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BA7103 ECONOMIC ANALYSIS FOR BUSINESS

UNIT-I
INTRODUCTION:
Economics is the study of scarcity. Resources are limited, and every society wants to
figure out how to allocate its resources for maximum benefit. The field of economics serves in
large part to help answer this resource allocation question. Economists study topics such as:
How prices and quantities of items are determined in market economies
How much value markets create for society
How taxes and regulation affect economic value
Why some goods and services are under-supplied in a market economy
How firms compete and maximize profit
How households decide what to consume, how much to save, and how much to work (or,
more generally, how people respond to incentives)
Why some economies grow faster than others
What effect monetary and fiscal policy has on economic well-being
How interest rates are determined
The need for a Management student to study Economics is that it is concerned with
decision making by managers and the main job of managers is mere decision making.
Microeconomics examines the behavior of basic elements in the economy, including individual
agents (such as households and firms or as buyers and sellers) and markets, and their
interactions. Macroeconomics analyzes the entire economy and issues affecting it, including
unemployment, inflation, economic growth, and monetary and fiscal policy.
Meaning:
Economics is the social science that analyzes the production, distribution, and
consumption of goods and services. The term economics comes from the Ancient Greek
oikonomia, "management of a household, administration"
Economics can be called as social science dealing with economics problem and mans
economic behavior. It deals with economic behavior of man in society in respect of consumption,
production; distribution etc. economics can be called as an unending science.
Economics =Decision Science +Business Management.
Definition:

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Economics is the study of how the societies use scarce resources to produce valuable
commodities and distribute them among different people.
In the words of Lionel Robbins Economics is a science which studies human behavior as
a relationship between ends and scarce means which have alternative uses
According to Spencer and Seigelman it is defined as the integration of economic theory
with business practice for the purpose of facilitating decision making and forward planning by
the management.
Significance:
Application of economic theory especially micro economic analysis to practical problem
solving in real business life.
Is a science as well as art facilitating better manufacturing discipline.
It is concerned with firms behavior in optimal allocation of resources.
Positive versus Normative Analysis in Economics
Positive economics explains the economic phenomenon as what is, what was and what
will be.
Normative economics prescribes what it ought to be.
Economics is a blending of pure of positive science with applied or normative science. It is
positive when it is confined to statements about causes and effects and to functional relations of
economic variables. It is normative when it involves norms and standards, mixing them with
cause- effect analysis.
While economics is largely an academic discipline, it is quite common for economists to
act as business consultants, media analysts, and advisers on government policy. As a result, it's
very important to understand when economists are making objective, evidence-based statements
about how the world works and when they are making value judgments about what policies
should be enacted or what business decisions should be made.
Positive Analysis
Descriptive, factual statements about the world are referred to as positive statements by
economists. The term "positive" isn't used to imply that economists always convey good news, of
course, and economists often make very, well, negative positive statements. Positive analysis,
accordingly, uses scientific principles to arrive at objective, testable conclusions.
Normative Analysis

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Normative approach in managerial economics has ethical considerations and involves
value judgments based on philosophical, cultural and religious positions of the community.
On the other hand, economists refer to prescriptive, value-based statements as normative
statements. Normative statements usually use factual evidence as support, but they are not by
themselves factual. Instead, they incorporate the opinions and underlying morals and standards
of those people making the statements. Normative analysis refers to the process of making
recommendations about what action should be taken or taking a particular viewpoint on a topic.
Examples of Positive vs. Normative
The distinction between positive and normative statements is easily shows via examples. The
statement
The unemployment rate is currently at 9 percent.
is a positive statement, since it conveys factual, testable information about the world. Statements
such as
The unemployment rate is too high.
The government must take action in order to reduce the unemployment rate are normative
statements, since they include value judgments and are of a prescriptive nature. It's
important to understand that, despite the fact that the two normative statements above are
intuitively related to the positive statement, they cannot be logically inferred from the
objective information provided.
To disagree with a positive statement, one must bring other facts to the table or question
the economist's methodology. In order to disagree with the positive statement about
unemployment above, for example, one would have to make the case that the unemployment rate
isn't actually 9 percent. One could do this either by providing different unemployment data or by
performing different calculations on the original data.
To disagree with a normative statement, one can either dispute the validity of the positive
information used to reach the value judgment or can argue the merits of the normative
conclusion itself. This becomes a more murky type of debate, since there is no objective right
and wrong when it comes to normative statements.
In a perfectly organized world, economists would be pure scientists who perform only
positive analysis and exclusively convey factual, scientific conclusions, and policy makers and
consultants would take the positive statements and develop normative recommendations. In

