other commodity are indirectly or inversely related. The larger the negative
coefficient, the greater is the complementarity between the two products.
Cross elasticity of independent goods (unrelated goods)
Unrelated goods mean those goods which do not have any relationship with one
another. Unrelated goods are also called independent goods. For example, Car and
Pepsi, Sugar and Shampoo, Pen and Butter etc. In case of independent goods
cross elasticity is zero or near to zero (the quantity demand of A does not change
with the change in price of B). If the price of pen rises or falls, the demand for Butter
remains the same.
In case of unrelated goods cross price elasticity of demand is zero. If the change in
price of good ‘B’ has no effect on the demand for good ‘A’, cross price elasticity of
demand will be zero.
Degrees of cross price elasticity of demand
Greater than unity
If the proportionate change in quantity demanded for good ‘A’, is greater than
proportionate change in price of good ‘B’. Cross Price Elasticity of Demand will be
greater than unity.
Equal to unity
If the proportionate change in quantity demanded for good ‘A’, is equal to the
proportionate change in price of good ‘B’. Cross Price Elasticity of Demand will be
equal to unity.
Less than unity
If the proportionate change in quantity demanded for good ‘A’, is less than the
proportionate change in price of good ‘B’. Cross Price Elasticity of Demand will be
less than unity.
Summary schedule
The Value of Cross Price Elasticity Coefficient and types of goods is summarized in
the following schedule:
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4.
Factors Influencing Elasticity of Demand
There are several factors which determine the elasticity of demand:
1.
Nature of the Commodity
The elasticity of demand for necessities of life is inelastic because due to
increase in price, the demand for that commodity does not contract
proportionately and for comforts and luxuries the elasticity of demand is
elastic because even a smaller change in price brings big changes in quantity
demanded.
2.
Availability of substitute
If the commodity has substitutes the elasticity of demand is elastic because
when price increases the substitutes become cheaper and demand of
substitutes increases. While demand for commodity falls substantially, the
response of demand is greater than the change in price.
3.
Share in Total Consumption Expenditure
If the share of commodity in total expenditure is greater to an increase in its
price demand falls more, therefore, demand is elastic and if the share is less
than it does not affect the demand more and demand is inelastic (for
necessities) for normal good it is elastic.
4.
Goods Having Several Uses
If a commodity is having several uses, the demand is elastic. If the price falls
it is used even in unimportant uses. i.e., response of demand is greater to a
change in price.
5.
Durable Goods
The more durable is good, the greater is the elasticity and is more perishable
is good less is the elasticity period.
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6.
Price Level
Elasticity of demand for those goods which are either high priced or low priced
is inelastic. Because with a small increase in price poor people cannot
purchase high priced commodity and if the commodity is low priced then it is
already purchased in sufficient quantity so further fall in price does not cause
an increase in demand.
7.
Income Level
For rich, elasticity of demand for different commodities is inelastic because an
increase in price does not affect their consumption expenditure. For poor,
elasticity of demand is elastic because even a smaller change in price brings
greater change in demand.
8.
Postponement of Demand / Delay in use
A commodity whose demand can be postponed elasticity is elastic because to
a smaller fall in price may bring greater demand and bigger rise in price may
bring smaller contraction in demand.
9.
Habit and Fashion or consumer loyalty
A commodity which is liked by the people or it is in fashion, demand
iszinelastic because people purchase even at higher price.
10.
Number of Compliments or Joint Products
If the good has many compliments the product has more demand. The
elasticity of demand for that product is inelastic.
11.
Future Expectations
If price of commodity is expected to rise or fall in future, a small change in
price brings a considerable change in demand. Therefore, elasticity for those
goods is relatively elastic.
12.
Consumer adjustment
If consumers are slow to react to a change in price, the amount bought is
largely unaffected and price elasticity is relatively inelastic.
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5.
Importance of Elasticity of Demand
The importance of elasticity of demand can be viewed from the following
1.
For Finance Minister
Basic job of a finance Minister is to prepare Budget. The concept of elasticity
of demand guides him and he levies more taxes on goods which are having
elastic demand i.e., luxuries and less taxes on goods where elasticity of
demand is inelastic.
2.
For Producers
The producers can increase the prices of those goods for which elasticity of
demand is inelastic and avoids increase in prices for those goods for which
elasticity of demand is elastic.
3.
Price Discrimination
A monopolist charges higher price from those persons whose income is high
and elasticity of demand is elastic while charges low price from poor.
4.
Determination of Fare
The concept of elasticity of demand is kept in view while determining fare in
transportation e.g. Pakistan Railways charges many types of fare from
different persons depending upon demand elasticity of the passengers.
5.
Joint Demand
In case of goods which are sold, purchased or used jointly, higher price is
charged for goods having inelastic demand and lower price is charged for
goods having elastic demand.
6.
For Exporters
Exporters are charging high prices for goods having inelastic demand and
lower price for goods having elastic demand.
7.
Increasing Returns Industry
When industry is subject to increasing returns, expansion in production lowers
the average cost of the product. If at the same time the demand of such
product is elastic, the producer can raise his profit by slightly reducing the
price and producing larger quantity.
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8.
Wages
If the demand for a particular type of labor is inelastic, the labor union can
easily get higher wages from the entrepreneurs for the workers.
9.
Paradox of Poverty in Plenty
If the demand for a product is inelastic, its increased production may
result in less profit. Take an example of potatoes. Suppose their demand is
inelastic at a certain period of time. Now if farmers grow more potatoes, their
total income will decrease rather than increase. So, for them, plenty of
potatoes means poverty.
10.
The Government
1.Knowledge of price elasticity of demand would be useful to the government
and the policy making authorities in general. It might be useful to the
government in assessing cost or the likely effectiveness of price support
schemes such as those common in agriculture.
2.Similarly, knowledge of price elasticity of demand would be useful if it was
decided to influence consumption through the use of taxes or subsidies. For
example taxes might be used to discourage the use of demerit goods, while
subsidies might be used to encourage the consumption of merit goods. Again,
knowledge of price elasticity of demand would provide an indication of how
successful the policy is likely to be and, in the case of subsidies it would be
useful in providing an estimate of likely cost of the subsidy.
3.For any government considering devaluation/revaluation of its currency,
knowledge of price elasticity of demand is essential in order to predict the
changes
in
import
expenditure
and
export
revenue
following
devaluation/revaluation.
11.
The Business Sector
Those involved in the business would find that knowledge of price elasticity of
demand is useful if they were considering a price change for their product. If
demand is inelastic, a price rise will lead to a rise in profits because revenue
will rise. In other situations such as price fall, the effect of profitability depends
on the proportionate change in cost and revenue following a price change.
Note, however that the aim of price fall is to increase sales revenue, it is
Business Economics (Study Text)
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important that demand is elastic. Firms might wish to increase sales as to
increase their market share or to enable them to reap important economies of
scale.
6.
Elasticity of Supply
Law of supply explains direct relationship between price and supply quantity
of that product. Where price is an independent variable and supply quantity is
a dependent variable i.e., supply shows reaction and response to a change in
price.
The price elasticity of supply or simply supply elasticity is defined as a degree
of responsiveness in supply to a change in price or a percentage change in
quantity supplied to a percentage change in price. It is explained with the help
of a formula
Price elasticity of Supply (PES)
=
Percentage change in supplied
Percentage change in price
Since supply curve is positively sloped therefore, supply elasticity is normally
positive.
6.1
Elasticity of Supply and Time
1.
Market period supply Market period is so short time period
when even variable factors of production cannot be changed
therefore, market period supply is nearly fixed e.g. supply of
perishable goods (vegetables, fruit, fresh milk etc.).
2.
Short period supply Short period is generally known as one
year time period (starting from one day to up to maximum one
year). In this time period only the variable factors of production
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can be changed while the fixed factors of production (e.g.,
building, plant & machinery) cannot be changed i.e., supply in
the short period can be increased or decreased only up to the
extent of changes in the variable factors of production.
3.
Long period supply Long period is so sufficient period that
even the fixed factors of production become variable. Long
period supply can be increased or decreased up to the extent of
variations in all the factors of production i.e., new firms can enter
into the industry.
7. Determinants of Elasticity of Supply (Factors Influencing
Elasticity of Supply)
1.
The Number of Firms in the Industry Generally the greater the
number of firms in an industry, relatively elastic is the industry
supply.
2.
The Length of the Production Period If the production
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converts input into output in few hours; supply will be relatively
elastic then when several months are involved, as in agriculture.
3.
The Existence of Spare Capacity If spare capacity exists and if
variable inputs such as labor and raw materials are available, it
should be possible to increase production quickly in the short
run supply may be elastic.
4.
The Ease of Accumulating Stocks If it is easy to store unsold
stocks at low cost, firms will be able to meet a sudden increase
in demand by running down stocks. Likewise, they can respond
to a sudden fall in demand and price by taking supply off the
market and by diverting production into stock accumulation in
both cases supply is elastic.
5.
The Ease of switching to other productions Many firms
produce a range of different products and are able to switch
machines and labor from one type of production to another. If
factors of production can be switched in this way, then the
supply of one particular product will tend to be elastic.
Exercise No. 1
Product A, currently sells at Rs. 40/- per unit and its demand at this price was
500 units. If price fell to Rs. 35/- P.U, its demand extends to 525 units.
Product B, currently sells at Rs. 70 per unit and its demand at this price was
300 units, it price fell to Rs. 60/- per unit, its demand extends to 400 units.
Required:
(i)
Calculate price elasticity of demand for both the products.
(ii)
Calculate changes in total revenue if demand is met in full before and
after the change in price.
Solution:
Price elasticity of demand =
Business Economics (Study Text)
Percentage change in demand
Percentage change in price
108
Product A:
Percentage change in demand =
Change in demand
Demand
Percentage change in demand =
25
x 100  5%
500
Percentage change in price =
Change in price
x 100
Price
Percentage change in price =
-5
x 100 = - 12.5%
40
Percentage elasticity of demand =
5
x 100 = - 0.4 (inelastic)
- 12.5
Product B:
Percentage change in demand =
Percentage change in price =
Price elasticity of demand =
100
100  33.3%
300
-10
x 100   14.29
70
33.3
= - 0.807(inelastic)
14.29
Change in Total Revenue for Product ‘A’.
Before change in price Total Revenue = 40 x 500 = Rs. 20,000 (PxQx)
After the change in price Total Revenue = 35 x 525 = Rs. 18,375
Firm’s total revenue will fall as a result of fall in price which is equal to Rs.
1625.
Change in Total Revenue for Product ‘B’.
Before change in price Total Revenue is Rs. 70 x 300 = Rs. 21,000
After the change in price Total Revenue is Rs. 60 x 400 = Rs. 24,000
Firm’s total revenue will increase as a result of fall in price which is Rs. 3000.
Exercise No. 2
(A)
Product ‘x’ currently sells at Rs. 550 per unit, the demand of product ‘y’
was 1100 units. If price of product ‘x’ fell to Rs. 500 per unit, the
demand for product ‘y’ increases to 1200 units.
Business Economics (Study Text)
109
(B)
Product ‘x’ currently sells at Rs. 550 per unit, the demand of product ‘y’
was 1100 units. If price of product ‘x’ fell to Rs. 500 per unit, the
demand for product ‘y’ decreases to 1000 units.
Required:
(1)
Calculate cross elasticity of demand (XED) for both the situations ‘A’
and ‘B”.
(2)
Which situation explains substitutes and which situation explain
compliments.
(3)
For substitutes XED, is positive or negative.
(4)
For compliments XED, is positive or negative.
Note: XED =
Percentagechange in demand of product ' y'
Percentagechange in price of product ' x'
Exercise No. 3
Given the table calculate income elasticity of demand (YED)
Note: YED =
Income
Demand
(Rs.)
(Units)
10,000
720
12,000
750
Percentagechange in demand
Percentagechange in income
Exercise No. 4
Product ‘x’ is currently sells at Rs. 96 per unit and its demand at this was price
220 units. If price fell to Rs. 95 per unit its demand increases to 225 units.
Required:
Calculate price elasticity of demand by using percentage method or by using
the formula PED =
Q P
.
P Q
Note: ΔQ is the change in demand quantity
ΔP is the change in price
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110
P is the price before it fell
Q is the demand before price fell
Exercise No. 5
Given the table, calculate price elasticity of demand by using A&C elasticity
method.
Price
Per unit
(Rs.)
Demand
Quantity
(Units)
P1600
150
Q1
P2500
250
Q2
Note: Formula for calculating A&C elasticity of demand is PED :
Q2  Q1 P2  P1
.
Q2  Q1 P2  P1
Exercise No. 6
Given the values of price elasticity per unit and supply by using percentage
method.
Price
Per unit
(Rs.)
Supply
Quantity
(Units)
750
125
800
150
Note: Formula is: PED :
Percentagechangeinsuppluy
Percentagechangeinprice
Summary
•
In this chapter we learned how to calculate various types of elasticity,
and the factors which influence both the elasticity of demand and
supply. Of particular significance is time.
Business Economics (Study Text)
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•
Both supply and demand are more elastic in the longer term than in the
short term.
•
An appreciation of price and income elasticity of demand is useful to
business and government alike.
–
Knowledge of price elasticity will help government to select the
most appropriate goods for taxation, and businesses to make
more rational pricing decisions to achieve higher levels of total
sales revenue.
–
Understanding income elasticity will help businesses to select
the most profitable products to produce when incomes are rising,
or to be aware of potential problems if they are not.
Self-test questions
Calculating price elasticity of demand
1.
Define price elasticity of demand and state its simple formula. (1.1)
2.
Is price elasticity of demand positive or negative? (1.4)
3.
If price elasticity of demand is −2 and price increases by 10%, by how
much will quantity demand decrease? (1.1)
Using price elasticity of demand descriptively
4.
Draw a graph showing the unitary elasticity of demand. What do you call
this graph? (1.6)
Income elasticity of demand
5.
What is a normal good? (2)
Cross elasticity of demand
6.
Is cross elasticity of demand for complements positive or negative? (3)
Factors affecting price elasticity of demand
7.
What are Giffen goods? (4)
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8.
If sa product is habit-forming, would you expect its demand to be
relatively elastic or relatively inelastic? (4)
Practical uses of price elasticity of demand
9.
If demand for a product is relatively elastic and the price of that product
rises, what will happen to the firm’s total revenue? (5)
Factors affecting price elasticity of supply
10.
Is supply more elastic in the short run or in the long run? (7)
Practice questions
Question 1
Which one of the following statements about the elasticity of supply is not true?
A
It tends to vary with time
B
It is a measure of the responsiveness of supply to changes in
price
C
It is a measure of changes in supply due to greater efficiency
D
It tends to be higher for manufactured goods than for primary
products
Question 2
If the demand for a good is price inelastic, which one of the following
statements is correct?
A
If the price of the good rises, the total revenue earned by the
producer increases
B
If the price of the good rises, the total revenue earned by the
producer falls
C
If the price of the good falls, the total revenue earned by the
producer increases
D
If the price of the good falls, the total revenue earned by the
producer is unaffected
Question 3
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113
A shift to the right in the supply curve of a good, the demand remaining
unchanged,
will reduce its price to a greater degree:
A
the more elastic the demand curve
B
the less elastic the demand curve
C
the nearer the elasticity of demand to unity
D
the more inelastic the supply curve
Question 4
When only a small proportion of a consumer’s income is spent on a good:
A
the demand for the good will be highly price elastic
B
the good is described as ‘inferior’
C
a rise in the price of the good will strongly encourage a search
for substitutes
D
the demand for the good will be price inelastic
Question 5
If the demand for a good is price elastic, which one of the following is true?
When the price of the good:
A
rises, the quantity demanded falls and total expenditure on the
good increases
B
rises, the quantity demanded falls and total expenditure on the
good decreases
C
falls, the quantity demanded rises and total expenditure on the
good decreases
D
falls, the quantity demanded rises and total expenditure on the
good is unchanged
Question 6
Business Economics (Study Text)
114
If the price of a good fell by 10% and, as a result, total expenditure on the
good fell by 10%, the demand for the good would be described as:
A
perfectly inelastic
B
perfectly elastic
C
unitary elastic
D
elastic
For the answers to these questions, see the ‘Answers’ section at the end of
the book.
Additional questions
Question 1: Elasticity of demand 1
The following data refer to the UK economy:
Activity
The equations for PES are:
PES = (percentage change in quantity supplied) / (percentage change in price)
and PES = 100 ×
× 100, where this time Q represents quantities
supplied, not quantities demanded.
As with demand, PES changes at different points on a supply curve, but we
sometimes use the term more loosely, describing supply curves as relatively
elastic or relatively inelastic (see figure).
P
P
S
S
0
Inelastic
Q
0
Elastic
Q
The reasoning behind the descriptions is the same as that for demand curves.
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Price Elasticity of Demand
Price elasticity of demand (P.E.D.) measures the responsiveness of demand
to a given change in price. The P.E.D. coefficient (value) is calculated by use
of either of the following equations
P.E.D. =
percentage change in quantity demanded
percentage change in price
Where P is the initial price, QD is the initial quantity demanded and  (delta)
means ‘the change in’.
Price
P
D
A
3
P
2
B
1
O
Q
Q
1
2
3
4
5
D
Quantity
Figure 1 Calculating P.E.D.

Under normal circumstances

The P.E.D. coefficient can be between zero and infinity ().

If P.E.D. is less than 1, demand is inelastic.

If P.E.D. is greater than 1, demand is elastic.

P.E.D. is usually treated as a positive number and any minus signs are
ignored.
Figure 2 show that the gradient (slope) of a demand curve generally reflects
Business Economics (Study Text)
116
its P.E.D. However, great care should be taken when interpreting the gradient
of a demand curve.
P
P
P
E=O
O
D1
(a)
E<1
Q
O
P
E=1
D3
D2
Q
(b)
O
Q
P
E=
E>O
D5
D4
O
(c)
(d)
Q
O
(e)
Q
Figure - 2
Demand curves with different price elasticity. In (a) the demand curve is a
vertical line; demand is perfectly inelastic; the P.E.D. coefficient is equal to 0;
and a price rise means no decrease in QD. In (b) the demand curve is a steep
line; demand is relatively inelastic; the P.E.D. coefficient is greater than 0 but
less than 1; and a price rise means a smaller percentage decrease in QD. In (c)
the demand curve is a rectangular hyperbola; demand is unitary elastic; the
P.E.D. coefficient is equal to 1; and a price rise means an equal percentage
decrease in QD. In (d) the demand curve is a shallow line; demand is relatively
elastic; the P.E.D. coefficient is greater than 1 but less than; and a price rise
means a greater percentage decrease in QD. In (e) the demand curve is a
horizontal line; demand is perfectly elastic; the P.E.D. coefficient is equal to ;
and a price rise means consumers buying perfect substitutes.
(i)
The slope of a demand curve is not necessarily a guide to price
Business Economics (Study Text)
117
elasticity. The scale of each axis affects P.E.D.
(ii)
On a steep demand curve, P.E.D. at points near the y-axis can be
elastic.
(iii)
On a flat demand curve, P.E.D. at points near the x-axis can be
inelastic.
(iv)
P.E.D. falls as you move down a linear demand curve.
(v)
A demand curve shifting to the left becomes more elastic.
Table 1 Factors influencing price elasticity of demand
Factors
The demand for a good is relatively price-inelastic
because
Number of
if there are few substitutes for a good, consumers are
substitutes
unlikely to switch products
Consumer loyalty if consumers are in the habit of buying a good, they are
unwilling to sue substitutes
Absolute price of if a good is inexpensive, a large percentage change in
the good
price represents only a few rupees
Proportion of
if the good takes up only a small proportion of income,
income
consumers will not react significantly
Number
of
if the good has many complements, the product is
complements
needed if the other items are used
Consumer
if consumers are slow to react to a change in price, the
adjustment
amount bought is largely unaffected
Price Elasticity of Supply
Price elasticity of supply (P.E.S.) measures the responsiveness of supply to a
given change in price
P.E.S. =
percentage change in quantity supplied
percentage change in price

The P.E.S. coefficient can be between zero and infinity ().

If P.E.S. is less than 1, supply is inelastic.

If P.E.S. is greater than 1, supply is elastic.
Figure 3 shows that the gradient of a supply curve generally reflects its P.E.S.
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118
P
P
S1
S3
S2
Both S3 and S4 are
unitary elastic at
all points
S4
Q
(a)
Q
(b)
(c)
Q
P
P
S5
(d)
Q
S6
(e)
Q
Figure 3
Supply curves with different price elasticity. In (a) supply is perfectly inelastic;
the P.E.S. coefficient is equal to 0; and a price fall means no decrease in Qs.
In (b) supply is relatively inelastic; the P.E.S. coefficient is greater than 0 but
less than 1; and a price fall means a smaller percentage decrease in Qs. In (c)
supply is unitary elastic; the P.E.S. coefficient is equal to 1; and a price fall
means an equal percentage decrease in Qs. In (d) supply is relatively elastic;
the P.E.S. coefficient is greater than 1 but less than ; and a price fall means
a greater percentage decrease in Qs. In (e) supply is perfectly elastic; the
P.E.S. coefficient is equal to  ; and a price fall means that suppliers halt
production.
It is important to remember that for linear supply curves
 P.E.S. is inelastic at all points when the supply curve intersects the x-axis first.
 P.E.S. is elastic at all points when the supply curve intersects the y-axis first.
 P.E.S. is unitary at all points when the supply curve intersects the origin.
Table 2 Factors influencing price elasticity of supply
Business Economics (Study Text)
119
Factor
The supply for a good is relatively price-elastic because
Time
in the long run, firms can adjust all factor inputs to change supply
easily
Production
if a good is manufactured quickly, supplies can be changed easily
time
Stocks
if a firm has a large amount of stocks, supplies can be changed
easily
Capacity
if labor and capital are underused, supplies can be changed easily
Factor
if resources can move in and out of the industry, supplies can be
mobility
changed easily
Income Elasticity of Demand
Income elasticity of demand (Y.E.D) measures the responsiveness of demand
to a given change in income.
Y.E.D. =
percentage change in quantity demanded
percentage change in income

Since Y.E.D. can be negative, it is important to include minus sign.

If Y.E.D. is negative, the product is an inferior good.

If Y.E.D. is positive, the product is a normal good.

If Y.E.D. is positive and greater than 1, the product is a superior good.
An Engel curve shows the amount of a good demanded at different level of
income. Figure 4 show that the slope of an Engel curve reflects it Y.E.D.
Y.
E.
D
.i
s
po
sit
ive
Quantity
demanded (QD)
Normal good
Y.E
.D
. is
ne
g
ati
ve
Inferior good
Income (Y)
Figure 4. An Engel curve with different income elasticity
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120
Types of Income Elasticity
(a)
Positive Income Elasticity (Substitute)
For normal good, an increase in income leads to an increase in
quantity demanded.
(b)
Negative Income Elasticity (Complimentary goods)
For inferior goods, an increase in income leads to a decrease in
quantity demanded.
(c)
Zero Income Elasticity (Unrelated or independently good)
The quantity demanded for a good does not change as income
changes.
Consumption
Engel’s
Curve
0
Income
Positive Income Elasticity
Consumption
Consumption
Engel’s
Curve
Engel’s
Curve
0
Income
0
Income
Factors Affecting Price Elasticity of Demand
a)
Percentage of income sent of the good
b)
Availability of substitutes
c)
The number of uses for a good
d)
Time period
Cross Elasticity of Demand
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121

Cross elasticity of demand (X.E.D.) measures the responsiveness of
demand for good A to a given change in the price of good B
X.E.D. =
percentage change in the quantity demanded of commodity A
percentage change in the price of commodity of B

Since X.E.D. can be negative, it is important to include minus signs.

If X.E.D. is positive, the two goods are in competitive demand  i.e.
substitutes.

If X.E.D. is negative, the two goods are in joint demand 
i.e.,
complements.

If X.E.D. is zero, the two products are unrelated  i.e. independent goods.
Types of Cross Elasticity of Demand
a)
Positive Cross Elasticity (Substitute)
A rise in the price of one good cause an increase in the demand
for its substitute.
E.g. butter and margarine
b)
Negative Cross Elasticity (Complimentary goods)
A rise in the price of one good cause a decrease in the demand
for its complement.
E.g. tea and sugar
c)
Zero Cross Elasticity (Unrelated or independent goods)
If two goods are independent of each other, a rise or fall in the
price of one good will not affects the demand for the other good.
E.g. pen and coffee.
Price Elasticity of Demand and Revenue
The effect of a price change on revenue depends on the elasticity of demand.
Figure 5 shows how a change in price can increase revenue.
Business Economics (Study Text)
122

If P.E.D. is elastic, a fall in price increases revenue.

If P.E.D. is inelastic, a rise in price increases revenue.
If P.E.D. is unitary, a price change leaves revenue unchanged.
P
P
A
P1
B
...............................................
.......
....................................................................................
..........................................................
.. ... ..
..........................................................................................
....................................................
...................................................
. . . . .... . ...................
...
..............................
. . ..
Q1
Q2
(a)
P2
P2
D1
P1
...
Revenue gained ..................
Revenue lost
K
. . . .. . .. . .
.........................................................................................................
.
.
.
.
.
...
..............................................................................
....
J
D2
Q
Q2 Q1
(b)
Q
Figure 5
(a)
Elastic demand and revenue. Since the price decrease results in a
proportionately larger increase in quantity demanded, revenue rises.
(b)
Elastic demand and revenue. Since the price increase results in a
proportionately smaller decrease in quantity demanded, revenue rises.
Business Economics (Study Text)
123
Business Economics (Study Text)
124
Contents
1. Utility and its kinds
2. Law of Diminishing Marginal Utility
3. Consumer’s equilibrium through Indifference Curve Technique
4. Price Effect, Income Effect and Substitution Effect
5. Consumer’s surplus.
Business Economics (Study Text)
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1.
Utility and its kinds
1.1 Utility
“The attribute, quality, power, characteristic or the capacity of a good or
service to satisfy some human want is called utility.”
Utility is possessed by each good or service as they have got the capacity to satisfy
some human wants.
‘Utility’ and ‘usefulness’ are not the same concepts. Utility has nothing to do with
usefulness or otherwise. Utility is simply the capacity of a commodity to satisfy some
human want good or bad, harmful or useful, e.g., All intoxicants possess ‘utility’ for
those have become habituated to use it, but from medical and ethical point of view
they have absolutely no ‘usefulness.’
1,2 Types of utility
Following are the major types of utility.
1. Initial utility
The utility that is derived by the consumption of the first unit of the commodity is
called ‘Initial Utility.’
2. Marginal utility
The utility derived by the consumption of the last unit of the commodity is called
‘Marginal Utility.’
The change in the total utility by consuming an extra unit of the commodity is
known as ‘Marginal Utility.’
3. Total utility
If we add up the utilities of all the units consumed at a particular time, the sum
total or the aggregate will be called ‘Total Utility.’
4. Saturation point
When Marginal Utility of a commodity is zero, Total Utility will be maximum and
the consumer attains full satisfaction at this point. It is called ‘Point of Satiety’ or
‘Point of Satisfaction’ or ‘Saturation Point.’
5. Negative utility
If a consumer continues the consumption of a commodity beyond the ‘Point of
Satiety’ the utility derived below zero, will be ‘negative Utility.’
1.3 Relationship between total utility and marginal utility
As consumer consumes more and more units of a commodity, the utility received by
every next unit of that commodity i.e., the marginal utility, decreases but the total
utility goes on increasing at a decreasing rate. When the marginal utility comes to
Business Economics (Study Text)
126
zero, total utility is the maximum. If consumption is increased further from this point,
marginal utility becomes negative and the total utility begins to decline.
Following schedule and diagram can explain the relationship between total utility
and marginal utility.
NO. OF MARGINAL
UNITS
UTILITY
0
0
st
1
10 Utils
2nd
8 Utils
rd
3
6 Utils
th
4
4 Utils
5th
2 Utils
th
6
0 Utils
th
7
-2 Utils
th
8
-4 Utils
TOTAL
UTILITY
0
10 Utils
18 Utils
24 Utils
28 Utils
30 Utils
30 Utils
28 Utils
24 Utils
This schedule shows that when the consumer does not consume any commodity, he
receives no total or marginal utility. When he starts utilizing the units of a commodity
one by one, he receives less and less marginal utility by the consumption of every
next unit of the commodity. But total utility goes on increasing. When the consumer
consumes sixth unit, marginal utility becomes zero, this is called the saturation point.
At this point total utility is maximum. If the consumer uses more units of the
commodity after saturation point, marginal utility becomes negative and total utility
starts declining.
From this schedule we come to know that following relationships exist between total
and marginal utilities.
Key Point
When Marginal Utility is positive, Total Utility increases.
When Marginal Utility is zero, Total Utility is maximum.
When Marginal Utility is negative, Total Utility decreases.
Adding the Marginal Utility, we get Total Utility.
MU is the slope of Total Utility; MU = ∆TU / ∆X
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127
In this diagram TU is the Total Utility Curve that rises up to point ‘A’. After this point it
starts falling. MU is the Marginal Utility Curve that slopes downward from left to right
and intersects x-axis at point ‘B’. This point is known as ‘Saturation Point’. At this
point consumer utilizes 6th unit of the commodity and receives zero marginal utility
i.e., the total utility he receives up to this point is maximum which is shown in this
diagram by point ‘A’ on TU curve. If the consumer utilizes more units of the
commodity, he will receive negative Marginal Utility as is shown in this diagram by
the lower segment of MU curve after point ‘B’ below the x-axis and similarly TU curve
starts declining after point ‘A’.
2. Law of diminishing marginal utility
This law deals with a basic reality of human life. The desire to obtain a commodity is
felt keenly in the beginning but the desire to have more of the commodity comes
down gradually with a continuous use of commodity.
Statement of law
“Other things remaining same, each additional unit of a commodity
gives less utility to the consumer than the previous unit if the commodity is
used continuously.”
According to Alfred Marshall,
“The additional utility which a person gets from a given increase of his
stock of a thing diminishes with every increase in the stock that he already
has.”
We can easily understand this law with the help of a simple example. Suppose in the
scorching heat of summer, a man is very thirsty. If water is not available, he might
Business Economics (Study Text)
128
lose his life. At such a moment, a glass of water will provide him with immense
satisfaction but one glass of water will not satisfy him fully. He will ask for other glass
of water and this 2nd glass will provide him less satisfaction as compared to the first
one. Similarly the satisfaction obtained from the 3rd and the 4th glass of water will go
on decreasing gradually till he arrives at the stage where his thirst is fully quenched.
If he does not stop at that point and goes on taking more glasses of water, then he
will receive negative additional utility and total utility will go on diminishing.
No.
Of Marginal
units
utility
total utility
0
0
0
1st
10 Utils
10 Utils
nd
2
8 Utils
18 Utils
3rd
6 Utils
24 Utils
4th
4 Utils
28 Utils
5th
2 Utils
30 Utils
th
6
0 Utils
30 Utils
7th
-2 Utils
28 Utils
8th
-4 Utils
24 Utils
This schedule shows that as the consumer goes on consuming more and more units
of a certain commodity, Marginal Utility diminishes. When the consumer consumes
6th unit, Marginal Utility becomes zero and this is the ‘Saturation point’ or ‘point of
Satiety’. If the consumer uses more units of the commodity after point of satiety,
Marginal Utility becomes negative.
In this diagram, MU is the Marginal Utility Curve. The trend of this curve is from
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left to right downward i.e., as the consumer goes on consuming more and more
units of a commodity, he receives less and less utils of utility as compared to the
foregoing units. From this diagram, we come to know that when the consumer
consumes sixth unit, Marginal Utility becomes zero and this is called ‘Saturation
Point.’ If the consumer consumes more units after saturation point, he receives
negative marginal utility that is shown by the lower segment of the MU curve after
Point of Satiety below the x-axis.
Assumptions of the law
Following are the assumptions of the Law of Diminishing Marginal Utility.
1. Suitable units
It is assumed that commodity is taken in suitable units. If a very small quantity is
considered as one unit, the law will not remain valid, as the MU will be increasing
instead of decreasing e.g., If instead of a glass of water, drops of water are taken
as units, each successive drop of water will provide higher MU than the previous
one.
2. Nature of the commodity
It is assumed that all the units of the commodity taken are of the same nature. If
there will be difference among the various units of the same commodity, this law
will not remain valid.
3. Continuous use
It is assumed that the commodity is used continuously. If there is a break
between the consumption of the two units of a commodity, MU of the second unit
may not be lower than that of the first unit.
4. State of mind
It is assumed that while consuming the commodity, the state of mind of the
consumer does not change e.g. MU of a certain medicine may be small to a
patient but if a Doctor prescribes that medicine for his treatment, MU of that
medicine will at once increase for him.
5. Constant income
It is assumed that the income of the consumer remains constant. The change in
consumer’s income brings about a change in his view and his consumption
planning e.g., in case of rise in income, a consumer’s MU may abruptly for pulses
but may rise for mutton and fish.
Limitations or exceptions of the law
The Law of Diminishing Marginal Utility does not operate in the following cases.
1. Knowledge and studies
With the increase in knowledge the desire to obtain more knowledge increases.
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So MU of knowledge and education does not decline.
2. Money and precious metals
With the increase in wealth, the desire to have more of it does not decrease.
3. Rare collections
With the increase in the number of historical articles, the desire to have more of
such articles goes on increasing.
4. Love of display
Man tries to have more and more units of a particular commodity just to satisfy
his mental ego to exhibit his riches and position and thus the marginal utility of
the commodity in question goes on increasing for him.
5. Intoxicants and drugs
The desire to have additional units of intoxicants and drugs, like tobacco, opium,
wine increases with their consumption.
6. Love of power
The desire to have more power and authority goes on increasing with the
increase in power and authority.
7. Fine art
Every artist wishes to be at the highest level in his field of art. His desire to have
more skill increases with every increase in his skill.
3. Indifference curve and its properties
Ordinal utility approach was given by Slutsky (1915) J.R. Hicks and R. G. D. Allen
(1934). This approach is also called Hicks-Allen Approach or Ranking Approach to
measure utility According to Hicks-Allen, utility can not be measured in cardinal
numbers because utility is a subjective matter. Utility is a qualitative variable that can
not be quantified. They measure utility in terms of ranking i.e. more preferred, less
preferred or not preferred. Ordinal utility approach consists of Indifference Curve
Analysis.
Indifference curve (Iso-utility curve)
“An Indifference Curve shows the various combinations of two commodities which
gives the same level of satisfaction to the consumer”
“An Indifference Curve is the locus of points or particular bundles or combinations of
goods, each of which gives the same level of satisfaction to the consumer, so he is
indifferent among the various combinations of commodities.”
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We can explain the concept of Indifference curve with the help of following schedule.
Pairs
This
1st
2nd
3rd
4th
5th
6th
good
‘x’
1
2
3
4
5
6
good
‘y’
18
13
9
6
4
3
satisfaction
A
A
A
A
A
A
MRSXY = Y/X
--------
5:1
4:1
3:1
2:1
1:1
schedule shows six combinations of the same level of satisfaction i.e., the consumer
will get the same level of satisfaction from each and every combination. So the
consumer is indifferent among these different combinations.
Suppose a consumer can consume only two different goods X and Y, each of which
is continuously divisible. This figure shows that the consumer considers all the
combinations of X and Y on Indifference Curve IC1 to be equivalent. He knows that
these combinations will yield the same level of satisfaction and he is indifferent
among them. The consumer is obviously willing to substitute X for Y in order to move
from point ‘a’ to point ‘b’, because he is indifferent among various combinations of X
and Y. At every level of satisfaction designated by a particular Indifference Curve,
the consumer is willing to substitute X for Y or Y for X at some rate so as to be on
the same curve but consuming different combinations of goods. Since X and Y are
assumed to be continuously divisible, so, IC specifies as an infinite number of
combinations that yield the same level of satisfaction.
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Properties of indifference curve
Following are the properties of Indifference Curve.
1. A higher Indifference Curve, to the right of another, shows a higher level
of satisfaction and preferable combinations of the two commodities.
This figure shows that on lower Indifference Curve IC1 at point ‘A’ the consumer
receives x1 units of x commodity and y units of y commodity. At upper Indifference
Curve IC2 at point ‘B’ the consumer receives x2 units of x commodity and y units of y
commodity. So, point B is more preferable to point A because point B has more
units x commodity than point A. Hence, IC2 gives more satisfaction than the lower
Indifference Curve IC1 and the higher the level of indifference curve, the higher the
level of satisfaction.
2. An Indifference Curve is negatively sloped. It falls downward from left to
right.
This figure shows that the indifference curve is negatively sloped it means that
marginal rate of substitution MRS is falling for the less substitute goods. So an
indifference curve can not be positively sloped.
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Now, we discuss three possible cases i.e. positively sloped, horizontal and
vertical which are not the indifference curves if both goods are ‘good’.
We know that all the points along the indifference curve are equally preferred. But in
the above figure, the combination ‘B’ is preferable to combination ‘A’, so indifference
curve can not be positively sloped (upward from left to right) in the case that both
goods are ‘good’.
This figure shows that the Indifference Curve is horizontal. At point ‘A’ the consumer
receives x1 units of x commodity and y units of y commodity. At point ‘B’ the
consumer receives x2 units of x commodity and y units of y commodity. So, point B is
more preferable to point A because point B has more units x commodity than point A.
Hence, IC cannot be horizontal if both goods are ‘good’.
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This figure shows that the Indifference Curve is vertical. At point ‘A’ the consumer
receives x units of X commodity and y1 units of y commodity. At point ‘B’ the
consumer receives x units of X commodity and y2 units of y commodity. So, point B
is more preferable to point A because point B has more units y commodity than point
A. Hence, IC cannot be vertical if both goods are ‘good’.
3. Indifference Curves can neither touch nor intersect each other.
In this figure two Indifference Curves intersect each other at point ‘A’. Points ‘A’
and ‘B’ on IC1 show the same satisfaction. The point ‘A’ and ‘C’ on IC2 show the
same satisfaction. It reflects that A=B and A=C so for as the satisfaction is
concerned. So we can conclude that B=C which is not possible because two
different ICs show different levels of satisfaction.
4. In between two Indifference Curves, there can be a number of other
Indifference Curves.
This diagram shows that satisfaction increases gradually by the consumption of
commodities. This shows that the commodities are infinitely divisible and there may
be many combinations of commodities which a consumer can purchase.
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5. An Indifference Curve must lie above its tangents at each point.
We draw tangents to check the convexity of curve. If the curve is above the tangents,
the curve, the curve is called convex. This diagram shows that the Indifference
Curve is above its all the tangents.
6. Indifference Curves do not touch or intersect the axes.
The Indifference Curves do not touch or intersect the axes because a rational
consumer always purchases the positive quantities of both goods. If the indifference
curve touches each of the axes, it means that the quantity of one good would be
zero. If the indifference curve intersects each of the axes, it means that the quantity
of one good would be negative. We assume that consumer purchases positive
quantities of both goods so the Indifference Curves do not touch or intersect the
axes.
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7. Indifference Curves are convex downward.
This rule implies that as the consumer substitutes X for Y, the MRS diminishes. It
means that as the amount of X is increased by equal amounts, quantity of Y
diminishes by smaller amounts. So, for less substitute indifference curve is
convex.
In this figure the curve is concave. MRSXY increases instead of diminishing i.e., more
of Y is given up to have additional unit of X. So this shape of IC is also unrealistic if
both goods are less substitutes. But for more substitute indifference curve is concave.
In this diagram the curve is a straight line or linear. In this case MRSXY remains
constant. So this shape of IC is also unrealistic if both goods are less substitutes. But
for perfect substitute indifference curve is linear.
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4. Marginal rate of substitution
“MRS is the rate of exchange between some units of goods X and Y.”
The Marginal Rate of Substitution is of two types.
1. MARGINAL RATE OF SUBSTITUTION OF X FOR Y
“MRSXY is defined as the number of units of commodity Y that must be given up
in exchange for an extra unit of commodity X, so that the consumer maintains the
same level of satisfaction.”
Following formula can be used for the measurement of MRSXY.
Y
MRSXY =
X
2. MARGINAL RATE OF SUBSTITUTION OF Y FOR X
“MRSYX is the amount of commodity X that will be given up for obtaining an extra
unit of commodity Y, so that the consumer maintains the same level of
satisfaction.”
Following formula can be used for the measurement of MRSYX.
MRSYX =
X
Y
We can explain MRSXY & MRSYX with the help of following schedule.
Pairs
good
x
good
y
1st
2nd
3rd
4th
5th
6th
1
2
3
4
5
6
18
13
9
6
4
3
MRSXY
Y/X
-----------
5:1=5
4:1=4
3:1=3
2:1=2
1:1=1
= MRSYX
X/Y
=
1:5=0.20
1:4=0.25
1:3=0.33
1:2=0.50
1:1=1.00
------------
In this schedule we have six combinations of the same level of satisfaction. Suppose
a consumer has first combination of X & Y. He wants to get one more unit of X and
he is ready to forego five units of Y i.e., MRSXY is five. Similarly, if he wants to get
one more unit of X, he will have to give up four units of Y. So MRSXY is four now. As
the consumer proceeds to have additional units of X, he will be willing to give away
less and less units of Y. It means that MRSXY diminishes, as the consumer wants to
have more and more units of X.
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On the other hand, in case of MRSYX, we will read this schedule upward from 6th
combination. At first consumer leaves one unit of X and obtain one unit of Y. So
MRSYX is one. But in the next combination, he leaves one unit of X and gets two
units of Y. Now MRSYX is one-half. As he proceeds further to have additional units of
Y, he is willing to give away less and less units of X. It means that MRSYX diminishes,
as consumer wants to have more and more units of Y.
This figure shows that at point ‘a’ consumer has 18 units of Y and 1 unit of X. But at
point ‘c’ he has 2 units of X and 13 units of Y. It means that in order to get one extra
unit of X; he has given up 5 units of Y. As the consumer moves along the
Indifference Curve from point ‘a’ to point ‘k’, MRSXY diminishes. It means that MRS
will change at every point on IC.
From the above diagram we can find out the MRSXY and MRSYX at different points.
Marginal rate of substitution of x for y:
MRSXY at point ‘c’
=
MRSXY at point ‘e’
=
MRSXY at point ‘g’
=
MRSXY at point ‘i’
=
MRSXY at point ‘k’
=
ab
bc
cd
ef
gh
1
3
1
2
=
hi
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4
=
fg
jk
1
=
de
ij
5
=
=
1
1
1
=5
=4
=3
=2
=1
139
This shows that as the consumer moves downward along the curve, he possesses
additional units of X and gives up lesser and lesser units of Y.
Marginal rate of substitution of y for x
MRSYX at point ‘i’
=
MRSYX at point ‘g’
=
MRSYX at point ‘e’
=
MRSYX at point ‘c’
=
MRSYX at point ‘a’
=
kj
ji
ih
hg
gf
fe
ed
dc
cb
ba
=
=
=
=
=
1
1
1
2
1
3
1
4
1
5
=1
= 0.5
= 0.33
= 0.25
= 0.20
This shows that as the consumer moves upward along the curve, he possesses
additional units of Y and gives up lesser and lesser units of X.
5. Budget line or budget constraint
“Budget Line is a set of commodities bundles that can be purchased if the entire
money income is spent.”
“Budget Line shows the various combinations or bundles of goods where income is
equal to expenditure while prices of commodities and income of the consumer are
given.”
Pa .Qa + Pb .Qb + Pc . Qc + ----------------------------------+ Pn . Qn = M
M= Total amount of money possessed by the consumer.
This condition shows that total expenditures on various goods must be equal to the
money income possessed by the consumer i.e., all the money income of the
consumer must be spent.
This definition of Budget Line has three points which are as follows:

Budget Line is the locus of points.

Each point shows a combination of two goods X and Y.
The consumer has to spend all of his money income if he wants to purchase
any of these combinations.
Suppose a consumer’s money income is Rs.20. He wants to buy two goods X &

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Y. Price of X is Rs.2/unit while price of Y is RE.1/unit.
Px. Qx + Py .Qy = M
Px. Qx + Py .Qy = M
2(10) + 1(0) = 20
20 + 0 = 20
20 = 20
2(0) + 1(20) = 20
0 + 20 = 20
20 = 20
Qx = 10
Qy = 0
Qx = 0
Qy = 20
He can buy 10 units of X or 20 units of Y by spending his entire money income. But if
he wants to buy both the commodities, he can buy them in different combinations.
In this diagram Budget Line shows AB that consumer can buy 20 units of Y i.e., OA
quantity of Y or he can buy 10 units of X i.e., OB quantity of X by spending Rs.20. By
joining two points A and B, we get a straight line and call it as a Budget Line. This
Budget Line shows different combinations of goods X and Y like A, C, D, E, F, and B
that can be purchased by the consumer by spending his entire money income e.g.
If the consumer wants to buy combination C i.e., 2X and 16Y, he will have to spend
Rs.4 on X and Rs.16 on Y. So, all of his money income will be spent. Same is the
case with all other combinations at Budget Line.
Effects of changes in income and prices
Shift in budget line
Budget Line may shift from its original position. There can be two possibilities.

Prices of both the commodities remaining the same, if the money
income of the consumer changes, the Budget Line will shift parallel to
the original Budget Line accordingly.
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This diagram shows that AB is the budget line. If money income of the consumer
decreases, prices of X & Y remaining unchanged, Budget Line will shift towards
origin i.e., A1B1 and if the money income increases, Budget Line will shift outward i.e.,
A2B2. Both these shifts are parallel to the original Budget Line.
Money Income of the consumer remaining unchanged, if the prices of
both the goods change proportionately, Budget Line will shift parallel
to the original Budget Line accordingly.