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reality, however, economists often play both of these roles, so it's important to be able to
distinguish fact from opinion, i.e. positive from normative.
THEMES OF ECONOMICS:
Scarcity and Efficiency refers to the Twin themes of Economics;
Scarcity occurs where it's impossible to meet all unlimited the desires and needs of the
peoples with limited resources i.e; goods and services. Society must need to find a balance
between sacrificing one resource and that will result in getting other.
Efficiency denotes the most effective use of a society's resources in satisfying peoples wants
and needs. It means that the economy's resources are being used as effectively as possible to
satisfy people's needs and desires.
Thus, the essence of economics is to acknowledge the reality of scarcity and then figure
out how to organize society in a way which produces the most efficient use of resources.
Scarcity-insufficient of resources like land, labor, and capital.
Efficiency-maximum use of resources.
Efficiency is concerned with the optimal production and distribution or these scarce
resources. There are different types of efficiency
1. Productive efficiency.
This occurs when the maximum number of goods and services are produced with a given
amount of inputs. This will occur on the production possibility frontier. On the curve it is
impossible to produce more goods without producing less services. Productive efficiency will
also occur at the lowest point on the firms average costs curve.
2. Allocative efficiency
This occurs when goods and services are distributed according to consumer preferences.
An economy could be productively efficient but produce goods people dont need this would be
allocative inefficient.
3. X inefficiency
This occurs when firms do not have incentives to cut costs, for example a monopoly
which makes supernormal profits may have little incentive to get rid of surplus labour.
Therefore a firms average cost may be higher than necessary
4. Efficiency of scale

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This occurs when the firms produces on the lowest point of its Long run average cost and
therefore benefits fully from economies of scale
5. Dynamic efficiency
This refers to efficiency over time for example a Ford factory in 1920 would be very
efficient for the time period, but by comparison would now be inefficient. Dynamic
efficiency involves the introduction of new technology and working practices to reduce costs
over time.
6. Social efficiency This occurs when externalities are taken into consideration and occurs at an
output where the social cost of production (SMC) =the social benefit (SMB)
7. Technical Efficiency
Optimum combination of factor inputs to produce a good related to productive efficiency
8. Pareto Efficiency
A situation where resources are distributed in the most efficient way. It is defined as a
situation where it is not possible to make one party better off without making another party
worse off.
THREE BASIC ECONOMIC PROBLEMS
The economic problem, sometimes called the basic, central or fundamental economic
problem, is one of the fundamental economic theories in the operation of any economy. It asserts
that there is scarcity, or that the finite resources available are insufficient to satisfy all human
wants and needs. The problem then becomes how to determine what is to be produced and how
the factors of production (such as capital and labor) are to be allocated. Economics revolves
around methods and possibilities of solving the economic problem.
In short, the economic problem is the choice one must make, arising out of limited means and
unlimited wants.
The Fundamental Economic Problem:
The fundamental economic problem is related to the issue of scarcity. Because of limited
resources and infinite demands, society needs to determine how to produce and distribute these
relatively scarce resources. It is possible that humans could limit their demands and be satisfied
with the basic necessities of life. In some tribal societies / spiritual communities there is no
economic problem because the limited resources are more than adequate to meet all their wishes.
However, society is mostly dominated by people wishing to consume.

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The basic economic problems:
What to produce?
How to produce?
And for whom to produce?
From these 3 key questions there are numerous alternatives and theories about the best
way to proceed. One of the fundamental questions has been the extent to which governments
should intervene in the production and distribution of resources. Basically, some economists
suggest the free market is the best way to proceed. However, other argue that a free market
creates many problems; notably inequality of distribution. Therefore, because of this it is
necessary for the government to intervene in the economic decision making process.