This diagram shows that AB is the Budget Line. If prices of X & Y increase by the
same ratio, money income of the consumer remaining unchanged, Budget Line will
shift inward i.e., A1B1 and if prices of X & Y decline, Budget Line will shift outward i.e.,
A2B2. These shifts will also be parallel to the original Budget Line.
Rotation of budget line

Money Income of the consumer and the price of one of the
commodities remaining the same, if the price of the other commodity
changes, Budget Line will rotate accordingly.
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This diagram shows that AB is the original Budget Line. Money Income of the
consumer and price of commodity Y remaining unchanged, if the price of X
increases, Budget Line will rotate inward as AB1 and if the price of X decreases,
Budget Line will rotate outward as AB2.
This diagram shows that AB is the original Budget Line. Money Income of the
consumer and price of commodity X remaining unchanged, if the price of Y
increases, Budget Line will rotate inward as A1B and if the price of Y decreases,
Budget Line will rotate outward as A2B.
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Slope of the budget line
Suppose a consumer has a money income M and he wants to purchase two goods X
& Y. The consumer knows the prices of both the commodities. This diagram shows
that the consumer can purchase OA quantity of Y when he will not buy X. We can
find this quantity of Y by dividing money income by the price of Y. Similar is the case
with the quantity of commodity X i.e., OB.
The formula to find out the slope of a line is Rise/Run. So according to this formula:
Px. Qx + Py .Qy = M
Px. Qx + Py (0) = M
Px. Qx = M
Q x = M / Px
Px. Qx + Py .Qy = M
Px. (0) + Py .Qy = M
Py .Qy = M
Qy = M / Py
Qx = M / Px
Qy = 0
Qx = 0
Qy = M / Py
Slope of the Budget Line = Rise / Run
M/PY
So the Slope of the Budget Line =
M/PX
Slope of the Budget Line =
PX
PY
M
PY
X
PX
M
Slope of the Budget Line =
6. Consumer’s equilibrium under ordinal approach
Ordinal utility approach was given by Slutsky (1915) J.R. Hicks and R. G. D. Allen
(1934).This approach is also called Hicks-Allen Approach or Ranking Approach to
measure utility According to Hicks-Allen, utility cannot be measured in cardinal
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numbers because utility is a subjective matter. Utility is a qualitative variable that can
not be quantified. They measure utility in terms of ranking i.e. more preferred, less
preferred or not preferred. Ordinal utility approach consists of Indifference Curve
Analysis.
Assumptions
In order to understand the concept of consumer’s equilibrium, we have to make the
following assumptions.
1. Rationality
It is assumed that the consumer is rational. He wants to maximize his satisfaction
by spending his limited income.
2. Two goods
It is assumed that the consumer will purchase two goods X & Y and he knows the
prices of these two goods.
3. Consumer’s income
It is assumed that the consumer’s income, taste and habits remain unchanged
throughout the analysis.
4. Consumer’s preferences
It is assumed that the consumer prefers more of X to less of Y that implies a
negatively sloped Indifference Curve i.e., if the consumer will purchase more of
commodity X, he will have to purchase less of commodity Y.
5. Perfect knowlwdge
It is assumed that the consumer possesses complete information about the
prices and alternatives of the goods in the market.
6. Divisibility of goods
It is assumed that the goods X & Y are perfectly divisible.
Ordinal utility approach consists of Indifference Curve Analysis and this analysis
depends on two concepts:

Indifference Curve
 Budget Line
Indifference curve
“An Indifference Curve shows the various combinations of two commodities which
gives the same level of satisfaction to the consumer so he is indifferent among the
various combinations of commodities.”
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Suppose a consumer can consume only two different goods X and Y, each of which
is continuously divisible. This figure shows that the consumer considers all the
combinations of X & Y on Indifference Curve (IC) to be equivalent. He knows that
these combinations will give the same level of satisfaction and he is indifferent
among them. The consumer is obviously willing to substitute X for Y in order to move
from point ‘a’ to point ‘b’ and so on because he is indifferent among various
combinations of X and Y.
Budget line
“Budget Line shows the various combinations or bundles of goods where income is
equal to expenditure while prices of commodities and income of the consumer are
given.”
A consumer can purchase two goods X and Y. In this diagram Budget Line shows
AB that consumer can buy OA quantity of Y or he can OB quantity of X by spending
given income. By joining two points A and B, we get a straight line and call it as a
Budget Line. This Budget Line shows different combinations of goods X and Y.
Objective of the consumer
The objective of the consumer is to maximize his/her satisfaction by spending his/her
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limited income.
Equilibrium of the consumer
When the consumer achieves his target, he would be in equilibrium. The
consumer will acquire equilibrium position with the constraint of his income, if
the following two conditions are fulfilled:
1. Necessary condition
‘Marginal Rate of Substitution X for Y must be equal to the ratio of commodity
prices.’
OR
‘Slope of the Indifference Curve must be equal to the slope of the Budget Line.’
MRSXY = PX / PY
2. Sufficient condition
The necessary condition must be fulfilled at the highest possible indifference
curve.
In this diagram we can see that AB is the budget line. IC1, IC2 and IC3 are
Indifference Curves showing different levels of satisfaction. If a consumer spends
all of his income on commodity Y, he can buy OA quantity of that commodity and
if he spends all of his income on commodity X, he can buy OB quantity of that
good. In this figure we can see that Budget Line AB is tangent on IC2 at point ‘E’.
IC2 is possible highest Indifference Curve that can be achieved by the consumer
with budget constraint AB.
At point ‘E’, the slope of the Budget Line PX/PY and the slope of the Indifference
Curve MRSXY are equal i.e., MRSXY = PX/PY. This is our first necessary condition
and second sufficient condition is also fulfilled because IC2 is convex to the origin.
So the consumer will maximize his satisfaction by buying OXE & OYE quantities
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of X & Y respectively and he will be in equilibrium at point ‘E’.
7. Price effect on consumer’s equilibrium
“The effect on consumer’s equilibrium with the change price of commodity is known
as price effect.”
To examine the Price Effect on Consumer’s Equilibrium, we have to make
following assumptions.
Assumptions

Money income of the consumer remains constant.

Price of good ‘Y’ also remains constant.

Only Price of good ‘X’ changes.
Consumer’s income and price of commodity ‘Y’ remaining the same, if price of ‘X’
falls, the budget line will rotate outward from AB to AC to AD to AF showing that the
consumer will buy more quantity of ‘X’ than before because ‘X’ has become cheaper.
Price effect in case of substitutes
Consumer will choose the combination where his/her budget line is tangent on
indifference curve. Movement from E1 to E2 to E3 to E4 is called Price Effect. The line
passing through equilibrium points is called Price-Consumption-Curve.
Price-consumption-curve (P.C.C.)
P.C.C. for good ‘X’ shows how changes in the price of ‘X’ affect the quantity of ‘X’
purchased while the price of ‘Y’ and money income remain the same.
P.C.C. starts from the pivot point ‘A’. It means that when price of ‘X’ increases,
consumer wants to buy lesser quantity of the good. Finally the price of ‘X’ becomes
so high that consumer cannot afford and does not wish to buy any unit of ‘X’, so he
spends all his income on ‘Y’ and none on ‘X’.
If the price of ‘X’ falls, the budget line rotates outward to the original budget line AB.
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The fall in price of ‘X’ will lead to the rotation of the budget line to from AB to AC to
AD to AF. In case of substitutes the shape of P.C.C. would be downward sloping as
is shown in the above diagram.
Price effect in case of complementary goods
In case of jointly demanded goods, P.C.C. slopes upward.
In this diagram, P.C.C. slopes upward. It means that consumer purchases more
quantities of goods ‘X’ and ‘Y’ at points E2 and E3 respectively. This shows that ‘X’
and ‘Y’ are complementary/jointly demanded goods.
Price effect in case of unrelated goods
In case of unrelated goods, P.C.C. will be horizontal.
In this diagram P.C.C. curve is horizontal which shows that a fall in the price of ‘X’,
increases the purchase of good ‘X’ but has no effect on the demand for good ‘Y’.
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Price effect in case of giffen goods
If the consumption on a good increases with the increase in its price and if the
consumption on a good decreases with the fall in its price, that good is called Giffen
Good.
In this diagram P.C.C. curve is backward sloping towards the Y-axis.. Demand for ‘X’
declines with every fall in its price. In this case ‘X’ is a Giffen Good.
8. Income effect on consumer’s equilibrium
“The effect on consumer’s equilibrium with the change in his income is known as
income effect.”
In order to study the income effect on consumer’s equilibrium, we have to
make following assumptions.
Assumptions

Relative prices of goods ‘X’ and ‘Y’ remain constant.

Consumer’s income changes i.e., there is a shift in Budget Line.
If the income of the consumer increases his budget line will shift upward to the right.
Similarly a fall in the income will shift the budget line inward to the left.
Income effect for superior (normal) good
Income effect for superior (Normal) good is positive. It means that if income
increases, quantity demand of superior (Normal) good also increases and if income
decreases, quantity demand of superior (Normal) good also decreases.
Income ↑ → Qd ↑
Income ↓ → Qd ↓
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Income effect for inferior good
Income effect for Inferior good is negative. It means that if income increases,
quantity demand of Inferior good decreases and if income decreases, quantity
demand of Inferior good increases.
Income ↑ → Qd ↓
Income ↓ → Qd ↑
Income effect for necessity
Income effect for Necessities is negligible. It means that if income increases or,
decreases quantity demand of Necessities almost remains the same.
Income ↓ or ↑ → Qd almost remains the same
Now we discuss the different cases:
1.
Income effect if both goods (x & y) are superior (normal goods)
In this figure parallel budget lines indicate that relative prices of goods ‘X’ and ‘Y’
remain unchanged. When the budget line is AB, the equilibrium point is E1 where the
budget line becomes tangent to the indifference curve IC1. With the increase in
income budget line shifts from AB to CD and the new equilibrium is at point E2.
Further increase in income shifts the budget line from CD to FG and so on. Shift from
E1 to E2 to E3 to E4 to E5 is called income effect. The line passing through these
equilibrium points is called Income-Consumption-Curve.
Income consumption curve (I.C.C.)
I.C.C. shows the effect of changes in consumer’s income on the purchases of
two goods. I.C.C. begins at the origin. It means that if the consumer has no income,
the quantities of ‘X’ and ‘Y’, he could command in the market place must be zero.
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In case of normal goods, I.C.C. is positively sloped. When income increases,
the consumer buys larger quantities of the two goods as shown in the above
diagram.
2. Income Effect if Y good is necessity and X good is superior (normal goods)
In this diagram I.C.C. slopes upward with the increase in income up to the
equilibrium E2 at the budget line CD. Beyond this point it becomes horizontal which
shows that consumer has reached the saturation point with regard to consumption of
good ‘Y’. With the further increase in income, he buys the same amount of ‘Y’. It
means that ‘Y’ is a necessity whose demand remains the same with the further
increase in income.
3. Income Effect if X good is necessity and Y good is superior (normal goods)
In this diagram we see that when the consumer reaches at the saturation point with
regard to the consumption of ‘X’, with the increase in income, he does not spend any
part of his income on good ‘X’. In this case I.C.C. is vertical and commodity ‘X’ is
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necessity.
In case of necessities, I.C.C. possesses a positive slope in the beginning but beyond
a certain point it becomes and stays horizontal or vertical when the consumer’s
income continues to increase.
4. Income Effect if Y good is superior (normal goods) and X good is inferior
When consumer’s income increases, the demand for inferior goods falls beyond a
certain level and he replaces them by superior substitutes.
In this diagram, commodity ‘X’ is inferior. Beyond the point E2, I.C.C. is negative
which shows the decreasing demand for commodity ‘X’ with the increase in income.
5. Income Effect if X good is superior (normal goods) and Y good is inferior
In this diagram commodity ‘Y’ is inferior, up to point E2 I.C.C. has a positive slope
and beyond this point the slope is negative which shows that the demand for good
‘Y’ decreases with the increase in income.
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In both the cases income effect is negative beyond point E2. This type of I.C.C shows
that the goods whose consumption decreases with the increase in income are
inferior goods.
6. Summary Diagram
We can also show the different types of Income-Consumption-Curves in one
diagram.
In this diagram

I.C.C.1 has positive slope and relates to normal goods.

I.C.C.2 is horizontal from point E, which means that ‘Y’ is necessity and ‘X’ is
superior good.

I.C.C.3 is vertical from point E, which means that ‘X’ is necessity and ‘Y’ is
superior good.

I.C.C.4 is of negative sloped from point E, which indicates the inferiority of
good ‘Y’.

I.C.C.5 also has negative slope from point E and shows commodity ‘X’ to be
an inferior good.
9. Substitution and income effects for normal goods
A change in the price of a commodity affects its quantity demanded. The change in
quantity demanded, that results from a change in the price of a good is actually the
sum of two effects, substitution effect and income effect.
PE = SE + IE
Substitution effect
A reduction in the price of ‘X’ makes ‘X’ relatively more attractive than ‘Y’. So
the consumer has to substitute the less expensive ‘X’ for the relatively more
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expensive ‘Y’.
“The substitution effect refers to this change in the quantity of ‘X’ due to change in
the price of ‘X’ while the consumer’s real income (purchasing power) and satisfaction
level remains the same.”
Income effect
When the price of ‘X’ is reduced, the real income of the consumer increases.
The income effect refers to the change in the quantity of ‘X’ through change in
the real income caused by a change in the price of ‘X’.
To isolate the income effect we must hold relative prices constant. Both income and
substitution effects refer to changes in the quantity of a good demanded due to a
change in the price of a good. The substitution effect of a price reduction always
increases the quantity demanded and the income effect also increases the quantity
demanded in case of superior or normal goods.
Both income and substitution effects go in the same direction in case of normal
goods.
Substitution effect and price effect
Substitution effect is similar to the price effect but it has some differences. In price
effect, consumer buys the quantity of ‘X’ more due to the decrease in price of ‘X’ and
he moves on a higher indifference curve. Therefore, in price effect, consumer’s real
income (purchasing power) and satisfaction level changes (increases). In contrast, in
Substitution effect, consumer purchases more of the quantity of ‘X’ due to the
decrease in price of ‘X’ and while his real income (purchasing power) and
satisfaction level remains the same. It means that consumer remains on the same
indifference curve.
In this diagram the first equilibrium position of the consumer is E1. When the price of
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‘X’ decreases, budget line rotates outward to the right from AB to AC and the
consumer is now on E3, the new equilibrium position. The total effect on the quantity
purchased of this price reduction is X1 – X3 shows Price Effect.
To isolate substitution effect, we must hold the real income and satisfaction constant.
Graphically we can show this ‘adjustment’ or ‘compensation’ by drawing a
compensating budget line A1C1, parallel to the new budget line AC. This line is
tangent to the original indifference curve IC1 at new equilibrium point of tangency of
E2. AA1 or CC1 is compensating variations.
The movement from E1 to E2 or change in quantity demanded X1 – X2 shows
Substitution Effect.
The movement from E3 to E2 or the change in quantity demanded X3 – X2, shows
Income Effect. This movement involves a change in real income while the relative
prices are being held constant.
From the diagram, it is clear that total Price Effect is the sum of substitution and
income effects i.e.
PE = SE + IE
X1 – X3 = (X1 – X2) + (X3 – X2)
10. Consumer surplus
“Consumer surplus is the difference between what a consumer is willing to pay for a
good and what the consumer actually pays when buying it.”
C.S = Willing Price – Paid Price (Actual Price/ Market Price)
“The difference between the total utility of a good and its total market value is called
Consumer Surplus.”
C.S = Total Utility – Market Value
“Consumer surplus is the area below the demand curve and above the market price.”
The surplus arises because ‘we receive more than we pay for’; such a bonus is
rooted in the Law of Diminishing Marginal Utility.
It is very easy to understand Consumer Surplus that how it arises. We pay the same
price for each egg i.e., we pay for each unit what the last unit is worth. By our
fundamental Law of Diminishing Marginal Utility, the earlier units are worth more to
us than the last. So we enjoy a surplus on each of these units. When trade stops
benefiting us and stops giving further surplus, we stop buying.
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This schedule illustrates the concept of consumer surplus for an individual. Suppose
that the price of the commodity is Re.1/unit. The consumer considers how many
units to buy at that price. The first unit is highly valuable and the consumer is willing
to pay Rs.9 for it. But this first unit costs only Re.1, the market price, so the
consumer has gained the surplus of Rs.8.
Consider the second unit. This is worth Rs.8 to the consumer, but again only costs
Re.1, so the surplus is Rs.7. And so on down to the 8th unit. The consumer
equilibrium comes at a point where eight units of a commodity are bought at a price
of Re.1 each. Even though the consumer has paid only Rs.8, the total value of the
commodity is Rs.44. Thus the consumer has gained the surplus of Rs.36 over the
amount paid.
Units
1st
2nd
3rd
4th
5th
6th
7th
8th
Marginal
utility
9 Utils
8 Utils
7 Utils
6 Utils
5 Utils
4 Utils
3 Utils
2 Utils
Willing
price
Rs.9
Rs.8
Rs.7
Rs.6
Rs.5
Rs.4
Rs.3
Rs.2
Price
paid
Re.1
Re.1
Re.1
Re.1
Re.1
Re.1
Re.1
Re.1
Consumer
surplus
Rs.8
Rs.7
Rs.6
Rs.5
Rs.4
Rs.3
Rs.2
RE.1
TOTAL
TU = 44
Rs.44
Rs.8
Rs.36
The theme of this diagram is that because of diminishing marginal utility, consumer’s
satisfaction exceeds what is paid. The horizontal line at Re.1 shows that the market
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price of a commodity is Re.1/unit.
The downward – stepping demand for the commodity reflects the diminishing
marginal utility. According to this diagram, the area between the demand curve and
the price line is the total Consumer Surplus.
Consumer surplus for a market
We can apply the concept of consumer surplus to a market as a whole. The market
demand curve is the horizontal summation of the individual demand curves.
The of the market demand curve above the price line, shown as NER in the diagram,
represents the total Consumer Surplus. It represents the extra utility that consumers
received over what they paid for the commodity.
The demand curve measures the amount would pay for each unit consumed. Thus
the total area under the demand curve OREM shows the total utility attached to the
consumption of the commodity. By subtracting what the commodity costs a
consumer that is equal to ONEM, we obtain the consumer surplus from the
consumption of the commodity as the triangle NRE.
Summary
•
In this chapter, we have delved into the fundamental principles of
consumer theory and market dynamics. We began by exploring utility
and
its
various
forms,
understanding
how
consumers
derive
satisfaction from goods and services. The Law of Diminishing Marginal
Utility elucidated the diminishing additional satisfaction as consumption
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increases, shaping demand curves and consumer behavior. Through
the Indifference Curve Technique, we analyzed consumer equilibrium,
where individuals optimize utility within budget constraints by balancing
preferences among different goods. Price Effect, Income Effect, and
Substitution Effect unveiled the intricate interplay of price changes on
consumer choices, illuminating how shifts in prices influence
purchasing behavior. Lastly, Consumer’s Surplus shed light on the
additional
welfare
consumers
gain
from
market
transactions,
emphasizing the importance of understanding consumer preferences
and market dynamics in economic analysis.
Utility is a measure of the satisfaction or pleasure that consumers

derive from consuming goods and services. It forms the foundation of
consumer choice theory in economics. Utility can be categorized into:
Total Utility (TU): The overall satisfaction received from
consuming a certain quantity of goods or services.
Marginal Utility (MU): The additional satisfaction gained from
consuming one more unit of a good or service. MU typically
decreases as consumption increases.
Cardinal Utility: Assumes that utility can be measured and
quantified in numerical terms (e.g., utils).
Ordinal Utility: Assumes that utility can be ranked in order of
preference but not measured numerically.

The Law of Diminishing Marginal Utility states that as a person
consumes more units of a good, the additional satisfaction (marginal
utility) from each additional unit decreases. This principle underpins the
downward-sloping demand curve, as consumers are willing to pay less
for additional units of a good.

Consumer’s Equilibrium occurs when a consumer maximizes their
utility, given their budget constraint. The Indifference Curve Technique
is used to analyze this equilibrium. Key components include:
Indifference Curves: Graphical representations of different
combinations of two goods that provide the same level of
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satisfaction to the consumer. These curves are typically convex
to the origin, reflecting the diminishing marginal rate of
substitution.
Budget Line: Represents all combinations of two goods that a
consumer can afford, given their income and prices of goods.
Equilibrium Point: The point at which the budget line is tangent
to an indifference curve. At this point, the marginal rate of
substitution (MRS) between the two goods equals the ratio of
their prices.

Changes in the price of a good affect consumer choices through two
main effects:
Substitution Effect: When the price of a good falls, the good
becomes relatively cheaper compared to other goods, prompting
the consumer to substitute the cheaper good for more expensive
ones. This increases the quantity demanded of the cheaper
good.
Income Effect: A price reduction effectively increases the
consumer's real income, allowing them to buy more of all goods,
including the good whose price has fallen.
Price Effect: The combined impact of the substitution and
income effects on the quantity demanded due to a price change.

Consumer’s Surplus is the difference between what consumers are
willing to pay for a good and what they actually pay. It represents the
extra utility consumers receive from purchasing goods at a market
price lower than their maximum willingness to pay.
Self-test questions
Utility and Its Kinds
1.
What is utility in economics? (1.1)
2.
Define total utility and marginal utility. (1.2)
3.
How does marginal utility change as consumption increases? (1.3)
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Law of Diminishing Marginal Utility
5. What does the Law of Diminishing Marginal Utility state? (2)
Consumer’s Equilibrium through Indifference Curve Technique
10. What are indifference curves, and how are they drawn? (3)
11. Describe the budget line and its significance in consumer equilibrium. (5)
12. How is consumer equilibrium achieved using the indifference curve
technique? (6)
Price Effect, Income Effect, and Substitution Effect
13. How the income effect changes consumer choices. (8)
14. How do changes in the price of a good affect consumer behavior? (7)
15. Explain how the substitution effect influences consumer choices. (9)
Consumer’s Surplus
17. What is consumer surplus? (10)
18. How is consumer surplus calculated? (10)
19. Explain the significance of consumer surplus in economic analysis. (10)
Practice questions
Question 1: What is utility in economics?
A) The satisfaction or pleasure derived from consuming goods and services.
B) The monetary value of goods and services.
C) The cost of production.
D) The market demand for goods and services.
(Correct Answer: A)
Question 2: According to the Law of Diminishing Marginal Utility, what
happens as a person consumes more units of a good?
A) The total utility increases.
B) The marginal utility increases.
C) The additional satisfaction from each additional unit decreases.
D) The demand curve shifts upward.
(Correct Answer: C)
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Question 3: How is consumer equilibrium achieved according to the
Indifference Curve Technique?
A) When the budget line intersects the indifference curve.
B) When the budget line is tangent to the indifference curve.
C) When the consumer spends all of their income.
D) When the consumer purchases equal quantities of all goods.
(Correct Answer: B)
Question 4: What effect occurs when consumers switch between goods
due to price changes?
A) Substitution Effect.
B) Income Effect.
C) Price Effect.
D) Total Utility Effect.
(Correct Answer: A)
Question 5: What does Consumer’s Surplus represent?
A) The difference between total utility and marginal utility.
B) The monetary value of goods purchased.
C) The maximum willingness to pay for a good.
D) The additional utility consumers gain from paying less than their maximum
willingness to pay.
(Correct Answer: D)
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Contents
1. Reasons for Price Instability in Markets for Primary Goods
2. Weather and agricultural output
3. Price Stabilization Policies
4. Minimum and Maximum Pricing Policies in Good Markets
5. Minimum and Maximum Pricing Policies in Factor Markets
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1. Reasons for price instability in markets for primary goods
Primary goods are raw materials and basic agricultural products that are
harvested or extracted directly from natural resources. They serve as the
essential inputs for manufacturing and industrial processes. Examples of primary
goods include:i) Basic foodstuffs such as wheat, maize, rice, milk, coffee, orange
juice ii) Raw materials such as cotton, rubber, hemp iii) Minerals and metals such
as oil, copper, bauxite, iron ore.
Producers of primary goods often rely heavily on the income from these products,
making their earnings vulnerable to price drops.
Inelastic supply and demand are key characteristics of some markets, especially
agricultural ones. This leads to two significant effects:
1. Cyclic variations in supply
2. The paradox that farmers' incomes
1.1 Causes of cyclic variation in supply
Some goods take a long time to adjust their production levels. This is especially
true for agricultural products, which often face long delays between deciding to
produce them and actually delivering them to the market. For instance, in
temperate climates, many crops are grown once a year, so farmers can only
change how much they produce once a year.
1.1.1 Hog Cycle
The long delays in adjusting supply cause prices and output to fluctuate in cycles.
A clear example of this cycle is seen in pork production in the USA. Pork
production has a notable cycle that typically lasts about four years. The
reproductive process of pigs includes a delay of about ten months from deciding
to increase production to actually bringing more pigs to market. This delay
causes the cycle.
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The 'hog cycle’ is illustrated in Figure 1.
Figure 1: The hog cycle
In the diagram, the horizontal axis shows the breakeven price and the average
national number of hogs. The cycle starts with a small price increase above the
breakeven point. As prices approach point A, producers decide to increase output.
To do this, they need more breeding stock, so they send fewer hogs to market.
This effectively reduces output toward point B, causing prices to keep rising.
About a year later, the increased breeding stock leads to higher output, reaching
point C. Consequently, prices start to fall past point D.
By the end of year 2 (T2), prices drop to the breakeven level, and farmers decide
to cut production. This can't happen right away, so in the short term, more
animals are sent to market to reduce breeding stock numbers. The production
curve goes up toward point E, while prices fall toward point F. Production then
decreases in year 4, while prices rise back to the breakeven point, starting the
cycle again. A similar cycle has been observed in potato production.
1.1.2 Cobweb effect
We can understand the effects of a slow supply response to changing prices
better by using the familiar supply and demand diagrams. These specific
diagrams, called cobweb diagrams, are named that way because the pattern of
market prices looks like a cobweb when you follow it in the diagrams below.
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Figure 2: Convergent cobweb
In Figure 2, we see a situation similar to the hog cycle. At first, the market isn't
balanced because the price (P1) isn't right. This leads producers to plan to supply
a certain amount (Q1) later. But when they bring this amount to the market, they
find the price has dropped to P2 because there's too much supply. So, in the next
period, they only produce a smaller amount (Q2). This shortage in supply causes
the price to go up to P3.
This cycle continues: the price and amount of goods keep changing until they
finally balance out at the right price. However, it's important to note that this
gradual convergence to the right price doesn't always happen.
In Figure 3, things look quite different. Instead of reaching a balance, the ups and
downs keep getting bigger. This means the market would keep swinging between
having too much or too little of something. Luckily, this is just a theory and doesn't
happen in real life. But it shows how prices in a market can get really unstable
when there's a big difference between how much is available and how much
people want.
Whether the swings in the market are big or small depends on how steep the
supply and demand curves are. If the supply curve goes up or down quickly
compared to the demand curve, the swings in the market will calm down over
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time, like in Figure 2. But if the demand curve changes a lot compared to the
supply curve, the swings will get bigger and bigger, like in Figure 3.
Figure 3: Divergent cobweb
There is the middle ground, where both curves change at the same rate. In that
case, the swings in the market will keep going on at about the same size forever.
Figure 4: Uniform cobweb
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2 Weather and agricultural output
Farming is greatly affected by the weather. In places with moderate climates, how
much crops are grown can change a lot from year to year. Interestingly, when the
weather is good for growing crops, it doesn't always mean that farmers will have
a profitable year, and the opposite is true as well. This is because the demand for
farm products does not change much overall. While people might switch between
different foods based on prices, they generally don't change how much they eat
overall.
2.1 influence of climate on farm incomes
In the chapter of price elasticity, we talked about what happens when prices go
up but people still buy the same amount, like when farmers sell crops even if they
are not in good condition. We found out that in these cases, farmers actually
make more money. It happens because when there is less of something to buy
(like crops during a bad harvest), the price goes up.
Figure 5: The effect of a poor harvest
In Figure 5, we see how a bad harvest affects the supply of goods. At the start
(time 0), the supply (S) was at a certain level, and the price (P₀) was set
accordingly. When the next harvest turns out poorly, by time 1, the supply
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decreases, shifting the supply curve to the left (S1). Although the quantity sold (Q₁)
doesn't drop much compared to before (Q₀), the price (P) rises noticeably from P₀
to P. While the loss in total revenue represented by area Y is unfortunate, the
extra revenue represented by area X more than makes up for it.
Keep in mind that customers might have to pay a lot for the product. Since this
product is food, the additional expenses could make it harder for poorer people to
maintain their living standards. However, if there's plenty of food available, it will
lead to the situation described in Figure 6 below.
Figure 6: The effect of a good harvest
At first, the balance between what's produced and what's bought is at a certain
price (Po) with a certain amount (Qo). When there's a good harvest, more of the
product becomes available (from S0 to S1), causing the price to drop. This drop
happens because two things occur:
(a) People don't usually buy much more even when the price falls because the
product is essential (like food).
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(b) The amount of the product available doesn't change much, even when the
price changes, because it takes time to grow more.
This means farming can be unstable. When there are a lot of good harvests in a
row, farmers might not make much money. They might even leave farming
altogether because it's not profitable.
3 Price stabilisation policies
Throughout history, governments have stepped in to deal with ups and downs in
farming prices. They use different methods to keep things steady in the
agricultural market. Here are a few:
Direct payments: The government gives money to farmers based on how much
they produce. For example, a beef farmer might get a certain amount for each
cow they raise. This amount is figured out based on the difference between what
the crop sells for on average and how much the government thinks the farmer
should earn.
Subsidies and set aside: Sometimes the government pays farmers not to grow
certain crops. This happens when there's too much of a product, which makes
prices drop. Instead, the government might pay farmers to grow something else
or to leave their land empty.
Government buying surplus: If there's a lot of crops left unsold, the government
might step in and buy them at a set price. Then, they store them and sell them
later if there's a shortage and prices go up.
Consequences of government intervention in agricultural markets
But there are downsides to government involvement in farming prices:
1. It's hard to figure out the right price to keep the market stable.
2. Intervening costs money, which comes from taxpayers, consumers, or both.
3. It can protect less efficient farmers and domestic producers, hurting
competition and countries that aren't as developed.
4. Buying surplus can lead to even more crops being produced, causing bigger
surpluses. Some countries, like the European Union, have a bad habit of selling
off their surplus on the global market, which hurts farmers in other places.
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4 Maximum and minimum pricing policies in goods markets
Governments sometimes intervene in markets in response to dissatisfaction from
some groups in society by instituting price ceilings or price floors. These prices
are called government regulated prices. These prices are set above and below
the equilibrium price which resultantly create surpluses and shortages.
maximum and minimum prices are also known as disequilibrium prices, price
ceiling and price floor, legeal prices and government regulated prices. This
intervention can have unintended and sometimes harmful consequences.
1. Price Ceiling
Price ceiling is also called Maximum Price. A price ceiling occurs when the price
is artificially held below the equilibrium price and is not allowed to rise.
Government announce maximum price for the benefit of consumers.
This price is usually announced to save the consumers from price rise by the
producers.
Price ceilings lead to shortages. Price ceilings provide a gain for buyers and a
loss for sellers.
2. Price Floor
Price floor is also called Minimum Price. A price floor occurs when the price is
artificially held above the equilibrium price and is not allowed to fall. Government
announce minimum price for the benefit of producers.
This price is usually announced to save the producers from price fall by the
consumers.
Price floor lead to surplus. Price floor provide a gain for sellers and a loss for
buyers.
Figure 7. Minimum and Maximum Prices
In Figure 7, equilibrium point E determines the equilibrium price at Pe and
equilibrium quantity is at Q3. If the price is fixed at PMin by the government, there
will be excess supply in the market which creates surplus. Similarly, if the price is
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fixed at PMax by the government, there will be excess demand in the market
which creates shortage.
5 Minimum and maximum pricing policies in factor markets
Minimum and maximum pricing can be applied in factor markets including the
labour market and the market for capital.
5.1 Price regulation in labour markets: Minimum wages
A minimum wage is like setting a bottom price for how much someone can be
paid for their work. It's meant to make sure that people who earn low wages can
still afford basic things. It also encourages workers to learn the skills they need
for their jobs. Minimum wages can be decided in different ways, like by making
laws or by agreements between workers and employers. When a minimum wage
is set, it's usually higher than what some people are currently paid. This can
make wages go up for some workers, but it might also mean fewer jobs are
available.
Figure 8. Minimum wage
In Figure 8, the free market is represented by W, and Qw workers would have
jobs. When a minimum wage (M) is introduced, the following things happen:
(a) The number of people employed decreases to Qm.
(b) The wages of workers who remain employed increase from W to M.
(c) The higher wage attracts more workers, resulting in too many people
looking for work compared to available jobs. This is called an excess supply of
labor, calculated as Qs minus Qm.
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(d) Some companies try to pay workers less than the minimum wage by
making informal deals with them.
5.2 Price regulation in capital markets
Governments can set rules on how much money can be charged for borrowing
money or investing in big projects. The price of borrowing money is called the
interest rate.
If the government wants to encourage companies to borrow money for things like
making their businesses better or creating more jobs, they might set a maximum
price for borrowing money. They can do this by:
(a) Giving money directly to companies at the highest price they think is okay.
(b) Telling banks to only lend money at the highest rate they allow.
(c) Changing how much money is available in the financial system by using the
country's main bank.
On the other hand, if a government doesn't like a certain type of business, like
importing goods, or if they want to control how much money is being invested,
they might set a minimum price for borrowing money. But this doesn't happen very
often.
Summary
The chapter delves into the factors contributing to price instability in primary goods
markets. It highlights how unpredictable weather conditions can significantly
impact agricultural output, consequently affecting prices. Additionally, the chapter
discusses various policies aimed at stabilizing prices in these markets, including
minimum and maximum pricing policies.
Minimum pricing policies involve setting a floor price for goods, often used to
regulate certain industries or allocate scarce resources. On the other hand,
maximum pricing policies set a ceiling on prices, typically employed to encourage
investment and boost economic activity.
Furthermore, the chapter examines the application of minimum and maximum
pricing policies in factor markets, where capital and labor are traded.
Governments may intervene in factor markets to regulate the cost of capital, either
by setting maximum prices to stimulate borrowing and investment or by imposing
minimum prices to control certain types of business activities. Similarly, minimum
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and maximum pricing policies can also be applied to labor markets to manage
wages and employment levels.
Overall, the chapter explores the complex dynamics of price instability in primary
goods markets and the role of government policies in mitigating these fluctuations
through minimum and maximum pricing interventions in both goods and factor
markets.
Self-test questions
Reasons for Price Instability in Markets for Primary Goods
1.
What factors contribute to price instability in primary goods markets?
Weather and Agricultural Output
2.
How does weather impact agricultural output?
Price Stabilization Policies
3.
What are some policies aimed at stabilizing prices in markets?
Minimum and Maximum Pricing Policies in Goods Markets
4.
What are minimum and maximum pricing policies in goods markets?
Minimum and Maximum Pricing Policies in Factor Markets
5.
How do governments use minimum and maximum pricing policies in
factor markets?
Practice questions
Question 1
What factors contribute to price instability in primary goods markets?
A) Weather conditions
B) Government regulations
C) Consumer preferences
D) Technology advancements
Correct Answer: A) Weather conditions
Question 2
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How does weather impact agricultural output?
A) It has no impact on agricultural output
B) It affects the supply of agricultural products
C) It influences consumer demand for agricultural products
D) It determines the market prices of agricultural products
Correct Answer: B) It affects the supply of agricultural products
Question 3
What are some policies aimed at stabilizing prices in markets?
A) Minimum wage laws
B) Tax incentives for producers
C) Price controls
D) Subsidies for consumers
Correct Answer: C) Price controls
Question 4
What are minimum and maximum pricing policies in goods markets?
A) Policies aimed at controlling supply and demand
B) Policies setting a floor and ceiling on prices
C) Policies regulating market competition
D) Policies promoting international trade
Correct Answer: B) Policies setting a floor and ceiling on prices
Question 5
How do governments use minimum and maximum pricing policies in
factor markets?
A) To regulate consumer spending
B) To control inflation rates
C) To influence investment decisions
D) To manage the cost of production
Correct Answer: C) To influence investment decisions
Business Economics (Study Text)
176
Business Economics (Study Text)
177
Contents
1.
Firm and basic problems of firms
2.
Economies of Scale (EOS)
3.
Internal and external economies of Scale
4.
Small scale production
5.
Laws of Returns (Short run)
6.
Laws of Returns to scale (Long Run)
7.
Law of Variable Proportions
8.
Relationship between Marginal, Average and Total Product.
9.
Production functions
Business Economics (Study Text)
178
1. Firm and Basic Problems of Firm
1.1 What is a Firm?
A firm is a decision-making unit, which has the power to make decision within
the areas under its control, i.e., a person or group of persons who start
business, manage it and take responsibilities. The basic aim of the firm is to
maximize profits.
Profit = Revenue – Cost
A firm can maximize its profits in three ways:
(i)
By Increasing the Selling Price
(ii)
By Decreasing Cost of Production
(iii)
By Decreasing Selling Price
Note: Profit maximization is generally the goal of a sole proprietorship firm
and it may not be the objective of a public limited company owned by
shareholders and run by non-shareholding owners.
1.2
Accounting Profits and Economic Profits
Accounting profits are equal to the sales revenue minus explicit costs of the
business e.g., material costs, labor costs, depreciation cost etc. while the
economic profit consist of total sales revenue minus explicit costs minus
implicit costs or economic profit are equal to accounting profit minus implicit
costs.
Accounting Profit = Revenue – Accounting Cost
OR
Accounting Profit
= Revenue – Explicit Costs
Economic Profit
= Revenue – Economic Cost
Economic Profit
= Revenue – Explicit Costs – Implicit Costs
Economic Profit
= Accounting profit – Implicit Costs
OR
Business Economics (Study Text)
179
2.
Economies of Scale
In the long run, the firm can increase output by varying all factors of
production. Economies of scale (EOS) are reductions in long-run average
costs which occur from an increase in production.
Output ↑ → LAC ↓

Internal EOS occur within the firm as output rises.

External EOS occur outside the firm and are independent of the size of
the individual firm.
Diseconomies of Scale
Diseconomies of scale (DOS) are increase in long-run average costs which
occur from an increase in production.
Output ↑ → LAC ↑
(i)
Internal DOS occur within the firm when increase in output raise longrun costs. They occur mainly because of managerial difficulties in
oversized firms
(1) managers are unable to exercise effective control or co- ordination
(2) internal communications within the company are difficult
(3)
workers feel isolated and out of touch with managers, and
industrial relations decline.
(ii)
External DOS occur outside the firm when the long-run costs of all local
firms rise when
2.1
(1)
local road congestion causes transportation delays;
(2)
local land and factories become scarce and rents rise;
(3)
labor shortages develop within the area and wages rise.
Economies of Scale (EOS)
Following are the economies of large-scale production:
1.Economies of buying and Selling
The large scale producer purchases raw material in larger quantities
and from the areas where its supply is larger and price is low and
Business Economics (Study Text)
180
therefore secure favorable terms on account of its large purchases. He
sells its product in the markets where its demand is greater and price is
high.
2.Optimum use of Machinery
Most of the goods of daily use are produced with the help of modern
machinery which produces larger quantities, of superior quality with
lower cost. But modern machinery can be used only by large scale
producer.
3.Division of Labor
Division of labor helps in increasing efficiency of labor. Efficient labor
can produce larger output and of better quality. But division of labor is
only possible in large scale.
4.By-Products
In large scale of production waste is not thrown away but it is utilized
for production of by-products which lowers the cost of production e.g. a
big sugar mill does not throw away the waste, but converts it into hardboards and etc.
5.Economies of Overhead Charges
Overhead charges do not change with the output. Overhead charges
per unit of output decreases with an increase in output so the expenses
of administration and distribution are much less in large scale
production that results in lower per unit cost.
6.Economies of Repair or Workshops
Large scale producer being financially strong establishes workshops
within the factory hence, production process continues without any
break and expenses of repair are much less.
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7.Analysis of Market Fluctuations
Market fluctuations mean changes in the price level. The organisers
who foresee these fluctuations benefit and for this purpose large scale
producer employs capable and experienced marketing managers who
survey the demand and supply positions in different markets and help
the large-scale producer in earning maximum profits.
8.Facing the Adversity
A large concern can face the adversity and depression in a better way
because of his vast resources. He can bear losses even for a longer
period in a hope to earn profits in future.
9.Advertisement and Salesmanship
In the present times none of the firms can introduce its products
without the advertisement and salesmanship. Only a large scale
producer
can
spend
heavy
amounts
on
advertisement
and
salesmanship. Thus, he captures the market and increases its revenue.
10.Cheap Credit
Govt. provides more concessions e.g. income tax holiday, exemption of
excise duty and low custom duties on import. The large-scale
producers also get credit facilities at a cheaper rate. Low costs of credit
reduce the cost of production and maximizes the profits.
11.Research and development (R & D)
It is admitted that expenses of development and research repay more.
Successful research and development may lead to a cheap method or
technique of production which in the long run reduces cost of
production. But only large-scale producer can afford the expenses of
research and development.
2.2
Diseconomies of Scale (DEOS)
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182
1.Over Worked Management
The large-scale producer is mostly involved with import and export
problems, concessions from the govt. and attainment of cheap credit.
Supervision becomes relaxed and there is a wastage of raw material,
leakage of finished goods, mishandling of machinery, inefficiency of
labor, dishonesty etc., and this appears when concern grows.
2.No Personal Element
As the concern grows personal contact between the employer and
employees disappear. The owner is usually absent. The business is
generally managed by paid employees. Personal contact and
sympathy between the employers and the employees are missing and
this sometimes mislead, strikes and lock up of the factory which is
harmful for the business.
3.Individual Tastes are Ignored
Large concerns are run with huge and most modern machinery which
only turn out standardized goods and control the quality. The large
quantities are produced hence, individual tastes, traditions and
customs are ignored.
4.Danger of Depression
If at any time in large scale production supply is greater, then the
demand price goes down, profit rate goes down and if production is
stopped there is a danger of depression because of unemployment.
5.Dependence on Foreign Markets
Large scale producers import raw material and machinery. If the supply
of raw material is cut off by war or due to political unrest in the
exporting countries, production process is disturbed. This makes the
business risky.
6.Cut Throat Competition
Large scale producers have the desire to increase output to earn more
profits. They fight for the markets and there is a wasteful competition
and as a result there may be over production and all the firms may face
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183
losses.
7.Lack of Adaptability
Large scale production in adversity or in depression finds it very difficult
to switch over from one business to another.
8.Danger of Monopolies
Large scale producers do not allow the small-scale producers to enter
into the business and if enter, large scale producers lower down price
per unit of output than the cost per unit of small-scale producer and
hence, become monopolist and earn super normal profits.
2.3
Types of Internal Economies of Scale
Types
of
internal Description
EOS
Specialization
Large firms have more scope for the division of
labor than have small firms
Indivisibilities
Some machines are of a minimum size which can
only be kept fully occupied by large firms
Increased dimension
The cost of capital does not increase in proportion
to the output of each machine
Principle of multiplies
Large firms use a machine combination which
eliminates
bottlenecks
caused
by
different
machines working at different speeds
Linked processes
Bringing together different stages of production in
one factory reduces costs
Managerial
Big firms can spread the cost of employing the
best managers over a large level of output.
Managerial costs do not increase in proportion
with output
Financial
Large firms offer more security and pay a lower
rate of interest on loans than do small firms. Large
firms can raise capital cheaply through a right
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184
issue
Commercial
Large firms buy raw materials and components in
bulk and are therefore given at discount
Marketing
Transportation and advertising costs do not
increase n proportion with output
Research
and Large firms can spread the cost of improving
development
2.4
product over a large level of output
Types of External Economies of Scale
Types of external EOS Description
Infrastructure
Proximity to a good transport and communications
network
Ancillary firms
Local back-up firms supply specialist support
services or components
Skilled local labor
An area may have trained workers looking for jobs
Education
An area may have colleges providing specialist
training
2.5 Internal and External Economies
When goods are produced at large scale, a firm's average total cost starts
decreasing i.e., it benefits from the economies. These economies can be
grouped under two headings:
(A)
Internal Economies
(B)
External Economies
(A)
INTERNAL ECONOMIES
"Internal economies are those economies in production which occur to
the firm itself when it expands its output or enlarge its scale of
production" (K.K. Dewitt). Internal economies are achieved through the
ability and long experience of the entrepreneurs. They are attached to
a specific business. Other entrepreneurs cannot benefit from them.
Business Economics (Study Text)
185
Internal economies may be of the following types:
1.
Administrative or Managerial Economies
When a firm expands its output or enlarges the scale of
production, it follows the principle of division of labor. Specialists
are employed and as a result production process works
smoothly. The entrepreneur gives attention to more important
jobs.
The
administrative
expenditures
do
not
increase
proportionally with the output.
2.
Technical Economies
Technical economies may arise due to large size of the plant
because it requires less energy, less staff, and proportionately
less cost of installing the plant. Specialized persons can only be
employed with large machinery and plant.
3.
Marketing Economies/Commercial Economies
These economies arise from the purchase of raw material and
sale of finished goods.
4.
Indivisibility
We can get total benefit from most of the factors of production
when they are being used at full capacity. If smaller output is
being produced it means that they are not working according to
their efficiency. This may be due to indivisibility.
5.
Financial Economies
These may arise due to the reason that large scale firms have
better credit facilities i.e., credit at cheaper rates, concession
from the government for credit.
(B)
EXTERNAL ECONOMIES
These economies arise as a result of the expansion of the industry as a
whole when industry expends machinery and raw material is available
to all the firms at cheaper rates. New and better techniques of
production are discovered. Better means of transportation and
Business Economics (Study Text)
186
communication are available.
The external economies may be of the following types:
1.
Transportation and Communication
Concentration of firms provide better communication system for
all, the transport system reduce cost.
2.
Skilled Labor
With the concentration of firms skilled labor is available to all the
firms because people living in the nearby areas get technical
training.
3.
Facility of Workshops
Concentration of firms provides incentive for the technical
persons to establish their workshops.
4.
Helping Industry
This economy arises because of concentration of firms. In local
industry it becomes possible to split up some of the processes
which are taken over by specialist firms.
5.
Research and Experiment
In local industry, research and development are centralized.
Each individual firm needs not to spend a separate amount on
research and development.
6.
Banking Facility
In a localized industry or business centers, bank opens their
branches and all the firms benefit from banking and credit facility.
2.6 Advantages of Small-Scale Production
The merits of small scale production are as follows:
1.Personal Element
In small scale production, the small scale producer has personal
contact with the employees. He can supervise his business himself so
those businesses which require personal supervision can only be
established at small scale.
Business Economics (Study Text)
187
2.Direct Relations with the Consumers
The goods produced in small scale are generally sold in the nearer
markets therefore; he does not ignore individual tastes and customs of
the people.
3.Better Relations with Labor
In small scale production the numbers of workers are not large
therefore, personal relations develop with the labor and a kind word is
thrown now and then which rules out the possibility of strike or any
other trouble.
4.Prompt Response to a Change in Demand
Another advantage of small scale business is that he can increase or
decrease its production according to rise or fall in demand easily.
5.Prompt Decisions
Small scale producer is capable of prompt and quick decisions about
the output, supply, demand and price. There is no divided responsibility.
He is the sole producer so he finds no difficulty in taking quick
decisions.
6.Better Distribution of Wealth
The small scale business can be started with smaller amount of capital
therefore, small businesses are established which increases circulation
of money and removes concentration of wealth.
7.Does not Require Complicated System of Accounts:
The small scale business does not require complicated system of
accounts there is a strong check to prevent fraud or waste of labor or
material.
8.Non-Dependence of Foreign Markets
The small-scale manufacturer purchases raw material from the
domestic markets and sells its product in the domestic markets hence,
he is free from external effects and runs business without any fear.
Business Economics (Study Text)
188
9.Adaptability
The small-scale producer can easily switch over to another business
because he is the sole proprietor and need not to consult with his
partners or share-holders.
10.No Danger of Over Production
As the smaller quantities are produced and there are large number of
producers so there is no danger of over production and monopolies.
2.7 Disadvantages of Small-Scale Production
The demerits of small-scale production are following:
1.Disadvantage of buying and Selling
The small-scale manufacturers buy small quantities of raw material and
sells its product in the nearer markets hence, do not enjoy the
economy of buying and selling.
2.Disadvantage of Division of Labor
As the small number of labor is employed hence, he cannot benefit the
economy of division of labor.
3.Disadvantage of by-Products
As the financial resources of the small-scale producer are limited so he
cannot use its waste for making by products and has to throw it away.
4.Use of Modern Technology
Lack of financial resources not allow him to use most modern
machinery so, he cannot increase the quantity of output, and cannot
improve the quantity of its product.
5.Cannot Face Adversity
Due to lack of financial resources he cannot face adversity. He cannot
bear losses for the long period so he has to close down his business.
6.No Advertisement/Research and Experiment
Small scale manufacturer cannot spend large sums of money on
advertisement and experiment. Hence, he can neither introduce his
product nor he can improve the quality of his product.
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189
7.High Cost Per Unit of Output
In the small-scale production fixed cost or overhead charges do not
spread over large quantities that are why cost per unit is higher.
8.Credit Facilities from the Government
He cannot secure cheap credit because of unstable conditions of his
business and lack of guarantee.
3.
Laws of Production or Returns
When the units of variable factor of production are employed on the fixed
factor of production, the marginal product (i.e., the product of every additional
unit employed in a production process) and the average product (i.e., total
product divided by the units of variable factor of production) may increase,
remain constant or may be diminishing. If the marginal Product and
average .product start increasing with the employment of variable factor of
production, the production process is said to be operating under the law of
increasing returns/product or output. And if the marginal product and average
product remains unchanged, the production process is said to be operating
under the law of constant returns and if the marginal product and average
product start diminishing with the employment of variable factor of production
the production process is said to be operating under the law of diminishing
returns.
3.1
Law of Increasing Returns
If with the continuous application of units of variable factors of
production on the fixed factor of production in agriculture, extractive,
industry, minerals marginal and average product start increasing , it is
said that the production process is operating under the increasing
returns or diminishing costs. The main reason of the application of
increasing return is the indivisibility of fixed F.O.P which is utilized
effectively and as a result marginal and average product increases.
The law can be explained with the help of schedule. Suppose that per
unit cost of variable factor of production is Rs. 300.
Business Economics (Study Text)
190
Note:
Marginal cost
=
Wage
Per unit Cost

Marginal physical product M arg inal Physical Pr oduct
Average cost
=
Wage
Per Unit Cost

Average Physical Product
Average Physical Pr oduct
Total
Fixed
Factor
of
Production
Marginal Average
Units of Variable Physical
Physical Physical
Labor (FOP)
Product
Product
Product
(TPP)
(MPP)
(APP)
Marginal
Cost
(MC)
Average
Cost (AC)
25 acres
1 (Rs. 300) PD 10
10
10
30
30
"
2
“
30
20
15
15
20
"
3
“
60
30
20
10
15
"
4
“
100
40
25
7.5
12
"
5
“
150
50
30
6
10
It is clear from the table that the quantity of fixed factor of production is
unchanged and the units of variable factor of production are increasing. Law
of increasing returns or diminishing cost can be explained with the help of
figures:
50
MP
40
M.P
A.P 30
AP
20
10
1
2
3
4
5
Units of Variable FOP
Fig. 1
Business Economics (Study Text)
191
30
24
M.C
A.C 18
12
AC
6
MC
1
2
3
4
Units of Variable
FOP Fig. 2
5
Assumptions
(i) Fixed Factor of production is indivisible
(ii) Homogeneous units of variable Factors of Production
(iii) Perfect Competition in Factors Market
(iv) Factors are substitutes
(v) Only applicable in the short run
(vi) No change in technology / method of production
3.2
Operation of Law of Increasing Returns
Law of increasing returns applies when there is no shortage of factors
of production there is a right combination of factors of production and
the indivisible factors are being fully utilized or in those production
processes where the involvement of human factor is much greater than
the nature e.g. in Industry.
3.3
Law of Diminishing Returns
According to Alfred Marshall an increase in capital and labor applied to
the cultivation of land causes, in general, a less than proportionate
increase in the amount of the production raised, unless it happens to
coincide with the improvement in the art of agriculture. According to
Business Economics (Study Text)
192
Richer A. Bilas "If the input of one resource is increased by equal
increment per unit of time while the inputs of other resources are held
constant, total product/output will increase but beyond some points, the
resulting output increase will become smaller and smaller".
The law of diminishing return can be explained with the help of a table:
Units
of Total
Average
Marginal
Fixed Factor Variable
Physical
Physical Physical
Land
F.O.P
Product
Product
Product
Labor
(TPP)
(APP)
(MPP)
50
Marginal Average
Cost
Cost
(MC)
(AC)
50
6
6
(Rs.)
25 acres
1 (300) PD 50
25
2
"
90
45
40
7.5
6.66
25
3
"
120
40
30
10
7.5
25
4
"
140
35
20
15
8.5
25
5
"
150
30
10
30
10
Note: Per unit cost of variable F.O.P. is Rs. 300 which is assumed to be constant:
Total Physical Pr oduct
Units of Variable FOP (Labor )
(i)
Average Physical Product =
(ii)
Marginal Cost
=
Per unit Cost
Marginal physical product
(iii)
Average Cost
=
P.U. cost
Average physical product
It is clear from the table that an increase in units of variable factors of
production, average and marginal product are diminishing and marginal and
average cost are increasing. As the cost per unit is unchanged and marginal
and average product are diminishing because of the application of law of
diminishing returns therefore, marginal and average cost are increasing, that
is why the law is also named as law of increasing costs.
Business Economics (Study Text)
193
The law can also be explained with the help of diagrams:
Y
Y
50
40
M.P 30
A.P
20
3.4
MC
AC
AP
10
O
MC
10
5
6
4
AC
2
MP
1
2
3
4
Units of Variable FOP
Fig. 1
8
X
O
1
2
3
4
Units of Variable FOP
Fig. 2
5
X
Assumptions
Law of diminishing returns is based on the following assumptions:
1.No change in the fixed factor of production
The law is based on the assumption that the quantity of fixed F.O.P.
does not change. If quantity of fixed F.O.P. increases the law will not
hold because with the application of extra units of variable F.O.P.
average and marginal products shall increase instead of decrease.
2.Law of increasing returns has actually completed
It is a necessary assumption for the law of diminishing returns that law
of increasing returns has actually completed. Sometimes due to bad
weather or unfavorable conditions the average and marginal product
decrease, but when weather conditions become favorable and
irrigation system is improved, marginal and average product again start
increasing. It does not mean that law of increasing returns has again
applied, but actually law of increasing returns had not completed yet.
3.No change in technology
If new and better methods of cultivation are discovered or pesticides,
urea or best quality seeds are used, marginal and average product will
Business Economics (Study Text)
194
increase and the law will not hold good.
4.Homogeneous units of variable factors of production
It is assumed that all the units of variable F.O.P. are homogeneous. If
the lateral units are better than the previous one then marginal and
average product will increase instead of decrease.
5.Factors are substitutes
It is assumed in the law that the factors of production are substitutes of
one another i.e. we can substitute variable with fixed factor of
production.
3.5
Application of law of diminishing returns
The main reason of the application of diminishing returns is the wrong
combination of F.O.P. When units of variable F.O.P. are increased, the
quantity of fixed F.O.P. remains the same, the variable F.O.P. cannot
show its efficiency. The second reason is that factors are not perfect
substitutes of one another.
3.6
Importance
1.Basis for the Malthusian Theory of Population
According to Malthus, Population increases at a faster rate than the
food production because law of diminishing returns applies in
agriculture.
2.Basis for Ricardian Theory of Rent
According to Ricardo, Rent is paid because less fertile lands are
cultivated as law of diminishing returns applies in the more fertile lands.
3.Optimum Size of Business
The optimum size of the business is that when law of increasing return
has completed and law of diminishing returns has not yet started. With
the help of this law we can determine this optimum level.
Business Economics (Study Text)
195
3.7
Compatibility of Increasing Returns and Diminishing Returns
It was argued in the past by the classicists that law of diminishing
returns applies only in agriculture and other extractive industries and
law of increasing returns applies in manufacturing industry. The
modern economists differ with the above argument of classicists and
they are of the views that the law of diminishing returns both applies in
agriculture and industry. The only difference is that it starts operating
earlier in agriculture and at some lateral stage in industry.
3.8
Why Law Operates More in Agriculture?
The law of diminishing returns applies more where nature's
interference is greater than the human beings. In industry the
interference by the nature is less and the entrepreneur with his ability
can postpone the law of diminishing return for a longer period, but in
agriculture the nature's interference is greater. In agriculture there is no
better check because of vast area of agricultural land, so economies of
large scale cannot be reaped in agriculture. Weather conditions play
important role and if weather conditions are not favorable marginal and
average product decrease. Another reason for the application of
diminishing returns is that the principle of division of labor cannot be
adopted.
3.9 Operation of The Law of Diminishing Returns in the Industrial
Sector
It was said in that past that the law of diminishing returns applies only
in agriculture and law of increasing returns applies in industry only on
the basis that all those sectors where the human being, law of
diminishing returns applies and where many of the charges can be
made with the involvement of human being, law of increasing returns
applies. The modern economists are of the view that the law of
diminishing returns not only applies in agriculture but also in the
industrial sector especially in those industrial units where the fixed
factors of production cannot be increased or substituted with the other
variable factors of production. In agricultural sector law of diminishing
returns applies quite earlier as compared to industry as units of fixed
Business Economics (Study Text)
196
factors of production cannot be changed proportionately with variable
factors of production.
We can conclude that one of the most important reasons for the
application of laws of diminishing returns is the wrong combination of
fixed factors of production and variable factors of production because
fixed factors cannot be increased proportionately with the variable
factors such as labors and raw materials.
The law of diminishing returns will not apply at any stage of production
if the factors of production become perfect substitutes.
3.10
The Law of Constant Returns or The Law of Constant Costs
Other things remaining the same when the additional units of variable
factors of production are applied on the fixed factor of production, there
arises a proportionate increase in total output is called the law of
constant returns.
It applies to those industries which represent a combination of
manufacturing as well as extractive industries. In manufacturing
industries, additional investment of labor and capital (variable FOP)
may result in more than proportionate increase. In the amount of goods
produced. While in extractive industries an increase in investment is
variable factors of production may result in less than proportionate
increase in the amount of goods produced. If the increased marginal
productivity is balanced with the diminishing productivity in the other
industries, we may state that the law of constant return is applying.
Conditions of the Law (Assumptions)
(i)
No increase in the prices of raw material in the industry.
(ii)
No change in the price of factors of production.
(iii)
The supply of factors of production is perfectly elastic.
(iv)
Indivisibility of fixed FOP.
(v)
Productive services are not fixed.
The law of constant returns can be explained be with the help of a schedule.
Business Economics (Study Text)
197
Fixed
POP
Land
Variable FOP Total
Marginal
Average
(Units) Labor
Physical
Physical
Physical
Marginal
300/= Product
Product
Product
Cost (MC)
(RS
Averag
e Cost
(AC)
P/day)
(TPP)
(MPP)
(APP)
25 acres
1
50
50
50
6
6

2
100
50
50
6
6

3
150
50
50
6
6

4
200
50
50
6
6

5
250
50
50
6
6
In the above schedule it is shown that the proportion of marginal physical
product and average physical product remains the same. On the other side
proportion of marginal cost is also equal to the proportion of average cost.
Note: MC =
P.U.Cost
AP
and AC =
P.U. Cost
A.P
The law can be explained with the help of diagrams.
Business Economics (Study Text)
198
3.11
Law of Variable Proportions/Non-Proportional Variables
Law of variable proportions explains that with a given technology when
units of variable factor of production are employed on the fixed factor of
production, marginal and average product increases in the beginning
but when the fixed F.O.P. is utilized fully or utilized more units of
variable F.O.P. gives less and less marginal and average product.
According to Bentham, "As the proportion of one factor in a
combination of factors is increased, after a point, first the marginal and
then the average product of that factor will diminish". According to P.A.
Samuelson, "An increase in some inputs relative to other comparatively
fixed inputs will cause the output to increase but after a point the extra
addition resulting from the same addition of input will decrease the
income".
3.12
Assumptions
The law of variable proportion is based on the following assumptions:
1.No Scientific Improvement
It is assumed that the state of technical knowledge is given and remains
unchanged, otherwise the marginal and average product will be increasing
instead of decreasing.
2.Fixed F.O.P. does not Change
The law holds only when fixed F.O.P. does not change i.e., only one
factor is variable, other factors being held constant.
3.Substitution of Factors of Production
It is assumed that factors are imperfect substitutes. It is only possible to
vary the proportions in which various inputs become variable.
4.Homogeneous Units of Variable (FOP)
All units of variable F.O.P are homogeneous. i.e., all the workers are
equal in physical health and mental capabilities.
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5.For the Short period only
It assumes that the period is short run, because in the long run all
inputs become variable.
The law can be explained with the help of a schedule and a diagram:
Suppose that fixed factor of production is 10 acres of land.
Total
Units of Variable Physical
factors
of Product
production
(Quintals)
(TPP)
Marginal
Physical
Product
(Quintals)
(MPP)
Average
Product
(APP)
1
5
5
5
2
15
10
7.5
3
30
15
10
4
40
10
10
5
45
5
9
6
45
0
7.5
7
40
-5
5.7
Physical
(Quintals)
It is clear from the table that until 3rd unit of variable F.O.P. marginal and
average product are increasing it is the stage 1, that represents increasing
returns. From 4th to 6th unit, the average product is diminishing, it is the
second stage. With the employment of 7th unit of variable F.O.P, the marginal
product is negative, it is 3rd stage i.e., of negative returns.
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Y
45
f
e
d
40
g
TP
35
c
M P 30
AP
TP 25
20
h
10
5
0
–3
i
b
15
p
J
n
q
r
s
AP
k
a
l
1
2
3
4
5
6
U n its o f Va ria b le
X
7
m
FO P
MP
In the figure, up to 3rd unit marginal and average product are
increasing. At 4th unit marginal product curve and average product
curve intersect each other i.e., marginal product is equal to average
product. At 7th unit marginal product is negative. From 1st unit to 3rd
unit marginal product and average product are increasing. It is first
stage which represents increasing returns. This stage is not so
important for the firm because there is an incentive for the firm to
employ more units of variable F.O.P., from 4th to 6th unit average
product and marginal product are diminishing, it is the 2nd stage. It
represents diminishing returns. This stage is the most important for the
firm. In this stage efficiency of variable F.O.P. is decreasing while the
efficiency of fixed F.O.P. is still increasing because total product is still
increasing. At 7th unit marginal product is negative and this stage is of
least importance for the firm because none of the firm can bear losses.
So the firm is not concerned with this stage. In this stage marginal
product is negative and total product is also diminishing. This stage
shows that both the variable and fixed factors of production are not
being used efficiently.
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3.13
Importance
The second stage is known as the variable proportions or non-variable
proportions. Law of variable proportions shows the efficiency of factors
of production in the production process. It also shows the technique of
production. Production process continues till total product is increasing
and production process is stopped when total product start diminishing.
4
Relationship Between Marginal Physical Product & Total
Physical Product
As the total physical product is addition of marginal physical products
therefore, as Marginal Physical Product is increasing, Total Physical Product
will increase and when Marginal Physical Product = 0, Total Physical Product
is maximum and when Marginal Physical Product becomes negative, Total
physical is zero product starts diminishing.
4.1
Marginal Physical Product and Average Physical Product:
Average Physical Product is derived dividing the total physical product
by units of variable Factors of Production and Total Physical Product is
the addition of the marginal physical product therefore, the behavior of
Marginal Product and the Average Physical Product will be the same
however the increasing and diminishing rate of marginal is always
faster than the average i.e., average increases or decreases at a slow
rate.
The relationship between marginal physical product and total physical
product, marginal physical product and average product can be
explained with the help of a schedule:
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Units
of Total
Average
Variable
Product
Physical
Physical
F.O.P.
(TPP)
Product
Product
Qtls
(MPP)
(AP)
Qtls
Qtls
1
5
5
5
2
15
10
7.5
3
30
15
10
4
40
10
10
5
45
5
9
6
45
0
7.5
–5
5.7
7
4.2
Physical Marginal
40
Relationship between Marginal Physical Product and Total
Physical Product:
1.
When marginal physical product is positive, total physical product
is increasing. In the table marginal physical product is positive up
to 5th unit and total physical product is increasing from 5 to 45.
2.
When Marginal physical Product is zero, total physical product is
maximum. In the table marginal product is zero at 6th unit and
total physical product is maximum i.e., 45.
3.
When marginal physical product is negative, total product
diminishing. In the table marginal physical product is negative at
7th unit and total physical product has fallen from 45 to 40.
4.
Total physical product is the addition of the marginal physical
products.
5.
Marginal physical product is the rate of change in the total
physical product. Per unit of variable factors of production
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4.3 Relationship between Marginal Physical Product and Average
Physical Product:
1.
When average physical product is increasing, marginal physical
product is also increasing. In the table average physical product
is increasing up to 3rd unit i.e., from 5 to 10 and marginal
physical product is increasing from 5 to 15 but average physical
product is increasing at a slower rate while marginal physical
product is increasing at a faster rate as evident from the gap.
2.
When average physical product is maximum, marginal physical
product is equal to average physical product. In the table
average physical product is maximum at 4th unit i.e., 10 and
marginal physical product is also 10.
3.
When average product is diminishing, marginal physical product
is also diminishing. In the table from 5th unit to 7th unit average
physical product is diminishing and marginal physical product
has also diminished from 5 to –5, but average physical product
is diminishing at a slower rate while marginal physical product is
diminishing at faster rate.
4.4
Short-Run Production Curves
In the short run, firms can increase output by adding extra units of labor
to a fixed amount of capital.

The addition to output made by each extra worker is called
marginal product of labor (MPL).

Output per worker is called average product of labor (APL).

The concept of returns compares the percentage change in labor
(%L) with the resulting percentage change in output (%Q).
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Table 1 Types of returns
Type of returns
Description
Marginal
product
Increasing returns %Q is greater than the %L
is rising
%Q is equal to the %L
Constant returns
is constant
%Q is smaller than the %L
Decreasing
is falling
returns

The law of diminishing returns states that, as extra units of a
variable factor are combined with a given amount of a fixed
factor, the marginal product of the variable factor will eventually
fall.

If only diminishing returns are referred to, this is taken to mean
diminishing marginal returns.
Output (Q)
A
B
MPL
APL
Labour (L)
In this Figure, product curves AP = Q/L; MP = Q/L. A is the point of
diminishing returns; B is the point of diminishing average returns.
4.5
The Law of Costs / The Law of Returns
The law of returns can also be expressed in terms of law of costs. We
have studied that marginal cost is diminishing during the operation of law
of increasing return, marginal costs remain the same during the
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operation of law of constant returns and the marginal costs start
increasing during the operation of the law of diminishing returns.
If the cost incurred on each unit of variable FOP is the same say Rs.
100/= P. day because of perfect competition in the factors market, the
above law can be explained with the help of a schedule.
Units
of
Fixed
variable
FOP
(Rs. 300/=)
Land
FOP
Marginal
Physical
Product (TPP)
Marginal Costs
(Labor)
25
1
10
30
25
2
20
15
diminishing
25
3
30
10
costs
25
4
30
10
constant
25
5
30
10
costs
25
6
20
15
increasing
25
7
10
30
costs
stage I
stage III
The law expresses the experience of the production process. Initially it is
operating under the law increasing return or diminishing costs, then it is operating
under the law of constant returns and constant costs and finally it is operating
under the law of diminishing returns or increasing costs. The law of costs can be
explained with the help of a figure
MC
The law of returns can also be explained with the help of a diagram.
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Y
Constant returns
Marginal
Marginal
Physical
Product
Product
MPP
O
5
Units of Variable FOP
X
Law of Returns To Scale
Diminishing marginal productivity applies when there is a fixed factor of
production, either the workers or machines. However, when the fixed factors
of production can be varied, diminishing marginal productivity does not strictly
apply. We approach to the concept of economies of scale which is generally
referred to as returns to scale. When both fixed factor (capital K) and variable
factor (labor) are allowed to vary simultaneously there can result a
proportionate, more than proportionate or less than proportionate increase in
output.
The law of returns to scale describes how the output of a production process
changes as all input factors are scaled up or down proportionately. It indicates
the relationship between proportional changes in all inputs and the resulting
change in output. There are three possible types of returns to scale:
A.
Increasing Returns to Scale (IRS)
IRS occurs when a proportional increase in all inputs results in a more than
proportional increase in output.
For example, if all inputs are doubled, and output more than doubles,
the production function exhibits increasing returns to scale.
This can happen due to factors like efficiencies gained from larger
production volumes, specialization of labor, or better utilization of fixed costs.
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B.Constant Returns to Scale (CRS)
CRS occurs when a proportional increase in all inputs results in an exactly
proportional increase in output.
For example, if all inputs are doubled, and output also doubles, the
production function exhibits constant returns to scale.
This suggests that the firm is operating at an optimal scale where inputs
and outputs are balanced perfectly.
C. Decreasing Returns to Scale (DRS)
DRS occurs when a proportional increase in all inputs results in a less
than proportional increase in output.
For example, if all inputs are doubled, and output less than doubles,
the production function exhibits decreasing returns to scale.
This might occur due to factors like inefficiencies in management,
difficulties in coordinating a larger workforce, or the overuse of resources
leading to diminishing productivity.
5.1
Laws of Returns are Showing Inputs – Output Relationship in The
Long Run
It is generally assumed that the output shows proportionate change to a
change in inputs i.e. if all the productive resources are doubled, output will
double but in fact there are three possibilities of change in output to a
change in inputs. For example, if inputs are doubled, it is not necessary
that the output will double. Change in output to same change in inputs may
be equal, less than or greater than the change in inputs. Main difference in
law of returns and the law of returns to scale is that in law of returns to
scale fixed factors production also became variable. The behavior of
output to a change inputs can be illustrated with the help of a schedule
and a diagram.
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RETURNS TO SCALE
Total
Marginal
Returns
Returns
Variable (FOP)
Fixed (FOP)
(Units)
(Units)
10 workers + 10 acres of land 100
100
Stage - I
20 workers + 20 acres of land 250
150
increasing
30 workers + 30 acres of land 450
200
to scale.
40 workers + 40 acres of land 750
300
50 workers + 50 acres of land 1250
500
Stage - II
60 workers + 60 acres of land 1750
500
Constant returns
70 workers + 70 acres of land 2000
250
Stage - II
80 workers + 80 acres of land 2150
150
Decreasing
returns
to Scale
returns to Scale
90 workers + 90 acres of land 2200
50
From the above table it is clear that with double inputs, output is greater than
double i.e. stage-I of increasing return. In stage – II, marginal return remained
constant at this stage of production a firm in the long run is experiencing
constant returns to scale. Additional increase in input does not yield equal
marginal returns as in stage – III, marginal returns starts decreasing with the
increase in variable and fixed factors of production. It is clear from the table
that there are three phases of returns to scale as shown in the table and in the
diagram below:
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Constant Returns to Scale
500
Decreasing
returns to
scale
450 Increasing returns to
scale
400
350
Stage II
300
250
200
150
Stage – I
Stage III
100
50
0
10
20
30
40
50
60
70
80
90
Inputs (Units)
From the figure, it is derived that from 10 to 50 units there is increasing
returns to scale i.e. stage – I, from 50 to 60 units there is constant returns to
scale i.e. stage – II and from 70 to 90 units, have of decreasing returns
applies i.e. stage – III.
This behavior in output can be summarized as below:(a)
If output increases more than the inputs, law of increasing returns to
scale is applying which is a result of economies of scale.
(b)
If output increases in the same proportion as inputs, law of constant
returns to scale is in application.
(c)
If output increases less proportionately to a change in output, law of
decreasing returns to scale is applying.
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Note:
(i)
During decreasing returns to scale inputs have to more than double to
double the production.
(ii)
Determination of returns to scale requires empirical studies of particular
industry.
(iii)
The achievable returns to scale depend on the production function.
(iv)
The law of returns to scale describes the output-input relationship in
the long run.
5.2 Returns to scale and scale economies
Returns to scale
Description
Scale
Slope
economies
LAC curve
Increasing returns to %  Q is greater than Economies
scale (IRS)
the %L&K
Horizontal
the %L&K
Decreasing returns % Q is smaller than Diseconomies
to scale (DRS)
of Falling
scale
Constant returns to %  Q is equal to Constant
scale (CRS)
of
the %L&K
Rising
of scale
5.3 Production Functions
The production function relates input and output relation. It explains the
technological relation between what is feed into the productive process by
way of raw materials and the inputs of factors of production services and what
is the relation in terms of output or production.
The production function can be explained and written as below in a
mathematical notation.Q = f(L.K)
Where Q is the quantity of output per unit of time, ‘L’ is labor employed in
production function, ‘K’ is units of capital services used, and f stands for
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functional relation that links q to L & K.
A production function may be of two types:
(i)
Linear homogeneous Production function in which the output would
change in exactly the same proportion as the change in inputs. Such a
production function expresses constant returns to scale.
(ii)
Non-homogeneous production functions of degree greater or less
than one. The former relates to increasing return to scale and the later
to decreasing returns to scale.
The production function exhibits technological relationships between
physical inputs.
Summary
Definition of a Firm:
A firm is an economic entity that organizes resources to produce goods and
services for profit. It coordinates production, manages resources, and makes
decisions to maximize its value.
Basic Problems of Firms:
1. Resource Allocation: Deciding how to allocate scarce resources
effectively.
2. Production Decisions: Determining what to produce, how much to
produce, and the production methods to use.
3. Cost Management: Controlling costs to maximize profitability.
4. Market Competition: Navigating competitive markets to sustain and grow
the business.
5. Adaptation to Change: Adjusting to technological changes, consumer
preferences, and regulatory environments.
6. Financial Management: Securing and managing finances to ensure
liquidity and solvency.
7. Human Resource Management: Recruiting, training, and retaining
employees.
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Economies of Scale (EOS)
Economies of Scale refer to the cost advantages that firms experience as
their production scale increases, leading to a decrease in per-unit production
costs.
Types of Economies of Scale
1. Internal Economies of Scale: Cost savings that arise from within the firm
as it expands.
2. External Economies of Scale: Cost benefits that accrue to a firm due to
external factors, often industry-wide.
Internal Economies of Scale
Technical Economies: Cost advantages due to the use of more efficient
technology or machinery.
Managerial Economies: Improved managerial efficiency and specialization.
Financial Economies: Lower interest rates on loans due to better
creditworthiness.
Marketing Economies: Reduced marketing costs per unit as scale increases.
Purchasing Economies: Bulk buying of materials at discounted rates.
External Economies of Scale
Industry Growth: Benefits from the overall growth and development of the
industry.
Infrastructure Development: Improved infrastructure that benefits all firms
within an industry.
Supplier Networks: Establishment of specialized suppliers.
Skilled Labor Pools: Availability of a skilled workforce due to the
concentration of firms in an area.
Small Scale Production
Small scale production refers to manufacturing processes carried out on a
smaller scale, typically characterized by limited capital investment and lower
output.
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Advantages
Flexibility: Ability to quickly adapt to market changes.
Customization: Capability to offer tailored products.
Lower Entry Barriers: Easier for entrepreneurs to start businesses.
Challenges
Higher Costs: Higher per-unit costs compared to large-scale producers.
Limited Resources: Constraints on capital and labor.
Market Reach: Difficulty in competing with larger firms in terms of market
presence and economies of scale.
Laws of Returns (Short Run)
The Laws of Returns in the short run describe how output changes when one
input is varied while other inputs are held constant.
Law of Increasing Returns:
In the initial phase of production, as additional units of a variable input (e.g.,
labor) are added to fixed inputs (e.g., capital), the output increases at an
increasing rate. This occurs due to improved efficiency and better utilization of
fixed resources.
Law of Constant Returns
In this phase, each additional unit of the variable input results in an equal
increase in output. The marginal product remains constant, indicating optimal
utilization of resources.
Law of Decreasing Returns
Beyond a certain point, adding more units of the variable input leads to
smaller increases in output. The marginal product declines because the fixed
inputs become overutilized, leading to inefficiencies.
Laws of Returns to Scale (Long Run)
The Laws of Returns to Scale describe how output changes when all inputs
are varied proportionally in the long run.
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1. Increasing Returns to Scale: Output increases by a larger proportion than
the increase in inputs.
2. Constant Returns to Scale: Output increases in the same proportion as
the increase in inputs.
3. Decreasing Returns to Scale: Output increases by a smaller proportion
than the increase in inputs.
Law of Variable Proportions
The Law of Variable Proportions states that if the quantity of one input is
increased while keeping other inputs constant, the overall output will initially
increase at an increasing rate, then at a diminishing rate, and eventually, it will
decrease.
Phases:
1. Phase of Increasing Returns: Marginal product of the variable input rises.
2. Phase of Diminishing Returns: Marginal product of the variable input
declines.
3. Phase of Negative Returns: Total output decreases as additional units of
the variable input are added.
Relationship between Marginal, Average, and Total Product
Total Product (TP)
The total quantity of output produced with a given qua intity of inputs.
Average Product (AP)
Output per unit of a particular input (AP = TP / Quantity of Input).
Marginal Product (MP)
The additional output produced by using one more unit of input (MP = Change
in TP / Change in Input Quantity).
Relationship:
When MP is greater than AP, AP rises.
When MP is less than AP, AP falls.
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TP increases at an increasing rate when MP is rising, increases at a
decreasing rate when MP is falling, and reaches its maximum when MP is
zero. TP starts to decline when MP becomes negative.
Production Functions
A production function describes the relationship between inputs (factors of
production) and the maximum output that can be produced with those inputs.
Homogeneous Production Functions
Homogeneous production functions are those in which if all inputs are scaled
by a constant factor, the output scales by some power of that factor. For
example, if a production function y=f(L, K) is homogeneous of degree n, then
f(tL,tK)=tnf(L,K). This property is useful in analyzing returns to scale. If n = 1,
the function exhibits constant returns to scale; if n > 1, increasing returns to
scale; and if n < 1, decreasing returns to scale.
Non-Homogeneous Production Functions
Non-homogeneous production functions do not exhibit a proportional scaling
of output when inputs are scaled by a constant factor. This means
f(tL,tK)≠tnf(L,K) for any constant n. These functions are more complex and do
not directly indicate returns to scale, requiring more specific analysis to
understand how output responds to changes in input levels.
Self-test questions
Firm and basic problems of firms
1. What are some common issues firms face in terms of managing resources
efficiently? (1)
Economies of Scale (EOS)
2. What are economies of scale, and how do they impact a firm's production
costs as output increases? (2)
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Internal and external economies of Scale
3. What are internal economies of scale, and how do they differ from external
economies of scale? (2.1)
4.How do external economies of scale benefit firms operating within a
particular geographic region or industry cluster? (2.5)
Small scale production
5. What are some advantages and disadvantages of small-scale production
for firms? (2.6 and 2.7)
Laws of Returns
6.What is the Law of Diminishing Returns, and how does it affect short-run
production? (3.3)
Laws of Returns to scale
7. What is the Law of Increasing Returns to Scale, and how does it differ from
the Law of Diminishing Returns?
Law of Variable Proportions
8. What does the Law of Variable Proportions state about the relationship
between inputs and outputs in the short run? (3.11)
Relationship between Marginal, Average and Total Product
9. How are marginal, average, and total product calculated in the context of
production? (4)
Production functions
13. What is a production function, and how does it describe the relationship
between inputs and outputs in production? (5.3)
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Practice questions
1. Firm and Basic Problems of Firms
Question 1: Which of the following is NOT a basic problem faced by firms?
A. What to produce
B. How to produce
C. For whom to produce
D. Why to produce
Answer: D. Why to produce
Question 2: Which of the following is a primary goal of firms?
A. Minimizing costs
B. Maximizing profits
C. Reducing employee benefits
D. Increasing market prices
Answer: B. Maximizing profits
2. Economies of Scale (EOS)
Question 1: Economies of scale refer to:
A. The reduction in average costs due to increased production
B. The increase in average costs due to increased production
C. The reduction in total costs due to decreased production
D. The increase in total costs due to decreased production
Answer: A. The reduction in average costs due to increased production
Question 2: Which of the following is a reason for economies of scale?
A. Diseconomies of scale
B. Improved managerial efficiency
C. Increased average costs
D. Higher input prices
Answer: B. Improved managerial efficiency
3. Internal and External Economies of Scale
Question 1: Internal economies of scale are achieved:
A. Within a single firm
B. Across an entire industry
C. By reducing external competition
D. Through government subsidies
Answer: A. Within a single firm
Question 2: External economies of scale occur when:
A. A firm reduces its internal costs
B. The entire industry benefits from growth
C. Only large firms benefit
D. A firm experiences higher costs due to industry growth
Answer: B. The entire industry benefits from growth
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4. Small Scale Production
Question 1: Small scale production is characterized by:
A. High levels of output
B. High levels of automation
C. Low capital investment
D. Significant economies of scale
Answer: C. Low capital investment
Question 2: One advantage of small scale production is:
A. Large market reach
B. Flexibility in operations
C. High production volume
D. High bargaining power with suppliers
Answer: B. Flexibility in operations
5. Laws of Returns (Short Run)
Question 1: The Law of Diminishing Returns states that:
A. Increasing all inputs leads to proportional output increase
B. Adding more of one input while keeping others fixed eventually reduces marginal
output
C. Total production decreases when all inputs are increased
D. Output remains constant regardless of input changes
Answer: B. Adding more of one input while keeping others fixed eventually
reduces marginal output
Question 2: In the short run, if a firm experiences increasing returns, it means:
A. Each additional unit of input yields less output
B. Total output is decreasing
C. Each additional unit of input yields more output
D. Costs are increasing
Answer: C. Each additional unit of input yields more output
6. Laws of Returns to Scale (Long Run)
Question 1: Increasing returns to scale occur when:
A. Doubling inputs less than doubles output
B. Doubling inputs exactly doubles output
C. Doubling inputs more than doubles output
D. Doubling inputs halves the output
Answer: C. Doubling inputs more than doubles output
Question 2: Constant returns to scale mean that:
A. Increasing inputs results in a proportional increase in output
B. Increasing inputs decreases output
C. Output does not change with increased inputs
D. Inputs and output decrease at the same rate
Answer: A. Increasing inputs results in a proportional increase in output
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7. Law of Variable Proportions
Question 1: The Law of Variable Proportions is most relevant in:
A. The long run
B. The short run
C. Both short run and long run
D. Neither short run nor long run
Answer: B. The short run
Question 2: The stage of diminishing returns occurs when:
A. Total product starts to decrease
B. Marginal product starts to decrease but total product is still increasing
C. Marginal product is at its maximum
D. Total product is at its maximum
Answer: B. Marginal product starts to decrease but total product is still
increasing
8. Relationship between Marginal, Average, and Total Product
Question 1: If the marginal product is greater than the average product, then:
A. The average product is increasing
B. The average product is decreasing
C. The total product is constant
D. The total product is decreasing
Answer: A. The average product is increasing
Question 2: When the total product is at its maximum, the marginal product is:
A. Positive
B. Negative
C. Zero
D. Equal to the average product
Answer: C. Zero
9. Production Functions
Question 1: A production function shows the relationship between:
A. Inputs and costs
B. Inputs and outputs
C. Outputs and revenue
D. Costs and profits
Answer: B. Inputs and outputs
Question 2: A production function is said to be homogeneous of degree n if:
A. Doubling all inputs doubles the output
B. Doubling all inputs increases output by n times
C. Doubling all inputs has no effect on output
D. Doubling all inputs quadruples the output
Answer: B. Doubling all inputs increases output by n times
Question 3: Homogeneous production functions exhibit:
A. Constant returns to scale
B. Decreasing returns to scale
C. Increasing returns to scale
D. Variable returns to scale
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Answer: A. Constant returns to scale (if the degree of homogeneity is 1)
Question 4: A non-homogeneous production function is one where:
A. Doubling inputs leads to more than double the output
B. Doubling inputs leads to less than double the output
C. The relationship between inputs and output does not scale proportionately
D. The relationship between inputs and output scales proportionately
Answer: C. The relationship between inputs and output does not scale
proportionately
Question 5: In economic terms, a homogeneous production function allows for
analysis of:
A. Absolute costs
B. Relative efficiencies
C. Scale economies
D. Marginal costs
Answer: C. Scale economies
Question 6: If a production function f(K, L) is homogeneous of degree 2, then:
A. Doubling all inputs will double the output
B. Doubling all inputs will quadruple the output
C. Doubling all inputs will halve the output
D. Doubling all inputs will keep the output constant
Answer: B. Doubling all inputs will quadruple the output
Question 7: Homothetic production functions are characterized by:
A. Constant elasticity of substitution
B. Proportionality in scaling inputs and output
C. Variable returns to scale
D. Increasing marginal returns
Answer: B. Proportionality in scaling inputs and output
Question 8: Which of the following is NOT a property of a homogeneous
production function?
A. Multiplicative scalability
B. Proportional increase in output with inputs
C. Constant elasticity of substitution
D. Identical returns to scale at all levels of output
Answer: C. Constant elasticity of substitution
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Content
1. Types of Cost
2. Short Run Cost Behaviour
3. Long Run Cost Behaviour
4. Impact of Long Run Costs on Industry Structure
5. Concepts of isoquant and Iso cost
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1.
Types of Cost
By cost of production means that all those expenditures incurred during the
production process either these are directly related with the production of
output, or indirectly related with the production of output, these include the
rent paid to the land owners or other property used, wages of labor, interest
on capital, profits of the entrepreneur, cost of raw materials and replacement
and repairing charges of machinery. Cost of production i.e., rewards of factor
of production, selling costs e.g. advertisement and other costs e.g. insurance
charges, rates and taxes.
Following is explanation of various types of costs, including definitions and
examples:
1. Sunk Costs
Sunk costs are expenses that have already been incurred and cannot be
recovered. These costs should not influence current decisions because they
remain the same regardless of the outcome of a decision.
If a company spends $100,000 on research and development for a new
product and then decides not to continue with the product, the $100,000 is a
sunk cost. It cannot be recovered and should not affect future decisions.
2. Opportunity Costs
Opportunity costs represent the value of the next best alternative foregone
when a decision is made. It reflects the benefits that could have been
obtained if resources were used in a different way.
If an entrepreneur decides to invest $1 million in a new restaurant instead of
putting that money into a high-interest savings account, the opportunity cost is
the interest income forgone from not choosing the savings account.
3. Incremental Costs
Incremental costs, also known as differential costs, are the additional costs
associated with a particular business decision or action. These are the extra
costs that will be incurred if a particular course of action is taken.
If a factory increases its production by 100 units, the incremental costs might
include additional labor, materials, and utilities specifically required for those
100 extra units.
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4. Implicit Costs
Implicit costs, also known as imputed or notional costs, represent the
opportunity costs of using resources owned by the firm. These costs are not
directly paid out or recorded but reflect the value of resources used in
production.
If a business owner uses their own building for business operations instead of
renting it out, the potential rental income they forego is an implicit cost.
5. Explicit Costs
Explicit costs are direct, out-of-pocket payments for expenses incurred in the
production process. These costs are clearly recorded and reported in financial
statements.
Payments for raw materials, wages, rent, and utilities are explicit costs
because they involve actual cash transactions.
6. Incremental Costs
Incremental costs are the additional costs incurred when increasing the level
of activity or production. These costs are specifically associated with the
increase in production.
If a company decides to produce an additional 500 units of a product, the
incremental costs might include the additional raw materials, labor, and
overhead required to produce those units.
7. Private Cost
Private costs (PC) are the costs borne directly by the producers or consumers
involved in a transaction. However, when externalities exist, private costs do
not account for the external effects imposed on third parties.
Private Cost (PC) = Social Costs (SC) - External Costs (EC)
Where:
PC represents the direct private costs incurred by the producers or
consumers.
EC represents the external costs imposed on third parties due to the
transaction.
8. Social Cost
Social costs (SC) reflect the total costs to society, including both the direct
private costs and the external costs imposed on third parties.
Social Cost (SC) = Private Costs (PC) + External Costs (EC)
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Where:
PC represents the direct private costs incurred by the producers or
consumers.
EC represents the external costs imposed on third parties due to the
transaction.
9. Fixed costs
Fixed cost are also called the supplementary costs or indirect costs. Fixed
costs are all those costs which have to borne even when the output is zero or
temporarily stopped. Fixed costs do not vary with the output. Fixed costs
include cost of plant and machinery, rent of land or building, salaries of
permanent administrative staff and interest on capital. Fixed costs are
independent of output. Generally fixed cost is incurred in hiring factors of
production whose amount cannot be altered in the short period. Fixed costs
are necessary to start production process but these are not directly involved in
the production process that is why these costs are also called the indirect
costs.
10. Variable costs
Variable cost are also called the direct or prime costs. Variable costs are those
expenditures of production which vary directly with the output. Variable costs
increase with the increase in output and decrease with the decrease in output
and when output is zero, variable costs are zero e.g. cost of raw materials
(primary and finished), electricity expenses, gas charges, water telephone
expenses and transport expenses. If output increases these expenditures
increase and with a decrease in output these expenditures decrease.
The difference in fixed costs and variable cost is only in the short period
because costs become variable costs in the long period.
11. Short Period and Long Period Costs
Short run is a period with in which the firm cannot vary fixed factor of
production such as plant and machinery, rent of land and building, salaries of
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permanent staff, overhead charges and interest or capital. In the short period
a firm can only vary the variable factors of production such as raw materials,
water, telephone and transport expenses. The costs incurred on variable
factors of production in the short run called the short run costs. Long period is
a period within which the firm can vary not only the variable factor of
production but also the fixed factor of production. If profit increase in the short
period the firm can increase production only by hiring services of more labor
and buying more raw materials but it cannot alter the size of plant, and
machinery or it can build a new plant. In the long run a firm can increase or
decrease the amount of variable as well as fixed factor of production. The
costs incurred on the variable as well as on the fixed factor of production are
called the long run costs.
2.
Short Run Cost Behaviour
‘The amount of money which is spent on the production of a particular
quantity of some commodity is called the Cost of Production’.
Factor Pricing is known as Cost of Production.
Cost = Rent +Wages + Interest + Profit
Short run costs
Short run is the period during which at least on factor of production is constant.
So total cost in the Short Run can be divided into two groups that are as
follows:
1) Total Fixed Costs
(TFC)
2) Total Variable Costs (TVC)
TC = TFC + TVC
1. Total Fixed Cost (TFC)
Total Fixed Costs (TFC) is the amount of money that is spent on the fixed
inputs by the firm in order to produce a particular quantity of some commodity.
Total Fixed Costs (TFC) is also referred as Overhead cost, Indirect cost,
Unavoidable cost, Supplementary cost.
‘The cost that does not vary with the change in output is called Total
Fixed Cost.’
It means that if output increases decrease or even it becomes zero, fixed
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cost remains the same.
TFC = AFC x Q
Q ↑ or Q ↓ or Q = 0 → TFC remains the same
Total Fixed Cost consists of:
a) Salaries of administrative staff or permanent staff
b) Depreciation of machinery c) Expenses for building depreciation
d) Normal Profit etc.
e) Rent of the building
f) Premium or Interest
Key Point
Fixed costs do not vary in direct relation to level of output.
2. Total Variable Cost (TVC)
Total Variable Costs (TVC) is the amount of money that is spent on the
variable inputs by the firm in order to produce a particular quantity of some
commodity. Total Variable Costs (TVC) is also referred as Direct cost,
avoidable cost, Prime cost, Floating cost.
‘The cost that varies with the change in output is called Total Variable cost.’
Total Variable cost rises when the firm increases output and falls when firm
decreases output and there is no variable cost when there is no output.
TVC = AVC x Q
Q ↑ → TVC ↑
Q ↓ → TVC ↓
Q = 0 → TVC 0
Total variable Cost consists of:
a) Raw material
b) Cost of direct labor
c) Running expenses of fixed capital such as fuel, ordinary repairs, routine
maintenance etc.
d) Cost of the raw material.
e) Transportation cost
f) Advertisement cost
g) Taxes
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Key Point
Variable costs vary in direct relation to level of output.
3. Total Cost (TC)
‘Total cost is the sum total Fixed and Total Variable costs.’
TC =TFC + TVC
TC = AC x Q
4. Average Fixed Cost (AFC)
‘The cost that can be obtained by dividing the total fixed cost by the units of
output is called Average Fixed Cost.’
AFC = TFC/Q where Q= Output
AFC = AC – AVC
5. Average Variable Cost (AVC)
‘The cost that can be obtained by dividing the total variable cost by the units
of output is called Average Variable Cost.’ i.e.,
AVC = TVC/Q
AVC = AC – AFC where Q= Output
6. Average Cost (AC)
‘Average Cost or the Average Total Cost can be obtained by dividing the total
cost by the units of output.’
AC = TC/Q
where Q= Output
‘The sum total of AFC and AVC is also called the Average Cost or Average
Total Cost.’
AC = AFC + AVC
6. Marginal Cost (MC)
‘Marginal Cost is the change in total cost due to the change in total output by
on unit.’
MC = ΔTC/ΔQ
MC = ΔTVC/ΔQ
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1
2
3
4
(2+3)
5
6
7
(5+6)
8
Q
TFC
TVC
TC
AFC
AVC
AC
(TFC+TVC) (TFC/Q) (TVC/Q) (TC/Q)
MC
(ΔTC/ΔQ)
(Units) (Rs)
(Rs)
(Rs)
(Rs)
(Rs)
(Rs)
(Rs)
0
120
0
120
-----
-----
-----
-----
1
120
60
180
120
60
180
60
2
120
80
200
60
40
100
20
3
120
90
210
40
30
70
10
4
120
105
225
30
26.25
56.25
15
5
120
140
260
24
28
52
35
6
120
210
330
20
35
55
70
First four columns of this schedule show that Total Fixed Cost remains the
same at each level of output while total variable cost and total cost increases
gradually.
Columns number 7 & 8 shows that Average Cost and Marginal Cost rise and
fall simultaneously. If average cost rises, marginal cost also rises and vice
versa. Rate of change of MC is greater than the rate of change of AC i.e.,
when AC increases, MC increases more than the AC and similarly when AC
declines, MC decreases more than the AC.
Columns number 6 & 8 show that AVC continues to fall so long as the
marginal cost is below it i.e., up to the 4th unit of output. AVC starts rising at a
point where MC crosses AVC i.e., from 4th unit of output.
We can explain the short-run cost curves with the help of two diagrams.
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This diagram shows that TFC curve is parallel to x-axis i.e., fixed costs remain
unchanged at each level of output. TVC curve represents the variable costs.
This curve bends to the right first and then rises upward. This is due to the
Law of Variable Proportions. TC curve is the resultant of the lateral
summation of the TFC and TVC curves.
This diagram shows that AFC curve falls from left to right downward. It
becomes closer and closer to the x-axis but it never touches the axis since
AFC cannot become zero. AVC, AC & MC curves fall, reach their minimum
points and starts rising. We can say that these curves are U-Shaped. This is
due to the Laws of Variable Proportions.
Relationship Between Average and Marginal Costs
Following relationships exist among the various types of costs.
 When AC curve falls, MC curve remains below AC curve.
 When AC curve rises, MC curve lies above this curve.
 When AC curve is at its minimum point, MC curve intersects it i.e., at
this point MC is equal to AC.
Relationship Between AC & AVC
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1.
2.
3.
AC = AFC + AVC, it means that AFC and AVC are the part of AC.
AVC and AC are U-Shaped and reflect the Law of Variable
Proportions.
Minimum point of AC occurs to the right of the minimum point of
AVC.
This is due to the following reasons:
a) As AC is the sum of AFC & AVC.
b) AFC decreases continuously with the increase in output.
c) When after minimum point AVC starts rising, its increase, to
some range, is offset by the decrease in AFC. So AC continues
to fall.
d) After some range the rise in AVC becomes greater than the fall
in AFC, therefore AC starts rising.
e) The AVC approaches AC as output increases.
Relationship between MC, AVC & AC
1. MC curve intersects the AVC and AC curves at their lowest points.
2. When MC increases AC also rises.
3. When MC decreases AC also falls.
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4. When MC is equal to AC, the AC remains constant.
5.
Why average cost curves in the short run are u-shaped?
In the Short Run average cost curves are U-Shaped. It means that they
reflect the Law of Variable Proportions. According to this law, at the initial
stages of production with a given plant as more of the variable factor is
employed, its productivity increases and average cost falls. This situation
continues until the optimum combination is reached. After this point as the
variable factor increases, its productivity decreases and average cost rises.
Why Costs Decrease?
There are two causes of decreasing average costs in the Short Run, which
are as follows:
a) In the beginning, with the increase in output, AFC starts decreasing
rapidly.
b) Before optimum combination of factors of production, AVC decreases
due to Law of Variable Proportions.
Why costs increase?
There are two causes of increase in average costs in the Short Run, which
are as follows:
a) Due to increase in output, AFCS have decreased so much that they do
not cause any more fall in average costs.
b) After optimum combination of factors of production, increase in variable
factor causes the increase in costs.
Due to these reasons average costs of a firm decreases initially, reaches their
minimum and start rising. Therefore, they are U-Shaped.
Table 2: Types of cost
Term
Symbol Definition
Total cost
TC
The
amount
Equation
spent
on TC = FC + VC
producing a given output
Variable costs
VC
Production
expenses VC = TC FC
dependent on the level of
output
Fixed costs
FC
Production
expenses FC = TC VC
independent of the level of
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Term
Symbol Definition
Equation
output
Average cost
AC
The
amount
spend
on AC = TC Q
producing each unit
Average
variable AVC
cost
Unit variable costs dependent AVC = VC  Q
on the level of output
Average fixed cost
AFC
Unit fixed costs independent of AFC = FC  Q
the level of output
Marginal cost
MC
The
amount
spent
on MC = TCQ
producing one extra unit

Accountancy and economic definitions of costs are different.