Problem 1:
This problem is what should the economy produce in order to satisfy consumer wants (as
seen by demand curves) as best as possible using the limited resources available. If a country
produces goods in a way that maximizes consumer satisfaction then the economy is allocatively
efficient.
What commodities are to be produced and in what quantities?
How much of each of the many possible goods and services should the economy make?
And when will they be produced?
Problem 2:
This problem is how to combine production inputs to produce the goods decided in
problem 1 as most efficiently as possible. An economy achieves productive efficiency if it
produces goods using the least resources possible. A productively effiecient economy is
represented by an economy that is able to produce a combination of goods on the actual curve of
the PPF.
How shall goods be produced?
By whom and with what resources and in what technological manner are they to
be produced?
Are goods be produced by hand or with machineries?
Problem 3:

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Should the economy produce goods targeted towards those who have high incomes or
those who have low incomes. What sort of demographic group should the goods in the economy
that are produced be targeted towards? If the economy is addresses this problem then it has
reached Pareto efficiency or Pareto optimality.
For whom shall goods be produced?
Who gets to eat the fruit of the economys efforts?
How is the product to be divided among different households?
If all three problems are addressed at any one time then the economy has achieved static
efficiency. If the economy achieves static efficiency over a period of time then it is dynamically
efficient.
All these problems are focused around the problem of unlimited wants and limited resources.
Where resources are the factors of production (such as labor, capital, technology, land..) which
are used to produce the products that satisfy the wants.

SOCIETIES CAPABILITIES
Each economy has a stock of limited labor, technological knowledge, factories and tools,
land and energy. In deciding what and how things to be produced , the economy is in reality
deciding how to allocate its resources among the thousand sof different possible commodities
and services.
Faced with the undeniable fact that goods are scarce relative to wants, an economy must
decide how to cope with limited resources. It must choose among, select from different
techniques of production and decide in the end who will consume the goods.
Every society must make choices about the economys input and outputs. Inputs are
commodities or services that are used to produce goods and services. An economy uses its
existing technology to combine inputs to produce output. Outputs are various useful goods or
services that result from the production process and are either consumed or employed in further
production. The term for inputs are classified under three categories namely land, labour and
capital. The economist
Takes the initiative in combining the resources of land, labor, and capital
Makes strategic business decisions
is an innovator

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Commercializes new products, new production techniques, and even new forms of
business organization
Takes risk to get profits

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PRODUCTION POSSIBILITY FRONTIES
The production possibility frontier or curve (PPF or PPC) shows the maximum
output that can be produced in an economy at any given moment, given the resources available.
If an economy is fully utilizing its resources then it will be producing on the PPF.
Consider the case of an island economy that produces only two goods: wine and grain. In a given
period of time, the islanders may choose to produce only wine, only grain, or a combination of
the two according to the following table:
Production Possibility Table
Production Possibility Frontier


A production possibility frontier (PPF) is a curve or a boundary which shows the
combinations of two or more goods and services that can be produced whilst using all of the
available factor resources efficiently.
We normally draw a PPF on a diagram as concave to the origin. This is because the extra
output resulting from allocating more resources to one particular good may fall. I.e. as we move
down the PPF, as more resources are allocated towards Good Y, the extra output gets smaller
and more of Good X has to be given up in order to produce the extra output of Good Y. This is
Wine
(Thousands of bottles)
Grain
(Thousands of bushels)
0 15
5 14
9 12
12 9
14 5
15 0

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known as the principle of diminishing returns. Diminishing returns occurs because not all
factor inputs are equally suited to producing different goods and services.

Combinations of output of goods X and Y lying inside the PPF occur when there are
unemployed resources or when the economy uses resources inefficiently. In the diagram above,
point X is an example of this. We could increase total output by moving towards the production
possibility frontier and reaching any of points C, A or B.
Point D is unattainable at the moment because it lies beyond the PPF. A country would require
an increase in factor resources, or an increase in the efficiency (or productivity) of factor
resources or an improvement in technology to reach this combination of Good X and Good Y.
If we achieve this then output combination D may become attainable.
Producing more of both goods would represent an improvement in our economic welfare
providing that the products are giving consumers a positive satisfaction and therefore an
improvement in what is called allocative efficiency. Reallocating scarce resources from one
product to another involves an opportunity cost. If we go back to the previous PPF diagram, if
we increase our output of Good X (i.e. a movement along the PPF from point A to point B) then

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fewer resources are available to produce good Y. Because of the shape of the PPF the
opportunity cost of switching resources increases i.e. we have to give up more of Good Y to
achieve gains in the output of good X.

The PPF does not always have to be drawn as a curve. If the opportunity cost for
producing two products is constant, then we draw the PPF as a straight line. The gradient of that
line is a way of measuring the opportunity cost between two goods.

PPF's AND OPPORTUNITY COST
Reallocating our resources creates an opportunity cost. Choosing more output of good
X usually means giving up output of good Y. If a change in demand from consumers means that

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more motor vehicles need to be produced (a movement along the PPF from point A to C) - there
may not be the economic resources available to maintain the output of personal computers.
The opportunity cost of a higher output of vehicles is the output of personal computers that has
to be given up.



A non-linear PPF and changing opportunity cost










Because the curve is non-linear, the opportunity cost
will change as we move along the production possibility frontier. For example, as more resources
are shifted into the notebook computer industry, the extra output declines. Therefore the
opportunity cost measured by the lost output of vehicles is increasing.
(See the change in the tangents between A-B and between C-D in the diagram above)
Explaining Shifts in the Production Possibility Frontier
The production possibility frontier will shift when:
o There are improvements in productivity and efficiency perhaps because of the
introduction of new technology or advances in the techniques of production)
o More factor resources are exploited perhaps due to an increase in the size of the
workforce or a rise in the amount of capital equipment available for businesses

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In the diagram below, there is an improvement in technology which shifts the PPF outwards. As
a result of this, output possibilities have increased and we can conclude (providing the good
provides positive satisfaction to consumers) that there is an improvement in economic welfare.
Technology, prices and consumer welfare
Improved technology should bring market prices down and make products more
affordable to the consumer. This has been the case in the market for personal computers and
digital products. The exploitation of economies of scale and improvements in production
technology has brought prices down for consumers and businesses.
External Costs
In the case of air pollution there is an external cost to society arising from the
contamination of our air supplies. External costs are those costs faced by a third party for which
no compensation is forthcoming. Identifying and then estimating a monetary value for air
pollution can be a very difficult exercise but one that is important for economists concerned
with the impact of economic activity on our environment. We will consider this issue in more
detail when we study externalities and market failure.
Shifted Production Possibility Frontier
The shape of this production possibility frontier illustrates the principle of increasing
cost. As more of one product is produced, increasingly larger amounts of the other product must
be given up. In this example, some factors of production are suited to producing both wine and
grain, but as the production of one of these commodities increases, resources better suited to
production of the other must be diverted. Experienced wine producers are not necessarily
efficient grain producers, and grain producers are not necessarily efficient wine producers, so the
opportunity cost increases as one moves toward either extreme on the curve of production
possibilities.
Suppose a new technique was discovered that allowed the wine producers to double their
output for a given level of resources. Further suppose that this technique could not be applied to
grain production. The impact on the production possibilities is shown in the following diagram:

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In the above diagram, the new technique results in wine production that is double its
previous level for any level of grain production.


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EFFICIENCY:
Adam smith recognized that the virtues of the market mechanism are fully realized only
when the checks and balances of perfect competition are present. Perfectly competitive markets
will produce an efficient allocation of resources, so the economy is on its production possibility
frontier.
Efficiency is one of the most important concepts to use in you're A Level Economics
course. There are several meanings of the term - but they generally relate to how well an
economy allocates scarce resources to meets the needs and wants of consumers. Make sure you


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know your definitions well, can illustrate them using appropriate diagrams and can apply them to
particular situations


Static Efficiency
Static efficiency exists at a point in time and focuses on how much output can be
produced now from a given stock of resources and whether producers are charging a price to
consumers that fairly reflects the cost of the factors of production used to produce a good or a
service. There are two main types of static efficiency
Allocative Efficiency
Allocative efficiency is achieved when the value consumers place on a good or service
(reflected in the price they are willing to pay) equals the cost of the resources used up in
production. Condition required is that price =marginal cost. When this condition is satisfied,
total economic welfare is maximised.
Pareto defined
allocative efficiency as a
situation where no one could be
made better off without making
someone else at least as worth
off.
Under monopoly, a
business can keep price above
marginal cost and increase total
revenue and profits as a result.
Assuming that a monopolist and a competitive firm have the same costs, the welfare loss under
monopoly is shown by a deadweight loss of consumer surplus compared to the competitive
price and output. This is shown in
the diagram below.
This can be illustrated using a
production possibility frontier - all
points that lie on the PPF can be

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said to be allocatively efficiency because we cannot produce more of one product
without affecting the amount of all other products available. Point A is allocatively
efficient - but at B we can increase production of both goods by making fuller use of
existing resources or increasing the efficiency of production.