Economists use the concept of opportunity cost when calculating
production costs.

If resources are owned by the firm, the imputed (estimated) transfer
earnings of the factor is included as a cost.
3.
Long Run Cost Behaviour
Long run is the period which is long enough for a firm to be in a position to
vary quantities of all inputs. Therefore, in the long run there is no fixed cost.
Because in the long period fixed factors of production also become variable. A
firm can easily build up any size of land and scale of production. Long run is
the addition of the short run so the behavior of the long run average cost
curve is the same as of short run cost curve. Short run average cost curve
decreases first due to increasing returns, it touches minimum level and then
starts increasing due to due to diminishing returns. As the long run is the
addition of the short periods so the long run average cost curve first
diminishes, touches minimum and then starts increasing. Suppose that a
firm's short run average cost curves are given in the diagram below:
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SAC 1
P1
P3
P2
O
S 1
SAC 2
SAC 3
LAC
S 3
S2
Q1
Q2
Q3
If short run average cost curve of the firm is SAC2 then the optimum level of
output is OQ2 because cost at this output is minimum i.e., S2Q2. Suppose
that a firm intends to increase its output up to OQ3 in the short period it has
average cost of S3Q3 because the scale of production in the short period is
fixed. But in the long run a firm adopts many alternative techniques of
production of producing goods or it can change the size of the plant. In the long
run a firm can produce OQ3 of output at P3Q3 average cost while in the short
period it was only possible for a firm to produce at S2Q2 average cost. A firm in
the long run can adopt three different scales of production i.e., it may be
increasing returns or return.
Long run average cost curve can be drawn from the addition of short period cost
curves or if a tangential curve is drawn on all the short run cost curves we get the
long run average cost curve or (L.A.C.) is given by a curve tangent to all the short
run average cost curves.
The long run average cost curve shows the minimum per unit output cost at
each level of output when desired scale of production can be build.
3.1 Why LAC is Flatter
The short run average cost curve is U-shaped. The shape of the LAC is the
same that first it decreases, touches the minimum level and then starts
increasing but it decreases and increases at a slower rate and when it
touches the minimum points it remains for a longer period and the LAC
becomes saucer shaped. The reason is that fixed factors of production
become variable in the long run and the ratio of variable costs increases while
Business Economics (Study Text)
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that of fixed cost decreases and fixed cost per unit of output decreases and it
becomes flatter.
The size of the firm increases due to increase in the fixed cost of the firm and
the firm takes advantage of large scale and average costs curve remains at
minimum level for a longer period.
In the short period if output increases after a certain limit, the average variable
cost starts increasing but in the long. run the size of the firm can also be
increased therefore, average variable costs do not increase at a faster rate as
in case of short period.
The factor combination in the long period becomes optimum, trained and
efficient labor becomes available, capital at lower interest rate may be
available and therefore, average costs diminish at a slower rate.
3.2 Causes of Rising Long Run Average Cost Curve:
1.
When size of the firm increases it may not be managed well and
average cost starts increasing (i.e., diseconomies of large scale).
2.
The selling cost (and the transportation cost) increases as the
market extends and average cost starts increasing (diseconomies
of scale).
3.3 Relationship Between SAC Curve and LAC Curve
1.
The short run average cost curve is U-shaped while the long run
average cost curve is saucer-shaped.
2.
The long run average cost curve never intersects the short run
average cost curves but it becomes tangent to them.
3.
The long run average cost curve keeps the short run average cost
curves within itself that is why it is also called Envelope curve.
4.
If the technology changes in the long run the shape of LAC
becomes L-shaped as shown in diagram below:
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Average Cost
Y
LAC
3.4
X
Output
O
Summary of Long-Run Cost Curves

A short-run average cost curve (SAC) shows the unit cost associated
with a given size of plant.

A long-run average cost curve (LAC) shows the minimum unit cost of
producing each level of output, allowing the size of plant to vary.

A LAC curve is founded by drawing a line tangential to each SAC curve.

Each SAC curve shows the unit cost from plants of different size.

The size of plant associated with SAC2 is the smallest needed to
minimize unit cost  i.e., minimum efficient plant size (MEPS).

The slope of the LAC curve is determined by internal EOS.

The position of the LAC curve is determined by external EOS.
SAC4
SAC1
A
SAC2
SAC3
B
C
Economies of
scale
Q1
Constant-scale
economies
LAC
D
Diseconomies
of scale
Q2
Figure 4 Long-run average curve
The concept of returns to scale compares the percentage change in
labor and capital (%  L&K) with the resulting percentage change in
output (%Q).
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3.5
Minimum efficient scale (MES)
The minimum efficient scale (MES) is the level of output on the LAC curve at
which average costs first reach their minimum point. Costs have fallen to their
lowest point, after which costs will be constant or may even eventually start
rising or MES is at which economies of scale start reaping the level of output
differs from industry to industry.
Definition
The MES is the level of output on the LAC curve at which average costs first
reach their minimum point, and it represents a natural barrier to entry in some
industries.
The MES is important because it represents one of the natural barriers to
entry in certain industries.
•
If the MES is high relative to the size of the total market demand, this
will tend to limit the number of firms that can enter and exist in that
market. For example, if the total market demand is five million units and
the MES is one million, then such a market cannot support more than
about five producers.
•
If the MES is high in absolute terms this may indicate a high level of
capital investment. The high cost may deter new entrants.
4.
Impact of long run costs on industry Structure
Long run is the time period when the industry is in a position to change the
fixed factors of production for example plant and machinery, land and building
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etc. and in the very long run (Secular time period) the industry is in a position
to control over the market.
In the long run industry enjoys economies of scale that is unit costs decreases
with the increase in output. The economies of scale are of two types internal
economies and external economies. (detailed discussion on economies is
included in chapter of production)
Long run costs have a great impact on
1.Output decisions
In the long run, businesses need to consider the costs associated with
producing different levels of output. Long-run costs include both fixed and
variable costs, and understanding these costs helps businesses make
decisions about how much to produce to maximize profits.
2.Expansion of industry
Long-run costs play a crucial role in determining whether a company can
afford to expand its operations or enter new markets. High long-run costs may
make expansion financially unfeasible, while low long-run costs can facilitate
growth and expansion.
3.Technological changes
Long-run costs influence decisions about adopting new technologies.
Investing in technological upgrades can sometimes reduce long-run costs by
improving efficiency, but the initial investment costs must be weighed against
the long-term benefits.
4.Sales decisions
Long-run costs affect pricing decisions and sales strategies. Businesses need
to consider their cost structure when setting prices to ensure profitability in the
long run.
5.Marketing decisions
Marketing efforts incur costs that affect the overall cost structure of a business.
Long-run cost considerations influence decisions about marketing
budgets, advertising strategies, and brand positioning.
6.Decisions regarding transportation
Transportation costs are a significant factor for many businesses, especially
those involved in manufacturing and distribution. Long-run costs impact
decisions about transportation methods, routes, and logistics strategies.
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7.Material costs
Material costs are a major component of long-run costs for many industries.
Fluctuations in material prices can significantly impact a company's cost
structure and profitability over time.
8.Costs of energy resources
Energy costs contribute to long-run costs for most businesses, especially
those in energy-intensive industries. Changes in energy prices and availability
can have a significant impact on overall operating expenses.
9.Impact of indirect taxes
Indirect taxes, such as sales taxes or value-added taxes, affect the cost of
production and can influence industry expansion. High indirect taxes increase
production costs, which may limit growth opportunities for businesses.
10.Changes in factor rewards
Long-run changes in factor rewards, such as wages, rents, and interest rates,
affect the cost of production for businesses. These changes can influence
supply decisions and overall industrial output.
11.Effect of high inflation rates
Inflation impacts the cost of production by increasing input costs over time.
High inflation rates can erode profit margins and make it challenging for
businesses to expand or remain competitive.
12.Impact of specialized personnel and advertising costs
Hiring specialized personnel and investing in advertising are important for
many businesses but can also add to long-run costs. These costs need to be
carefully managed to ensure they contribute to overall profitability and
industrial development.
5.
Concepts of Iso-quant and Iso-cost
5.1 Iso-quant curve (Iso-product curve)
‘An iso-quant curve is the locus of different available or possible combinations
of capital (K) and labor (L) which can produce the same quantity of output’.
“An iso-quant curve shows the various combinations of two factors of
production which gives the same level of output to the producer”
Business Economics (Study Text)
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We can explain the concept of iso-quant curve with the help of following
schedule.
Pairs
Labor
Capital
Output
‘L’
‘K’
1st
1
18
100
2nd
2
13
100
3rd
3
9
100
4th
4
6
100
5th
5
4
100
6th
6
3
100
This schedule shows that different combinations of labor and capital are
available to the entrepreneur who can produce 100 units of output by using
any one combination out of these available combinations because these can
produce the same quantity of output.
In this diagram we can see that IQ is iso-quant curve. If the entrepreneur is at
point ‘a’ on this curve, he uses one unit of labor and nine units of capital and if
he is at point ‘C’, he uses three units of labor and four units of capital. Al the
points at IQ show the same level of output so that entrepreneur is indifferent
about these points. Iso-Quant is also known as Production Indifference Curve.
Business Economics (Study Text)
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5.2 Iso-cost curve (Firm’s Budget line)
“Iso-Cost Line shows the various combinations or a pairs of two factors of
production where firm’s income is equal to firm’s expenditure on these factors
of production while prices of factors of production and firm’s income (total
outlay) are given.”
“Budget Line is the locus of combinations or pairs of two factors of production
that can be purchased if the firm’s entire money income is spent.”
PL . QL + PK .QK = M
M= Total resources possessed by the Firm.
This condition shows that total expenditures on two factors of production must
be equal to the resources possessed by the producer i.e., all the resources of
the producer must be spent.
This definition of Firm’s Budget Line has three points which are as follows:
Budget Line is the locus of points.
Each point shows a combination of two factors of production L and K.
The producer has to spend all of his resources if he wants to purchase any of
these combinations.
Suppose that price of labor ‘PL’ and the price of capital ‘PK’ is rupee one per
unit and the total outlay of the firm is rupees ten T.O. = Rs.10.
PL. QL + PK .QK = M
1(10) + 1(0) = 10
10 + 0 = 10
10 = 10
Qx = 10
Qy = 0
Business Economics (Study Text)
PL. QL + PK .QK = M
1(0) + 1(10) = 10
0 + 10 = 10
10 = 10
Qx = 0
Qy = 10
242
The firm can buy 10 units of L or 10 units of K by spending all resources. But
if the firm wants to buy both the factors of production, it can buy them in
different combinations.
In this diagram we see that if the firm spends all of its total outlay on capital, it
can purchase 10 units of capital. If the firm spends all of its total outlay on
labor, it can buy 10 units of labor. By joining these two points by a straight line,
we get the iso-cost line of the firm.
Summary
•
Of particular importance for understanding the behavior of firms in different
types of market, is the concept of the profit-maximizing output. This always
occurs at that level of output where marginal revenue equals marginal cost.
Self-test questions
The short run and long run
1.
What is the difference between the short run and the long run?
2.
Distinguish between a fixed cost and a variable cost. (2.1, 2.2)
3.
What happens to average fixed cost as output rises? (2.1)
4.
State the law of diminishing returns. (2.3)
5.
At what point of average cost is marginal cost equal to average cost?
Practice questions
Question 1
The minimum price needed for a firm to remain in production in the short run
is equal to:
A
average fixed cost
B
average variable cost
C
average total cost
D
marginal cost
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Question 2
Marginal cost is best defined as:
A
the difference between total fixed costs and total variable costs
B
costs that are too small to influence prices
C
the change in total costs when output rises by one unit
D
fixed costs per unit of output
Question 3
Which one of the following would be a variable cost to a firm?
A
Mortgage payments on the factory
B
The cost of raw materials
C
Depreciation of machines owing to age
D
Interest on debentures
Question 4
According to the traditional theory of the firm, the equilibrium position for all
firms will be where:
A
profits are maximized
B
output is maximized
C
revenue is maximized
D
costs are minimized
Question 5
The ‘law of diminishing returns’ can apply to a business only when:
A
all factors of production can be varied
B
at least one factor of production is fixed
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C
all factors of production are fixed
D
capital used in production is fixed
Question 6
Economies of scale:
A
can be gained only by monopoly firms
B
are possible only if there is a sufficient demand for the product
C
do not necessarily reduce unit costs of production
D
depend on the efficiency of management
Question 7
Decreasing returns to scale can only occur:
A
in the short run
B
in the long run
C
if there is one fixed factor of production
D
if companies have monopoly power
Question 8
The long-run average cost curve for a business will eventually rise because of:
A
the law of diminishing returns
B
increasing competition in the industry
C
limits to the size of the market for the good
D
diseconomies of scale
Question 9
The benefits to a company when it locates close to other companies in the
same industry include all of the following except which one?
A
The benefits of bulk buying
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B
The provision of specialist commercial services
C
The development of dedicated transport and marketing facilities
D
The supply of labor with relevant skills
Question 10
Which one of the following is not a source of economies of scale?
A
The introduction of specialist capital equipment
B
Bulk buying
C
The employment of specialist managers
D
Cost savings resulting from new production techniques
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Contents
1. Methods of Business Integration
2. Measures of Market Competition and Concentration
3. Effects of Monopoly and Collusive Practices
4. Competition Policy
5. Nature of Externalities
6. Government Measures to deal with Externalities
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1. Methods of business integration
Companies want to get bigger so they can make their owners happier and save
money by getting bigger. When companies can save a lot of money by getting bigger,
it's a good idea for them to grow. There are two main ways companies can grow: by
doing it themselves (called organic growth) or by joining with other companies (called
mergers and acquisitions). Growing can mean different things, like joining with other
companies that do similar things (horizontal integration), joining with companies that
do different things (conglomerate diversification), or taking control of suppliers or
customers (vertical integration).
Key term
Business integration
Business integration means when two or more separate businesses come together
to create one big business.
1.1 Directions of business growth
Companies want to make more money, so they try to sell more things to increase
their sales. The different ways they can grow are shown in Figure 1, which is called
the Ansoff Growth Matrix after Professor Igor Ansoff who created it.
Products
Markets
Current
New
Current
New
Market
Penetration
Product
Development
Market
Development
Diversification
Figure 1. Ansoff Growth Matrix
The figure shows four different ways a company can grow.
(a) Market penetration means selling more of the products the company already
has. This involves taking customers away from other companies.
(b) Product development is when a company offers more types of products to its
current customers by adding new items.
(c) Market development is finding new types of customers or new places to sell the
products.
(d) Diversification is when a company starts doing something completely different.
This might mean making its own supplies or selling to itself, like a movie studio
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starting its own TV channel. It can also mean entering a totally new industry, like an
airplane maker also making cars, or a music instrument company making
motorcycles.
1.2 Forms of growth
The chance to save money by expanding should motivate companies to grow. There
are two main ways to do this:
(a) Organic growth: This means gradually increasing the company's own resources,
such as by developing new products, buying more equipment, hiring more workers,
and opening new stores. Organic growth is usually a slow but steady process.
(b) Growth through mergers and acquisitions: This involves combining two or
more companies into one. An acquisition is often when one business takes over
another without the other company's full approval. A merger is when two companies
agree to join together and form a new company.
1.3 Mergers and acquisitions
Acquisition
This happens when one company buys shares from another company's
shareholders to take control of that business and its assets.
Merger
This occurs when the shareholders of two or more companies agree to exchange
their shares for shares in a new company that combines the activities of the original
companies.
Types of Mergers and Acquisitions
The nature of a merger or acquisition can be classified based on whether the
companies involved are in the same line of business, very similar businesses,
related businesses but at different stages of production and selling, or completely
unrelated businesses.
Horizontal Integration
When two companies in the same business merge, it's called horizontal integration.
This can create monopolies. For example, if The Chocolate Co with a 15% market
share merges with Splendid Choc Co which has a 20% market share, the new
company could hold a 35% market share.
Vertical Integration
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When two companies at different stages of the production and selling process merge,
it's called vertical integration. For example, an oil refining company might take over
an oil shipping company (backward vertical integration) or a company with a fleet of
petrol tankers and petrol stations (forward vertical integration).
Conglomerate Diversification
When a company merges with or takes over another company in a completely
different business, it is called diversification. A group of such diversified companies is
known as a conglomerate.
2. Measures of market competition and concentration
2.1 Market concentration
Market concentration refers to how much control a few large companies have over a
market. It can be measured by looking at the biggest companies (concentration ratio)
or by using tools like the Herfindahl index and the Gini coefficient, which consider
all companies. The Gini coefficient works alongside the Lorenz curve to show
concentration visually.
Very large suppliers can influence market prices because they reduce the number of
substitutes available, making demand less sensitive to price changes. When demand
is less responsive to price changes, these companies can raise prices to boost their
revenue.
2.2 Measuring Market Concentration
2.2.1 Market Concentration Ratio
A simple way to measure concentration is to look at the share of output or
employment held by the largest producers. This is known as the concentration ratio.
For a single market, concentration ratios can be calculated for the top three, four, or
five producers.
The concentration ratio (CR) measures the market dominance of the largest
companies. We calculate this by adding up the market share of the largest Ncompanies.
In general, this ratio tells us the market concentration on big companies. Although
the ratio is useful to help us determine the market structure, it does not become an
absolute measure of market power
The ratio will be equal to 0%, indicating perfect competition and 100% for
monopolies. A low ratio of around 0% to 40% suggests the market ranges from
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perfect competition to oligopoly. Furthermore, a ratio of more than 40% to less than
100% leads to oligopoly.
An increase in the ratio over time indicates that the market is increasingly
concentrated. Large companies increasingly dominate the industry.
The ratio commonly used is the concentration ratio of four companies (CR4). The
ratio is the sum of the market share (S) of the four largest companies in an industry.
In addition to CR4, the CR8 ratio is also commonly used to measure market
concentration in the eight largest companies.
In general, we calculate the concentration ratio using the following formula:
CRn = S1 + S2 + …+ Sn
Where, S is the nth largest company market share. While for, CR4 and CR8, we
calculate it using the formula:
CR4 = S1 + S2 + S3 + S4
CR8 = S1 + S2 + S3 + S4 +S5 + S6 + S7 + S8
Where S is market share by n-largest company = Company Sales / Total industry sales) x100
Example
A numerical example illustrates the calculation of a market concentration ratio,
specifically the four-firm concentration ratio (CR4).
Let's say we have a market with seven firms, each with the following market shares:
Firm 1: 33%
Firm 2: 12%
Firm 3: 8%
Firm 4: 22%
Firm 5: 15%
Firm 6: 7%
Firm 7: 3%
From this data, for CR4, we need to add up the market share of the four largest
companies, which is equivalent to 33% + 22% + 15% + 12% = 82% The figure
shows that four companies control a substantial market share. Therefore, we
suspect the market operates on oligopoly.
How to measure Market share
Market share measures the market dominance of a company. We usually measure it
by dividing the company’s sales to total market sales in a certain period, expressed
as a percentage. Sales figures can be in terms of quantity or money (revenue). In
addition to sales, we may use total output or total assets, depending on the needs
and relevance of our analysis. Mathematically, the market share formula is:
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Market share = (Company sales / Total market sales) x 100%
2.2.2 The Herfindahl index
The Herfindahl index measures how concentrated an industry is by looking at the
market shares of all firms, not just the big ones. To calculate it, you square each
firm's market share percentage, which makes the bigger firms stand out more. Then,
you add up these squared numbers to get the index. A higher index means the
market is less competitive and more dominated by a few firms.
Example: Herfindahl index
Let's compare two industries, each with 40 small companies, each having 1% of the
market's total sales. In Market A, there are also four slightly larger companies, each
holding 2% of the market, and one very large company that controls the remaining
52% of sales. In Market B, there are six large companies, each with 12% of the
market.
It's clear that Market A is likely to be much less competitive than Market B. However,
both markets have the same five-firm concentration ratio because in both markets,
the top five firms account for 60% of total sales.
The Herfindahl indices for the two markets are calculated as follows:
Index A = 522 +4(22) +40(12)=2704+16+40=2,760
Index B = 6(122)+40(12)=864+40=904
The difference in size between the two indices shows how concentrated the two
markets are better than the market concentration ratio. Market A has a higher index,
meaning it's probably less competitive because one company controls 52% of the
market.
A Herfindahl index of zero means the market is very competitive, with many equally
sized companies. An index of 10,000 means there is a total monopoly, where one
company controls all the sales.
2.2.3 The Lorenz curve and Gini coefficient
The Lorenz curve and Gini coefficient may also be used to show market
concentration.
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Lorenz curve
A Lorenz curve of market concentration is drawn with the horizontal axis showing the
cumulative percentage of all firms in the industry, starting from the smallest. The
vertical axis shows the cumulative percentage of total industry sales or revenue that
these firms generate.
Figure 2: Lorenz curve
If you have a graph where the line goes up at a 45-degree angle from the starting
point, it represents a perfectly fair market. This means that as more companies join
the market, the total market share increases at the same rate. In graphs called
Lorenz curves, the line usually gets steeper as it moves towards 100%. This
happens because smaller companies have less than the average share of the
market. As the percentage of total market share increases, bigger companies start to
count too. When the line reaches a point where it's at a 45-degree angle, it means
the average company size is reached. After that, the line gets steeper because
bigger companies, which have more than the average share, are included.
Gini coefficient
The construction of the Lorenz curve is such that the greater the area between the
curve and the forty-five degree line, the greater is the concentration in the market.
The Gini coefficient measures the deviation of the Lorenz curve from the forty-five
degree line. It is the ratio of the area between the curve and the forty-five degree line
to the whole area below the forty-five degree line. In Figure this is the ratio of area A
to (area A + area B).
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The Gini coefficient of a perfectly competitive industry would thus be zero: that is to
say, the Lorenz curve would not deviate from the forty-five degree line, as explained
above. Th Gini coefficient of a pure monopoly would be unity area B would disappear
completely, since the Lorenz curve would run along the horizontal axis until the
100% market share point was reached and then would rise vertical Thus, any Gini
coefficient will be between zero and one the higher it is, the greater the degree of
market concentration.
2.3 Problems with measures of market concentration
Defining the market
One big issue with measuring market concentration is how we define the market
itself. Companies often focus on specific things they're good at. So, if we define the
market too broadly, it might seem like there's not much concentration. But actually,
there could be a lot of power held by certain companies in specific parts of the
market.
For instance, let's think about the market for screwdrivers. At first glance, it might
seem pretty competitive, with a bunch of medium-sized companies selling them. But
if we look closer, we might find that one of these companies specializes in making
really long screwdrivers and basically controls that part of the market all by itself.
New entrants
When a new company starts doing business in a market, it usually helps lessen how
much one company controls things. But this doesn't necessarily change the
concentration ratio unless the new company quickly grabs a big part of the market.
And even if it does, it might not change the Lorenz curve or the Gini coefficient,
which show how unequal the market is.
3 Effects of monopolies and collusive practices
Monopolies happen when there is only one supplier, or just a few, for a product.
These suppliers can take advantage of the lack of competition by raising prices.
Collusive practices occur when several firms in the same industry agree to set prices
and control production together. This cooperation, known as a cartel, allows them to
increase their profits by keeping prices high.
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3.1 Conditions for effective monopoly
For a market to be a monopoly, three things must happen:
(a) There is only one supplier.
(b) The product has no close substitutes.
(c) There are barriers to stop other companies from entering the market.
These conditions allow the company to control the market.
For example, Coca Cola might claim it is the only supplier of its specific drink, and
Ford might say the same for its cars. However, this doesn't create a monopoly
because there are other drinks and cars available.
Monopolies use their power to increase profits, which attracts other companies to
enter the market. To maintain high prices over time, the monopoly must prevent this
competition. More details on this will be discussed later.
3.2 Impact of monopoly on price
Monopolies can make prices higher in a market by keeping the supply lower than it
would be if there were many competing companies providing the same product.
Monopolists are called price-makers because they control the whole market's
demand. They can decide the price based on how much they choose to supply.
Figure 3 shows what happens when one company controls the whole market.
Figure 3: Impact of monopoly on market price
To understand Figure 3 easily, think of an industry that started with many
companies competing against each other. Over time, one company bought all
the other companies, turning the industry into a monopoly.
When there were many companies, the industry supply curve was Sc. The
market price was Pc, and the amount of goods bought and sold was Qe.
The total profits for all the competing companies together formed a triangle
labeled ABPC. This is because the supply curve represents the lowest price
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at which the companies would produce the product, where their total revenue
equals their total cost. So, any price higher than the supply curve means the
companies would make a profit.
A monopoly controls the market supply, represented by the supply curve SM,
and sets the market price at PM. The monopoly might have reached this price
in two ways:
1. The monopoly limited production to QM, creating a shortage that made the
price rise to PM.
2. The monopoly set the price at PM and then limited production to QM to
prevent having too much product left over.
In both cases, the price goes up to PM and the amount people buy goes down
to QM. The monopoly's profits are shown by the area AMN PM.
This suggests that monopolies might not be as good for society as
competitive markets.
3.3 Arguments against monopolies
1. Higher Prices and Lower Output: Monopolies produce less and charge more
than if there were more competition. This means the monopoly owners benefit while
society as a whole suffers.
2. Inefficient Resource Use: Monopolies don't use their resources as efficiently as
they could. They limit production and don't focus on cutting costs because they can
rely on higher prices for profit.
3. Lack of Cost Control and Innovation: Without competition, monopolies might
not bother controlling costs or innovating. They can afford to be lazy because they
don't have to worry about rivals.
4. Suppressing Competition: Monopolies can stifle competition by buying out
smaller competitors or creating barriers that prevent other companies from entering
the market.
5. Diseconomies of Scale: Large monopoly firms might face problems that make
them less efficient as they grow bigger.
3.4 Arguments in favour of monopolies
1. Economies of Scale
Larger firms can benefit from economies of scale, which reduce unit costs.
Monopolies argue that they use resources more efficiently and offer lower prices to
consumers due to these cost savings.
2. Investment in Innovation
Monopolies can afford to invest more in research and development. They can better
exploit technological advances and secure patents to protect their innovations.
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3. Market Order
Monopolies can promote common technical standards, especially in software and
technology industries, providing stability and order to the market.
4. Risk Cushion
High profits and assured sales provide monopolies with the cushion needed to take
on risky innovations and new business ventures.
5. Global Competition
Large firms need to be big to compete with large global players in their industry.
Access to Capital
Monopolies can more easily raise new capital on the markets, financing new
technologies and products. This ability can contribute to a country’s economic growth.
3.5 Barriers to entry
Monopolies can protect their profits for a long time by creating barriers that make it
hard for new companies to enter the market. These barriers can be classified into
several groups:
1. Product Differentiation: A monopolist can convince consumers that their
product is the best, making it hard for new companies to compete. New
companies would have to create a better product or spend a lot of money on
advertising and research to convince customers.
2. Exclusive Control: A monopolist might have exclusive access to cheaper raw
materials or special knowledge, giving them a cost advantage over new
companies.
3. Economies of Scale: When large production volumes lower the cost per unit,
a monopolist benefits more because they can produce at a lower cost than new
entrants, who need a large market share to achieve similar benefits.
4. High Fixed Costs: The large initial investment required to enter the market
can be a significant barrier for new companies.
5. Legal Barriers: Laws can protect monopolies. For example, some industries
might be nationalized, or a company might hold patents that prevent others from
making similar products.
6. Cartel Agreements: Companies might agree to work together and not
compete, effectively creating a monopoly by fixing prices or dividing the market
among themselves.
7. Geographical Barriers: In remote areas, high transportation costs can
prevent new companies from entering the market. However, the growth of online
shopping has reduced these barriers.
3.6 Collusive practices
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In industries with few companies, firms sometimes deliberately work together to
set prices or control the market, acting like a monopoly. Each firm can make
more profit if they all agree to control prices and production together, sharing the
market output. This cooperation is called collusion.
In most countries, collusion is illegal because it usually results in higher prices
and lower production compared to a free market. However, it is more common
globally due to the lack of international laws to prosecute these actions.
A price cartel or price ring forms when a group of firms in an oligopoly agree on a
selling price. Even if the market would buy more at a lower price, the cartel tries
to keep prices high for more profit by limiting the supply.
Figure 4 shows that in a competitive market, with supply curve S1 and demand
curve D1, the price would be P₁ and the output would be Q₁. A cartel might agree
to set the price at P2, higher than P₁. To achieve this, they must also agree to
reduce the supply from Q₁ to Q₂, shifting the supply curve to S₂.
Figure 4: Price cartel
3.7 Establishing a cartel
Effective cartels are those that can control the industry's supply, agree on prices, and
share sales among their members. To establish a cartel, three things are needed:
(a) The cartel must control the market supply.
(b) The members must agree on a price and how much each should produce.
(c) There must be barriers to prevent new competitors from entering the
industry.
In Figure 4, if the market price is set at P2, firms would want to supply output Z in a
free market. This can't be allowed because it would lower the price P2.
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The main problem with cartels is that each firm aims for the best results for itself.
This creates an incentive for firms to secretly increase their output and sell at the
fixed price. If all firms do this, the cartel will fail because the high price can't be
maintained without restricted output, leading to excess supply and a drop in price.
This has often happened with the oil-producing countries of OPEC. They have tried
to limit output to raise prices, but some countries exceed their quotas or sell below
the agreed price, causing the agreements to fail.
The success of a price cartel depends on several factors:
(a) Whether it includes most or all producers of the product.
(b) Whether there are close substitutes for the product. For example, if taxi drivers
form a cartel, people might switch to buses or trains.
(c) The ease of regulating supply. For primary commodities like wheat or coffee,
supply depends on weather and political events.
(d) The price elasticity of demand for the product. Cartels work best for goods with
inelastic demand. Raising prices by cutting output of an elastic good might lead to a
large drop in demand and little rise in price, reducing total income.
(e) Whether producers can agree on their shares of the total restricted supply. This is
often the hardest part.
4.Competition Policy
Competition policy is a set of laws designed to prevent companies from abusing their
monopoly power in the market. In the USA, this is also called antitrust law because,
in the past, companies hid their control through anonymous trusts, making it hard to
see who was in charge.
4.1 Overview of the main provisions of competition policy
Competition policy involves enforcing laws against unfair business practices.
Governments or their regulators can ask courts to fine companies that break these
laws, force them to split up, or make them share their trade secrets to encourage
competition. The policy also stops mergers and acquisitions that would greatly
reduce competition.
In some places, company directors and officers can be fined or jailed if they take part
in anti-competitive practices.
Competition policy assumes that large companies with market power can harm
customers and the economy.
Since laws differ between countries like the USA, Japan, the UK, and regions like the
European Union, approaches to competition policy vary. The International
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Competition Network, started in 2001, helps coordinate these laws across 107 major
competition agencies.
The main goals of competition policy are to stop restrictive trade practices, prevent
abuse of market power, and regulate mergers and acquisitions.
Competition policy has three main goals:
1. Stop unfair trade practices: This means stopping agreements or actions that
limit competition between businesses or keep new companies out of the market. One
example is cartels, where companies work together to control prices. Another
example is when companies try to control who wins contracts unfairly, like in
construction or public services.
2. Prevent big companies from abusing their power: This includes things like
selling products at very low prices to force other companies out of business, or
charging too much for products that other businesses need by refusing to work with
them. For instance, if a big car parts supplier charges independent service stations
too much, that's unfair.
3. Watch over mergers and buyouts: This means using the law to stop mergers
that would reduce competition, or making sure that when companies join together,
they sell off some parts of their businesses so competition can still happen.
4.2 Approaches to competition policy
Different ways of handling competition rules fall into two main groups: rule-based
and discretionary.
A) Rule-based approaches to competition policy
These ideas start with the belief that if one company has a big share of the market,
especially more than 25%, it will act in ways that are unfair to competition. The
company is seen as doing something wrong unless it can prove it's not.
This way of thinking was common in the USA after the Sherman and Clayton Acts
were passed in the late 1800s and early 1900s. It led to breaking up big companies
like Standard Oil and AT&T, and trying to break up others like Steel companies.
Issues with this Approach
1. Narrow Focus
It only looks at how the company affects consumers, ignoring how it might harm
suppliers, workers, or local communities. It also doesn't consider how a big company
might benefit the country as a whole.
2. Market Definition Problems
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It's hard to decide what counts as a market. Many companies sell more than one
type of product and operate in many areas. A big company might seem dominant
nationally but not be as big in each local area.
3. Competitive Disadvantage
Companies operating under strict rules might not be able to grow as much or do as
much research as those in more flexible systems. This argument, made by the
Chicago School in the USA, led the government to change its approach in the late
1980s.
4. Burden on Firms
Companies have to spend a lot of money proving they're not doing anything wrong.
This encourages regulators to unfairly target them for political reasons or to look like
they're doing something important.
B)Discretionary approach
This approach agrees that big companies can sometimes harm competition, but it
looks at each situation to see how it affects things instead of just focusing on how big
the company is.
There are different signs that can show if a big company is using its power in a bad
way:
1. Prices: If a big company charges lower prices because it can save money, it
might be allowed to keep doing that.
2. Profits: If a company makes a lot more money compared to others in the industry,
it could be seen as using its power unfairly.
3. Service Quality: This looks at whether the company is cutting corners on service
to save money.
4. Reliability: Sometimes bigger companies are better at providing what people
need compared to smaller ones.
5. Impacts on Others: A big company might be hurting smaller suppliers or causing
problems in the community, like pollution, because there's no other work available.
6. Public Benefits: This considers how much good the company does overall, like
supporting research or helping the community.
These signs are like gateways that a company needs to pass through. If it meets
these criteria, it might be allowed to merge with another company or avoid getting
fines or orders. In Europe, this approach is more common.
But there are some problems with this approach:
1. Random: Companies might not know when they'll be looked into because just
seeming to not do well in one of the signs above could start an investigation. Large
supermarkets in the UK have faced several investigations in the last decade.
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2. Politics: Even if investigations are supposed to be fair, politics and what the
government wants can affect them. Some decisions, like ones about who owns
media companies or government contracts, have been criticized for this reason.
5.
Nature of Externalities
5.1 Social costs and private costs
Following are the equations of Social Cost, Private Cost and External Cost.
Social Cost = Private Cost (Internal Cost) + External Cost
Private Cost (Internal Cost) = Social Cost - External Cost
External Cost = Social Cost - Private Cost (Internal Cost)
In a free market, individuals and businesses decide what to produce and buy based
on their own interests. This means that the costs and benefits they consider are their
own, not necessarily what's best for society overall.
Private costs and benefits, which focus on individual gains, can differ from the
broader social costs and benefits that affect society as a whole.
(a) Private cost measures what it costs a firm to produce a good.
(b) Social cost measures the overall cost to society of a firm's resource use.
(c) Private benefit measures the direct benefit to a supplier or consumer.
(d) Social benefit measures the total benefit to society from a transaction.
When private benefits or costs don't align with social ones, decisions based solely on
private considerations may not be best for society as a whole.
Here are some examples of situations where private cost and social cost differ:
(a) When a firm produces a good and pollution is released into the air during
production, the private cost to the firm includes the resources needed to make the
good. However, the social cost includes not only the private cost but also additional
costs borne by other members of society who are affected by the pollution.
(b) The private cost of transporting goods by road is the cost incurred by the haulage
firm for providing the transport. However, the social cost of road haulage includes not
only the private cost but also the cost of repairing and maintaining the road system,
which suffers damage from heavy goods vehicles, as well as any environmental
costs such as harm to wildlife habitats from road construction or pollution emitted by
the transport vehicles.
5.2 Private benefit and social benefit
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Following are the equations of Social Benefit, Private Benefit and External benefits.
Social Benefit = Private Benefit (Internal Benefit) + External Benefit
Private Benefit (Internal Benefit) = Social Benefit - External Benefit
External Benefit = Social Benefit - Private Benefit (Internal Benefit)
Here are some examples where the benefit to individuals and the benefit to society
are different:
(a) Imagine customers at an outdoor cafe enjoying live music played by hired
musicians. The customers pay for this service through their purchases and directly
benefit from it. But people passing by who aren't customers might also enjoy the
music without paying. They're essentially getting a free ride, benefiting without
contributing. So, while the cafe's customers get a private benefit, the social benefit of
the musicians' service is even greater because it extends beyond just the paying
customers.
(b) Consider a big company investing in training its employees to become
accountants. The company expects some of these trained employees to leave for
better opportunities once they're qualified. The private benefit for the company
comes from the trained employees who stay on. But the social benefit includes not
only the improved productivity of those employees who stay but also the overall
economic boost from those who take their skills to other companies.
5.3 Externalities
Externalities are also known as spillover effects, third party effects and
neighbourhood effects. Externalities means external effects. External effects are
external benefits and external costs.
Externalities = External benefits + External costs
Externalities happen when actions in a market create effects on others and society
that go beyond what the original parties involved consider. They're like ripples from
a transaction that touch everyone, not just those directly involved. In simpler terms,
externalities are the differences between what something costs or benefits someone
privately and what it costs or benefits society as a whole. They occur because the
market only reacts to individual signals, not to how those actions impact everyone.
Using demand and supply analysis, we can see these effects. For instance, if a
transaction has negative consequences for society (like pollution), the total cost to
society will be higher than what the parties involved initially consider, which means
the supply curve reflecting those overall costs will sit above the standard market
supply curve.
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Figure 5 presents two scenarios:
(a) In a free market scenario, the quantity of the product produced is determined by
the interplay between demand (represented by curve D) and supply (represented by
curve S). In this case, the output would be Y, with a price of PY.
(b) If social costs are factored in and the market functions efficiently, the supply
curve should shift to the left. Consequently, the quantity of the product produced
should decrease to X, with a corresponding price of PX.
Figure 5 Externalities
In a free market, the output of a good may exceed its ideal level (by Y-X in
Figure 5), resulting in over-allocation of resources to its production.
Externalities can manifest in four ways:
(a) Positive externality in consumption
Positive externality in consumption occurs when the benefits of consumption
extend beyond the original purchaser. For instance, when a newspaper is
bought, read, and then left in a public place for others to read.
(b) Positive externality in production
Positive externality in production arises when the production process
generates benefits to individuals beyond those directly involved in the buying
and selling. For example, farmers cultivating crops also create an appealing
landscape for people to enjoy.
(c) Negative externality in consumption
Negative externality in consumption happens when the consumption of a
product by one individual reduces the well-being of others. For instance, the
noise generated by a person riding a loud motorcycle through a quiet village.
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(d) Negative externality in production
Negative externality in production occurs when the social costs of production
surpass the private costs. For example, pollution emitted from a factory
chimney falling on a nearby town.
Key point
Which of the following statements are true or false?
A
The cost of packaging for cigarettes is a negative externality.
TRUE / FALSE
B
The benefits to society from education are a positive externality.
TRUE / FALSE
C
The fine incurred for polluting a watercourse is a negative externality.
TRUE / FALSE
D
Damage to pine forests from pollution is a negative externality.
TRUE / FALSE
6.4 Public goods
Public goods are goods or services that are non-excludable and non-rivalrous in
nature. This means that once provided, individuals cannot be effectively excluded
from using the good, and the consumption of the good by one individual does not
reduce its availability for others. Examples of public goods include national
defense, street lighting, public parks police services, and roads.
5.4.1 Conditions for public goods
Conditions for public goods are exemplified by the classic example of a
lighthouse. The beam from a lighthouse meets two key conditions for a public
good:
(a) Non-diminishable (or non-rivalrous): The consumption of the good or
service by one individual or group does not significantly reduce its availability for
others.
(b) Non-exclusive: It is impossible to exclude anyone from benefiting once the
good has been provided. For example, if one shipping firm builds a lighthouse, all
shipping companies benefit from its use.
Public goods are characterized by public consumption rather than public
production. The essential conditions for public goods are non-diminishability (or
non-rivalry) and non-exclusivity. It's important to note that public goods are not
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necessarily provided by the public sector nor are they necessarily free for
everyone.
5.4.2 The free-rider problem
Since the good is non-exclusive, individuals can derive benefits from it without
having to pay. Consequently, without mechanisms in place to ensure payment or
exclude non-paying users, there would be little economic incentive for businesses
to produce such goods, as they would not generate revenue.
This challenge has been addressed through various means:
(a) Mandatory payment: Examples include licensing fees for road usage and
television access, or compulsory contributions through taxation for defense and
police services.
(b) Exclusion of non-payers: Techniques like smart card systems for decoding
satellite TV signals or paywalls on websites restrict access to paying users only.
(c) Public provision: Governments may directly offer services and recover costs
through taxation imposed on the population.
6 Government Measures to deal with externalities
The analysis of demand and supply can be employed to assess how
implementing an indirect tax or subsidy influences a market, affecting the
consumption or production of goods with externalities.
6.1 Indirect taxes
Indirect taxes are applied to the expenditure on goods or services rather than
directly to incomes, as is the case with direct taxation. A specific type of indirect
tax, known as selective indirect tax, is imposed on certain goods, often at varying
rates compared to others.
The implementation of indirect taxation can be utilized to enhance resource
allocation, particularly in scenarios where there are negative externalities.
When an indirect tax is imposed on a product, it causes the supply curve to shift
upwards (leftwards) by an amount equivalent to the tax added to the price of
each item. This adjustment occurs because although consumers pay a price that
includes the tax, suppliers receive revenue only based on the price net of tax. For
instance, referring to Figure 6:
- The original supply curve, without any tax, is represented by S0.
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- After factoring in the tax cost, the supply curve becomes S1.
- The tax amount is determined by the difference between P₁ and P₂, or the
distance between points A and B.
- Prior to the tax implementation, the equilibrium quantity supplied and demanded
was X0. However, following the tax imposition, the equilibrium quantity decreases
to X₁.
- At this equilibrium point (where demand equals X₁), consumers pay price P₁,
while suppliers receive only price P₂.
- The difference between P₁ and P₂ signifies the tax amount payable.
Figure 6: Effect of an indirect tax
In the absence of the tax, the output would be X0 with a price of P0. The total
expenditure (prior to the tax imposition) can be illustrated by the rectangle
OP0TX0.
(a) Upon the imposition of the tax, output declines to X1 and the price, including
the tax, increases to P₁. Total expenditure becomes OP1AX1, where P2P1AB
represents the tax revenue and OP2BX1 represents the total revenue for
producers.
(b) A new price equilibrium emerges at point A.
(i) The price for the customer rises from P0 to P1.
(ii) Producers' average revenue decreases from P0 to P2.
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(iii) The tax burden is divided between producers and consumers, with CB borne
by suppliers and AC borne by consumers. Consumers contribute P0P1AC to the
total tax revenue, while producers contribute P₂P0CB.
As a result, less of this product is being produced, and the government gains tax
revenue to mitigate adverse effects.
6.2 Elasticity effects
The incidence of a tax or subsidy pertains to its recipient or payer, determined by
the price elasticities of demand and supply. The extent to which the consumer
shoulders the tax burden, as opposed to the supplier, hinges on the elasticities of
demand and supply in the market.
Figures 7(a) and 7(b) depict the extremes of perfectly elastic demand and
perfectly inelastic demand, respectively.
Figure 7: Elasticity of demand
Attempt to deduce (either through general principles or by examining Figure 7) who
carries the weight of taxation in these extreme scenarios.
In Figure 7(a), featuring perfectly elastic demand, any price increase leads to
demand plummeting to zero. Consequently, the entire tax burden falls upon the
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supplier. Despite the tax imposition, the market price remains constant, yet the
quantity supplied dwindles from Q1 to Q2. The supplier's earnings amount to only P₂
after offsetting the tax expense of P1 - P₂.
Conversely, in the scenario of perfectly inelastic demand (as shown in Figure 7(b)),
the supplier can transfer the entire tax burden to consumers by elevating the price
from P₁ to P₂. The demand remains unaffected by the price hike. Because the
supplier can increase prices to cover the tax liability, the quantity supplied remains
unaltered.
Moreover, the elasticity of supply holds significance. Figure 8 demonstrates that with
a given demand curve, the less elastic the supply curve, the more substantial the
share of tax borne by the supplier.
Figure 8: The effect of elasticity illustrated
It's crucial to examine the interplay between demand elasticity and supply elasticity
when determining the distribution of tax burden between producers and consumers.
In scenarios where demand is less elastic than supply, as depicted in Figure 9(a),
consumers will shoulder a larger portion of the tax burden. Conversely, if demand is
more elastic than supply, illustrated in Figure 9(b), producers will bear the majority of
the tax burden.
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Figure 9: Tax burden illustrated
6.3 Subsidies
A subsidy is a financial assistance or support provided by a government or
organization to encourage or promote the production, consumption, or use of a
particular product, service, or activity. Subsidies are typically aimed at reducing
costs for producers or consumers, stimulating economic activity, achieving social
objectives, or addressing market failures. They can take various forms, such as
direct cash payments, tax breaks, reduced prices for goods or services, or other
forms of financial aid.
A subsidy is like an indirect taxation in reverse.
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Figure 10: Subsidy
In Figure 10, the supply curve S0 represents the supply in the absence of any
subsidy. The introduction of the subsidy causes the supply curve to shift downwards
(outwards) to S1.
Without the subsidy, the equilibrium price in the free market would be P0, and the
output would be Q0. With the introduction of a subsidy equivalent to AB per unit,
suppliers become willing to produce Q0 at a reduced price (P1 instead of P0). This
results in the outward shift of the supply curve from S0 to S1. Consequently, the
equilibrium quantity produced shifts to Q2, which can be sold in the market at price
P2. Therefore, the subsidy brings about two effects:
- An increase in the equilibrium quantity supplied (from Q0 to Q2).
- A decrease in price (from P0 to P2), although this price decrease is smaller than
the value of the subsidy itself (P0 - P1).
The decrease in price, from P0 to P2, will be offset by the subsidy value itself (P0 P1), resulting in a smaller net reduction in price.
Referring to Figure 10, let's assess how the subsidy's benefits are distributed
between consumers and suppliers, and who bears its cost:
The benefit of the subsidy is distributed between consumers and suppliers:
(a) Consumers gain from the reduction in prices from P0 to P₂.
(b) Suppliers also benefit, as although they receive a lower price, P₂, they receive
the subsidy of AB per unit.
The cost of the subsidy is borne by the government, effectively the taxpayer.
Summary
The chapter explores various methods by which businesses integrate, including
mergers, acquisitions, joint ventures, and strategic alliances. These integration
strategies aim to achieve synergies, economies of scale, and enhanced market
power.
It delves into metrics used to assess market competition and concentration, such as
the Herfindahl-Hirschman Index (HHI), concentration ratios, and market share
analysis. These measures help policymakers and analysts understand the degree of
competition within industries.
The chapter discusses the detrimental effects of monopoly power and collusive
practices on market efficiency, consumer welfare, and innovation. Monopolies can
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lead to higher prices, reduced output, and stifled competition, while collusion among
firms undermines market competitiveness.
It examines the role of competition policy in promoting market competition,
preventing
anticompetitive
Competition
authorities
behavior,
enforce
and
antitrust
safeguarding
laws
and
consumer
regulations
to
interests.
prevent
monopolistic practices, cartels, and unfair competition.
Externalities are discussed as spillover effects of economic activities that impact third
parties, either positively or negatively, without compensation. Examples include
pollution, congestion, and noise, which impose costs on society beyond those borne
by producers and consumers involved in transactions.
The chapter outlines various government interventions to address externalities,
including taxes, subsidies, regulations, and market-based mechanisms like cap-andtrade systems. These measures aim to internalize external costs or benefits, align
private incentives with social welfare, and promote more efficient resource allocation.
Self-test questions
Methods of Business Integration
1.
What are the main methods of business integration?
2.
How do mergers differ from acquisitions?
Measures of Market Competition and Concentration
3. What metrics are commonly used to measure market concentration?
4. How does the Herfindahl-Hirschman Index (HHI) assess market
competition?
Effects of Monopoly and Collusive Practices
5. What are the negative effects of monopoly power on consumer welfare?
6. How do collusive practices among firms affect market competitiveness?
Competition Policy
7. What is the purpose of competition policy?
8. How do competition authorities enforce antitrust laws?
Nature of Externalities
9. What are externalities?
10. Provide examples of positive and negative externalities.
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Government Measures to Deal with Externalities:
11. What are some government interventions to address negative
externalities?
12. How do taxes, subsidies, and regulations help internalize external costs?
Practice questions
Question 1
Which of the following is NOT a method of business integration?
A) Merger
B) Acquisition
C) Outsourcing
D) Joint Venture
Solution: C) Outsourcing
Question 2
Which metric is commonly used to measure market concentration?
A) Consumer Price Index (CPI)
B) Gross Domestic Product (GDP)
C) Herfindahl-Hirschman Index (HHI)
D) Average Revenue per Unit (ARPU)
Solution: C) Herfindahl-Hirschman Index (HHI)
Question 3
What are the negative effects of monopoly power on consumer welfare?
A) Increased competition
B) Lower prices
C) Reduced choice and innovation
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D) Market diversification
Solution: C) Reduced choice and innovation
Question 4
What is the main purpose of competition policy?
A) To protect monopolies
B) To promote fair competition
C) To limit consumer choices
D) To encourage collusive practices
Solution: B) To promote fair competition
Question 5
Which of the following is an example of a negative externality?
A) A scholarship program
B) A public park
C) Air pollution from a factory
D) Scientific research funding
Solution: C) Air pollution from a factory
Question 6
How does the government typically address negative externalities?
A) By imposing tariffs
B) By providing subsidies
C) By reducing taxes
D) By increasing regulations
Solution: D) By increasing regulations
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Contents
1
National Income: Definition and Concepts
2 Approaches to measuring Gross Domestic Product
3 Nominal GDP, Real GDP and GDP Deflator
4 Circular Flow of Income
5 Stages in the Trade Cycle
6 Investment Multiplier
7 The acceleration Principle
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1.National income: Definition and Concepts
National Income is an uncertain term which is used interchangeably with National
dividend, National output and national expenditure. Simon Kuznets (Nobel Prize in
Economics in 1971) introduced the national accounting system. National income is a
term which is used interchangeably with national output (product) and national
expenditure. We can understand his with an example. We go to a shop to buy a
product for a price of Rs.50 now this Rs.50 will have three different names, i.e.

Income of the shopkeeper
= Rs.50

Expenditure of the consumer = Rs.50

Money value of product
= Rs.50
On this basis, different economists have defined national income in different ways:
Dr. Alfred Marshall
Dr. Marshall has defined national income according to Product Method.
“National income (N.I) is the total sum of money value (market value) of all final
goods and services, produced in an economy in specific time period of one
year”
Goods mean all kinds of material things, which are being produced in any sector, i.e.
agriculture, industry, trade, minerals, forests, transport and communication etc.
Services mean economic activities of doctors, engineers, teachers, judges etc. So,
value of all goods and services is national income.
P. A. Samuelson
Samuelson has also defined national income according to Product Method.
“N.I is money value of annual flow of goods & services in an economy”
Ackley
Ackley has defined national income according to Income method
“Individuals income is the amount of his earnings from the productive services
currently provided by him or by his property. So, national income is the sum of
all individuals’ incomes”
Ackley has divided Individuals income into two groups:

Reward for the productive services of individuals and by individuals’
property.
Generally in a society an individual performs his productive services as a laboure or
as an entrepreneur and gets his reward in the form of wage and profit respectively.
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Those who are unable to get their income by their productive services, earn their
income through services by their property (land and capital) in the form of rent and
interest. Thus, an individual can have his income in any one of the four forms, i.e.
wage, profit, rent, interest.
Brooman
Brooman has defined national income according to Expenditure Method.
“National expenditure becomes the total expenditure of consumer spending,
public authorities spending and capital formation at home and overseas, i.e.
the sum of final expenditure by the residents of the country”
Brooman’s definition of national income shows the aggregate expenditure by the
people on consumer goods and capital goods and also similar expenditure by the
government at home or abroad in one year become part of the total expenditure and
hence national income.
Irving Fisher
Irving Fisher has defined national income according to Expenditure method
“The quantity of goods and services which is consumed in one year is called
national income”
We have noted that all the definitions are explaining the same thing i.e. national
income. The reason for this is that national income is represented by the of money
value of all final goods and services, produced in an economy. Since these goods
and services are produced by the four factors of production through out the year so
money value of all these goods and services, is distributed among the four factors of
production as rewards. And the four factors of production spend their reward to
purchase these goods and services. Therefore, national income is a term which can
be used interchangeably with national output (product) and national expenditure.
Concepts of national income
Following are the basic concepts of National Income:
1. Gross Domestic Product (GDP)
GDP measures the total output in the domestic economy. GDP consists of all
output produced within the boundaries of country. GDP counts income according
to where it is earned rather than who owns the factors of production.
In equation from:
GDP = C + Ig + G + (X - M)
GDP = GNP - NFI
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Where:
C = Consumption expenditure
Ig = Gross investment (Net investment + Depreciation Allowances)
G = Government Expenditure
X = Gross exports of goods and services
M = Gross Imports of goods and services
X- M = Export surplus or Net Exports or cumulative exports (NX)
2. Gross National Product (GNP)
GNP includes all output produced by the country’s economic resources
regardless of their location i.e. whether the resources are located inside or
outside the country.
Gross National Product (GNP) is the market value of all final goods and services
produced by the "nationals" of a country during a specific period.
In equation from:
GNP = C + Ig + G + (X - M) + Net Factor Income from Abroad
Where:
C = Consumption expenditure
Ig = Gross investment
G = Government Expenditure
X = Gross exports of goods and services
M = Gross Imports of goods and services
X- M = Export surplus or Net exports or cumulative exports (NX)
Net factor Income from Abroad = Income received by residents from abroad for
factor services – Payments made to the non-residents who contribute to the
domestic economy.
So, NFI is the difference between the income foreign investors earn from their assets
in Pakistan and what Pakistani investors earn from their (foreign) assets abroad.
GNP = GDP + NFI
GNP = GDP + Factor payments from abroad - Factor payments to abroad

If NFI = 0 , GNP = GDP

If NFI = +ive , GNP > GDP
 If NFI = -ive , GNP < GDP
GDP and GNP are same if when all resources owned by the residents of that country
are producing output in that country. GNP is greater than GDP when the residents of
that country employ their resources to produce output outside that country.
GNP reflects citizenship whereas GDP reflects residency. So, the production of a
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Mexican company located in the US will be part of the GDP of the United States, and
it will also be part of the GNP of Mexico.
3. Net Domestic Product (NDP)
GDP is gross output and it ignores depreciation of capital goods in the production
process. If depreciation is deducted from GDP, we get the Net Domestic Product
(NDP).
In equation from:
NDP = C + Ig + G + (X - M) – Depreciation Allowance
NDP = C + In + G+ (X - M)
Where:
C = Consumption expenditure
In = Net investment (Gross investment - Depreciation Allowances)
G = Government Expenditure
4. Net National Product (NNP)
GNP is gross output and it ignores depreciation of capital goods in the production
process. If depreciation is deducted from GNP, we get the Net National Product
(NNP).
In equation from:
NNP = GNP - Depreciation Allowances
NNP = C + Ig + G + (X - M) + NFI – Depreciation
Allowance
NNP = C + In + G + (X - M) + NFI
Where:
C = Consumption expenditure
In = Net investment (Gross investment - Depreciation Allowances)
G = Government Expenditure
X = Gross exports of goods and services
M = Gross Imports of goods and services
X- M = Export surplus or Net exports or cumulative exports (NX)
Capital Consumption Allowances
Capital Consumption Allowances (CCAs) are the total costs of the wear and tear or
depreciation of the capital stock i.e. machinery, tools, plants, roads, power grids,
buildings, bus fleet, trains, railways etc within an economy usually within a given year.
Another name for the CCAs is the depreciation of capital stock or its depreciation
costs.
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5. National Income (NI)
National income is the income received by households in the form of wages,
rents, profits, and interest, irrespective of whether they are earned domestically
or abroad.
It is the market value of all final goods and services produced in an economy in
one year after deducting depreciation allowances and indirect taxes and adding
subsidy in GNP. Note that the national income includes net income earned from
abroad
In equation from:
NI = C + In + G + (X – M) + NFI – Indirect taxes + Subsidy
NI = NNP – Indirect taxes + Subsidy
NI = R + W + I + π
Subsidies
Subsidies are government expenses that are generally extended to business firms,
farmers among other groups to defray their production costs or to reduce prices for
consumers. Subsidies are also called negative taxes because they impose
expenses on government budgets instead of contributing revenues.
Indirect Taxes
Indirect Taxes are government revenues that result from taxes that are not received
directly from the earned incomes of households, businesses etc. Thus sales taxes,
highway tolls, excise taxes etc are forms of indirect taxes as opposed to direct taxes
that are take out from earned incomes.
6. Personal Income (PI)
Personal income is national income net of deductions for corporate and social
security taxes. Personal income includes any income transfers from the people and
government such as gifts, food stamps etc.
In equation from:
PI = NI +Transfer payments - undistributed corporate profit (un-dividends) –
corporate income taxes – social security contributions (Reserve fund)
Transfer payments
Transfer payments are the income received by an individual with out performing any
economic activity such as, zakat, gifts, pension, scholarships etc.
Dividends
Dividends are the amount of profit, which is distributed among share holders in joint
stock companies.
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Un-dividends
Un-dividends are the amount of profit, which is not distributed among share holders
in joint stock companies.
Corporate Income tax
It is a tax on income or profit of corporation.
7. Disposable Personal Income (DPI)
DPI is the amount of income individuals receive and have available for spending.
All income paid to the factors of production is not received by individuals and
available for consumer spending. It is the amount which is left with the individuals
after paying the direct taxes to the govt. Thus the remaining amount (DPI) can be
spent or save.
In equation from:
DPI =PI – Direct taxes (Personal taxes)
DPI = Consumption + Saving
8. ACTUAL GDP
Actual GDP is the monetary value of all final goods and services which are really
being produced in an economy by existing employed resources.
9. Potential GDP
Potential GDP is the monetary value of all final goods and services that can be
produced in an economy at full employment of labor force.
10. GDP gap
The difference between potential and actual GDP is called the GDP Gap.
GDP Gap = Potential GDP – Actual GDP
GDP Gap can be positive, negative or zero.

If Potential GDP = Actual GDP then GDP Gap = Zero

If Potential GDP > Actual GDP then GDP Gap = Positive

If Potential GDP < Actual GDP then GDP Gap = Negative
11. PER-CAPITA INCOME
Per-capita income means average income per person. It is calculated by following
formula:
Per-Capita Income = National income / Population
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2. Approaches / Methods of Measuring Gross Domestic Product
GDP measures the total output in the domestic economy. GDP consists of all output
produced within the boundaries of country. GDP counts income according to where
it is earned rather than who owns the factors of production.
In equation from:
GDP = GNP - NFI
There are three aggregate measures of the economy’s output. These measures are
as follows:
1. Output Approach
2. Income Approach
3. Expenditure Approach
1) Output Approach
This approach is also called Product method or GDP at current or market prices.
According to this method, economy is divided into different sectors, as agriculture,
mining, manufacturing, commerce, transport and other services. The money value of
all final goods and services produced of a country in one year is added up to find
GDP. Therefore, the money value of primary and intermediate goods and services is
not to be added to find GDP.
Now we make a hypothetical table to explain the measurement of GDP through
product approach.
GDP: OUTPUT APPROACH
Goods
Services
and Total product
(Q)
Current Prices
(P)
Total Value
(billions
of
dollars)
Wheat
100 metric ton
$ thousand per metric ton
---
Rice
500 metric ton
$ thousand per metric ton
---
Cotton
100 bales
$ thousand per bale
---
Radio
2000 units
$ hundred per unit
---
Computer
1000 units
$ hundred per unit
---
Coal
40 metric ton
$ thousand per metric ton
---
Cement
100 metric ton
$ thousand per metric ton
---
Doctors
10 persons
$ thousand annual earnings
---
Teachers
25 persons
$ thousand annual earnings
---
GDP
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Advantage
Product method is useful to know the relative importance of various sectors of
economy by showing their respective contribution to the national income.
Precautions
Measurement of GDP through this method requires some safety measures which are
as follows:
1- Avoid Double Counting
While calculating the GDP of a country, we must avoid the mistake of double
counting i.e., we must not add the value of any good or service more than once.
There are two ways to avoid double counting.
The first method is that we should count the value of only the final goods and
services leaving aside the money value of primary and intermediate goods that
are used to produce the final goods, i.e. if we are to calculate the money value of
a shirt, we must leave aside the money value of cotton as it has already been
counted in the value of shirt.
Valuing Output Of Industries
The Second method is the VALUE ADDED method that is the calculation of the
value of goods and services at each and every stage or process. Value added of
any producer is the value of its output minus the value of inputs it purchases from
other producers. We can explain this with the help of following example:
Example
Sales Value
Value added
A tree is cut form the forest and sold $50
to a mill as timber for $50.
$50
The mill cuts the timber into lumber 80
and sells it to a furniture company
for $80.
30
The furniture company makes a 150
chair out the lumber and sells it to a
retailer for $150.
70
The retailer (furniture store) sells $200
the chair to a consumer for
$200.
50
$200
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Note that the sum of the added values is same as the price of the final product. The
last value added in the production process the chair in this simple example is $50
worth of retailing service provided by the retailer.
2- Avoid Counting Free Services
The value of such services should not be counted which are offered without any
reward or as a hobby e.g., services of housewives, self-gardening or self-shaving
etc.
3- Deprecation Allowances
Depreciation allowances should be deducted from the total value of GNP.
4- Indirect Taxes
Indirect taxes (sales tax, excise duty etc) should be subtracted from the market
value of goods and services.
5- Subsidy
Subsidy should be added in the market value of goods and services.
2) Income Approach
The method explains the concept of GDP as “the sum total of the incomes of all
persons of a country during one year” The income method shows the
distributional aspect of GDP.
This method measures the GDP after it has been distributed and appears as income
earned or received by individuals of the country. According to this method GDP is
obtained by adding up the incomes of all the individuals in the country. Individuals
earn income by contributing their own services and the services of their property. So
the GDP is calculated by adding up the rent of land, wages and salaries of
employees, interest on capital, profits of entrepreneurs, and income of self-employed
people. Let's see how the income approach works.
We can divide incomes into four categories:

Compensation of employees

Net interest

Rental income

Profit (Corporate profits and Proprietors' income)
compensation of employees
Compensation of employees is the payment for labor services. It includes net wages
and salaries (called "take-home pay") that workers receive plus taxes withheld on
earnings plus fringe benefits such as social security and pension fund contributions.
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Net interest
Net interest is the interest households receive on loans they make minus the
interest households pay on their own borrowing.
Rental income
Rental income is the payment for the use of land and other rented inputs. It includes
payments for rented housing and imputed rent for owner-occupied housing. (Imputed
rent is an estimate of what homeowners would pay to rent the housing they own
and use themselves. By including this item in the national income accounts, we
measure the total value of housing services, whether they are owned or rented.)
Profit
Profits can be classified into proprietors' income and corporate profits.
o proprietors' income
Proprietors' income is a mixture of the previous items. Proprietors' incomes are their
reported net profits. It is difficult to split the income earned by the owner-operator
of a business into compensation for labor, payment for the use of capital, and
profit.
o corporate profits
Corporate profits are the profits of corporations. Some of these profits are paid to
households in the form of dividends, and some are retained by corporations as
undistributed profits. They are all income. So, corporate profits are corporations' net
earnings after business expenses. Corporate profits are divided into three parts:
 Corporate income taxes
 Distributed dividends
 Retained(undistributed)profits
GDP: INCOME APPROACH
Item
Compensation of
Employees
Net interest
Rental Income
Corporate Profits
Amount
(billions of dollars)
4449
405
127
650
Proprietors' income
Indirect taxes Less subsidies
Capital Consumption (depreciation)
518
569
858
Gross Domestic Product (GDP)
7576
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The above table shows these five incomes and their relative magnitudes.
Compensation of employees is the largest income category.
The sum of these five categories of incomes is called net domestic income at
factor cost. The term factor cost is used because factor of production is another
name for a productive resource. But net domestic income at factor cost is not GDP.
We must make two further adjustments to get to GDP, one from factor cost to market
prices and another from net product to gross product.
Factor Cost to Market Prices
When we add up all the final expenditures on goods and services, we arrive at a
total called domestic product at market prices. These expenditures are valued at the
market prices that people pay for the various goods and services. Another way of
valuing goods and services is at factor cost. Factor cost is the value of a good or
service measured by adding together the costs of all the resources used to produce
it. If the only economic transaction were between households and firms—if there
were no government taxes or subsidies the market price and factor cost values
would be the same. But the presence of indirect taxes and subsidies makes these
two methods of valuation differ.
An indirect tax is a tax paid by consumers when they buy goods and services. (In
contrast, a direct tax is a tax on income.) State sales taxes and taxes on alcohol,
gasoline, and tobacco products are indirect taxes. Because of indirect taxes,
consumers pay more for some goods and services than producers receive. Market
price exceeds factor cost. For example, if the sales tax is 7 percent, when you buy a
$1 chocolate bar you pay $1.07. The factor cost of the chocolate bar including
profit is $1. The market price is $ 1.07.
A subsidy is a payment by the government to a producer. Payments made to grain
growers and dairy farmers are subsidies. Because of subsidies, consumers pay less
for some goods and services than producers receive. Factor cost exceeds market
price.
To get from factor cost to market price, we add indirect taxes and subtract subsidies.
Making this adjustment brings us one step closer to GDP; we must make one
further adjustment.
Net Domestic Product To Gross Domestic Product
What do the words gross and net mean? Gross means before subtracting
depreciation (the decrease in the value of the capital stock that result from wear and
tear and obsolescence). Net means after subtracting depreciation.
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Gross investment is a component of aggregate expenditure. So total expenditure
includes depreciation and is a gross measure. The net profit of businesses (profit
after subtracting depreciation) is a component of aggregate incomes. So total
income excludes depreciation and is a net measure.
To get gross domestic product from the income approach, we must add depreciation
to aggregate income.
Advantage
The advantage of this method of measurement is that it indicates the distribution of
GDP among different income groups. Therefore, this method is called GDP by
Distributive Shares.
Precautions
Measurement of GDP through this method requires following safety measures:
1- Transfer Payments
Transfer Payments such as gifts, Zakat, charity, pocket money, and scholarships
should not be included because these are already counted as part of the rewards.
Transfer Payments, no doubt, are source of personal incomes for some people
but they do not make any addition to GDP in true sense. These are payments
received without performing any economic activity.
2- Illegal Incomes
Illegal Incomes such as smuggling, theft, bribery, hoardings should not be
added.
3) Expenditure Approach
GDP can also be computed by adding the total expenditure done by the people and
government during a year. Every rupee spent on a good or service is income to
somebody, that is, to every rupee of income there is a rupee of expenditure.
Income can be spent either on consumer goods or capital goods. Therefore, we can
get GDP by summing up all consumption expenditure and investment expenditure
made by all individuals and government during a year.
The expenditure approach measures GDP by using data on consumption
expenditure, investment, government purchases, and net exports. Following
table shows this approach.
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GDP: EXPENDITURE APPROACH
Symbol
Item
Amount
(billions of dollars)
Personal
Consumption C
Expenditure
Gross
Private
Domestic I
Investment
5152
Government Purchases
Goods & Services
Net Exports of Goods
Services
Gross Domestic Product
(GDP)
of G
1407
& X-M or (NX)
-99
Y
1116
7576
The first column gives the terms. The next column gives the symbol GDP using the
expenditure approach is the sum of personal consumption expenditures (C), gross
private domestic investment. (I), government purchases of goods and services (G)
and net exports of goods and services (NX).
a) Personal Consumption Expenditure (C)
Personal consumption expenditures are the expenditures by households on goods
and services produced in the Pakistan and in the rest of the world. They include
goods such as CDs and books and services such as banking and legal advice.
They do not include the purchase of new homes, which is counted as part of
investment.
b) Gross Private Domestic Investment Expenditure (I)
Gross private domestic investment is expenditure on capital equipments and
buildings by firms and expenditure on new homes by households. It also includes
the change in business inventories.
c) Government Purchases of Goods And Services (G)
Government purchases of goods and services are the purchases of goods and
services by all levels of government. This item includes expenditures on national
defense and garbage collection. But it does not include transfer payments. These
payments such as medical aid and social security benefits, are not purchases of
goods and services. They are transfers of funds from government to households.
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d) net exports of goods and services (X-M)
Net exports of goods and services are the value of exports minus the value of
imports. This item includes cotton (a Pakistan export) that Pakistan sells to Japan,
and Mazda that Pakistan buys from Japan (a Pakistan import).
Precautions
Measurement of GDP through this method requires safety measure which is as
follows:
Expenditures not in GDP
Aggregate expenditure, which equals GDP, does not include all the things that
people and businesses buy. To distinguish total expenditure on GDP from other
items of spending, we call the expenditure included in GDP final expenditure. Final
expenditure is the amount of spending on the ultimate purchases of output. So,
spending on the ultimate purchases of output should be added only. Spending on
intermediate goods and services, used goods and financial assets is not part of
final expenditure and not the part of GDP. Now we discuss them in detail:

Intermediate goods and services

Used goods
 Financial assets
Intermediate Goods And Services
Intermediate goods and services are the goods and services that firms buy from
each other and use as inputs in the goods and services that they eventually sell to
final users. When Dell Corporation buys computer chips from Intel Corporation, it
buys an intermediate good. A Dell computer is a final good, but an Intel chip is an
intermediate good. To count the expenditure on intermediate goods and services
as well as the expenditure on the final good involves counting the same thing twice—
called double counting.
A good can sometimes be an intermediate good and sometimes a final good. For
example, the ice cream that you buy on a hot summer day is a final good, but the ice
cream that a diner buys and uses to make sundaes (a special ice cream with fruits,
nuts, syrup etc.) is an intermediate good. Whether a good is intermediate or final
depends on what it is used for, not on what it is.
Used Goods
Expenditure on used goods is not part of GDP because these goods were counted
as part of GDP in the period in which they were produced and in which they were
new goods. For example, a 2000 automobile was a part of GDP in 2000. If the car
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is traded on the used car market in 2008, the amount paid for the car is not part of
GDP in 2008.
Financial Assets
Firms often sell financial assets such as bonds and stocks to finance purchases of
newly produced capital goods. The expenditure on newly produced capital goods is
part of GDP, but the expenditure on financial capital securities is not. GDP includes
the amount spent on new capital, not the amount spent on pieces of paper.
3. Nominal GDP, Real GDP and GDP Deflator
There are two types of GDP: nominal and real. Nominal GDP is measured in
current dollars, i.e., goods are valued at current prices. Consider a single good for
simplicity.
Nominal GDP = Price x Quantity of the good produced.
If nominal GDP increases from $100 in 1997 to $110 in 1998, this increase may either
be coming from price level increase or quantity increase or both. If quantity has not
increased and only the price level has increased, output has not increased in real
terms; the increase is only nominal, in dollar terms. Real GDP is a measure of the
real level of output, adjusted for effects of inflation. Real GDP is the GDP measured
in constant dollars, in prices of the base year.
Nominal GDP
Nominal GDP measures the value of goods and services during a given period at the
prices of that period e.g., in 1990, Nominal GDP measures the value of goods and
services produced in 1990 at the market prices that prevail in1990.
Nominal GDP changes from year to year for two reasons:

Physical output of goods changes
 Market price changes
Nominal GDP is also called GDP at current prices.
Real GDP
Real GDP is a measure that attempts to isolate changes in physical output in the
economy between different time periods by valuing all goods produced in the two
periods at the same prices. Real GDP is also called GDP at constant prices3.
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We can elaborate the concept of Nominal GDP and real GDP with the help of following
schedule. Consider a simple closed economy that produces only for categories of
products: A, B, C, D.
Nominal GDP 1990
Products P1990
A
$10
2
5
B
C
D
4
Nominal GDP 1995
Q1990 P1990
Q1990
5
$ 50
x P1995 Q1995 P1995
Q1995
$12 6
$72
$250
$407
50
4
20
100
20
80
3
6
5
60
5
25
Real GDP 1995
(at
1990
prices)
x P1990 x Q1995
180
30
125
$ 60
120
25
100
$305
The value of the 1990 GDP in current (1990) prices is $250: Nominal GDP
The value of the 1995 GDP in current (1995) prices is $407: Nominal GDP
The value of the 1995 GDP in 1990 prices is $305: adjusted or Real GDP
The difference between these two values reflects the price inflation between the two
years.
GDP Deflator
The GDP deflator measures the average level of prices of all the goods and services that
are included in GDP:
GDP deflator is a price index that reveals the cost of purchasing the items included in the
GDP during the specified period, relative to the cost of purchasing those same items
during a base year.
To calculate the GDP deflator or inflation rate between the two years we divide the
nominal GDP by the real GDP and multiplying it by 100.
GDP price index (or GDP deflator) = Nominal GDP / Real GDP x 100
In this formula, nominal GDP is GDP valued in the current year's prices. It is the dollar
value of GDP. Real GDP is GDP in a base year (currently 1990) scaled up by the real
GDP since the base year.
The GDP price index (or GDP deflator) allows us to adjust the nominal GDP for inflation
and determine the (real) GDP in terms of the (constant) prices of a certain reference (base)
year.
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We have estimated nominal GDP and Real GDP of 1995 in the previous topic. Now we
plug in the values in the formula of the GDP deflator. Nominal GDP in 1995 is $407 and
Real GDP in 1995 is $305, so the GDP deflator is:
Nominal GDP
407
GDP price index (or GDP deflator) = ---------------- x 100 = ------ x 100 =133.44
Real GDP
305
A GDP deflator of 133.44 tells us that the price level m the current year is 33.44 percent
higher than the price level in the base year. In the base year, nominal GDP equals real
GDP and the GDP deflator is 100.
4. Circular Flow of National Income
The circular flow of income and expenditure refers to the process, whereby the national
income and expenditure of an economy flow in circular manner continuously through times.
The various components of national income and expenditure such as saving investment,
private consumption expenditure, etc. are shown in diagrams in the form of currents and
cross currents in such a manner that national income equals national expenditure.
The circular flow of income and expenditure in such an economy is shown in figure,
where the product market is shown in the upper portion and the factor market in the
lower portion. In the product market, the household sector purchases goods and
services from the business sector while in the factor market the household sector
receives income from the former for providing services. Thus the household sector
purchases all goods and services provided by the business sector and makes
payments to the latter in lieu of these.
The business sector, in turn, makes payments to the households for the services
rendered by the latter to the business, wage payments for labor services, profits for
organisation, rent to land owners and interest for capital supplied, etc.
Thus payments go around in a circular manner from the business sector to the
household sector, and from the household sector to the business sector, as shown by
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arrows in the outer portion of the figure. There are also flows of goods and services in
the opposite direction to the money payments flows. Goods flow from the business
sector to the household sector in the factor market, as shown in the inner portion of the
figure.
(Expenditures)
Payment for Goods and Services
Supply of Goods Services
(Output/Product)
Business/
Firm
Injections to the
flow of N.I funds
(i) Investments  I
(ii) Government spending's  G
(iii) Exports  X
House Holds/
Consumers
Services of FOP
Withdrawls
(i) Saving  S
(ii) Taxes  T
(iii) Imports  M
Rewards Paid to FOP
(Incomes)
Figure
4.1 Withdrawals and Injections into the Circular Flow of National Income
In a national economy there are three withdrawals from and three injections
into the circular flow of national income. Withdrawals from the national income
flows are savings (A), Taxes (T) and Imports (M) and Injections into the
circular flow of national income are Investment expenditures by firms (I),
Government expenditures (G) and Exports (X).
Leakages and injections
Leakages from the circular flow
It is now necessary to modify some of the earlier simplified assumptions.
People do not spend all they earn within the same short time period; there is
trade between different countries, and the government has a considerable
effect on the total flow of activity.
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Savings
For the purposes of national income analysis the part of income that is not
consumed within the same short time period is defined as savings.
Imports
Part of the money paid for the consumption of goods and services goes to
producers outside the country. Payments for imported goods and services
represent a further leak from the circular flow.
Taxation
A distinction must be made between gross and net income. A substantial
share of total income passes to the government in the form of taxation. Some
of the tax is deducted directly from gross income paid by firms as income tax
(and really in much the same way by national insurance contributions). Some
is paid to the government instead of firms through indirect taxation when
buying goods and services (e.g. value added tax). Whatever the form of tax, it
has the effect of causing a leakage of income out of the circular flow of activity.
Injections into the circular flow
Each of the three leaks, however, has a corresponding injection − although
there is no guarantee that each always has the same value as its ‘partner’.
Investment
Much of what is saved is placed with various kinds of financial institution;
banks, building societies, insurance companies, pension funds and trusts.
These institutions in turn provide funds for investment by firms in new capital
and stocks. This may be in the form of loan finance, or investment by
insurance companies, pension funds and trusts in the capital of firms.
Therefore, much of what is saved finds its way back into the circular flow via
the investing activities of the financial institutions.
Exports
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Some income is spent on imports but, at the same time, some production is
sold to foreign buyers and increases the flow of income within the domestic
economy In addition to this there will be inflows and outflows of money as a
result of international investment activity.
Government spending
Clearly, not all incomes earned by households or revenues earned by firms
come from one another. Some result from the spending activities of central
and local government. This may be spending on things like housing,
education, health or roads, grants or subsidies to firms, and payment of
various types of benefit, such as pensions or unemployment benefit.
Figure: Circular flow of income in an open economy
National income equilibrium is reached not only by the equality of aggregate
demand and aggregate supply but also the planned withdrawals from the flows
of national income must also be equal to planned injections into the circular
flow of national income i.e. withdrawals = Injections or S + T + M = I + G + X.
(a)
Any difference in the balance of payments deficit or surplus is
equal to the long values of import payments (M) and export
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receipts (X) of goods and services long. In the short run this
difference is filled by borrowings or lending from or to abroad.
(b)
The difference between public expenditure and public revenue
can be filled by public sector borrowing requirements (PSBR)
and public sector debt repayments (PSDR).
(c)
Although people who save and invest are different even then in
the long run savings are made equal to investment through
capital market.
Lord Keynes explained the difference between planned withdrawals and
planned injections in terms of trade cycles.
5. Numerical Illustration of Different Concepts Of National Income
Example
Given the following data of a firm in an economy during a certain period
of time. Calculate GDP according to
(a)
Income approach
(b)
Expenditure approach
(c)
Value added approach
Rupees
(i)
Raw material imports
400,000
(ii)
Wages and salaries paid
900,000
(iii)
Output sold
(iv)
Profits
700,000
(v)
Pays its post-tax profits to Shareholders as dividend
400,000
(vi)
Taxes on labor are 200,000 and on the company
300,000
(vii)
Domestic consumer's expenditure
2,000,000
1,100,000
(1,100,000 = 700,000 wages + 400,000 (profits) dividends)
(viii)
Govt expenditures
(500,000 = 200,000 tax on labor + 300,000 tax
(ix)
on company)
500,000
Export
400,000
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SOLUTION
(a)
The expenditure approach.
(i)
Consumer expenditures
Rs. 11,00,000
(ii)
Govt expenditures
Rs.
Total expenditure
Rs. 16,00,000
Exports
Rs.
(iii)
5,00,000
4,00,000
20,00,000
(iv)
Imports
(–) 4,00,000
GDP Expenditure approach
(b)
16,00,000
Income Approach
Income received by the labor force (Pretax)
=
Rs. 900,000
Gross profits of the firms (Pretax)
=
Rs. 700,000
GDP Income approach
(c)
Rs. 16,00,000
Value added approach/output approach.
Total output produced & sold
=
Imports of raw material
Rs. 2,000,000
Rs. (–) 4,00,000
GDP Value added approach
Rs. 16,00,000
EXERCISE
The following data relates to the economy of a country over one year period.
Rs. in million
Consumers expenditures
20,000
Federal government expenditures
4,500
Capital formation
5,100
Physical decrease in stocks
(100)
Exports receipts
7000
Imports payments
6500
Taxes on expenditures
6000
Subsidy
500
Net property income from abroad
500
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Depreciation (Capital consumption Expenditures) 2,000
Required
(i)
GDP at market prices
(ii)
GDP at factor cost
(iii)
GNP at market prices
(iv)
GNP at factor cost
(v)
National income at factor cost
(vi)
NNP at Market price
SOLUTION
Rs. million
Consumption expenditure
20,000
Federal Govt. Consumption expenditures
4,500
Capital formation
5,100
Value of physical decrease on stocks
(100)
______
Total domestic expenditures
29,500
Exports
7,000
Imports
(6500)
I
30,000
GDP at market prices
Net property income from abroad
II
GNP at market prices
30,500
GDP at market prices
30,000
Taxes on expenditure
(6000)
Subsidy
III
500
GDP at factor cost
Net property income from abroad
500
24,500
500
______
IV
GNP at factor cost
25,000
_____
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Depreciation (Capital Consumption)
(2000)
V
National Income at factor cost
23,000
VI
GNP Pat market price
30,500
( - ) Capital consumption
(2,000)
NNP at market prices
28,000
Note NO. 1
GDP at market prices = Consumption expenditures + Federal Govt.
expenditures + Capital formation – physical decrees in stocks +
Exports–Imports
NOTE NO. 2
GNP at market prices = GDP at market prices (+) Net property income
earned from abroad.
NOTE NO. 3
GDP at factor cost = GDP at market prices – Taxes on expenditures
+ subsidies
NOTE NO. 4
GNP at factor cost = GDP at factor cost + Net property income earned
from abroad.
NOTE NO. 5
National income at factor cost = GNP at factor cost – Depreciation i.e.,
capital
(NNP at factor Cost) consumption.
Example
The Economic Survey of the government of Pakistan discloses the
following
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Rupees
in millions
Government expenditure
7,500
Sales value of output of firms
30,000
Imports
6,000
Profit before tax of firms
10,500
Consumers’ expenditure
16,500
Wages etc. received by employees
12,000
Tax deducted out of wages
1,500
Exports
6,000
Cost of goods and services purchased from outside country firms
6,000
You are required to compute Gross Domestic Product (GDP) by using:
(i)
expenditure approach
(ii)
income approach
(iii)
value added approach
Solution
(i)
Computation of G.D.P. by expenditure approach
Rupees in million
(ii)
(a)
Consumer’s expenditures
16,500
(b)
Government expenditure
7,500
(c)
Total exports
6,000
(d)
Total imports
(6,000)
Total expenditures
24,000
Computation of G.D.P. by income approach
(a)
Profit before tax of firms
10,500
(b)
Wages etc. received by employees
12,000
(c)
Tax deducted out of wages
1,500
Total income
24,000
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(iii)
Computation of G.D.P. by value added approach
(a)
Sale value of output of firms
30,000
(b)
Cost of goods and services purchased
from outside firms
( 6,000)
Total value
24,000
Exercise
Following data relates to the economy of a country over a year period.
Capital consumption
2,625
Subsidies
450
Exports
9,675
Imports
(9,360)
Consumers’ expenditure
27,600
Taxes on expenditure
(4,140)
Net property income from abroad
315
Value of physical decrease in stocks
(30)
Gross domestic fixed capital formation
7,380
General government final consumption
6,810
Required:
You are required to compute the following, showing necessary workings
a. Gross Domestic Product (GDP) at market prices and at factor cost
b. Gross National Product (GNP) at market prices and at factor cost
c. National Income at factor cost and at Market price
Solution
(a)
GDP at market prices
= Consumption expenditure +
Federal Government expenditure + capital
formation  physical decrease in stocks +
exports  imports.
(i)
Consumers expenditure
(ii)
Gross domestic fixed capital formation
(iii)
General Govt. final consumption Rs. 6,810 million
(iv)
Physical decrease
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Rs. 27,600 million
Rs. 7,380 million
Rs. (30) million
303
(b)
(v)
Exports
Rs. 9,675 million
(vi)
Imports
Rs. (9,360) million
GDP at market prices
Rs. 42075
GDP at factor costs
GDP at market prices  Taxes
on expenditure + subsidies.
(i)
GDP at market prices
Rs. 42,075million
(ii)
Subsidies
Rs. 450 million
(iii)
Taxes on expenditure
Rs. (4,140) million
GDP at factor cost
________
Rs. 38,385
(c)
GNP at market prices
GDP at market prices + Net
property income earned from
abroad.
(i)
GDP at market prices
Rs. 42,075 million
(ii)
Net property income from abroad Rs. 315 million
GNP at market prices
__________
Rs. 42,390
(d)
GNP at factors cost
GDP at factor cost + net
property income from abroad.
(i)
GDP at factor prices
Rs. 38,385 million
(ii)
Net property income from abroad Rs. 315 million
GNP at factor cost
________
Rs. 38,700
(e) National income at factor cost
GNP at factor cost ()
Capital Consumption
(i)
GNP at factor cost
Rs. 38,700 million
(ii)
Capital consumption
Rs. 2,625 million
National Income at factor cost
________
Rs. 36,075
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(f)
NNP at Market prices
(i)
GNP at market prices
Rs. 42,390
(ii)
Capital consumption
Rs.(2,625)
NNP at Market prices
Rs. 39,765
6.Trade Cycle
Business cycles or trade cycles are the continual sequence of rapid growth in
national income, followed by a slow-down in growth and then a fall in national
income (recession). After this recession comes growth again, and when this has
reached a peak, the cycle turns into recession once more.
According to J.M. Keynes
“A trade cycle is composed of period of good trade characterized by rising
prices and low unemployment percentages alternating with periods of bad
trade characterized by falling prices and high unemployment percentages.”
Four main phases of the business cycle can be distinguished.

Depression

Recovery

Boom
 Recession
Recession tends to occur quickly, while recovery is typically a slower process. Figure
below can be used to help explain the phases of a business cycle.
Four Phases of Business Cycle
6.1
ry
ce
ss
io
n
o ve
Re
Rec
R eco
ver y
B o om
O
Economic Activity
Boom
Depre ssion
Tim e
Depression
Meaning
Depression means slump. It is used to explain such a time when
economy is under crises and difficulties. In words of Keynes
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depression can be called a bad period. There is very low economic
activity
Characteristics of Depression
Following are the characteristics of depression phase.
1.
Very low economic activity
2.
Low prices of goods and services
3.
General disappointment among investors and businessmen.
4.
Due to fall in revenues and income, investor and businessmen
become pessimistic.
5.
Due to falling revenues, the old capital equipment is not
replaced.
6.
Many firms and companies shut down their business.
7.
The demand from the consumer side declines.
8.
Heavy stocks of goods pile up in stores and warehouses.
9.
The production of capital goods is reduced. This situation could
be alarming because capital goods are necessary to maintain
steady rate of growth so that the country is pulled out of
depression
10.
The factories fail to operate at normal capacity level.
11.
The capital market and stock exchanges are also the major
victim of depression. The stocks business face a sharp fall in
trading and investors try to transfer their capital abroad.
12.
It also affects the imports and exports of the country. Due to low
production the exports may fall leading towards trade deficits
and disequilibrium in balance of payments.
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6.2
Revival
Meaning
The second phase of trade cycle is called recovery or revival. Just like
a sick person recovers from illness over a time so a sick economy
recovers from financial ills. But the recovery of the economy is very
slow and time consuming.
Following are the characteristics of this stage.
Characteristics
1.
At this stage the stock of goods that have piled up in the
depression comes to an end.
2.
The demand of consumer goods grows.
3.
The increase in demand is a signal to producer to accelerate the
production process.
4.
The government also plays a role in initiating revival. During
depression it takes different expansionary measures and incurs
capital expenditures. Results of such activities start appearing in
the revival phase.
5.
Economy takes a move after a nap of depression.
6.
Prices start increasing and profit margin that have disappeared
in the previous phase, reappears.
7.
Due to start of production and manufacturing processes
unemployment starts to decline.
8.
The savings begin to show signs of improvement. This helps in
increasing the credit supply to the sick economy.
9.
Various mega projects are initiated by the government in order
to induce growth in the sluggish economy.
10.
Privatization can be a distinctive feature of this phase.
Governments normally try to hand over state owned units to
private sector. This also leads to liberalization of the economy.
11.
The entrepreneurs start chalking out new plans and policies.
They also decide to take risks in the hope of better returns.
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6.3
Boom
Meaning
Boom means a period of very rapid economic activities and high
revenues. It means the state of overall bliss and happiness.
Characteristics
Following are the characteristics of this phase:
1.
There is a rapid rise in production in response to a rise in
consumer demand.
2.
Demand for factors of production increases, unemployment falls
and wages increase.
3.
Investors earn a very healthy return over their investments.
4.
Capital equipment is quickly replaced as it wears out or become
obsolete due to new inventions or discoveries or innovations.
5.
There is a wide spread prosperity and improvement in living
standard.
6.
As profit rate exceed cost of borrowing so borrowing increases
and supply of credit rises.
7.
The credit and money supply grow rapidly. The easy availability
of loans induce investors to start new projects.
8.
People find themselves free from financial worries.
9.
The governments and other institutions also pay attention
towards socio-economic activities.
10.
Boom also helps in payment of internal and external debts.
11.
During boom the foreign capital and expertise fly in the country
to take benefit of higher return.
12.
More and more resources are explored and brought to
production.
13.
Due to higher production there may be environmental problems
such as pollution and loss of wild life etc. however when the
economy is expanding rapidly such problems will lead to further
research and innovations resulting in the establishment of
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environment friendly processes of production.
14.
The boom stage also leads to structural changes in all the
industries of the economy. New capital will be installed and firms
will be more competitive.
15.
The capital market also flourishes rapidly. New companies are
incorporated and capital base strengthens.
6.4
Recession
Meaning
As we say that after every rise, there is a fall and once you reach a
mountain peak you have nowhere to go but to come down from the
other side. So after an economy has reached a boom it gradually
moves towards recession. The recession period starts because of the
following reasons:
1.
Decreasing to Scale
2.
Diseconomies of Scale
3.
Incompatible Combination of Resources
Characteristics
1.
Due to increased, demand in boom periods, demand for factors of
production also increases but as the resources are scarce, so
increase in demand leads to increase in prices of these resources.
This increases the cost of production and hence the prices also
rise.
2.
To check the rise in prices, the credit controls are exercised. This
increases cost of borrowing and investment fall. The fall in
investments act as breaks on business activity. Prices begin to fall
and profit margin decrease.
3.
On the other hand due to increased interest rates people prefer to
save than to consume. This result in the fall in consumer demand.
Stocks of unsold-goods start piling up again.
4.
Signals are sent to producers to stop or decrease production. The
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decrease in production compelled the producers to lay off workers
that have been hired at high cost in boom periods. Due to this
unemployment increases.
5.
The government also reduces its capital expenditures. The result
is that the economy contracts.
6.
Due to higher savings, Withdrawals from the economy increase.
On the other ‘hand due to high cost of borrowing the investments
fall. All this leads to contraction of the economy.
The recession is a slow and gradual process that finally ends in depression
and in this way, a cycle comes to an end.
7. Investment Multiplier
“Multiplier is the numerical co-efficient showing how large an increase in income will
result from each increase in investment”.
“Multiplier is the number by which the change in investment must be multiplied in
order to get the resulting change in income”.
“Multiplier is the ratio of change in income to the change in investment”.
Multiplier is also called Income Multiplier or Investment Multiplier. It tells us that a
given increase in investment results in many times increase in income. That is why it
is called Income or Investment Multiplier. It indicates how many times the total
income increases due to initial increase in investment.
Mathematically, multiplier can be shown as;
K = ∆Y / ∆I
Where
K
=
Multiplier
∆Y
=
Change in Income
∆I
=
Change in Investment
If an investment of Rs.10 million results in increase in income by Rs.40 million, the
multiplier is 4.
MPC, MPS and Multiplier
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Income Multiplier directly depends upon the marginal propensity to consume. If the
MPC is high, the value of multiplier will also be high and vice versa.
Mathematically, multiplier is the inverse of one minus MPC and can be shown as;
K = 1 / 1-MPC = 1/MPS
MPC
MPS
K = 1 / 1-MPC = 1/MPS
0.1
0.9
1.1
0.2
0.8
1.25
0.3
0.7
1.43
0.4
0.6
1.66
0.5
0.5
2
0.6
0.4
2.5
0.7
0.3
3.33
0.8
0.2
5
0.9
0.1
10
The size of the multiplier varies directly with the size of the marginal propensity to
consume. When MPC is high, the multiplier is high and when MPC is low, multiplier
is low.
Suppose an investment of Rs.1000 takes place. The first impact of this will be of
increase in income by Rs.1000. The process does not end there. The persons who
receive the income will spend it according to their propensity to consume. If the MPC
is 3/4, people will spend Rs.750 and Rs.250 will be saved. Their spending will
become the income of the sellers. Now these sellers will spend their income
according to their propensity to consume which is also 3/4, so Rs.562.50 will be
spent and Rs.187.5 will be saved. This process continues. If the MPC remains stable,
the series of successive expenditures become a geometric progression:
1000 + 1000(3/4) + 1000(3/4)2 + 1000(3/4)3 + 1000(3/4)4 + ----------------------∆Y = 1000[1 + (3/4) + (3/4)2 + (3/4)3 + (3/4)4 + ----------------]
∆Y = 1000(1/1-3/4) = 1000(1/1/4)
∆Y = 1000 x 4
∆Y = 4000
We can conclude that an initial primary increase in investment of Rs.1000 results in
an increase of income by Rs.4000. This result shows that the value of the multiplier
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is 4. This can be calculated with the help of the above formula.
K = 1 / 1-MPC
K = 1 / 1-3/4
K = 1 / 1/4
K=4
Importance
The study of multiplier helps to understand the effects of investment on national
income, output and employment. It is also useful to study the concept of trade cycle.
Assumptions
Assumptions of the theory of multiplier are as follows:

There is no induced investment

There are no changes in the prices of consumer goods

Economy is a closed one

Resources of production are available

MPC remains constant
Leakages Of Multiplier
There are some leakages from the stream of national income which affect the
operation of the multiplier. These leakages weaken the multiplier effect. These are
as follows:
1. Preferences of the people to hoard money
2. Purchase of old stock and securities
3. Payment of debt
4. Purchase of imported goods
5. Savings
6. Taxes
8. The Acceleration Principle
“Accelerator is the numerical value of the relation between an increase in income
and the resulting increase in investment”.
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J. B. Clark introduced the Principle of Acceleration in 1914. According to this
principle when income increases, spending power of the people increases, their
consumption increases, and demand for consumer goods increases which leads to
greater investment.
Multiplier shows the effect on income due to a change in investment while the
accelerator shows the effect of change in consumption on induced investment.
Acceleration principle tells us that with the increase in income of the people, demand
for consumer goods, derived demand for factors of production, demand for
producers’ goods especially machines to make consumer goods rises. The
investment in making of machines increases faster than the demand for the product.
According to the acceleration principle, “Level of investment is a function of the rate
of change in the level of income”.
Working of Accelerator
We can explain the working of accelerator with the help of a simple example. In
order to make the example clear we assume that; Cloth is being produced. To
produce cloth worth Rs.100, we require one machine worth Rs.300 (the value of
accelerator is 3). Initial demand for cloth is of worth Rs.500. To meet initial demand
for cloth five machine worth Rs.1500 are required. At the end of the year, one
machine worth Rs.300 depreciates.
Demand for Cloth
(Rupees)
Required
Capital
Replacement
Expenditure
Net
Investment
Gross
Investment
I
500
5 Machines
Rs. 1500
1 Machine
Rs.300
0 Machine
Rs.300
II
500
5 Machines
Rs.1500
1 Machine
Rs.300
0 Machine
Rs.300
II
800
8 Machines
Rs.2400
1 Machine
Rs.300
3 Machines
Rs.900
Rs.1200
IV
1000
10 Machines
Rs.3000
1 Machine
Rs.300
2 Machines
Rs.600
Rs.900
V
1000
10 Machines
Rs.3000
1 Machine
Rs.300
0 Machine
Rs.300
VI
800
8 Machines
Rs.2400
1 Machine
Rs.300
-2 Machines
Rs.-600
Rs.-300
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This table shows that in the first period the demand for cloth is of Rs.500. Five
machines worth Rs.1500 are required to meet this demand. After a year one
machine will depreciate, so replacement expenditures Rs.300 will be borne by the
firm at the end of the first year.
During the second period if the demand for cloth does not change, no new
investment will be required and at the end of the period, firm has to bear depreciation
expenditures equal to Rs.300.
If the demand for cloth rises to worth Rs.800, eight machines will be required to meet
this demand. So the firm has to install three new machines worth Rs.900 and will
also bear the depreciation expenditures equal to Rs.300 at the end of the third year.
There will be the gross investment of Rs.1200. Gross investment rises from Rs.300
in second period to Rs.1200 in third period. Gross investment increases 400% as a
result of 60% rise in demand for cloth.
Demand for cloth rises by 25% from Rs.800 to Rs.1000 during the next period, gross
investment declines by 25% from Rs.1200 in third period to Rs.900 in the fourth
period.
During the next period demand for cloth remains fixed at Rs.1000, gross investment
falls to Rs.300 i.e., 66.7% while net investment falls to zero. This is the destabilizing
role of accelerator.
Assumptions
Acceleration principle depends upon the following assumptions:

Replacement expenditures are assumed to be fixed for each period

Relationship between capital stock and total output (3:1 ratio) is determined
by technological factors.

Real profits move with aggregate output
When output stabilized during the periods four and five, investment decreases
speedily. Stagnation in the increase in output results in an accelerated contraction in
investment spending. We see that there is no gross investment in sixth period. This
shows that at lower levels of output, system is in excess capacity.
Acceleration principle does not work as good in the down turn as it does during the
up turn. This principle explains the large cyclical fluctuations of investment spending.
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Summary
This chapter delves into the fundamental concepts and methodologies associated
with understanding and measuring a nation's economic performance. Here's a
concise summary of the key topics covered:
National income represents the total value of all goods and services produced by a
country over a specific period, usually a year. It encompasses various concepts,
including Gross Domestic Product (GDP), Gross National Product (GNP), Net
National Product (NNP), and Personal Income. Understanding these concepts is
crucial for evaluating the economic health and living standards of a nation.
GDP can be measured using three main approaches:
Production Approach: Calculates GDP by adding the value of output produced by
every industry in the economy.
Income Approach: Sums up all the incomes earned by individuals and businesses,
including wages, profits, and taxes minus subsidies.
Expenditure Approach: Adds up all expenditures made in the economy, including
consumption, investment, government spending, and net exports (exports minus
imports).
Each approach provides a different perspective but ultimately yields the same GDP
figure.
Nominal GDP measures the value of all final goods and services produced within a
country at current market prices. Real GDP, on the other hand, adjusts for inflation
and reflects the true volume of production. The GDP deflator is a price index that
measures the change in price levels and helps convert nominal GDP into real GDP,
providing a more accurate reflection of an economy's performance over time.
The circular flow of income illustrates how money moves through an economy. It
highlights the interactions between different economic agents: households,
businesses, government, and the foreign sector. In this model, households provide
factors of production (labor, land, capital) to businesses and receive income (wages,
rent, interest) in return, which they then spend on goods and services produced by
businesses, creating a continuous flow of income and expenditure.
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The trade cycle, or business cycle, consists of four stages: expansion, peak,
contraction (recession), and trough. During expansion, economic activity rises,
leading to increased employment and consumer spending. The peak is
characterized by maximum economic activity. Contraction sees a decline in
economic activity, rising unemployment, and reduced spending. The trough is the
lowest point, signaling the end of a recession and the start of recovery. Each stage
has distinct impacts on businesses and the overall economy.
The investment multiplier concept explains how an initial increase in investment can
lead to a greater overall increase in national income. It is based on the idea that an
increase in spending (investment) leads to increased income and consumption,
which in turn stimulates further production and income, creating a multiplied effect on
the overall economy.
The acceleration principle describes how changes in consumer demand can lead to
larger changes in investment. When consumer demand increases, businesses are
motivated to invest in additional capital to meet the higher demand. Conversely,
when demand decreases, investment falls sharply. This principle highlights the
sensitivity of investment to changes in demand and its significant role in influencing
economic fluctuations.
Self-test questions
National Income: Definition and Concepts
1. What does national income represent?
2. Name two concepts included in national income.
3. Why is national income important?
Approaches to Measuring Gross Domestic Product
4. What are the three main approaches to measuring GDP?
5. How does the production approach calculate GDP?
6. What does the income approach sum up?
7. What is included in the expenditure approach?
Nominal GDP, Real GDP, and GDP Deflator
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8. What is nominal GDP?
9. How does real GDP differ from nominal GDP?
10. What does the GDP deflator measure?
Circular Flow of Income
11. What does the circular flow of income illustrate?
12. Name the four economic agents in the circular flow model.
13. How do households contribute to the circular flow?
Stages in the Trade Cycle
14. What are the four stages of the trade cycle?
15. What characterizes the expansion stage?
16.What happens during a contraction?
Investment Multiplier
17. What is the investment multiplier?
18.How does an initial increase in investment affect national income?
The Acceleration Principle
19. What does the acceleration principle explain?
20. How does consumer demand influence investment according to this principle?
Practice questions
Question 1
What does national income represent?
A. Total value of imports and exports
B. Total value of all goods and services produced in a country
C. Total savings of a nation
D. Total foreign investments
Solution: B
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Question 2
Which of the following is included in national income?
A. Gross Domestic Product (GDP)
B. Personal Income
C. Net National Product (NNP)
D. All of the above
Solution: D
Question 3
Why is national income important?
A. It measures population growth
B. It evaluates economic health and living standards
C. It tracks government spending
D. It assesses technological progress
Solution: B
Question 4
What are the three main approaches to measuring GDP?
A. Production, Distribution, Consumption
B. Production, Income, Expenditure
C. Income, Savings, Investment
D. Production, Consumption, Investment
Solution: B
Question 5
How does the production approach calculate GDP?
A. By summing up total expenditures
B. By adding the value of output produced by every industry
C. By calculating total income earned
D. By measuring total savings
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Solution: B
Question 6
What does the income approach sum up?
A. Total expenditures in the economy
B. All incomes earned by individuals and businesses
C. Total production output
D. Total savings in the economy
Solution: B
Question 7
What is included in the expenditure approach?
A. Consumption, investment, government spending, and net exports
B. Wages, rents, interest, and profits
C. Production costs and savings
D. Imports and exports only
Solution: A
Question 8
What is nominal GDP?
A. GDP adjusted for inflation
B. GDP measured at current market prices
C. GDP calculated using past prices
D. GDP excluding government spending
Solution: B
Question 9
How does real GDP differ from nominal GDP?
A. It includes inflation
B. It adjusts for inflation
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C. It excludes investment
D. It measures only consumer spending
Solution: B
Question 10
What does the GDP deflator measure?
A. Change in consumer spending
B. Change in production levels
C. Change in price levels
D. Change in export values
Solution: C
Question 11
What does the circular flow of income illustrate?
A. The movement of money through an economy
B. The total amount of imports and exports
C. The distribution of national income
D. The levels of national savings
Solution: A
Question 12
Name the four economic agents in the circular flow model.
A. Households, businesses, government, and foreign sector
B. Banks, households, government, and businesses
C. Producers, consumers, savers, and investors
D. Households, producers, investors, and government
Solution: A
Question 13
How do households contribute to the circular flow?
A. By providing factors of production and receiving income
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B. By saving all their income
C. By only consuming goods and services
D. By producing goods and services
Solution: A
Question 14
What are the four stages of the trade cycle?
A. Growth, Decline, Recovery, Stability
B. Expansion, Peak, Contraction, Trough
C. Boom, Bust, Recovery, Recession
D. Growth, Peak, Decline, Recovery
Solution: B
Question 15
What characterizes the expansion stage?
A. Decreasing employment and spending
B. Increasing economic activity and employment
C. Maximum economic activity
D. Lowest economic activity
Solution: B
Question 16
What happens during a contraction?
A. Economic activity increases
B. Unemployment falls
C. Economic activity declines
D. Consumer confidence rises
Solution: C
Question 17
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What is the investment multiplier?
A. The ratio of consumer spending to savings
B. The effect of an initial investment increase on total income
C. The increase in investment due to government spending
D. The reduction in investment during a recession
Solution: B
Question 18
How does an initial increase in investment affect national income?
A. It decreases national income
B. It has no effect on national income
C. It leads to a multiplied increase in national income
D. It causes inflation without affecting income
Solution: C
Question 19
What does the acceleration principle explain?
A. How investment affects inflation
B. How changes in consumer demand lead to larger changes in investment
C. How government spending accelerates economic growth
D. How saving rates impact investment
Solution: B
Question 20
How does consumer demand influence investment according to the acceleration
principle?
A. Increased demand leads to reduced investment
B. Increased demand leads to increased investment
C. Decreased demand has no effect on investment
D. Decreased demand leads to increased investment
Solution: B
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Contents
1
2
3
4
5
6
7
8
Macroeconomic Policy Objectives
Elements of Public Finance
Unemployment
Inflation
Inflation and Unemployment: The Phillips Curve
Fiscal Policy
Monetary Policy
Supply-side Policies
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1.Macroeconomic Policy Objectives
Modern governments are generally expected to manage their national economies to
some extent. People typically believe that government actions can either support or
hinder their country's prosperity and therefore look to their governments for effective
macroeconomic policies. There are four main objectives of economic policy, though
there is ongoing debate about their relative importance:
(a) To achieve economic growth and increase national income per capita. Growth
implies a real increase in national income, excluding the effects of price inflation,
which does not represent a true increase.
(b) To control price inflation and achieve stable prices. This has become a central
objective of economic policy in recent years.
(c) To achieve full employment. Full employment means maintaining low levels of
unemployment, with any involuntary unemployment being short-term.
(d) To achieve a balance between exports and imports over a period of years.
Maintaining this balance is crucial for a country’s relative wealth, creditworthiness as
a borrower, and fostering goodwill in international relations.
2. Elements of government finance
2.1 Size of Government Budget
The size of the government budget refers to the total amount of money that the
government plans to spend during a specific period, typically a fiscal year. It
encompasses both government expenditures and revenues.
The size of the government budget, particularly in relation to GDP, provides valuable
insights into the fiscal policy stance of a country and its overall economic health. Two
key metrics used to gauge the size of the government budget are government
spending as a percentage of GDP and tax revenue as a percentage of GDP.
A) Government Spending as a Percentage of GDP
Government spending as a percentage of GDP measures the total expenditures
made by the government relative to the size of the economy. It reflects the extent to
which the government is involved in economic activities and the provision of public
goods and services. A high level of government spending relative to GDP indicates a
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larger role of the government in the economy, while a lower level suggests a more
limited role.
High Government Spending: When government spending as a percentage of GDP
is high, it may indicate a more extensive welfare state with significant investments in
public infrastructure, healthcare, education, and social welfare programs. While high
government spending can stimulate economic growth and support social welfare, it
may also lead to concerns about fiscal sustainability, crowding out private investment,
and potential inefficiencies in resource allocation.
Low Government Spending: Conversely, when government spending as a
percentage of GDP is low, it suggests a smaller role of the government in the
economy, with fewer resources allocated to public goods and services. While low
government spending may promote fiscal discipline, encourage private sector growth,
and reduce the tax burden on citizens, it may also result in inadequate provision of
essential services and infrastructure, widening income inequality, and social
disparities.
B) Tax Revenue as a Percentage of GDP
Tax revenue as a percentage of GDP measures the total tax collections by the
government relative to the size of the economy. It reflects the government's ability to
raise revenue for financing its expenditures and meeting its fiscal obligations. The
level of tax revenue as a percentage of GDP is influenced by various factors,
including tax policies, economic conditions, and the tax base.
High Tax Revenue: When tax revenue as a percentage of GDP is high, it indicates
a relatively high tax burden on individuals and businesses. High tax revenue can
provide the government with ample resources to finance its expenditures, reduce
budget deficits, and invest in public infrastructure and social programs. However,
excessive taxation may hamper economic growth, discourage investment and
entrepreneurship, and lead to tax evasion and avoidance.
Low Tax Revenue: Conversely, when tax revenue as a percentage of GDP is low,
it suggests a lower tax burden on individuals and businesses. While low taxes may
stimulate economic activity, promote investment, and incentivize entrepreneurship,
they may also limit the government's ability to fund essential services, address social
needs, and maintain fiscal sustainability. Inadequate tax revenue can lead to budget
deficits, reliance on debt financing, and pressure to cut spending or raise taxes in the
future.
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2.2 Makeup of Government Expenditures
Government expenditures can be categorized into various components, including:
Public Goods and Services: This includes spending on infrastructure (such as
roads, bridges, and public transportation), education, healthcare, defense, and public
safety.
Transfer Payments: These are payments made by the government to individuals or
groups, such as social security benefits, unemployment benefits, welfare payments,
and subsidies.
Interest Payments: Governments often incur interest expenses on their debt
obligations, which constitute a significant portion of government expenditures.
Administrative Expenses:This includes the costs associated with running
government agencies, salaries of government employees, and other administrative
overhead.
2.3. Committed and Discretionary Government Spending
Committed Spending: This refers to government expenditures that are
predetermined and difficult to alter in the short term. Examples include payments for
social security benefits, interest payments on debt, and contractual obligations like
salaries of civil servants.
Discretionary Spending: This refers to government expenditures that can be
adjusted or altered through the budgetary process. Examples include spending on
infrastructure projects, education programs, healthcare initiatives, and defense
spending.
2.4. Cyclical and Structural Deficit
Cyclical Deficit: This type of deficit arises as a result of fluctuations in the business
cycle. During economic downturns, government revenues tend to decrease due to
lower tax collections, while expenditures may increase due to higher demand for
social welfare programs like unemployment benefits. The cyclical deficit reflects the
temporary imbalance between revenues and expenditures caused by economic
fluctuations.
Structural Deficit: This type of deficit exists regardless of the stage of the business
cycle and reflects a persistent mismatch between government revenues and
expenditures. It arises when government spending consistently exceeds its revenues,
even during periods of economic growth. Structural deficits may result from factors
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such as unsustainable fiscal policies, demographic changes (such as an aging
population), or structural inefficiencies in the economy.
2.5 Functions of Taxation
Taxation serves various functions:
(a) It raises revenues for the government, enabling it to fund the provision of public
and merit goods like defense, healthcare, and education.
(b) Taxation plays a role in managing aggregate demand. Lowering taxes can boost
aggregate demand, while increasing taxes can reduce it.
(c) Taxation provides a stabilizing effect on national income by mitigating the impact
of the multiplier. For instance, higher taxation during economic booms can slow
down the growth of Gross National Product (GNP) and alleviate inflationary
pressures.
(d) Taxes can be used to internalize social costs associated with certain products.
For example, taxes on tobacco products account for the social costs of smokingrelated diseases, thereby adjusting prices to reflect these externalities. Similarly,
taxes can discourage activities deemed undesirable.
(e) Taxation is utilized for income and wealth redistribution. Implementing higher tax
rates on higher incomes contributes to income redistribution, while inheritance tax,
as observed in the UK, aids in redistributing wealth.
(f) Taxes can protect domestic industries from foreign competition. Levying duties on
imported goods increases their prices, shifting demand towards domestically
produced goods and safeguarding local industries.
2.6. Principles of Taxation
The canons of taxation provide a set of principles or guidelines for designing an
efficient, equitable, and effective tax system. Adam Smith, in wealth of nations,
described the first four ‘canons’ or principles of taxation.
1. Equity or Fairness: Taxation should be fair and equitable, ensuring that
individuals and businesses contribute to the government's revenue based on their
ability to pay. This principle encompasses both horizontal equity (similarly situated
individuals should be taxed similarly) and vertical equity (individuals with higher
incomes should bear a greater tax burden).
2. Certainty: Taxpayers should have a clear understanding of their tax obligations,
including the amount of tax they owe, the basis of taxation, and the time and manner
of payment. Certainty in taxation helps promote compliance and reduces
administrative costs and taxpayer frustration.
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3. Convenience: Taxation should be convenient for taxpayers, minimizing the
administrative burden associated with tax compliance. This includes providing
accessible channels for filing tax returns, making tax payments, and resolving
disputes with tax authorities.
4. Economy or Efficiency: Taxation should be structured in a way that minimizes
administrative and compliance costs for both taxpayers and the government.
Efficient tax systems avoid unnecessary complexity and administrative burdens,
ensuring that resources are allocated efficiently across the economy.
5. Flexibility: Tax systems should be flexible enough to adapt to changing economic
and social conditions. This includes the ability to adjust tax rates, exemptions, and
deductions in response to evolving economic circumstances and policy objectives.
6. Neutrality: Taxation should not distort economic decision-making or resource
allocation. Neutral tax systems avoid favoring certain industries, activities, or
individuals over others, allowing market forces to operate freely and efficiently.
7. Stability or Predictability: Tax systems should provide stability and predictability
to taxpayers and the economy, minimizing uncertainty and volatility. Stable tax
policies promote long-term investment, economic growth, and confidence in the tax
system.
These canons collectively provide a framework for policymakers to design tax
systems that generate sufficient revenue for the government while minimizing
distortions, promoting economic efficiency, and ensuring fairness and compliance
among taxpayers.
2.7. Types of Taxation
1. Progressive Tax: A progressive tax is a tax system where the tax rate increases
as the taxable amount or income increases. In other words, individuals with higher
incomes are taxed at higher rates, while those with lower incomes are taxed at lower
rates. The aim of a progressive tax is to redistribute income and reduce inequality by
placing a greater burden on those who can afford it most.
2. Regressive Tax: A regressive tax is a tax system where the tax rate decreases
as the taxable amount or income increases. This means that individuals with lower
incomes pay a higher proportion of their income in taxes compared to those with
higher incomes. Regressive taxes tend to place a greater burden on low-income
individuals and may exacerbate income inequality.
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3. Proportional Tax: Also known as a flat tax, a proportional tax is a tax system
where the tax rate remains constant regardless of the taxable amount or income. In
other words, all individuals, regardless of their income level, pay the same proportion
of their income in taxes. Proportional taxes are often seen as fair and simple but may
be considered regressive if the tax burden disproportionately affects lower-income
earners.
4. Degressive Tax: Degressive taxation is a tax system where the tax rate
decreases as the taxable amount or income increases, but only up to a certain
income threshold. Beyond that threshold, the tax rate may remain constant or even
increase. Degressive taxes aim to provide tax relief for low- and middle-income
earners while still generating revenue from higher-income individuals.
5. Specific Tax: A specific tax is a fixed amount of tax imposed per unit of a
particular good or service. This type of tax is not based on the value or price of the
product but rather on its quantity or volume. Examples of specific taxes include
excise taxes on cigarettes, gasoline, alcohol, and luxury items.
6. Ad Valorem Tax: An ad valorem tax is a tax imposed as a percentage of the
value of a good or service. Unlike specific taxes, ad valorem taxes are based on the
price or value of the product. Common examples of ad valorem taxes include sales
taxes, value-added taxes (VAT), and property taxes.
7. Compound Tax: A compound tax is a combination of different types of taxes
applied to the same tax base or transaction. For example, a compound tax may
include both an ad valorem tax and a specific tax on a particular product or service.
2.8. Direct and Indirect Taxation
The concepts of tax impact and tax incidence refer to how the burden of a tax is
distributed among different parties in an economy. In the case of direct taxes and
indirect taxes, the relationship between tax impact and tax incidence varies.
Direct Tax
Tax Impact: In the case of direct taxes, the tax impact and tax burden fall directly on
the taxpayer. For example, when an individual pays income tax, they bear the full
burden of the tax directly.
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Tax Incidence: The tax incidence of a direct tax is also on the same entity that
bears the tax impact. In other words, the person or entity legally responsible for
paying the tax is also the one who ultimately bears the economic burden of the tax.
Indirect Tax
Tax Impact: In the case of indirect taxes, the tax impact is initially on the producer or
seller of the goods or services. For example, when a manufacturer pays a sales tax
on goods produced, the tax impact falls on the producer.
Tax Incidence: However, the economic burden of the tax, or the tax incidence, may
not necessarily fall on the producer. Instead, the burden of the tax is often passed on
to consumers in the form of higher prices. Therefore, while the tax impact initially
falls on the producer, the actual burden of the tax is borne by consumers who pay
higher prices for the taxed goods or services.
With direct taxes, the tax impact and tax incidence are the same, as the burden of
the tax falls directly on the taxpayer. However, with indirect taxes, although the tax
impact is on the producer or seller, the actual burden or tax incidence is often shifted
to consumers through higher prices, resulting in a disconnect between the entity
legally responsible for paying the tax and the party bearing the economic burden.
2.9 Disincentive effects of taxation
Taxing profits directly can discourage individuals from taking risks and engaging in
entrepreneurial activities. Such taxes decrease the net return from new investments,
particularly when they are progressive. Furthermore, they diminish the capacity to
invest. Retained profits often serve as a significant source of financing for new
investments, so taxing corporate profits limits firms' ability to save, thereby
constraining available funds for investment.
High levels of taxation can also disincentivize legitimate employment. When marginal
tax rates, or the proportion of additional income taken as tax, are elevated,
individuals may react in two primary ways. Firstly, they might opt to forego
opportunities to increase their income through additional effort, reasoning that the
marginal increase in net income does not adequately compensate for the effort or
risk involved. Alternatively, individuals may turn to working in the informal "black"
economy to evade paying taxes.
2.10 The Laffer curve and tax yields
The Laffer curve, named after Professor Arthur Laffer, demonstrates the impact of
tax rates on government revenue and national income.
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In the hypothetical economy depicted in Figure below, a tax rate of 0% results in the
government receiving no tax revenue, regardless of the level of national income.
Conversely, a tax rate of 100% would discourage work entirely, leading to zero total
tax revenue once again. In our example, at a tax rate of 25%, the government would
collect a total tax revenue of $30 billion, equivalent to the revenue generated at a tax
rate of 75%. Consequently, the level of national income when taxes are set at 25%
must be $120 billion, compared to only $40 billion when taxes are at 75%. This
suggests that high taxation acts as a disincentive, leading to a reduction in national
income.
The government's objective is to identify the tax rate, denoted as 'Tr', that maximizes
revenue. It aims to avoid setting taxes higher than this optimal rate, as doing so
would deter work due to the increased tax burden.
Three implications arise from this analysis of the Laffer curve:
(a) High taxation rates serve as a disincentive to work, leading to reduced output and
employment as individuals opt for leisure over labor. This phenomenon, known as
the disincentive effect, highlights the negative impact of excessive taxation on
economic productivity.
(b) Governments cannot indefinitely increase tax revenue by raising tax rates. There
exists a critical tax rate beyond which the decline in national income, stemming from
diminished incentives and effort, outweighs the revenue gains from higher tax rates.
In Figure above, the peak tax revenue, denoted as Tx, is achieved at the average tax
rate Tr. Tax rates exceeding Tr result in diminishing tax revenues, prompting
governments to consider lowering tax rates to bolster revenue.
(c) There are typically two tax rates that yield identical total tax revenue: one
associated with a high level of national income and another linked to a lower level.
Consequently, governments with high expenditure commitments may not necessarily
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require high tax rates. Opting for lower tax rates, within this duality, can generate the
same revenue as higher rates.
Furthermore, arguments against high tax rates include:
o
High income tax rates can deter work effort, especially when considering
marginal tax rates—the tax levied on additional income—which influence
decisions on employment and overtime. Excessive tax rates may discourage
individuals from pursuing higher-paying jobs or extra work.
o
High tax rates could trigger a "brain drain" as highly skilled workers seek
countries with more favorable tax environments, resulting in lost tax revenue
and expertise.
o
Narrowing wage differentials through high marginal tax rates may reduce
incentives for skill development, leading to a shortage of skilled labor.
o
High tax rates may create a "poverty trap" where unemployed individuals have
little incentive to accept low-paying jobs due to the loss of benefits and high
tax rates.
Tax avoidance, such as exploiting legal loopholes, may increase with high tax
o
rates, necessitating stricter enforcement measures by tax authorities.
o
There's a risk of tax evasion, particularly among self-employed individuals,
which could inflate enforcement costs and undermine tax compliance.
Reduced tax liabilities may dampen wage demands, alleviating inflationary
o
pressures from wage increases.
3 Unemployment
People are unemployed when they are able and willing to work but cannot find a job.
The level of unemployment should be distinguished from the rate of unemployment.
The level of unemployment refers to the total number of people who are unemployed
whereas the rate of unemployment is the number of unemployed people as a
percentage of the labor force. So in an economy with a labor force of 50 million
people, 4.3 million of whom are unemployed, the rate of unemployment is 8.6%
Unemployment Rate= Unemployed Persons / labour force x100
3.1 Types of Unemployment
Unemployment can be divided into three main types: frictional, structural and cyclical.
Each of these types has different causes.
1. Frictional Unemployment
Frictional unemployment is unemployment that arises when workers are between
jobs.
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Search unemployment, Casual unemployment and seasonal unemployment are
three forms of frictional unemployment.
i)
One form of frictional unemployment is search unemployment. This arises
when workers do not accept the first job or jobs on offer but spend some
time looking for a better paid job.
ii)
Casual unemployment refers to workers who are out of work between
periods of employment including, for example, actors, supply teachers and
construction workers.
iii)
In the case of seasonal unemployment, demand for workers fluctuates
according to the time of the year. During periods of the year, people
working in, for example, the tourism, hospitality, building and farming
industries may be out of work.
The unemployment that arises from the normal labor turnover in labor market in
which people entering and leaving the labor force and from the ongoing creation and
destruction of job is called frictional unemployment.
Frictional unemployment is a permanent and healthy phenomenon in a dynamic,
growing economy.
2. Structural Unemployment
As its name suggests, structural unemployment arises due to changes in the
structure of the economy.
Over time the pattern of demand and supply will change. Some industries will be
expanding, and some will be contracting.
If workers cannot move from one industry to another industry, due to a lack of
geographical or occupational immobility, they may become structurally unemployed.
Structural unemployment can take a number of forms.
i)
ii)
iii)
One is technological unemployment. In this case, people are out of work
due to the introduction of labor-saving techniques.
When declining industries are concentrated in a particular area of the
country, the resulting unemployment is sometimes referred to as regional
unemployment.
Another form of structural unemployment is international unemployment.
This is when workers lose their jobs because demand switches from
domestic industries to more competitive foreign industries.
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The unemployment that arises when changes in technology or international
competition change the skills needed to perform jobs or change the locations of
jobs is called structural unemployment.
Structural unemployment is painful, especially for older workers for whom the best
available option might be to retire early or take a lower-skilled, lower paying job.

Frictional and structural unemployment arise largely due to problems on the
supply side of the economy.

Structural unemployment usually lasts longer than frictional unemployment
because workers must retrain and possibly relocate to find a job.
3. Cyclical Unemployment
The third main type of unemployment is cyclical unemployment or demanddeficient unemployment that arises due to a lack of aggregate demand. Cyclical
unemployment will affect the whole economy, with job losses occurring across a
range of industries.
The fluctuating unemployment over the business cycle that increases during a
recession and decreases during an expansion i.e. the higher than normal
unemployment at a business cycle trough and the lower than normal
unemployment at a business cycle peak is called cyclical unemployment.
A worker who is laid off (out of work) because the economy is in a recession
(trough) and who gets rehired some months later when the expansion begins has
experienced cyclical unemployment.
3.3 Full Employment and The Natural Rate Of Unemployment
Full employment is considered to be the highest level of employment possible. It
is often considered to be achieved when the unemployment rate falls to 3%,
although the rate may vary between countries.
This may appear to be somewhat surprising as it might be expected that it would be
0% unemployed. However, in practice, at any particular time some people may be
experiencing a period of unemployment as they move from one job to another job.
The natural rate of unemployment can also be referred to as the nonaccelerating inflation rate of unemployment (NAIRU). This is largely a monetarist
concept. The natural rate of unemployment is the unemployment that exists when
the aggregate demand for labor equals the aggregate supply of labor at the current
wage rate and price level. The inflation rate is constant, with the actual inflation rate
equaling the expected one at this rate of unemployment.
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
Natural unemployment is the unemployment that arises from frictions and
structural change when there is no cyclical unemployment (when all the
unemployment is frictional and structural). Natural unemployment as a
percentage of the labor force is called the natural unemployment rate.

Full employment is defined as a situation in which the unemployment rate
equals the natural unemployment rate.
3.4 Consequences of Unemployment
Unemployment leads to the following challenges:
(a) Diminished output: When labor remains unemployed, the economy operates
below its potential output capacity. Consequently, total national income falls short
of its maximum potential due to underutilization of economic resources.
(b) Erosion of human capital: Unemployment undermines the maintenance of
skills among the workforce, as skills tend to deteriorate without regular
employment.
(c) Exacerbation of income inequality: Unemployed individuals typically earn
less than their employed counterparts. Thus, as unemployment rises, disparities in
income distribution widen, resulting in heightened poverty levels.
(d) Social repercussions: Unemployment engenders personal hardships and
distress among individuals, often accompanied by an upsurge in criminal activities
such as theft and vandalism.
(e) Amplified welfare expenditures: The escalation in unemployment places a
significant strain on government finances, as administrations are compelled to
allocate more resources towards welfare payments while simultaneously
experiencing reduced tax revenues.
3.5 Government Employment Strategies
The goal of job creation and reducing unemployment often aligns, yet it's
conceivable to increase job opportunities without effectively decreasing
unemployment.
(a) This scenario arises when the influx of individuals into the job market exceeds
the number of new job openings. For instance, if 500,000 new positions emerge
within a year, but 750,000 additional school graduates seek employment,
unemployment rises by 250,000.
(b) Conversely, it's feasible to lower official unemployment figures without
generating new employment opportunities. For instance, individuals participating
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in government-funded training programs are removed from the unemployment
registry, despite lacking full-time employment.
Governments have various avenues to address job creation and unemployment
reduction:
(a) Directly allocating more funds to job creation endeavors, such as expanding
the civil service workforce.
(b) Stimulating growth within the private sector of the economy. During periods of
rising aggregate demand, firms are inclined to bolster output to meet market
needs, consequently increasing employment levels.
(c) Promoting skills development through training initiatives. Addressing
unemployment among unskilled laborers while addressing shortages in skilled
labor by subsidizing training programs can bridge the skills gap and meet industry
demands.
(d) Providing financial incentives to employers in strategic regional areas.
(e) Facilitating labor mobility by offering financial aid for relocation expenses and
enhancing the dissemination of job vacancy information.
Additional policies may focus on aligning real wages with market equilibrium levels:
(a) Eliminating "closed shop" agreements that restrict certain job opportunities to
trade union members.
(b) Evaluating minimum wage regulations to ascertain if current thresholds hinder
employers from hiring new staff.
4. Inflation
4.1 Inflation and Price Level
Inflation is a process in which the price level is rising persistently and money is losing
value. If the price level rises persistently, then people need more and more money to
make transactions. Incomes rise, so firms must pay out more in wages and other
payments to resource owners. And prices rise, so consumers must take more
money with them when they go shopping. But the value of money gets smaller and
smaller.
A change in one price is not inflation. For example, if the price of apples jumps to
$25 and all other money prices fall slightly so that the price level remains constant,
there is no inflation. Instead, the relative price of apples has increased. If the price
of apples and all other prices rise by a similar percentage, there is inflation. But a
one-time jump in the price level is not inflation. Instead, inflation is an ongoing
process.
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Inflation is a serious problem, and preventing inflation is the main task of monetary
policy and the actions of the Fed. Now, we would learn how inflation arises and see
how we can avoid the situation. But first, let's see how we calculate the inflation rate.
To measure the inflation rate, we calculate the annual percentage change in the
price level. For Example, if this year's price level is 126 and last year's price level was
120, the inflation rate is 5 percent per year. That is,
Inflation rate = Pt – Pt-1 / Pt-1 x 100
= 126 -120 / 120 x 100
= 5 percent per year.
This equation shows the connection between the inflation rate and the price level.

For a given price level last year, the higher the price level in the current year,
the higher is the inflation rate.

If the price level is rising, the inflation rate is positive.

If the price level rises at a faster rate, the inflation rate increases.

The higher the new price level, the lower is the value of money, and the
higher is the inflation rate.
4.2 Causes of Inflation
Inflation can result from either an increase in aggregate demand or a decrease in
aggregate supply. These two sources or causes of inflation are called:

Demand Pull Inflation
 Cost Push Inflation
We first study a demand-pull inflation.
Demand-Pull Inflation
An inflation that results from an initial increase in aggregate demand is called
demand-pull inflation. Such inflation can arise from any factor that increases
aggregate demand such as an:
1. Increase in the money supply
2. Increase in government purchases
3. Increase in exports
Cost-Push Inflation
An inflation that results from an initial increase in costs is called cost-push inflation.
The two main sources of increases in costs are:
1. An increase in money wage rates
2. An increase in the money prices of raw materials
At a given price level, the higher the cost of production, the smaller is the amount
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that firms are willing to produce. So if money wage rates rise or if the prices of raw
materials (for example, oil) rise, firms decrease their supply of goods and services.
Aggregate supply decreases, and the short-run aggregate supply curve shifts
leftward.
5. Inflation and Unemployment: The Phillips Curve
The aggregate supply—aggregate demand model focuses on the price level and
real GDP. Knowing how these two variables change, we can work out what happens
to the inflation rate and the unemployment rate. But the model does not explain
inflation and unemployment.
A more direct way of studying inflation and unemployment uses a relationship called
the Phillips curve. The Phillips curve approach uses the same basic ideas as the
AS-AD model, but it focuses directly on inflation and unemployment. The Phillips
curve is so named because New Zealand economist A.W. Phillips popularized it. A
Phillips curve is a curve that shows a relationship between inflation and
unemployment. Phillips curves can be explained for two time periods:

The short-run Phillips curve

The long-run Phillips curve
5.1 The Short-Run Phillips Curve
The short-run Phillips curve is a curve that shows the tradeoff between inflation and
unemployment, holding constant:
The expected inflation rate
1.
2.
The natural unemployment rate
Figure (a) shows a short-run Phillips curve (SRPC). Suppose that the expected
inflation rate is P1 percent a year and the natural unemployment rate is U2 percent,
point a in the figure.
A short-run Phillips curve passes through this point. If actual inflation rises above its
expected rate, unemployment falls below its natural rate. This joint movement in
the inflation rate and the unemployment rate is illustrated as a movement up the
short-run Phillips curve from point a to point b in the figure. Similarly, if actual
inflation falls below its expected rate, unemployment rises above the natural rate. In
this case there is movement down the short-run Phillips curve from point a to point
c.
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5.2 The Long-Run Phillips Curve
The long-run Phillips curve is a curve that shows the relationship between
inflation and unemployment when the actual inflation rate equals the expected
inflation rate. The long-run Phillips curve is vertical at the natural unemployment
rate. It is shown in figure (b) as the vertical line LRPC.
Figure (b)
The long-run Phillips curve tells us that any anticipated inflation rate is possible at
the natural unemployment rate. When inflation is anticipated, real GDP equals
potential GDP. And with real GDP equal to potential GDP, unemployment is at the
natural rate.
When the expected inflation rate changes, the short-run Phillips curve shifts.
If the expected inflation rate is P1% (10 percent) a year, the short-run Phillips curve
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is SRPCo. If the expected inflation rate falls to P1’% (7 percent) a year, the short-run
Phillips curve shifts downward to SRPCI. The distance by which the short-run Phillips
curve shifts downward when the expected inflation rate falls is equal to the change in
the expected inflation rate.
Shifting Of The Long-Run Phillips Curve
The short-run Phillips curve shifts when the expected inflation rate and natural
unemployment rate changes.
Changes In Expected Inflation Rate
To see why the short-run Phillips curve shifts when the expected inflation rate
changes, suppose that there is full employment, and a P1% (10 percent) a year
anticipated inflation is raging (powerful). The Fed now begins an attack on inflation
by slowing money supply growth. Aggregate demand growth slows, and the inflation
rate falls to P1’% (7 percent )a year. At first, this decrease in inflation is
unanticipated, so wages continue to rise at their original rate. The short-run
aggregate supply curve shifts leftward at the same pace as before. Real GDP falls,
and unemployment increases. In figure (b), the economy moves from point a to point
c on SRPCo.
If the actual inflation rate remains steady at P1’% (7 percent) a year, this rate
eventually comes to be expected. As this happens, wage growth slows and the
short-run aggregate supply curve shifts leftward less quickly. Eventually, it shifts
leftward at the same pace at which the aggregate demand curve is shifting rightward.
The actual inflation rate equals the expected inflation rate, and full employment is
restored. Unemployment is back at its natural rate. In figure (`b), the short-run
Phillips curve has shifted from SRPCo to SRPCI and the economy is at point d.
An increase in the expected inflation rate has the opposite effect to that shown in
figure (b). Another important source of shifts in the Phillips curve is a change in the
natural rate of unemployment.
Changes In The Natural Unemployment Rate
The natural unemployment rate changes due to many reasons. A change in the
natural unemployment rate shifts both the short-run and long-run Phillips curves.
Figure (c) illustrates such shifts.
If the natural unemployment rate increases from U2 to U3 (6% to 9%), the long-run
Phillips curve shifts from LRPCO to LRPCI and if expected inflation is constant at P1%
(10 percent) a year, the short-run Phillips curve shifts from SRPCo to SRPCI.
Because the expected inflation rate is constant, the short-run Phillips curve SRPC I
intersects the long-run curve LRPC I (point e) at the same inflation rate at which
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the short-run Phillips curve SRPCo intersects the long-run curve LRPCO (point a).
Figure (c)
6. Fiscal Policy
Fisc word means treasury. Fiscal policy is related with the matters of treasury or
public finance (government revenues and government expenditures).
“The use of the federal budget to achieve macroeconomic objectives such as full
employment, sustained economic growth, and price level stability is called fiscal
policy.”
According to M. Lee, fiscal policy considers:
(1) Imposition of taxes (2) Government expenditures
(3) Public Debt
(4) Management of public debt
So, the government controls fiscal policy.
6.1 Objective and importance of fiscal policy
1. Price stability
The capitalist economies have to deal with the major economic problems of inflation
and deflation. Due to inflation, purchasing power of fixed income groups and poor
people is badly affected. Moreover, the inflation generates a lot of long-run social
and economic problems. So, government can control inflation with fiscal tablets, i.e.,
government expenditures and taxes. During inflation, if government expenditures are
decreased and taxes are increased, it will reduce national income and purchasing
power of people. Thus, aggregate demand decreases and prices will go down.
During deflation, if government expenditures are increased and taxes are decreased,
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it will increase national income and purchasing power of people. Thus, aggregate
demand increases and prices will go up.
2. Effects on the level of employment
Every country wants to attain the full employment level but the developing countries
due to high population growth, shortage of resources etc. are facing the
unemployment problem. Fiscal policy is used to overcome this situation. If
government expenditures are increased and taxes are decreased, it will increase
national income and purchasing power of people. Thus, aggregate demand
increases and prices will go up. The expansions in national income and prices will
increase the level of investment and employment. In this way, the fiscal policy will
affect the employment situation.
3. Effects on consumption pattern
In the poor capitalist economies, government expenditures are influenced by political
decisions. The governments usually do not interfere in the consumption patterns of
people. However, for the welfare of society, government has to interfere. Therefore,
if government wants to decrease the consumption of some products, it imposes tax
on those products. If government wants to increase the consumption of any
commodity, it gives subsidy on its production and consumption. In addition, imposing
higher import taxes on the luxurious imports etc can reduce imports.
4. Economic development
Economic development is the process whereby the real national income of a country
increases over a long period of time. The developing countries are vigorous for
economic development. But shortage of capital is the main hurdle in this way. So,
easy fiscal policy i.e. reduction in taxes, increase in government expenditures and
granting of subsidies to the producers to increase investment is used. When the
process of investment starts, it increases national income manifold. The continuous
increase in national income leads towards economic development.
5. Income redistribution
Fiscal policy is also used to correct the imbalances between the distributions of
income. The poor capitalist economies are facing low per capita income along with
great inequalities in income distribution. So, there is need of redistribution of income.
Progressive taxation system is used for this purpose. Increased income of the rich
people would be taxed and from this income government gives subsides therefore,
the income and expenditures of the poor increase. They are provided with free
housing, medical and educational facilities to improve their standard of living.
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6. Effects on balance of payments (Bop)
Deficit in BOP exists when a country’s foreign payment are greater than its foreign
receipt. This situation has a bad impact on foreign exchange reserves and country
has to face foreign debt problem. Hence, it is a need to remove deficit. So, the
government by adopting a strict fiscal policy reduces its expenditures and increase
taxes which will reduce national income manifold. Hence, reduced national income
will decrease imports and exports will increase of the country Eventually, BOP
position is improved. But a strict fiscal policy will have negative effect on country’s
investment, output and employment.
6.2 Instruments Or Tools of Fiscal Policy
(1) Government Expenditures (G)
(2) Taxes (T), both direct and indirect
(3) Deficit financing, i.e., printing of new notes, government borrowing etc.
(4) Transfer payments i.e., unemployment allowances, scholarships, stipends etc.
(5) Subsidies
Following are the instruments or tools of fiscal policy which the government can use
to achieve the particular purpose.
1. Taxes
Taxes are used to control the fluctuations of business cycles. When there is a
rise in prices, profits, and the need is to contract the inflationary pressure, the
progressive taxation curtails the surplus purchasing power from the economy. In
the opposite situation, under progressive taxation system, the situation is
automatically controlled.
2. Welfare Payments
Governments of the developed countries give unemployment compensation and
other welfare payments to the people when they are out of job. With the increase
in national income of a country, unemployment fund increases due to the
following two reasons:
 Governments receive greater amounts of payroll taxes from the employees.
 Unemployment compensation decreases.
So in this way unemployment compensation reserve funds help in controlling the
inflationary situation during the boom years. When the economy is contracting,
these funds stimulate the income stream.
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3. Farm Aid Programs
This program also helps in controlling the inflationary or deflationary situation.
When the prices of agricultural products are falling and there is a danger of
depression, governments purchase the surplus products of the farmers. In this
way income and expenditures of the farmers remain stable. When the economy
is expanding, governments sell these stocks and try to absorb the surplus
purchasing power. So in this way farm aid program helps to stabilize the
economy.
4. Savings
Companies, corporations and individuals also play an important role in controlling
the inflationary or deflationary situation. Saving is their instrument. When JSCS
withhold a part of their profits in order to distribute this withholding during the year
of low profit, in fact they contract or expand the purchasing power of their
shareholders. Similar is the case with the individuals.
5. Precautionary Measures
The entrepreneurs, in capitalism, are not aware of each others investment plans,
so they cause overproduction and unemployment in the economy. If the
governments publish the investment plans and MEC in various industries,
investors may invest at a moderate speed and there can be stability in income,
production, and employment.
6. Tax Rates
It is also an important instrument of fiscal policy in order to control the fluctuations
of business cycle. When the economy is under inflationary pressure, the
governments may increase the tax rates. Higher taxes reduce the disposable
incomes of the masses which results in a cut to their expenditures. In this way
inflationary pressure can be removed. Similarly deflationary pressure can be
removed by decreasing the tax rates.
7. Public Works Programs
Public expenditures also affect the economic activity. In case of depression, the
governments can initiate public works programs to increase the income of the
people and in case of boom; governments can withdraw funds from the public
works projects to decrease the income of the people.
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8. Transfer Payments
Governments can also achieve their targets of stabilizing the economy by making
changes in transfer payments. When there is a boom situation in the economy,
governments can decrease the transfer payments and vice versa.
9. Credit Aids
Governments can also control the situation by offering long-term loans to the
investors during the depression for the commencement of business. The financial
help can also be extended to bankers and insurance companies by the
governments in order to prevent the financial crisis in the economy.
6.3 Kinds of fiscal Policy
Fiscal policy refers to the use of government spending and taxation to influence
the economy. There are three main types of fiscal policy:
1. Expansionary Fiscal Policy

Expansionary fiscal policy involves increasing government spending
and/or reducing taxes to stimulate economic growth and counteract
recessionary pressures.

Increased government spending on infrastructure projects, education,
healthcare, and social welfare programs aims to boost aggregate demand,
create jobs, and stimulate investment.

Tax cuts provide individuals and businesses with more disposable income,
encouraging consumption and investment.

Expansionary fiscal policy is typically implemented during economic
downturns to stimulate economic activity, increase employment, and
prevent or mitigate recession.
2. Contractionary Fiscal Policy

Contractionary fiscal policy involves reducing government spending and/or
increasing taxes to cool down an overheating economy and control
inflationary pressures.

Decreased government spending aims to reduce aggregate demand, limit
inflationary pressures, and prevent the economy from overheating.

Tax hikes reduce disposable income, dampen consumption, and
investment, thus helping to slow down economic growth.

Contractionary fiscal policy is typically implemented during periods of high
inflation or economic overheating to curb inflation, stabilize prices, and
prevent the economy from overheating.
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3. Neutral Fiscal Policy

Neutral fiscal policy aims to maintain a stable level of government
spending and taxation without actively stimulating or dampening economic
activity.

Government spending and taxation remain relatively constant, with
adjustments made to ensure fiscal sustainability and long-term budgetary
balance.

Neutral fiscal policy is often pursued during periods of stable economic
growth and low inflation, where there is neither a need to stimulate nor
restrain economic activity.
These fiscal policies are tools used by governments to achieve macroeconomic
objectives such as price stability, full employment, and sustainable economic
growth. The choice of fiscal policy depends on the prevailing economic conditions,
policy objectives, and political considerations.
6.4 Crowding out Effect
The crowding out effect refers to the phenomenon where increased government
borrowing and spending leads to a reduction in private sector investment. This
occurs when the government competes with private borrowers for available funds
in the financial markets. Here is how the crowding out effect works:
1. Government Borrowing: When the government increases its borrowing to
finance budget deficits or fund new projects, it issues government bonds to raise
funds from the financial markets. Investors purchase these bonds, providing the
government with the necessary capital.
2. Increased Demand for Loanable Funds: As the government borrows more, it
increases the demand for loanable funds in the financial markets. This
heightened demand can lead to upward pressure on interest rates as lenders
seek higher returns to compensate for the increased risk of lending to the
government.
3. Higher
Interest Rates: The rise in interest rates makes borrowing more
expensive for businesses and individuals in the private sector. As a result, private
investment becomes less attractive, leading to a reduction in borrowing and
spending by businesses on capital projects, expansions, and other investments.
4. Crowding Out Private Investment: With higher interest rates and reduced
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access to credit, private sector investment declines. This reduction in private
investment offsets the initial increase in government spending, limiting the overall
stimulative effect of fiscal policy on the economy.
6.5 Fiscal Policy and Aggregate Demand
Fiscal policy can be used to both increase and decrease aggregate demand,
depending on the economic conditions and policy objectives. Fiscal policy can
affect aggregate demand in both scenarios:
Increasing Aggregate Demand:
1. Expansionary Fiscal Policy: During periods of economic downturn or
recession, governments often implement expansionary fiscal policy to boost
aggregate demand and stimulate economic growth. This involves increasing
government spending and/or reducing taxes to inject more money into the
economy.
2. Increased Government Spending: When the government increases
spending on infrastructure projects, education, healthcare, and social welfare
programs, it directly increases demand for goods and services. This additional
demand creates job opportunities, boosts consumer spending, and encourages
businesses to invest in production and expansion.
3. Tax Cuts: Lowering taxes puts more money in the hands of consumers and
businesses, leading to increased disposable income and higher spending.
Consumers may increase their consumption of goods and services, while
businesses may invest in capital projects and hire more workers.
4. Multiplier Effect: Expansionary fiscal policy can trigger a multiplier effect,
where the initial increase in government spending or tax cuts leads to a series of
subsequent increases in spending throughout the economy. This amplifies the
initial impact on aggregate demand, further stimulating economic activity and
growth.
Decreasing Aggregate Demand:
1. Contractionary Fiscal Policy: When the economy is experiencing high
inflation or overheating, policymakers may implement contractionary fiscal policy
to reduce aggregate demand and control inflationary pressures.
2. Reduced Government Spending: Cutting back on government expenditure,
particularly on non-essential programs and projects, reduces overall demand in
the economy. This decrease in government spending can lead to lower demand
for goods and services, which may slow down economic growth and dampen
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inflationary pressures.
3. Tax Increases: Raising taxes reduces disposable income for consumers and
decreases profits for businesses, resulting in lower spending and investment.
Higher taxes can lead to reduced consumption, decreased investment, and lower
overall demand in the economy.
4. Crowding Out Effect: Contractionary fiscal policy may also lead to a crowding
out effect, where increased government borrowing to finance budget deficits
absorbs available funds in the financial markets, crowding out private investment
and reducing overall aggregate demand.
7. Monetary Policy
Monetary policy refers to the measures which the central bank of a country takes in
controlling the money and credit supply in the country with a view to achieve certain
specific economic objectives.
Monetary policy has two major aspects:
Quantitative Tools or Instruments
The aim of the quantitative control is to regulate the total volume of money.
Qualitative Tools or Instruments
The aim of the qualitative control is to restrict the bank advances to certain specific
purposes (use of credit).
7.1 Objectives of Monetary Policy
Following are the main objectives of monetary policy:

Achievement of full employment without inflation.

Elimination of inflationary and deflationary pressures in the economy.

Achieving stability in foreign exchange rates.

Increasing the standard of living of the people.

7.2 Quantitative Instruments
Quantitative instruments of the monetary policy are as follows:
1. Open Market Operations (OMOs)
‘Open Market Operations refers to the purchase or sale of government securities in
the open market by the commercial banks’.
If at any time, the bank wants to increase the cash held by the commercial banks for
lending purpose, it undertakes buying securities in the open market. The sellers of
securities receive cheques from the central bank which they pay into their accounts.
The cash balances of the commercial banks increase by the value of securities. The
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lending power of the commercial banks goes up and vice versa.
The purchase and sale of securities in the open market is a powerful instrument to
control the volume of member banks reserves.
2. Discount Rate Policy (Bank Rate Policy)
‘Bank rate is the official rate at which the central bank of a country is lends to the
commercial banks.
‘Discount rate is the official rate at which the central bank of a country is prepared to
discount or more correctly to say rediscount the first-class bills of exchange’.
The central bank controls and regulates the volume of bank reserves by discount
rate charges. When the central bank wishes to control the inflationary direction in the
country, it raises the discount rate or bank rate. Borrowing becomes expensive for
the investors. So, the demand for loanable funds reduces which results in fall in
investment. Due to fall in investment, aggregate demand decreases and hence result
is decrease in price level. The pattern is reversed when central bank wants easier
credit in the country. The discount rate is reduced to encourage borrowing and
investment.
3. Cash Reserve Requirements (CRR)
Each commercial bank has to deposit a specific percentage of its deposits with the
central bank. It is the central bank which fixes this reserve ratio and can also change
it for the sake of economic stabilization. If central bank enhances this ratio, the
resources of the commercial banks will decrease and they could be able to advance
less loans. While because of decrease in the reserve ratio, the commercial banks
could be able to advance more loans. In this way the investment, production and
employment could be promoted.
4. Statuary Liquidity Requirements (SLR)
It is compulsory for each commercial bank to keep with itself a certain percentage of
its total deposits. Such ratio is fixed by central bank and central bank can change it
whenever it likes. If central bank finds that the commercial banks are becoming
responsible for excessive credit creation it will enhance the liquidity ratio. This will
hamper their power to lend. In this way, the money market could be controlled. While
by decreasing such liquidity ratio the commercial banks could be able to advance more
loans.
7.4 Qualitative Instruments
Qualitative credit controls are the measures which influence the allocation of credit.
The qualitative credit controls can either be positive or negative.
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Positive credit controls are those which aim to increase the supply or reduce the cost
of credit for specified purposes.
The negative credit controls seek to decrease the supply or increase the cost of
credit for certain specified purposes.
Weapons of qualitative credit controls are as follows:
1. Margin Requirements on Security Loans
‘Margin requirements mean minimum percentage down payments which the
purchaser of stock must make on the market value of the securities’.
Margin requirement is the difference between the market value of the security and its
maximum loan value e.g. If a security has a market value of Rs.200/-, in case of
margin requirement is 60%, the maximum loan which can be advanced for the
purchase of security is Rs.80/-. An increase in the margin requirements reduces the
amount that can be borrowed for the purchase of a security and vice versa.
The quantitative technique is employed to limit the borrowing for the purchase of
listed common stocks so that economic difficulties do not arise in speculative stock
market purchases.
2. Credit Rationing
This method is applied by the central bank in times of financial crises. The central
bank rations the credit of each scheduled bank. It fixes the maximum amount which
each bank can draw by rediscounting bills of exchange.
3. Consumer Credit Control
This technique of monetary management can be applied when there arises a
scarcity of certain listed articles in the country. The central bank will invoke specific
restrains on consumer credit by raising the required down payment and shortening
the maximum period of repayment.
4. Moral Persuasion
The central bank employs a minor instrument of ‘Moral Persuasion’ to influence the
total borrowing at the central bank. Moral caution means friendly precaution in the
regulation of credit by the monetary authorities to the competitive bankers. It includes
policy statements, public pronouncements or outright appeal to community spirit or a
heart to heart talk with the bankers etc.
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5. Direct Action
If the commercial banks are following a policy which is inconsistent with the
monetary policy of the central bank, it can take direct action. It can either refuse to
discount the bills of exchange or impose penalty rate over and above the official rate.
7.5 Kinds of Monetary Policy
There are two main kinds of monetary policy:
1. Expansionary Monetary Policy
Expansionary monetary policy involves measures aimed at increasing the money
supply and lowering interest rates to stimulate economic activity. The key tools used
in expansionary monetary policy include:
Lowering Interest Rates: Central banks decrease interest rates to encourage
borrowing and spending by consumers and businesses. Lower interest rates make it
cheaper to borrow money for investments, mortgages, and other loans, stimulating
consumption and investment.
Open Market Operations: Central banks purchase government securities (bonds)
from the open market, injecting money into the banking system and increasing the
supply of credit.
Lowering Reserve Requirements: Central banks can reduce the reserve
requirements for commercial banks, allowing them to lend more money and increase
the money supply.
Expansionary monetary policy is typically employed during economic downturns to
boost aggregate demand, stimulate investment, and reduce unemployment.
2. Contractionary Monetary Policy
Contractionary monetary policy involves measures aimed at reducing the money
supply and increasing interest rates to slow down economic growth and control
inflation. The key tools used in contractionary monetary policy include:
Raising Interest Rates: Central banks increase interest rates to discourage
borrowing and spending. Higher interest rates make it more expensive to borrow
money, leading to lower consumption and investment.
Open Market Operations: Central banks sell government securities (bonds) to the
open market, reducing the money supply and tightening credit conditions.
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Raising Reserve Requirements: Central banks can increase the reserve
requirements for commercial banks, limiting their ability to lend money and reducing
the money supply.
Contractionary monetary policy is typically employed during periods of high inflation
to cool down an overheating economy and prevent excessive price increases.
Both expansionary and contractionary monetary policies are used by central banks
to achieve macroeconomic stability and promote sustainable economic growth over
the long term. The choice between these policies depends on prevailing economic
conditions, such as inflation rates, unemployment levels, and overall economic
performance.
8. Supply side Polices
Supply-side policies refer to a set of economic strategies aimed at increasing the
productive capacity and efficiency of an economy. Unlike demand-side policies,
which focus on managing aggregate demand through fiscal and monetary measures,
supply-side policies target the factors that influence the production of goods and
services, such as labor, capital, technology, and entrepreneurship. These policies
aim to stimulate economic growth, enhance productivity, and improve the long-term
potential output of an economy. A detailed explanation of supply-side policies is:
1. Labor Market Reforms

Labor market reforms aim to increase the quantity and quality of the workforce,
thereby boosting productivity and economic growth.

Policies may include measures to improve education and training programs,
enhance skills development, reduce barriers to labor mobility, and encourage
workforce participation.

Reforms to labor market regulations, such as flexible employment contracts
and reduced labor market rigidities, can also improve efficiency and
competitiveness.
2. Investment in Physical Capital

Supply-side policies emphasize the importance of investment in physical
capital, such as infrastructure, machinery, and technology, to enhance
production capabilities.

Governments may invest in infrastructure projects such as roads, bridges,
ports, and telecommunications networks to improve transportation and
communication, reduce production costs, and facilitate trade and commerce.
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
Incentives such as tax breaks, subsidies, and grants may be provided to
encourage businesses to invest in new technologies, equipment, and
machinery, leading to higher productivity and innovation.
3. Promotion of Innovation and Entrepreneurship

Supply-side policies promote innovation and entrepreneurship as drivers of
economic growth and competitiveness.

Governments may support research and development (R&D) initiatives, fund
technology transfer programs, and provide grants and subsidies to innovative
firms and startups.

Intellectual property rights protection and patent laws are enforced to
incentivize innovation and ensure that innovators can reap the rewards of
their inventions, fostering a conducive environment for entrepreneurship.
4. Deregulation and Market Liberalization

Supply-side policies advocate for deregulation and market liberalization to
reduce barriers to entry, foster competition, and promote efficiency in product
and factor markets.

Governments may streamline bureaucratic processes, eliminate unnecessary
regulations, and reduce red tape to make it easier for businesses to operate,
innovate, and compete.

Market liberalization measures may include trade liberalization, privatization of
state-owned enterprises, and deregulation of industries to encourage
investment, increase efficiency, and stimulate economic growth.
5. Tax Reforms

Supply-side policies often involve tax reforms aimed at improving incentives
for work, investment, and entrepreneurship.

Tax cuts on income, corporate profits, capital gains, and dividends can
incentivize individuals and businesses to work, invest, and innovate.
Simplifying tax codes, reducing tax compliance costs, and eliminating
distortive taxes can improve efficiency and promote economic growth.
Supply-side policies are designed to enhance the productive capacity of an economy
by addressing structural constraints, fostering innovation and entrepreneurship, and
improving incentives for investment, production, and employment. By focusing on the
supply side of the economy, these policies aim to create a more dynamic,
competitive, and resilient economic environment conducive to sustainable growth
and prosperity.

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Summary
In this chapter, we explored various aspects of macroeconomic policy and its
objectives, along with key elements of public finance. We began by examining the
twin challenges of unemployment and inflation, which are central concerns for
policymakers. Unemployment reflects underutilization of labor resources and can
lead to social and economic hardships, while inflation erodes the purchasing power
of money and distorts price signals in the economy.
We then delved into the Phillips Curve, which illustrates the inverse relationship
between inflation and unemployment. Understanding this relationship is crucial for
policymakers when formulating macroeconomic policies.
Next, we discussed fiscal policy, which involves government taxation and spending
measures aimed at influencing aggregate demand and stabilizing the economy.
Fiscal policy can be expansionary, aimed at boosting demand during economic
downturns, or contractionary, designed to cool down an overheating economy.
Monetary policy was another focal point, involving the control of money supply and
interest rates by the central bank to achieve macroeconomic objectives. By
influencing borrowing costs and liquidity in the financial system, monetary policy can
affect consumer spending, investment, and inflationary pressures.
Lastly, we explored supply-side policies, which focus on enhancing the productive
capacity and efficiency of the economy. These policies aim to stimulate long-term
economic growth by promoting investment, innovation, labor market flexibility, and
deregulation.
Self-Test Questions
Macroeconomic Policy Objectives
1. What are the goals of macroeconomic policy?
2. How does macroeconomic policy contribute to economic stability?
Elements of Public Finance
3. What are the sources of government revenue?
4. How does public expenditure influence economic outcomes?
Unemployment
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5. What types of unemployment exist?
6. What measures can reduce unemployment?
Inflation
7. How does inflation affect consumer behavior?
8. What tools can control inflation?
Inflation and Unemployment: The Phillips Curve
9. What does the Phillips Curve illustrate?
10. How does the Phillips Curve impact policymaking?
Fiscal Policy
11. What are the objectives of fiscal policy?
12. How does fiscal policy influence economic activity?
Monetary Policy
13. What are the goals of monetary policy?
14. How does the central bank implement monetary policy?
Supply-side Policies
15. What is the purpose of supply-side policies?
16. How do supply-side policies impact economic growth?
Practice Questions
Question 1
1. What are the primary objectives of macroeconomic policy?
A. Reducing income inequality
B. Maximizing government revenue
C. Achieving price stability and full employment
D. Controlling population growth
Solution: C. Achieving price stability and full employment
Question 2
How does macroeconomic policy contribute to economic stability?
A. By increasing government spending
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B. By reducing taxation
C. By managing aggregate demand and supply
D. By promoting international trade
Solution: C. By managing aggregate demand and supply
Question 3
What are the main sources of government revenue?
A. Borrowing and grants
B. Taxes and subsidies
C. Exports and imports
D. Investments and donations
Solution: A. Borrowing and grants
Question 4
How does public expenditure influence economic outcomes?
A. By reducing government debt
B. By increasing aggregate demand
C. By decreasing consumer spending
D. By lowering interest rates
Solution: B. By increasing aggregate demand
Question 5
What types of unemployment exist?
A. Structural and frictional
B. Seasonal and cyclical
C. Demand-pull and cost-push
D. Voluntary and involuntary
Solution: A. Structural and frictional
Question 6
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What measures can reduce unemployment?
A. Increasing taxes
B. Decreasing government spending
C. Implementing job training programs
D. Tightening monetary policy
Solution: C. Implementing job training programs
Question 7
How does inflation affect consumer behavior?
A. It encourages saving
B. It reduces purchasing power
C. It decreases interest rates
D. It increases investment
Solution: B. It reduces purchasing power
Question 8
What tools can control inflation?
A. Expansionary fiscal policy
B. Tightening monetary policy
C. Increasing government subsidies
D. Decreasing international trade
Solution: B. Tightening monetary policy
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Contents
1.
Inflation in Pakistan: Causes and Remedial measures
2.
Key features of Pakistan’s current fiscal and monetary policy
3.
Functions and role of Central bank and State bank of Pakistan
4.
Interest rate determination and its trends in Pakistan
5.
Balance of payments and trade and their trends in Pakistan
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1. Inflation in Pakistan: causes and remedial measures
Causes of high inflation in pakistan
High inflation in Pakistan is driven by a combination of domestic and external factors.
Inflation refers to the sustained increase in the general price level of goods and
services over time. These are some of the key causes of high inflation in Pakistan:
1. Monetary Factors
Excessive Money Supply
When there is an excessive growth in the money supply relative to the country's
economic output (GDP), it can lead to demand-pull inflation. The central bank may
print more money or maintain low interest rates, increasing the availability of money
in the economy.
Monetary Policy
The effectiveness of the central bank's monetary policy in controlling inflation can
influence the inflation rate. If monetary policy is too loose, it can fuel inflationary
pressures.
2. Fiscal Factors
Budget Deficits
Persistent budget deficits occur when government expenditures exceed revenue. To
cover these deficits, the government may resort to borrowing or printing money, both
of which can contribute to inflation.
Subsidies
Government subsidies on essential goods and services can distort prices, leading to
imbalances in supply and demand and contributing to inflation.
3. Exchange Rate Movements
Exchange rate depreciation can increase the cost of imported goods and services,
which can lead to cost-push inflation. Pakistan's reliance on imports for various
goods, including petroleum, makes it vulnerable to exchange rate fluctuations.
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4. Energy Prices
Fluctuations in energy prices, particularly oil and gas, can have a significant impact
on the cost structure of the economy. Increases in energy prices can lead to higher
production costs and push up overall prices.
5. Food Insecurity
Pakistan's agriculture sector faces challenges related to water scarcity, crop failures,
and inadequate infrastructure. These issues can disrupt food production and
distribution, leading to food price inflation.
6. Global Commodity Prices
Pakistan imports a variety of commodities, and changes in global commodity prices
can affect the cost of production and contribute to inflation.
7. Supply Chain Disruptions
Disruptions in supply chains due to factors like natural disasters, political instability,
or logistical issues can lead to shortages and increase prices for various goods.
8. Demand-Pull Inflation
Rising consumer demand can also drive up prices. Population growth, urbanization,
and increased consumer spending can create demand pressures that lead to
inflation if supply cannot keep up.
9. Inflation Expectations
When people and businesses expect prices to rise in the future, they may adjust
their behavior by demanding higher wages or increasing prices. These expectations
can become self-fulfilling and contribute to inflation.
10. Structural Issues
Structural problems in the economy, such as inefficient production processes, a lack
of competition in certain industries, and poor infrastructure, can hinder productivity
and contribute to higher prices.
11. Government Policies and Regulations
Government policies and regulations, such as price controls and import restrictions,
can distort markets and lead to imbalances in supply and demand, resulting in
inflation.
12. Political Instability and Uncertainty
Political instability, corruption, and uncertainty can undermine economic confidence
and deter investment, affecting overall economic stability and contributing to inflation.
Measures to decrease inflation
Controlling inflation is a critical economic challenge for many countries, including
Pakistan. High inflation erodes the purchasing power of consumers, reduces the
standard of living, and can hinder economic growth. To decrease inflation in Pakistan,
the government and central bank can consider implementing a combination of
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monetary, fiscal, and structural measures. These are some key measures that can
be taken:
1. Monetary Policy
a. Interest Rate Adjustments: The State Bank of Pakistan (SBP) can use its
monetary policy tools to control inflation. Raising interest rates is a common method
to reduce inflation by making borrowing more expensive, thereby reducing consumer
spending and investment.
b. Open Market Operations: The SBP can engage in open market operations to
buy or sell government securities to influence the money supply and interest rates.
c. Reserve Requirements: Adjusting the reserve requirements for commercial
banks can also affect the money supply. Increasing reserve requirements can
reduce lending by banks and decrease money supply growth.
2. Fiscal Policy
a. Government Spending: The government can reduce its spending, especially
on non-essential projects and programs. This reduces the overall demand in the
economy, helping to control inflation.
b. Taxation: Increasing taxes can reduce disposable income, leading to reduced
consumer spending. However, it's important to target tax increases carefully to avoid
stifling economic growth.
c. Subsidy Reforms: Targeted subsidy reforms can reduce the fiscal burden on
the government and help manage inflation. Subsidies that primarily benefit higherincome groups can be reduced or eliminated.
3. Exchange Rate Management
a. Exchange Rate Policy: A stable exchange rate can help control inflation by
reducing imported inflation. The central bank can intervene in the foreign exchange
market to stabilize the currency.
4. Supply-Side Policies
a. Improving Infrastructure: Investments in infrastructure development, such as
improving transportation and energy supply, can increase the productive capacity of
the economy and reduce supply-side bottlenecks.
b. Agricultural Reforms: Since food prices often play a significant role in inflation,
improving agricultural productivity through reforms and investments can help
stabilize food prices.
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c. Competition and Antitrust Measures: Encouraging competition and
implementing antitrust policies can help prevent monopolies or oligopolies from
exerting excessive pricing power.
5. Central Bank Communication
Clear and effective communication by the central bank regarding its inflationtargeting policies and objectives can help shape inflation expectations in the
economy.
6. Inflation Targeting
Explicitly adopting an inflation targeting framework can help anchor inflation
expectations. The central bank can set a specific inflation target and adjust monetary
policy to achieve that target.
7. Financial Sector Reforms
Strengthening the financial sector, improving access to credit, and enhancing the
effectiveness of monetary policy transmission mechanisms can help control inflation.
8. Wage and Price Controls
While not a preferred method, in extreme cases, temporary wage and price controls
can be imposed to curb inflation. However, this approach is often associated with
negative side effects, such as black markets and reduced supply.
9. Global Trade Agreements
Facilitating trade through bilateral and multilateral agreements can help reduce the
cost of imported goods and mitigate inflationary pressures.
10. Data and Research
Regularly collecting and analyzing inflation data is crucial for policymakers to make
informed decisions. Reliable economic data is essential for effective policy
formulation.
It is important to note that implementing these measures requires careful
consideration and coordination among various government agencies and institutions.
Additionally, the effectiveness of these measures can vary depending on the specific
economic conditions and challenges facing Pakistan at any given time.
2. Key features of current fiscal policy (2023-2024)
The recently announced Budget 2023-24 has generated considerable interest and
anticipation among the public, policymakers, and businesses alike. With a total
budget of PKR 14.5 trillion, Finance Minister Ishaq Dar presented an ambitious plan
to drive economic growth, address social challenges, and foster development across
various sectors. We will delve into the key features of Budget 2023-24, highlighting
the initiatives, allocations, and growth targets that will shape the upcoming fiscal year.
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key features of budget 2023-24
The budget for the fiscal year 2023-24 presents several key highlights aimed at
addressing the nation’s economic challenges and promoting growth.
Some of the key features of Budget 2023-24 include:

Economic growth target fixed at 3.5% for FY 2023-24

Inflation is forecasted to average at 21%

Tax-to-GDP ratio to stand at 8.7%

Current account deficit is projected to be USD 6 billion by the end of FY
2023-24

Government has allocated PKR 1.8 trillion for defence spending

PKR 1.1 trillion earmarked for subsidies

PKR 761 billion allocated for pensions

Government to spend PKR 950 billion on Public Sector Development
Programme

PKR 22.7 billion earmarked for the health sector

Agricultural credit limit enhanced from PKR 1,800 billion to PKR 2,250
billion

Solarisation of 50,000 agriculture tube wells through PKR 30 billion

Withdrawal of all duties and taxes on imported seeds, combined
harvesters, dryers, and rice planters

PKR 10 billion earmarked for PM’s Youth Business and Agriculture
Loans scheme

PKR 6 billion subsidies announced on imported urea

Targeted subsidy announced on wheat flour, ghee, pulses, and rice

35% increase in salaries of government servants of grades 1-16 in the
form of ad-hoc relief

30% increase in salaries of government servants of grades 17-22 in the
form of ad-hoc relief

Tax-free imports of software and hardware by IT and IT-enabled
services equal to 1% of their exports with a ceiling of USD 50,000

No sales tax return is required by freelancers with exports of USD
2,000 per month

Increase in Benazir Income Support Programme allocation from PKR
400 billion to PKR 450 billion

Upward revision in pensions and increase in minimum pension to PKR
12,000

PKR 10 billion was set aside for the provision of 100,000 laptops for
students
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
Exemption of customs duty on the import of raw material for batteries,
solar panels, and inverters
Development initiatives in FY 2023-24
The Annual Development Program (ADP) has been allocated a budget of PKR 1,150
billion and PKR 90 billion has been earmarked for the Public Sector Development
Program (PSDP).
The following are the details of the initiatives in FY 2023-24:

PKR 170 billion has been reserved for Special Initiatives of the Prime Minister
and Development Schemes of lawmakers

PKR 58.59 billion are reserved for Dasu Hydropower Project

PKR 17 billion are allocated for Karachi Greater Water Supply Scheme

PKR 17.63 billion will be used for purchasing railway freight wagons and
passenger bogies

PKR 14.86 billion allotted for Karachi Coastal Power Project

PKR 26 billion is reserved for Merged districts of Khyber Pakhtunkhwa

PKR 31 billion will be utilised for a 10-year development plan for the former
tribal areas

PKR 10.5 billion has been allocated for Mohmand Dam Hydropower Project

PKR 12 billion reserved for Jamshoro Coal Power Project

PKR 16 billion will be allocated for the Pakistan-Tajikistan transmission line

PKR 6 billion has been allotted for the Rehabilitation of flood-affected areas

PKR 5.70 has been set aside for the Hyderabad-Sukkur Motorway project

PKR 5 billion has been reserved for New Gwadar International Airport

PKR 5 billion allotted for Lahore-Sialkot Motorway, from Narang Mandi to
Narowal
Growth targets for various sectors for 2023-24
The budget for the fiscal year 2023-24 also outlines growth targets for different
sectors. The target for GDP growth rate is set at 3.5%, with the agriculture sector
and major crops also expected to grow by 3.5% each. The industrial production
growth target is 3.4%, while manufacturing is targeted at 4.3%. The services sector
is projected to grow by 3.6%.
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Other growth targets include 3.6% for the livestock sector, 7.2% for cotton canning,
3% for forestry and fisheries, 3.2% for large-scale manufacturing, 2.2% for electricity
generation and gas distribution, 2.8% for the wholesale and retail sector, and 5% for
transport and communication sector. The education sector is aimed at a 3% growth
rate, while the private sector production is expected to increase by 5%. The real
estate sector is targeted at 3.6% growth, and the financial and insurance sector at
3.7%.
Tax relief for builders
In Budget 2023-24, tax relief for builders and individuals undertaking construction
projects includes a 10% or PKR 5 million deductions on business income for three
years. The individuals undertaking construction projects will get a tax relief of 10% or
PKR 1 million for the next three years. Concessional tax rates for banks providing
loans to construction, agriculture, and SMEs are extended. Land developers will be
taxed at a lower rate of 5% of turnover.
3. Key features of current monetary policy
Contrary to market expectations, the Monetary Policy Committee (MPC) of the State
Bank of Pakistan (SBP) on Thursday kept the key policy rate unchanged at 22%.
At its meeting today, the MPC decided to maintain the policy rate at 22%,” the SBP
said in a statement.
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This decision takes into account the latest inflation outturn reflecting the continuing
declining trend in inflation from its peak of 38% in May to 27.4% in August.
Even though global oil prices have risen recently and are being passed on to
consumers through adjustment in administered energy prices, inflation is projected to
remain on the downward trajectory, especially from the second half of this year
As such, real interest rates continue to remain in positive territory on a forwardlooking basis. Moreover, the expected ease in supply constraints owing to better
agriculture output and the recent administrative measures against speculative
activity in the FX and commodity markets would also support the inflation outlook.
The MPC said it noted four key developments since its July meeting.

First, agriculture outlook has improved, based on the latest data on cotton
arrivals, better input conditions, and satellite data indicating healthy vegetation
of other crops.

Second, global oil prices have been rising and are now hovering over
$90/barrel level.

Third, as anticipated, the current account posted a deficit in July after
remaining in surplus for the last four months, partly reflecting the impact of the
recent ease in import restrictions.
Finally, recent administrative and regulatory measures aimed at improving
availability of essential food commodities and curbing illegal activities in the
foreign exchange market have begun to yield results. This has helped in
narrowing the gap between the interbank and open market exchange rates.
The statement said the MPC will continue to monitor the risks to the inflation outlook
and, if required, it will take appropriate action to achieve the objective of price
stability.
At the same time, the MPC also stressed on maintaining a prudent fiscal stance to
keep aggregate demand in check. This is necessary to bring inflation down on a
sustainable basis and to achieve the medium-term target of 5-7 percent by end-FY25.

4. State bank of Pakistan and its functions
Bank
Bank is a financial institution which borrows for lending. Banks get surplus money
from the people as deposits and advance the same as loans to those who need it for
their business.
Central Bank
It is the most important of all banks. Almost every country of the world has its own
central bank. Our central bank is the State Bank of Pakistan. Reserve Bank of India,
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Bank of England and Federal Reserve System are the central banks of India,
England and U.S.A. respectively.
The central bank is the head, the leader and the supervisor of the banking and
monetary system of a country. It controls total amount of currency and credit. It has
the monopoly of note-issue. It also acts as adviser to the government in monetary
matters. Central hank in most countries is generally all autonomous body and many
of its policies are independent of direct government control.
State Bank of Pakistan
The central bank of our country is called the State Bank of Pakistan. It was
established just a few months after the independence of the country. This is the most
important financial institution of Pakistan and is the leader in this field. The State
Bank of Pakistan is not guided by profit motive. It acts only in the interest of the
country.
Constitution and Set up of SBP
State Bank was established on 1st July 1948 as a semi-government institution. The
government held 51% of the shares and the remaining 49% were held by the private
sector.In 1974, the bank was nationalized along with commercial banks. Now it is
completely a government bank. Powers of the State Bank to regulate money supply
and control financial institutions in the country were increased in 1956, 1974 and
1997. (The National Assembly increased the powers through its acts: State Bank of
Pakistan Act 1956, Banks Nationalization Act 1974, and Banking Companies Act
1997).
Management of SBP
The management and supervision of the bank vests in the Central Board of Directors.
This board has one Governor, two Deputy Governors and eight directors. The
governor is appointed for five years. The Governor is the Chief Executive Officer and
directs and controls the whole affairs of the Bank, on behalf the Central Board. The
Central Board of Directors must have at least six meetings in a year. There is an
Executive Committee headed by the governor, which controls day-to-day business of
the bank, on behalf of the Central Board of Directors. Its head office is at Karachi.
There are local hoards at Lahore and Karachi.
Departments
The organization of the Bank has been divided into Nineteen Departments. The
more important are:
1. Issue Department
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This department issues notes. The Bank is required to keep reserve of gold or silver
bullion and approved foreign currencies against each note issued.
2. Banking Supervision Department
This department is concerned with the supervision of banking business in the
Country. It controls the amount of credit issued by commercial banks. The banks,
which work under control of State Bank, are called scheduled banks.
3. Exchange and Debt Management Department
This is responsible for the control of foreign exchange. It fixes exchange rates of
various currencies. It gets foreign exchange from the exporters and distributes the
same among importers. The department prepares balance of payments accounts.
4. Research Department
The State Bank maintains a research department to make studies and analysis of
monetary, economic and commercial problems. It publishes reports about the
economic condition of the country.
5. Islamic Banking Department
To promote Islamic banking, the State Bank established Islamic Banking Department
in 2003. It will provide opportunities to the people to manage their financial
relationships in line with their Islamic beliefs. It issues licenses for Islamic
commercial banks.
Functions of State Bank of Pakistan
The State Bank of Pakistan performs all those functions, which a central bank is
supposed to do. Like a Central Bank in any developing country, the State Bank of
Pakistan performs both the traditional and developmental function to achieve macro
economic goals. The traditional functions may be classified into two groups:
a) Primary Functions
Primary functions include issue of notes, regulation and supervision of the financial
system, bankers' bank, lender of the last resort, banker to Government, and conduct
of monetary policy.
b) Secondary Functions
Secondary functions include the agency functions like management of public debt,
management of foreign exchange, etc. and other functions like advising the
government on policy matters and maintaining close relationships with international
financial institutions.
c) Non-Traditional or Promotional Functions
The non-traditional or promotional functions performed by the State Bank include
development of financial framework in Pakistan, regulating institutional arrangements
for savings and investment, provision of training facilities to bankers, and provision of
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credit to priority sectors like agriculture. The State Bank also has been playing an
active part in the process of Islamization of the banking system.
Main functions and responsibilities of the State Bank are as follows:
1. Monopoly of Note Issues
The State Bank of Pakistan has the monopoly of note issue. It issues 5-rupeee, 10rupee, 50-rupee, 100, 500, 1000 and 5000-rupee notes. The bank follows the
proportional reserve system. All notes issued by it are backed by reserves in the
form of gold coins, gold bullion and approved foreign currencies. Presently 99% of
the currency in circulation in Pakistan consists of notes issued by the State Bank.
2. Banker to the Government
The State Bank conducts the banking business of Federal and Provincial
governments. The Bank provides the following services to the governments:
 holds cash balances of the governments (free of interest).
 accepts the deposits of cash, cheques and drafts by the Government provides
short term loans to the government.
 collects tax revenue and makes payments on behalf of the government.
 pays salaries of the government employees.
3. Bankers' Bank
The State Bank is the leader of banking system. It works as bankers' bank. The
State Bank can give directions to commercial banks pertaining to any matter
concerning their business, and can call for any information in respect of their
transactions. Thus:
 All banks are required to keep some fraction of their cash reserves with State
Bank.
 It provides loans to banks through rediscounting of bills.
 It provides guidance and direction to other banks to formulate their policies
about deposits, credit, investment and interest rate.
 It fixes the cash/deposit ratio for commercial banks.
 All banks send weekly statements about their deposits and reserves to State
Bank. They also submit annual report to Bank.
4. Adviser to the Government
In financial and monetary matters, the federal and provincial governments seek the
advice of the State Bank i.e. currency, fixing of exchange rates, saving schemes,
Islamization of banking etc. are made under the guidance of the State Bank. It also
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acts as representative of the government of Pakistan in international organizations.
The State Bank prepares the Annual Credit Plan in consultation with the govt.
5. Manager of Public Debt
The Bank is responsible for the management of domestic and foreign debt of the
government. It makes interest payments, arranges prize-bond draws.
6. Clearing House
All banks have accounts at the State Bank. So the mutual claims of commercial
banks are settled and cleared through transfer of funds from account of one bank to
another. No cash is used. The State Bank maintains clearing houses.
7. Guardian of Reserves
The State Bank is the guardian of all types of monetary reserves. Gold and foreign
exchange reserves of the government are kept with the bank.
8. Manager of Foreign Exchange
All payments and receipts of foreign currencies are done through this bank. Foreign
aid is also handled by the bank. The Bank is responsible to keep the exchange rate
of the rupee at an appropriate level and prevent it from wide fluctuations.
9. Relationships with International Financial Institutions
Pakistan is the member of International Monetary Fund. The State Bank of Pakistan
deals with the IMF on behalf of the Government of Pakistan.
10. Lender of Last Resort
Whenever some bank runs short of cash and is unable to get help from other
sources, the State Bank comes to its rescue. The State Bank lends enough funds to
them to ensure their liquidity and solvency. For this reason, people have more
confidence in scheduled banks than in non-scheduled banks.
11. Controller of Credit (Monetary Policy)
The State Bank is the guardian of money market. It is responsible to regulate the
monetary and credit system of the country in such a manner that ensures monetary
stability in the economy in the country. The government has given it vast powers to
regulate the volume and direction of bank loans. It adopts the following methods for
this purpose.
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12. Promoter of Economic Stability and Growth
The State Bank is responsible for suggesting and taking all those measures, which
can bring economic and financial stability to the country. It co-operates with the
government to ensure that the economy grows at a satisfactory rate.
13. Non-traditional Functions
Scope of Bank's operations has been widened considerably by including the
economic growth objective in its responsibilities, development of new financial
institutions and debt instruments, establishment of Development Finance Institutions
(DFIs), directing the use of credit according to development priorities, providing
Subsidized credit, and development of capital market.
14. Annual Reports
Prepares annual and quarterly reports on the state of the economy and presents the
same in Parliament.
5. Role of state bank in Pakistan economy
The role of a central bank in a country's economy has generally two aspects:
Regulatory
First aspect is to supervise and control the banking and monetary system of the
country.
Promotional and Developmental
Second aspect is to expand the scope of banking operations, create specialized
institutions and provide funds for development, programs in agriculture, trade,
transport and industry. So far as the State Bank of Pakistan is concerned, it gives us
satisfaction to note that the bank has been playing very active and significant role on
both accounts.
Summary of Achievements and Performance
1. Sound Currency System
Economic development leads to expansion of markets, greater specialization and
more use of money. Economic growth can continue only if currency system is
regulated to avoid inflation and depression situations. By means of controlled
expansion of credit, the State Bank has ensured stability in monetary sector.
2. Expansion of Banking System
The State Bank has been helping in the establishment of new banks. It sponsored
National Bank of Pakistan in 1949. Recently, First Women Bank, First Micro Finance
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Bank, Khushali Bank and SME Bank for small and medium size enterprises have
been established.
3. Establishment of Specialized Institutions
To promote development in various sectors of the economy, the State Bank of
Pakistan extended valuable help to establish of specialized institutions e.g. Zarai
Traqiati Bank of Pakistan (ZTBP), IDBP. House Building Finance Corporation
(HBFC), SME Bank.
4. Price Stability
State Bank controls price level. Pakistan faced inflation during the 1970s and 80s but
due to policies of the State Bank, the situation remained under control. In 2009-10,
the, inflation rate is high. The Bank is following policies to control it.
5. Balanced Distribution of Credit
Under the guidance and control of the State Bank, the pattern of lending by
commercial banks has changed. This is a good sign for the country's development.
6. Annual Credit Plan
The Bank prepares Annual Credit Plan for the economy and fixes targets of loans for
govt. and private sectors. The banking sector works to achieve the target.
7. Wider Distribution of Credit
In the past, Pakistan faced the problem of concentration of bank credit in few hands.
A small number of industrial groups and families got major part of loans. SBP
changed the trend and directed banks to provide more funds for small loans.
8. Special Financing Schemes
The State Bank has introduced many schemes to provide special financial facilities
to small enterprises in agriculture, business and industry.
 Small loans scheme
 Small agricultural loans by commercial banks.
 Financing local sale and Export of locally manufactured machinery
 Credit Guarantee Scheme to cover the risk of commercial banks in case of
small loans.
 Export Finance Scheme to provide loans to exporters at low rate of interest
 Poverty alleviation Fund has been created to help the poorest sections of the
society.
 Deposit insurance scheme has been introduced to protect small depositors
9. Training
The SBP has imparts training in banking practices to its own staff as well as staff
from other local and foreign banks of developing countries.
10. Islamic Banking
The State Bank runs an Islamic Banking Department to promote Islamic modes of
banking. It has issued licenses to Meezan Islamic Bank and others.
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11. Expanding Money Market and Capital market
A well-developed money market and capital market are prerequisites for the financial
stability and development of a country. The State Bank (i) established stock
exchanges at Karachi and Lahore, and Islamabad to promote capital market. (ii)
established auction market (bill market) of Treasury Bills (iii) Appointed authorized
money changers to deal in foreign exchange.
12. Recovery of Default Loans
During past few years because of political influence many borrowers did not pay
back bank loans. The State Bank started a drive to recover these loans.
13. Source of Income for the Government
The State Bank is also a source of income for the government. This income helps
the government to finance its expenditures.
14. E-banking
To transform its own offices and other banks into a highly professional, efficient and
institutions, SBP is actively pursuing the policy of technology up-gradation
automation and use of new information technology.
15. Strengthening of Payment Systems
To increase efficiency of national payment system SBP has introduced reforms that
include migration from a mainly cash and paper-based system to electronic
payments.
16. Publications
The State Bank also publishes different articles which are as follows:




Annual Report
Banking Statistics of Pakistan (Annual)
Index Numbers of Stock Exchange
Pakistan Balance of Payments (Annual)
17. Scholarships for PhD
The Bank has started scholarships for PhD in economics and finance in order to
meet its needs for professionally qualified personnel in these fields.
6. Interest rate determination
An interest rate is the percentage yield on a financial security such as a bond or a
stock. The higher the price of a financial asset, other things remaining the same, the
lower is the interest rate. An example will make this relationship clear. Suppose the
federal government sells a bond that promises to pay $10 a year. If the price of the
bond is $100, the interest rate is 10 percent per year—$10 is 10 percent of $ 100. If
the price of the bond is $50, the interest rate is 20 percent—$10 is 20 percent of $50.
And If the price of the bond is $200, the interest rate is 5 percent—$10 is 5 percent
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of $200.
People divide their wealth between bonds (and other interest-bearing financial
assets) and money, and the amount they hold as money depends on the interest
rate. We can study the forces that determine the interest rate either in the market for
bonds or the market for money. Because the Fed can influence the supply of money,
we focus on the market for money.
Money market equilibrium
The interest rate is determined by the supply of and demand for money. The quantity
of money supplied is determined by the actions of the banking system and the Fed.
On any given day, the supply of money is a fixed quantity. The real quantity of
money supplied is equal to the nominal quantity supplied divided by the price level.
At a given moment in time, there is a particular price level, and so the quantity of real
money supplied is also a fixed amount. The supply curve of real money is shown in
following diagram as the vertical line labeled MS.
The quantity of real money supplied is M2 trillion. On any given day, all the influences
or factors of demand for money except for the interest rate are constant. But the
lower the interest rate, the greater is the quantity of money demanded. The figure
above shows a demand for money curve, MD.
Equilibrium
When the quantity of money supplied equals the quantity of money demanded, the
money market is in equilibrium. Figure above illustrates equilibrium in the money
market. Equilibrium is achieved by changes in the interest rate. If the interest rate is
too high, people demand a smaller quantity of money than the quantity supplied.
They are holding too much money. In this situation, they try to get rid of money by
buying bonds. As they do so, the price of a bond rises and the interest rate falls to
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the equilibrium rate. Conversely, if the interest rate is too low, people demand a
larger quantity of money than the quantity supplied. They are holding too little money.
In this situation, they try to get more money by selling bonds. As they do so, the price
of a bond falls and the interest rate rises to the equilibrium rate. Only when the
interest rate is at the level at which people are holding the quantity of money
supplied do they willingly hold the money and take no actions that change the
interest rate.
Changing the interest rate
Suppose that the economy is overheating and the Fed fears inflation. It decides to
take action to decrease aggregate demand and spending. To do so, it wants to raise
interest rates and discourage borrowing and expenditure on goods and services.
What does the Fed do?
The Fed sells securities in the open market. As it does so, it mops up bank reserves
and induces the banks to cut their lending. The banks make a smaller quantity of
new loans each day until the stock of loans outstanding has fallen to a level that is
consistent with the new lower level of reserves. The money supply decreases.
Suppose that the Fed undertakes open market operations on a sufficiently large
scale to decrease the money supply from M2 trillion to M1 trillion. As a consequence,
the supply curve of real money shifts leftward, as shown in following diagram, from
MSo to MSI.
The demand for money is shown by MD. With an interest rate of i3 percent and M1
trillion of money in the economy, firms and households are now holding less money
than they wish to hold. They attempt to increase their money holding by selling
financial assets. As they do so, the prices of bonds fall and the interest rate rises.
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When the interest rate has increased to i4 percent, people are willing to hold the
smaller M1 trillion of money that the Fed and the banks have created.
Conversely, suppose that the Fed fears recession and decides to stimulate spending
by increasing the money supply. If the Fed increases the real money supply to M3
trillion, the supply of money curve shifts rightward from MSo to MS2. Equilibrium
occurs when the interest rate has fallen to i2 percent.
7. Trends of trade in Pakistan
Exports
An analysis of group wise data suggests that major groups registered a negative
growth. Food group decreased by 3.4 percent and reached $ 3.8 billion during JulMar FY2023 as against $ 3.9 billion same period last year. Within the food group,
rice exports decreased both in quantity and value by 18.8 percent and 10.9 percent,
respectively.
Structure of Exports
The food Group
Basmati Rice
The basmati rice exports decreased both in quantity and value by 21.5 percent and
7.2 percent, respectively during Jul-Mar FY2023. The major decline was observed in
rice exports to Afghanistan (98 percent), followed by China (57 percent). Likewise,
the other varieties under rice group during Jul-Mar FY2023 witnessed a decline of
12.1 percent in value and 18.4 percent in quantity.
Fruits
Exports earnings from fruits during Jul-Mar FY2023 decreased by 42.6 percent in
value despite an increase of 4.1 percent in quantity, Vegetables witnessed an
increase in quantity by 53.4 percent but decline by 5.5 percent in value.
Fish & fish preparation
Fish & fish preparation subgroup during Jul-Mar FY2023 witnessed an increase of
13.9 percent in value and 29.8 percent in quantity, due to several reasons including:
China has lifted sanctions on imports of Jellyfish from Pakistan in July 2022.
Moreover, some species like squids, cuttlefish and ribbon fish have fetched better
prices in the world markets.
The exports of fish & fish preparation continued to soar mainly due to the
diversification of the exportable commodities from Pakistan, earlier shrimp, lobsters,
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ribbonfish, and large cuttlefish (Pharaoh Cuttlefish) were the main exports. Now four
additional species of cuttlefish are being exported. Further, another Pakistani fishing
processing plant has joined European Commission (EC) for fishery exports. This is
the third Pakistani company listed in the EC. In 2013, after a six year, EC has lifted a
ban and granted permission to only two companies to export fishery product to
European countries. In addition, large quantities of fish meal are exported to China
for the aquaculture industry. Many modern fish meal plants have been set up,
manufacturing high-quality fish meal for export. Export of shellfish such as whelks,
clams and razor clams are now considered important seafood commodities which
are exported in live, frozen and chilled forms.
Oil Seeds, Nuts & Kernels
Exports of oil seeds, nuts & kernels witnessed an increase of 14.0 percent in quantity
despite a decline in value by 5.5 percent during Jul-Mar FY2023.
Meat and meat preparation
Meat and meat preparation exports increased both in value and quantity by 21.4
percent and 22.5 percent, respectively during Jul-Mar FY2023.The exports of meat
sector have had gradual growth over a period, due to opening of new markets,
compliance with the food standards set by of various exporting countries, and use of
advanced machinery and new practices to Pakistan. The meat exports include raw
and frozen beef, mutton, lamb, and chicken. The exports of by-products include
casing, bones, horns and hooves, gelatine, etc. Pakistan’s exports of meat and meat
preparations are gradually penetrating different countries in terms of volume and
value as it recorded a staggering increase. The major meat exports destinations
include: Gulf countries including Saudi Arabia, United Arab Emirates, Kuwait, Qatar,
Bahrain, Hong Kong, Maldives, and Vietnam. Recently, the Malaysian government
has approved certification of four Pakistani meat exporter companies, which is a
major breakthrough as Malaysia is lucrative market for exports of Halal meat.
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Table: Structure of Exports
Textiles and apparel sector
Textiles and apparel sector occupies a pivotal position in Pakistan’s economy having
most intensive backward and forward linkages compared to any other sector. It
contributes approximately 60 percent in total exports and 40 percent in industrial
employment. Pakistan is the fifth largest cotton producing country with tremendous
potential for further improvement in its share in the world.
During Jul-Mar FY2023, exports of textile group witnessed a decline of 12.4 percent
and reached US$ 12.5 billion compared to US $ 14.2 billion during the corresponding
period last year. Textile sector faced multiple issues including energy shortages, high
electricity tariffs, elevated financing costs, and global slowdown. Moreover, the
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devastating flood has destroyed cotton crop which possess severe challenges for the
industry. The zero-COVID policy in China is providing more opportunity for other
economies to seize its exports share. Bangladesh has grabbed this opportunity with
both hands. However, in Pakistan the domestic economic issues are creating hurdle
in exploiting this opportunity. The other problem is of the turnaround time of exports.
Raw material is being imported, processed, and re-exported. The turnaround time in
Pakistan is 5 to 6 months higher than in Bangladesh which is 1 to 2 months.
According to U.S. Department of Agriculture, “Cotton: World Markets and Trade”
report, the global cotton production in 2022-23 up to 116.5 million bales and
attributed to higher production in China, Mexico, and Uzbekistan. Consumption is
lowered more than 500,000 bales to 109.6 million and attributed to lower use in
Bangladesh. The world’s three largest consumers – China, India, and Pakistan – are
forecast to account for more than half of the global increase. Of the top ten
consuming countries, all are expected to have higher use. After significant reductions
for India, Pakistan, and Bangladesh in the previous year, a general easing of
financial pressures and greater supplies are expected to support consumption.
Textile sector is currently experiencing a shortage of raw material and unavailability
of foreign currency for the import of essential machinery, which is hindering
production. In that backdrop, many textile firms had suspended operations, therefore,
exports would remain under pressure until the situation normalised.
In case of home textiles, bedwear decreased both in quantity and value by 23.3
percent and 17.0 percent; respectively, whereas towels exports also decreased in
both quantity and value by 13.2 percent and 9.1 percent in Jul-Mar FY2023. The
unsatisfactory performance of towel exports is mainly attributed to limited access to
technology, ineffective image building and brand- development strategies. Moreover,
towel industry is labour intensive, but scarcity of skilled labour force obstruct exports
growth in terms of quality, productivity and value addition. Knitwear exports grew by
10.6 percent in quantity, despite a decline of 9.1 percent in value during Jul-Mar
FY2023.The exports of readymade garments increased in quantity by 56.8 percent,
however, its value declined by 7.2 percent during Jul-Mar FY2023.The exports of
intermediate commodities like cotton yarn witnessed a decline in both quantity and
value by 28.4 percent and 36.9 percent, respectively, during Jul-Mar FY2023.
The Petroleum group
The Petroleum group’s exports posted a decline of 8.4 percent during Jul-Mar
FY2023. Furthermore, petroleum product exports also plummeted 19.9 percent and
reached US$ 216.1 million during Jul-Mar FY2023.
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Leather Tanned
Exports of leather tanned declined both in quantity and value by 28.3 percent and
17.9 percent, respectively. Footwear exports increased both in quantity and value by
47.9 percent and 18.7 percent, respectively, during Jul-Mar FY2023. According to
the World Footwear 2022, Yearbook the Pakistani footwear industry predominantly
geared the domestic market and is the 7th largest in the world and employs around
one million people. The main markets are Europe, the USA and Arab countries.
Sports Goods
In the case of sports goods, Gloves exports decreased both in quantity and value
32.2 percent and 7.5 percent, respectively, during July-Mar FY2023 and recorded at
US$ 52.4 million. Other major exports of sports goods are football witnessed an
increase both in quantity and value by 36.5 percent and 33.7 percent, respectively.
Pakistan produces high-quality hand-stitched footballs with an uncompromised
quality of the football, its price, and its performance.
Carpets, Rugs, And Mats
Export of carpets, rugs, and mats registered a decline of 7.2 percent in value,
despite an increase in its quantity by 6.4 percent during JulMar FY2023. Pakistan’s
hand-made carpet industry had lost its footings in the global market on account of
elevated prices of raw material, costly labour, and higher freight charges.
Furthermore, troubles in the import of semifinished raw materials through Torkham
Border, ultimately affecting the delivery of finished goods.
Cement
The export of cement witnessed a decline both in quantity and value by 44.4 percent
and 32.1 percent, respectively, during Jul-Mar FY2023 on account of increased
production cost, higher freight charges and soaring coal prices.
Guar and guar products
Exports of Guar and guar products registered growth in quantity by 4.4 percent and
its value declined by 2.2 percent during Jul-Mar FY2023. India meet 85-90 percent of
global guar demand, whereas, Pakistan has a share of 10-15 percent in world’s total
supply. Pakistan has 11 companies making guar split with Pak Gum Industries being
the largest producer. Most of the processing facilities are 20-30 years old which
undermines the quality.
Chemicals And Pharmaceuticals
Exports of chemicals and pharmaceuticals product decline by 2.0 percent and
recorded at US$ 1072.3 million during Jul-Mar FY2023. Chemicals, other than the
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ones used in pharmaceutical and plastic products, had the highest share. The
Pakistan Export Strategy (2023-27) outlines a proposed path for the development of
the pharmaceutical industry in Pakistan. It is a five-year endeavour that was defined
through a consultative process between public and private sector stakeholders. The
strategy addresses constraints in a comprehensive manner and defines concrete
opportunities that can be realized through the specific steps detailed in its Plan of
Action. The Pharmaceuticals Export Strategy is an integral part of Pakistan’s
Strategic Trade Policy Framework (STPF).
Surgical goods & Medical Instruments
During Jul-Mar FY2023, Surgical goods & Medical Instruments exports were
recorded at US$ 335.7 million. European Parliament has passed a new “Medical
Device Regulation” (MDR), which will be effective in May 2024.In order to avoid
adverse effects of the new regulations and safeguard interests of the country, a
consultant firm is being hired to educate, guide and build capacity of the surgical
instrument/medical device sector to comply with the new EU regulations.
Moreover, Pakistan specialised in conventional surgical products, but the demand for
these products in developed countries is declining during last few years due to the
rise of Artificial Intelligence-enabled and electronic products with high precision.
Owing to lack of research and development, the surgical products will lose market
share not only in Europe but also globally.
Concentration of exports
The potential export growth is hindered owed to lack of diversification in export
goods. The trend of Pakistan’s exports of major items remains more or less same
having concentrated on three items, namely cotton manufactures, leather and rice.
These three categories account for 68.1 percent of total exports during Jul-Mar
FY2023.
Among these few items cotton manufactures remain major contributor with 57.3
percent share in total exports, followed by leather (3.2 percent), rice (7.6 percent)
and other items (31.9 percent).This pattern shows that Pakistan’s export is still
exporting few items.
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Table: Pakistan’s Major Exports
(Percentage Share)
Direction of exports
As far as the top export destinations are concerned, USA still remained the largest
exports market for Pakistan during Jul-Mar, FY2023. Exports to USA have
moderately decreased to 19 percent in Jul-Mar FY2023 as compared to 21 percent
last year. Similarly, Chinese share in exports has decreased to 8 percent during the
period under review. The table below presents detailed bifurcation of major export
markets.
Table: Major Exports Markets
(Rs. billion)
Imports
The total imports during Jul-Mar, FY2023 amounted at US$ 43.7 billion as compared
to US$ 58.9 billion in the same period last year, declined by 25.7 percent, reflecting
the impact of policy tightening and other administrative measures.

The food group with a share of 12.2 percent in total imports, increased by 3.8
percent during Jul-Mar FY2023, and its import were recorded at US$ 7333.7
million as against US$ 7068.1 million during the comparable period last year.
Within food group, surge has been observed in the imports of wheat unmilled,
palm oil, soya bean oil and pluses.

The edible oil (Soybeans & Palm) imports remained the significant items in
food group, increased in both quantity and value by 9.3 percent and 11.7
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percent, respectively. The increase in the import bill of edible oil was mainly
attributed to the rise in global palm oil prices. On similar reasons, the import
bill of pulses surged by 58.6 percent during the review period.

The import of petroleum group declined by 11.7 percent during Jul-Mar
FY2023 and reached US$ 13083.1 million as compared to the US $ 14810.1
million corresponding period last year. Within the petroleum group, the
imports of petroleum products decreased both in quantity and value by 34.0
percent and 19.9 percent, respectively. Petroleum crude increased in value by
4.7 percent and quantity decreased by 12.7 percent during Jul-Mar FY2023
as compared to the same period last year. The crude oil prices starting
declining in mid-2022, but are still above the pre- pandemic level.

Imports of Liquefied Natural Gas (LNG) imports decrease by 14.1 percent in
value and Liquefied Petroleum Gas (LPG) imports surged by 3.8 percent
during Jul-Mar FY2023 as compared to the corresponding period last year.
The increase in LNG imports is due to soaring prices of gas in the
international market. The surge in global gas prices due to shortages in
Europe which has put pressure on other markets as well.

Machinery Group imports decreased substantially by 48.2 percent and
reached US$ 4,496.4 million during Jul-Mar FY2023 as compared to
US$ 8,676.3 million the same period last year. Within this group, import bill of
power generating machinery decreased by 67.7 percent and reached
US$ 399.2 million as compared to $ 1,235.9 same period last year. The
import bill of textile machinery registered a decline of 53.9 percent and
reached US$ 286.5 million during Jul-Mar FY2023 against US$ 621.8 million
last year.

Electrical Machinery & Apparatus imports dropped by 17.2 percent
(US$ 1249.1 million) during Jul-Mar FY2022 against ($1509.4 million) in the
same period last year. Within the machinery group, telecom sector imports
decelerated by 65.1 percent (US$ 744.9 million) during Jul-Mar FY2023
(US$ 2137.1 million) last year. Mobile phone imports in Pakistan declined by
71.0 percent during Jul-Mar FY2023 and reached US$ 462.7 million as
compared to US$ 1596.3 million same period last year.

The imports of transport group receded by 54.4 percent and reached
US$ 1536.1 million during Jul-Mar FY2023 as compared to US$ 3367.3
million last year. The import of road motor vehicle decreased by 52.0 percent
of which CBU declined by 71.1 percent and CKD/SKD decreased by 48.4
percent.

Metal group imports decreased by 33.3 percent and reached US$ 3344.3
million. The imports of iron and steel declined both in quantity and value by
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36.0 percent and 31.7 percent, respectively. Imports of iron and steel scrap
decreased both in quantity and value by 41.8 percent and 47.6 percent,
respectively during Jul-Mar FY2023.

In the textile group, imports of raw cotton witnessed an increase in both
quantity and value by 6.1 percent and 16.3 percent, respectively, during Jul-
Mar FY2023 as compared to the same period last year.
Table: Structure of Exports
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Direction of imports
Like exports, Pakistan’s imports are also highly concentrated in few countries.
Pakistan imports from countries like China, Saudi Arabia, UAE, and Indonesia
constitute around 50 percent of the total imports. The share of imports from China
has decreased from 28 percent to 21 percent during Jul-Mar FY2023, while the
share of imports from USA has decreased from 5 percent to 4 percent during the
period under review. Change in Pakistan‘s imports pattern in subsequent years is
shown in Table below:
Table: Major Imports Markets
(Rs. billion)
8. Balance of payments (BOP)
The Balance of Payments of a country is a systematic record of its receipts and
payments in international transactions during a given year.
“The Balance of Payments is the statistical record of the dimensions of the
country’s economic relations with the rest of the world.”
We can say that the Balance of Payment is a record of a country’s external trade
with the rest of the world during a year. Its main purpose is to provide the aid to
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banks, firms and individuals engaged in international trade and finance in their
business decisions.
The Balance of Payments of a country is constructed on the principle of DoubleEntry Book-Keeping. Each transaction is entered on the credit and the Debit sides of
Balance Sheet. But the Balance of Payments Accounting differs from the Business
Accounting.
When a payment is received from a foreign country, it is a credit transaction while
payment to a foreign country is a debit transaction.
The Balance of Payments of a country consists of following three types of accounts.
1. Current Account
Current account determines the national income, output and employment. The
current account of a country consists of all the transactions relating to trade in:

Goods (wheat, rice, machines, etc.)

Services (travel, tourism, insurance, banking, education, health, delegations
etc.)
 Unilateral Transfers (donations, pensions, grants, gifts, remittances etc.)
In the Current Account, exports and imports of goods is the most important item. In
this account, the exports of goods and services and transfer receipts are entered as
Credits because they represent receipts from foreigners. On the other hand, the
imports of goods and services and transfer payments to foreigners are entered as
Debits because they represent payments to foreigners.
The difference between exports and imports of visible items (goods) of a
country is called its Balance of Trade (BOT).
2. Capital Account
Capital account determines the position of a country whether it is a borrower or a
lender. Capital account of a country consists of all transactions in financial assets in
the form of short-term and long-term lending, borrowing and private and official
investments. The capital account shows international flow of investments and
represents the country’s assets and liabilities.

Short term Capital Receipts means foreigners purchase Pakistani private
and official securities which duration is one year or less than one year.

Long term Capital Receipts means foreigners purchase Pakistani private
and official securities which duration is more than one year.

Borrowing from Foreign countries means Pakistan borrows from the world
market bilaterally or multilaterally.

Short term Capital Payments means Pakistani purchase foreigners private
and official securities which duration is one year or less than one year.
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
Long term Capital Payments means Pakistani purchase foreigners private
and official securities which duration is more than one year.
Lending to Foreign countries means Pakistan lends to the world market
bilaterally or multilaterally.
In Capital Account, borrowing from foreign countries and direct investments by
foreign countries represents capital inflow or Credits because they are receipts from
foreigners. On the other hand, lending to foreign countries and direct investments to
foreign countries represents capital outflow or Debits because they are payments to
foreigners.
3. Official Reserve Account
The official reserve account shows that to correct the BOP how much reserves a
country has? The official reserve account demonstrates transactions in country’s
official reserve assets. The official reserve account is in fact a part of the capital
account. Balance of payments accounts of U.K. and U.S.A. show it as a separate
account. This account measures the changes in nation’s liquid and non-liquid
liabilities to foreign official holders and the change in a nation’s official reserve assets
during the year. The official reserves assets of a country include its gold stock,
holding of its convertible foreign currencies and SDRs or ODRs4 and its net position
in the IMF.

The sum of the current and capital accounts is zero. The BOP of a country ‘A’ is
constructed as under:
Balance of Payments Account
CREDIT (+)
(Receipts)
DEBIT (-)
(Payments)
1. Current Account
a) Exports of Goods (Visible)
a) Imports of Goods (Visible)
b) Exports of Services (Invisible)
b) Imports of Services (Invisible)
c) Transfer Receipts
c) Transfer Payments
2. Capital Account
a) Short term Capital Receipts
a) Short term Capital Payments
b) Long term Capital Receipts
b) Long term Capital Payments
c) Borrowing from Foreign countries
c) Lending to Foreign countries
3. Official Reserve Account
a)Purchase of Foreign Currencies
a)Payment in Foreign Currencies at
at official level.
Official levels
Special Drawing Rights (SDRs) is the currency of IMF. It is also called Paper Gold. It means loan without
interest. Ordinary Drawing Rights (ODRs) means loan with interest.
4
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b)Borrowing of SDRs or ODRs
from IMF
b)Repayment of loan of SDRs or
ORDs from IMF
BOP = Current A/C + Capital A/C
In above table we have two parts.
1. Autonomous Transactions
2. Accommodating Items
Current and capital accounts are known as autonomous transactions and these have
profit motive. Current and capital accounts are called Items above the line. Official
settlement or Official reserve account is known as Accommodating items. Official
settlement or Official reserve account is called Items below the line.
Types of BOP
1. Favorable (Surplus) BOP
If receipt side of the BOP is greater than its payment side, the BOP is in surplus or
favorable.
2. Unfavorable (Deficit) BOP
If receipt side of the BOP is less than its payment side, the BOP is in deficit or
unfavorable.
3. Equilibrium BOP
If receipt side of the BOP is equal to its payment side, the BOP is in equilibrium.
9. Disequilibrium in BOP: causes and solutions
Surplus or deficit in the BOP is known as disequilibrium. Normally in LDCs BOP is in
deficit so we are discussing here the causes of deficit in the BOP. There are many
factors that bring disequilibrium in the Balance of Payments. The problem of deficit in
balance of payment has two core causes.

Low Export Capacity
 Excessive Import Needs
Low Export Capacity
1. Narrow Export Base
Our export base is narrow. Pakistani exports are less than its imports. Due to low
prices Pakistani exports and high prices of imports, the value of total annual exports
is quite less than the value of imports. Therefore, for most of the years, Pakistan
balance of payments has been in deficit.
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2. Consumption Oriented Society
In Pakistan, people are mostly consumption oriented. Demonstration effect, imitation
of foreign fashion and style and rapid rise in population has increased consumption
habits. So, demand for imported goods has increased and demand for locally
produced goods has decreased. As a result, Pakistan balance of payments is in
deficit.
3. Increase in Prices of Imports
Due to high prices of imports, value of imports is quite high. This leads to rise in the
costs of the imported capital goods and industrial raw material. So, domestic industry
faces the cost-push inflation and their production decreases. As a result, balance of
payment adversely affects.
4. Out-dated Technology and Machinery
Pakistani producers use out-dated technology and machinery, which result in
decrease the quantity and quality of goods. Exports remain low due to fall in the
quantity and quality of goods.
5. Devaluation
The devaluation of rupee against dollar has not helped us in increase of exports. For
devaluation, it is necessary that demand for exports and imports should be more
elastic. But in Pakistan, demand for exports and imports is less elastic. That is why,
devaluation as tool for boosting exports is useless and futile.
6. Increase in the Sick Indusial Units
Sick industrial units are those industries which are closed or in loss. In Pakistan,
there are a large number of sick industrial units due to nationalization of industries.
The performance of the public sector industries is also not so satisfactory therefore
government is adopting privatization policy. The fall in production reduces the
exportable surplus and adversely affects the BOP.
7. Technical Barriers
The developed countries hesitate to transfer the modern technology to developing
countries. Even they impose technical barriers such as patent copyright, trademarks
etc. on their imports. Pakistan will have to adopt modern technology to improve the
quality of its products in the international market.
8. Tough Competition
The quantity and quality of our commodities is very low because we do not use
modern methods of producing, packing, marketing etc. But foreigners use these
techniques so their share in the world trade is large. So, the tough competition in the
foreign market has reduced the volume of foreign trade in Pakistan.
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9. Deterioration in Terms of Trade
Terms of trade are defined as the value of exports divided by value of imports. In
Pakistan, the import value remained greater than the exports value. So, terms of
trade deteriorated and balance of payment remained deficit.
10. Less Production of Value Added Goods
Pakistan is agro-based country. Its exports are agriculture products like rice, cotton
yarn and fish and semi-manufactured goods like cotton yarn. The share of primary
products and semi-manufactured goods in exports is about 11% and 61.4%
respectively. The share of manufacturing sector in the GDP is round 21%. Due to
fewer shares of value added goods, balance of payment adversely affects.
11. Political Instability
Due to political instability, local and foreign investors hesitate to invest in the country
because every new government has its own interests and polices. There create
uncertainty, which affect the efficiency of the industries. The volume of production
falls and export earnings reduce.
Excessive Import Needs
12. Import of Capital Goods
Pakistan imports capital goods for industrialization in the country. Prices of capital
goods in world market are very high therefore importing bill increases and balance of
payment remains in deficit.
13. Defense
Pakistan has to purchase modern weapons at every cost from different countries
because India has rivalry with Pakistan. For defense Pakistan has to become military
power and for this purpose Pakistan spends a lot of foreign exchange on it, which
increases pressure on our balance of payment, and it becomes adverse.
14. Rise in Oil Prices
The sharp rise in the prices of oil in last three decades and heavy dependence on
foreign petroleum products have adversely affect the balance of payment.
15. Increase in Import Payment for Fertilizer
Due to increase in prices of fertilizers, edible oil and petroleum, there is an increase
in the import bill and balance of payment remains in deficit.
Besides, the above-described two cores causes i.e. Low Export Capacity and
Excessive Import Needs, following are more causes of the problem of deficit in
balance of payment.
16. Income Type of Disequilibrium
The most important cause of disequilibrium in BOP is National Income. If the
National Income of the country increases, it will lead to an increase in imports
thereby creating a deficit in its BOP. If the country is already at full employment level,
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an increase in income will lead to rise in prices, which may increase its imports, and
this brings disequilibrium in the BOP.
17. Price Type of Disequilibrium
Price differential among the countries is another cause of disequilibrium in the BOP.
If there is inflation in the economy, prices of exports increase and as a result exports
fall. At the same time demand for imports increases. Thus fall in the value of exports
and rise in the value of imports result in adverse BOP.
18. Structural/Chronic Changes
Following structural changes also cause disequilibrium in BOP of a country.
a. Population
If population increases, the consumption of commodities will increase. As a result
imports of the country will rise.
b. Tastes
If the tastes of importer country change, the exports of the exporter country will
decline.
c. Natural Resources
If the stock of natural resources lessens in those countries in which exports depend
largely on these resources, the exports of those countries will decline.
d. Discovery of Import Substitutes
If any country discovers the import substitutes, the exports of the exporter country
will decline. Due to all these ups and downs in exports and imports, the BOP will be
in disequilibrium.
19. Technological Changes
The technological changes in the methods of production may affect the country’s
ability to compete in the foreign markets. Due to technological changes, costs, prices
and the quality of products would change.
20. Capital Outflows
Capital outflow is another cause of disequilibrium in the BOP. If the capital moves
from one country to another country in the form of War Cost, Foreign Debt Servicing,
etc., it may cause the disequilibrium in BOP of that country from where capital is
moving to the other country.
Measures to Correct Adverse BOP
A deficit in the BOP of a country is adjusted by adopting certain policy measures.
These measures are discussed below. BOP can be corrected in two ways:

Export led growth

Reduction in imports
Export Led Growth
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1. Labor Intensive Industries
Labor is abundant and cheaper factor in Pakistan. Planners should adopt such a
policy that the labor-intensive industries would be established because these
industries can produce cheaper goods, which can be exported, and foreign
exchange can be earned.
2. Manufactured Goods
Pakistan is agro-based country. Its exports are agriculture products like rice, cotton
yarn and fish and semi-manufactured goods like cotton yarn. The share of
manufactured products and semi-manufactured goods in exports should be
increased because these products have high prices in the world market.
3. Marketing of Exportable
Pakistan should adopt proper marketing techniques. For this purpose, government
agencies can arrange industrial fairs in abroad so that Pakistani products can be
introduced to the foreigners and demand can create. Export Promotion Bureau (EPB)
should be more active to increase exports.
4. Reducing Immoral Practices
Pakistani people usually do immoral practices in trade. They sell inferior quality
commodities. They do adulteration. So, it creates bad name to our trade and country.
All these practices should be restricted.
5. Improving the Quality
Pakistan produces low quality products therefore these goods cannot be exported.
Due to poor quality as compared to international standard Pakistani products are
awarded low price. Pakistan should adopt modern machines and technology to
improve the quality of its products so that these products can be sold at high prices.
6. Packing
To increase exports, high quality packing is very important. If packing is not attractive
and durable, it will not occupy the foreign market.
7. Foreign Investment
Foreign investment can play an important role to correct the BOP. Foreign investors
can establish industries and can boost up the exports.
Reduction in Imports
8. Import of Essential Items
Pakistan should try to minimize imports. Only essentials commodities should be
imported. Import of luxuries should be minimized. People should be educated to
come out of demonstration effect.
9. Direct Control on Foreign Exchange
To correct the disequilibrium in the BOP, governments also adopt direct control on
foreign exchange so that there is no wastage of foreign exchange and the volume of
imports reduces.
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10. Establishment of Import Substitution Industries
Import Substitution (IS) industries are those industries, which are established at
home to produce the goods, which are imported from abroad. So the establishment
of these industries can reduce the reliance on the foreign countries and save the
foreign exchange.
Other Measures
11. Decrease in Consumption
To reduce the consumption, taxes should be imposed on many items. Rich people
spend extravagantly on unnecessary consumption items. So foreign exchange is
waste.
12. Control of Smuggling
Smuggling is an economic evil. The government should take strict measures to
eliminate smuggling.
13. Population Control
Many of our problems are arising due to rapid increase in population. Efforts should
be made to decrease growth rate of population. People should be educated for this
purpose.
14. Adjustments through Capital Movements
A country can use capital to correct a deficit in BOP. When capital is perfectly mobile
within countries, a small rise in rate of interest brings a large inflow of capital. The
BOP is said to be in equilibrium when domestic rate of interest equals the world
interest rate. By increasing the domestic interest rate with respect to the world
interest rate, a country is able to make capital inflow possible and correct the BOP.
ANSWERS TO END OF CHAPTER QUESTIONS
Chapter 1
PRACTICE QUESTIONS
Question 1
The central economic problem stems from the fact of relative scarcity, i.e.
that human wants will always outstrip the resources available to satisfy those
wants. The correct response is therefore D.
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C is wrong because, although it refers to the allocation of resources, it
stresses the optimum allocation. The fact that resources are not allocated in
an optimum way is an economic problem but it is not the central one of the
need for this allocation in the first place, i.e. scarcity.
A is incorrect because it refers to money and not to real resources; and B
again concentrates on an issue which, while an important economic problem,
is not the central one.
Question 2
Each statement should be considered separately to test its validity. B is the
correct response since it is the only one which is not true − profit will not be
the same in absolute terms in all firms, even if they are equally efficient. The
most we can say is that all firms will earn normal profit, but this is not the
same thing. Each firm’s normal profit will be a different amount and will
depend on subjective factors such as the size of the firm, its expectations etc.
All the other statements are true by definition.
Question 3
The correct answer is B.
Question 4
The correct answer is B.
The market mechanism operates automatically through prices to provide
information for producer and consumer decisions and producers’ concern
with profit promotes technical efficiency, hence a reduction in costs.
Question 5
The correct answer is C.
The opportunity cost of producing a commodity or service is the alternatives
sacrificed given that resources are limited.
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Question 6
The correct answer is B.
It can be argued that the free market mechanism does allocate income in the
form of wages, rent and profit; however, it is not based on need, which is
obviously subjective.
Question 7
The answer is C.
Consumer demand will mainly determine which goods are produced. In a
market economy, supplying goods that consumers do not want will result in
business failures and resources being switched into producing goods that are
in demand.
Question 8
The correct answer is B.
Opportunity cost is the alternative forgone, therefore B – the value of goods
and services that could otherwise have been produced with the resource
used to build the road – is correct.
ADDITIONAL QUESTION
Allocation of resources
(a)
People want more of almost everything, but the resources available to
meet these wants are limited. Society must decide what to produce and
who gets the final product – the state, individuals, businesses or future
generations. This decision is the central problem that economics tries
to solve – how to allocate the limited resources, or factors of production,
which are land, capital, enterprise and labor, to meet unlimited wants.
The allocation of resources is important, because only if the right
decisions are made will economic welfare be maximized.
(b)
A mixed economy is one in which the free-market economy operates
with some degree of state intervention. Britain is an example of a
mixed economy. There is a lot of free enterprise and many decisions
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are driven by the market mechanism. Businesses make their own
production and
pricing
decisions
(largely
free
of
government
intervention), and consumers decide what they will buy with their
income (mostly without government intervention). But government does
intervene in the working of the market mechanism to:
(i)
promote competition and limit the growth of monopoly power;
(ii)
ensure the production of merit and public goods;
(iii)
make some goods illegal or discourage their consumption;
(iv)
ensure that externalities are reflected in producer's costs and
thus in prices.
Within a competitive market, consumers decide what they want to buy
at the prevailing market prices and signal their decisions to producers
by the way they spend their income. If this causes surpluses or
shortages at current prices, the prices change. A shortage causes price
rises and a surplus causes price falls. These price changes signal to
businesses whether it is profitable to increase production or not. In
search of profits, firms will increase production of a good in short
supply and thus increase their demand for resources used in the
production of such goods. This will result in a rise in the price of these
resources. In the same way, businesses cutting back on the production
of goods where there are surpluses, reduce their demand for the
resources they employ, their price falls and fewer resources are
supplied to those lines of production. Thus it is consumer choice that
determines the allocation of resources.
The extent of government intervention in the mixed economy varies
according to political persuasion. But it typically includes the following:
(i)
To promote competition and thus ensure that consumer demand
results ultimately in higher production and not just higher prices,
governments act to restrict monopoly power. Examples from the
UK are the Competition Commission, the 'Watchdogs' created to
oversee the privatized industries, and the legislation restricting
the power of the trade unions.
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(ii)
Merit goods are goods which are generally believed to be
beneficial and which the State may supply to ensure that they
are available to all consumers regardless of income. Examples
are education or health care.
(iii)
Public goods are goods which must be provided communally
because their consumption is non excludable. Examples are
roads and street lighting.
(iv)
Uneconomic goods are goods that the government wishes to
see produced, which would not be produced in a pure market
economy. Examples are foodstuffs and armaments.
(v)
The government may believe that some goods are bad and will
intervene in the market economy to prevent them being
produced,
or
levy
taxes
on
them
to
discourage
their
consumption. Examples are drugs and cigarettes.
(vi)
Finally, prices established in the free market do not take into
account any external costs or benefits owing to externalities.
The government may intervene with, for example, taxes to curb
pollution
from
factories
or
subsidies
to
encourage
the
continuation of a social benefit such as bus services for rural
communities.
Thus in the mixed economy, resources are allocated by both the price
mechanism reflecting consumer preferences and by decisions made by the
State.
Chapter 2
PRACTICE QUESTIONS
Question 1
The demand curve will shift to the right when consumers are buying more of
the good for some reason other than a reaction to a change in the price − B
is therefore incorrect. The correct answer is D because, if a close substitute
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becomes more expensive, people will buy more of the first product even
though its price has not changed.
C is wrong because the normal reaction to an increase in the price of a
complement is to buy less of both products − the demand curve for the first
product would therefore shift to the left.
A is wrong because a decrease in production costs will cause the supply
curve to shift and not the demand curve.
Question 2
The correct answer is C.
Indirect taxes such as VAT shift a producer’s supply curve to the left. At each
price the producers supply less because part of sales income goes in tax to
the government.
Question 3
The correct answer is C.
A is concerned with the supply curve not the demand curve. B would lead to
a movement along the demand curve not of the whole curve. D would lead to
the demand curve moving to the left.
Question 4
The correct answer is C.
When the price of a good is held above the equilibrium price, supply will
exceed demand which will cause a surplus of the good, therefore C is correct.
Chapter 3
PRACTICE QUESTIONS
Question 1
The correct answer is C.
A, B and D are all true statements about the elasticity of supply. C is to do
with productivity.
Question 2
The correct answer is A.
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If a good is price inelastic, then the ratio of the percentage change in quantity
demanded to the percentage change in price is less than one. In other words,
the proportionate change in quantity demanded is less than the proportionate
change in price, so an increase in price will increase total revenue and a fall in
price will reduce total revenue. Hence only A is correct.
Question 3
The correct answer is B.
Question 4
The correct answer is D.
A consumer will not change the amount normally demanded of a good even if
its price changes provided that it does not affect significantly his or her overall
spending pattern.
Question 5
The correct answer is B.
If a good is price elastic it means that the demand for it is price sensitive,
hence a rise in price will lead to a greater proportional fall in demand so that
overall expenditure on the good falls.
Question 6
The correct answer is A.
Elasticity of demand measures how responsive consumers are to changes in
price. Demand is elastic when a fall in price brings about an increase in total
expenditure. If expenditure fell by the same amount as the price fall then
demand must be perfectly inelastic to A.
Chapter 6
PRACTICE QUESTIONS
Question 1
Each of the options should be considered carefully to see which one follows
logically from the original statement. A is the correct answer because if wages
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form a large proportion of costs, then an employer will resist or avoid raising
wages so as not to escalate total cost.
B is incorrect because if the demand for the product is price inelastic, the
producer could raise the wages of the workers, raise the price of the product
to preserve the profit margin and increase the revenue, since consumers
would not respond by buying a lot less.
C is incorrect because if it is not easy to substitute capital for labor, then a
demand for higher wages by the union could be successful in that the
employer has no alternative factor of production to use, and would have to
keep the workforce happy.
D is wrong because, if the demand for the product is expanding, then the
producer could afford to pay higher wages and raise the price of the product
without losing sales.
Question 2
B is the correct answer.
Any payment to a factor of production that is greater than its supply price is a
kind of surplus that is known as economic rent. Considering the diagram, the
economic rent is the shaded area, PP1R.
Price
S
P
R
P1
D
Q
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402
As the supply curve for labor becomes more inelastic, so the shaded area
above the curve increases, as shown below.
Price
S
P
R
D
P1
Q
Quantity
A is therefore incorrect as it assumes the opposite. C and D are incorrect as
they are dealing with the demand curve for labor, when economic rent
concerns the supply curve for labor.
Question 3
The correct answer is B.
If the minimum wage is below the market wage, there will be no effect on
unemployment. If the demand for labor is inelastic, then the imposition of a
minimum wage will not significantly affect demand or the level of
unemployment. But the more elastic the demand the bigger the fall in demand
in response to the minimum wage and thus the greater the resulting
unemployment.
Question 5
The correct answer is C.
The elasticity of the supply of labor is primarily determined by the response of
workers to a change in the wage and this in turn is dependent on the mobility
of labor between occupations. If there are barriers of entry into a job or
profession owing to, say a long training period, then the supply curve will be
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more inelastic. Hence A and B are incorrect. D is also incorrect as elasticity
has nothing to do with the actual wage level.
Question 6
The correct answer is A
Wages are a factor of production. If they are a high proportion of total costs,
firms will be sensitive to wage increases; if demand for the industry’s product
is price elastic, so too will be consumers. If labor and capital are easily
substituted, labor will be replaced by capital. So, by process of elimination, A
is correct.
ADDITIONAL QUESTION
Determination of wages
(a)
The demand for labor is a derived demand in that it comes from
demand for the final product or service.
Factors that affect the demand for labor include:
•
the productivity of workers and the sales value of the end
product or service as shown by the Marginal Revenue Product
of Labor (MRPL)
•
the cost of labor as shown by the Marginal Cost of Labor (MCL).
Another worker will be employed until MRPL = MCL, as shown
in the diagram below.
Wages
MRPL
MCL
w
0
D
L
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404
The demand for labor
A quantity of 0L workers will be employed at a wage rate of £0W. According to
the classical theory, if MRPL were to increase, by means of increased
productivity or an increase in the final selling price of the good or service, it
would shift to the right and result in a higher equilibrium wage and a possible
increase in the number of workers employed.
(b)
The supply of labor is the result of the number of workers willing to
work for a particular wage. The supply of labor can be reduced by
cultural and legal considerations which may make some groups of
people ineligible for work, for example, under/over certain ages,
academic or other requirements, physical attributes, etc.
Factors affecting the supply of labor include:
•
non-monetary rewards which may encourage workers to enter
low paid work, for example housing, travel, job satisfaction, etc.
•
the length of training periods
•
the requirement of specific skills or talents, for example agility,
physical strength, typing skills, sporting ability, etc. – some may
be taught but some may be talents common to very few in the
5population
•
workers may find difficulty in moving between occupations or
geographical areas because of language skills, work permit
requirements, housing availability and cost, social and family
ties, qualifications and experience, etc.
(c)
The classical theory of wage determination is based on market forces
of supply and demand as shown by Marginal Revenue Product of
Labor (MRPL) and Marginal Cost of Labor (MCL). The more skilled the
worker, the higher the price that can be commended for the finished
product or service and the higher is MRPL, as shown in the diagram
below.
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Wages
Ws
MRPL1
w
MRPL
0
Quantity of labor
Increased MRPL and the effect on wage rates
The effect of shifting MRPL to the right is a wage rate increase from 0W to
0Ws.
The existence of non-monetary rewards in some occupations may keep
monetary wages lower and, in the opposite case, the existence of dangerous
or difficult working conditions may increase wage rates. In practice, MRPL
may be difficult to calculate. In cases where there is no identifiable final
product (service industries), or where workers work in teams or where
machinery is part of the process, MRPL per worker cannot be calculated.
In the last resort, wages must reflect cost and benefit to the community and
must be seen as ‘fair’.
(d)
A minimum wage represents an attempt to ensure that workers are not
exploited and the state does not support exploitative employers by
paying ‘top up’ amounts to their employees.
Regulations for a national minimum wage in all industries, will affect
industries that for whatever reason pay low wages, and the effects may
be both positive and negative.
The positive effects may include:
•
increased spending by a section of the population leading to an
increase in output to meet the demand and, as a result,
economic growth.
•
preventing the worst exploitation of groups such as part-time
workers, workers with disabilities, immigrant workers and nonunionized workers.
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•
a reduction in state benefits paid to low paid workers.
•
an increase in taxation revenue as more people take up
employment and existing workers earn more and pay more tax.
The negative effects may include:
•
an increase in unemployment due to the creation of a surplus in
the labor market.
•
an increase in the rate of inflation as workers demand wage
increases to maintain the differential between skilled and
unskilled rates of pay.
•
an increase in state benefit payments as more workers are
unemployed.
•
a reduction in training and other benefits that employers may
have been prepared to offer.
Chapter 6 and 7
PRACTICE QUESTIONS
Question 1
The correct answer is B.
Note: we are talking about the short-run situation, obviously in the long run all
costs must be covered.
Question 2
The correct answer is C.
Question 3
The correct answer is B.
Neither A, C nor D vary directly with the level of production whereas the cost
of raw materials used does.
Question 4
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The correct answer is A.
The traditional theory of the firm is based on the premise that the objective of
a firm is to maximize profits and will thus strive to achieve this situation by
producing at the equilibrium position where marginal cost equals marginal
revenue.
Question 5
The correct answer is B.
Question 6
The correct answer is B.
A is not true as any firm can benefit from economies of scale providing it is of
sufficient size to obtain such economies. C is not true by definition. D is not
true as management can generally be inefficient and still make some good
decisions.
Question 7
The correct answer is B.
Unlimited expansion of scale of output may not result in ever-decreasing costs
per unit as average costs may begin to rise as the size of the business
becomes uneconomic. However, this will only happen in the long run.
Question 8
The correct answer is D.
As firms become very big the effects of economies of large-scale production
are outweighed by other opposing factors such as complex management
structures which become relatively more costly, labor relations become more
unwieldy and staff become less motivated.
Question 9
The correct answer is A.
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Question 10
The correct answer is D.
An economy of scale takes place when unit costs are reduced as a result of
expanding output. Cost savings resulting from new production techniques
reduce costs at every level of output, therefore D is the answer.
Chapter 7
PRACTICE QUESTIONS
Question 1
The correct answer is B.
A perfectly competitive industry must have many producers, none of which
can have any dominance in the market. They are all price takers. Industries A,
C and D do not have this organisational set up.
Question 2
The correct answer is C.
If fixed costs are high in comparison with variable costs, there is less
opportunity for a producer to gain a competitive edge by being more efficient
and reducing unit costs.
Question 3
The correct answer is C.
One condition of a perfectly competitive market is a homogeneous product.
Due to this fact alone, if a producer charged a different price, it would go out
of business, either because of lack of demand if the price were higher than all
the other producers or because it was not making normal profit if the price
were lower.
Question 4
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The correct answer is B.
This was a straightforward question testing the properties of perfect
competition. Differentiated goods are a feature of imperfect competition.
Alternatives (i), (iii) and (iv) are all features of perfect competition so, by
process of elimination, B is the answer.
ADDITIONAL QUESTION
Revenue and costs
(a)
The completed table looks like this:
Output
Total
Marginal
revenue
revenue
Total Marginal cost
0
-
-
110
-
1
50
50
140
30
2
100
50
162
22
3
150
50
175
13
4
200
50
180
5
5
250
50
185
5
6
300
50
194
9
7
350
50
219
25
8
400
50
269
50
9
450
50
325
56
10
500
50
425
100
Marginal revenue is defined as the addition to total revenue from producing
one more unit. The marginal revenue is the same at all levels of output, i.e.
total revenue increases by Rs 50 each time an extra unit is produced.
Marginal revenue is therefore constant throughout and must be the same as
average revenue or price. Graphically, average revenue is thus a horizontal
straight line, i.e. the demand curve is perfectly elastic. This can happen only
under conditions of perfect competition and this firm is operating in a perfect
market.
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(b)
The fixed costs of a firm are those that, in the short run at least, do not
vary with output. Fixed costs have to be paid even when output is zero
and they are the only ones paid when no production is taking place,
since variable costs are incurred only when output is being produced.
The firm’s fixed costs are therefore the total cost of zero output, i.e. Rs.
110.
The marginal costs are the additions to total cost of producing extra
units, and are shown in the table above.
(c)
The firm aims to maximize profits and it will do this where the marginal
revenue gained from selling the last unit is just equal to the marginal
cost of producing that unit. The only output level where marginal
revenue equals marginal cost is 8 units, where both MR and MC are
Rs. 50. The firm will thus produce 8 units.
Profit equals total revenue minus total cost. At 8 units this is Rs. 400 –
Rs. 269 = Rs. 131.
(d)
There are no barriers to entry in a perfect market and so new
producers can come in. They will do so, however, only if there is
enough profit to attract them in, i.e. only if the existing firm (or firms) is
making a supernormal profit. The industry will be in equilibrium, i.e.
new firms will stop entering when all firms are making a normal profit.
Normal profit is that amount of profit which will just keep a firm in
business and it is earned when the firm covers all its costs, including
the opportunity cost of giving up the next best alternative employment.
The entry of new producers will reduce the supernormal profit being
earned by the existing firm and will also cause its output to fall. This
can be illustrated graphically.
Price
P1
M
P2
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AT
AR1 = MR1 P1
AR2 = MR2P2
S1
S2
411
When new firms enter the market, the industry supply curve increases
i.e. shifts to the right. The new supply curve S2 interacts with the
original demand curve and causes market price to fall from P1 to P2.
Each firm therefore receives a lower price and average and marginal
revenue curves fall from AR1 to AR2 and from MR1 to MR2. The firm’s
output is reduced from Q1 to Q2. Output and price will continue to fall
as new firms continue to enter until all firms are earning just normal
profit − there is now no further incentive for any more firms to join the
industry.
In conclusion, the firm’s output and profits will both fall as new
producers enter the market.
Chapter 8
PRACTICE QUESTIONS
Question 1
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D is the right answer since pure public goods are those that must be provided
communally, e.g. defense or public transport.
C is incorrect since the consumption of a public good by one person must not,
by definition, reduce the amount available for another person. A and B are
incorrect since in both cases the goods are not produced according to the
conditions stated in D and C above.
Question 2
The correct answer is A.
The tax means that true cost of production will be reflected in prices, which
improves resource allocation.
Question 3
The correct answer is A.
Public goods, merit goods and goods for which there is a natural monopoly in
production need to be produced in the public sector if they are to be produced
in sufficient quantity to ensure the public good.
Question 4
Alternatives A and B are fairly obvious reasons why firms in an industry would
choose to locate close together. External economies of scale arise from
having some local advantage, e.g. supply of labor, so the odd one out is D.
Chapter 9
PRACTICE QUESTIONS
Question 1
Withdrawals from the circular flow of income are those amounts not passed
on from firms to households or vice versa. There are three categories of
withdrawals − savings, taxation and imports. The correct response is D
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because it includes tax payments and imports − distributed profits and interest
paid on bank loans are both types of income which are passed on from firms
to households and are thus not withdrawals.
Question 2
The correct answer is C. A and B are measures of Gross Domestic Product
(GDP). D measures national income (net).
Question 3
Transfer payments are payments made for which there were no productive
services in exchange. The receiver of an educational scholarship is not
contributing anything back. The answer is A.
ADDITIONAL QUESTION
National income
(a)
National income calculations are based on the circular flow of income
model which assumes that all output is sold, all income is spent and all
resources are fully employed. It should be possible to look at total
output, total income or total expenditure in an economy and arrive at
the same figure, whichever route is chosen. This total represents the
economic activity or national income of the economy for a specified
period of time.
The three methods are therefore:
•
Output – the total value of production for all industries in the
economy
•
Income – the rewards for the use of the factors of production
which are paid in the form of rent, wages, interest and profit
•
Expenditure – the spending by both households and firms on
the final products and services of the production process. The
prices paid must be adjusted by deducting taxes (added to price)
and adding back subsidies (deducted from price).
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(b)
(i)
The ‘black economy’ is the name given to the value of goods
and services produced in the economy but never officially
recorded and are therefore excluded from national income
figures. When paid work is done illegally by those workers
officially classed as unemployed, or income is under-declared
on official forms such as income tax returns, the national income
figures will not reflect the actual activity of the economy. In some
countries without a tradition of centrally collected written data,
the output of the black economy may exceed that of the official
economy. In such economies national income figures have little
meaning.
(ii)
Unpaid work occurs when goods and services are not traded
through the market and do not become part of official figures.
Examples of unpaid work include DIY, housework, childcare and
gardening. Differences between cultures may reflect the amount
of unpaid work and therefore reported national income; care
should be taken when making comparisons.
(c)
National income is the monetary value of the output of an economy,
adjusted for inflation, for a specified period of time. Standard of living
reflects national income to some extent, but is also dependent on other
factors such as climate, environmental issues and health issues.
(i)
The quality of goods and services is not always reflected in their
price. As the price of goods and services increases, so does the
value of national income. An inflation index such as the Retail
Price Index (RPI) is based on average price increases. Using
the RPI to remove inflation from national income figures will not
remove price increases that are higher than the average inflation
rate. Although the price of such goods and services has risen,
there is no guarantee that the quality has improved or even
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stayed the same. If the quality has not risen with price then the
standard of living cannot be said to have increased.
(ii)
National income figures are a reflection of market prices
adjusted for taxation, subsidy and inflation. Pollution is an
externality in that it is a social cost not reflected in market price.
Market price is concerned with private cost and private benefit
and not social cost or social benefit. Industrialization, processes
to remove waste materials and transport all create pollution
which reduces the quality of life and has a detrimental effect on
the standard of living, none of which is reflected in national
income figures.
(iii)
National income figures such as Gross Domestic Product (GDP)
may be shown as a total figure for the economy or may be
divided by the population total to show national income per head
of population (per capita). GDP per capita represents a fictitious
amount that everyone in the economy is assumed to receive as
income. In practice, the distribution of national income is more
likely to be uneven, with a few people receiving considerably
more than the per capita figure and many receiving much less.
The standard of living for most people is therefore unlikely to
reflect GDP per capita.
(d)
Apart from being used to compare the standard of living in other
economies, national income figures may also be used to:
• loan future government spending so as to achieve economic growth.
• determine whether past plans have achieved economic growth by
comparing current national income in real terms with the figures for
last year.
• determine economic trends, such as booms and slumps, and so
enable specific government strategies to be prepared and put into
action.
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• give confidence to producers and investors in the economy that
government actions have achieved targets and are therefore likely
to achieve future targets.
• persuade voters to re-elect the government.
Chapter 10
PRACTICE QUESTIONS
Question 1
The correct response is D.
In the conditions stipulated, a reduction in direct taxation would immediately
feed through into increased demand and increase inflationary pressures. So
would a fall in private investment in the longer run given unchanged
conditions. But the question carefully asks what factor would be most likely to
lead to inflation.
Question 2
The correct answer is A. Both C and D are likely to fuel inflation rather than
reduce it since both will contribute towards an increase in aggregate demand
in the economy.
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