Economic efficiency
Economic efficiency is a term typically used in microeconomics when discussing
product. Production of a unit of good is considered to be economically efficient when that unit of
good is produced at the lowest possible cost. Economics by Parkin and Bade give a useful
introduction to the difference between economic efficiency and technological efficiency:
There are two concepts of efficiency: Technological efficiency occurs when it is not possible to
increase output without increasing inputs. Economic efficiency occurs when the cost of
producing a given output is as low as possible. Technological efficiency is an engineering matter.
Given what is technologically feasible, something can or cannot be done. Economic efficiency
depends on the prices of the factors of production. Something that is technologically efficient
may not be economically efficient. But something that is economically efficient is always
technologically efficient.
A key point to understand is the idea that economic efficiency occurs "when the cost of
producing a given output is as low as possible". There's a hidden assumption here, and that is the
assumption that all else being equal. A change that lowers the quality of the good while at the

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same time lowers the cost of production does not increase economic efficiency. The concept of
economic efficiency is only relevant when the quality of goods being produced is unchanged.
Productive Efficiency
Productive efficiency refers to a firm's costs of production and can be applied both to the
short and long run. It is achieved when the output is produced at minimum average total cost
(AC). For example we might consider whether a business is producing close to the low point of
its long run average total cost curve. When this happens the firm is exploiting most of the
available economies of scale. Productive efficiency exists when producers minimise the wastage
of resources in their production processes.
All the explanations have implicitly assumed that the economy is producing efficiently,
that is it is on, rather than inside, the production possibility frontier. The efficiency means that
the economys resources are being used as effectively as possible to satisfy peoples needs and
desires. One important aspect of overall economic efficiency is productive efficiency.
Productive efficiency occurs when an economy cannot produce more of one good without
producing less of another good; this implies that the economy is on its production-possibility
frontier.
Trade-offs between efficiency and equity
There is often a trade-off between economic efficiency and equity. Efficiency means
that all goods or services are allocated to someone (theres none left over). When a market
equilibrium is efficient, there is no way to reallocate the good or service without hurting
someone. Equity concerns the distribution of resources and is inevitably linked with concepts
of fairness and social justice. A market may have achieved maximum efficiency but we may be
concerned that the "benefits" from market activity are unfairly shared out.
Social Efficiency
The socially efficient level of output and or consumption occurs when social marginal
benefit =social marginal cost. At this point we maximise social economic welfare. The presence
of externalities means that the private optimum level of consumption / production often differs
from the social optimum.

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In the diagram
above the social
optimum level of
output occurs where
social marginal cost
= social marginal
benefit (point B). A
private producer not
taking into account
the negative
production
externalities might choose to maximise their own profits at point A (where private marginal cost
=private marginal benefit). This divergence between private and social costs of production can
lead to market failure.
ECONOMIC GROWTH
Economic growth is an increase (or decrease) in the value of goods and services that a
geographic area produces and sells compared to an earlier time. If the value of an area's goods
and services is higher in one year than the year before, it experiences positive growth, usually
simply called "economic growth." In a year when less value than the year before is produced and
sold, it experiences "negative economic growth," also called "recession" or "depression.
Economic growth can occur due to an increase in the number of goods or services. It can
also occur due to production of more expensive goods and services. For example, often as people
become wealthier, the types of food that they want change. While individuals may not eat more
food, they may reduce the amount of pasta and potatoes they eat and may increase amounts of
more expensive foods like meat and dairy.
[1]
Meeting these changes in consumer demand could
create an increase in the value of goods produced and thus, economic growth
Defining economic growth
Economic growth represents the expansion of a countrys potential GDP or national
output. Put differently, economic growth occurs when a nations production possibility frontier
shifts outward.
Economic growth involves the growth of potential output over the long run. The growth

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in output percapita is an important objective of government because it is associated with rising
average real incomes and living standards.
Economic growth is best defined as a long-term expansion of the productive potential
of the economy. Sustained economic growth should lead higher real living standards and rising
employment. Short term growth is measured by the annual % change in real GDP.
Advantages of Economic Growth
Sustained economic growth is a major objective of government policy not least because of
the benefits that flow from a growing economy.
Higher Living Standards for example measured by an increase in real national income
per head of population see the evidence shown in the chart below
Employment effects: Growth stimulates higher employment. The British economy has
been growing since autumn 1992 and we have seen a large fall in unemployment and a
rise in the number of people employed.
Fiscal Dividend: Growth has a positive effect on government finances - boosting tax
revenues and providing the government with extra money to finance spending projects
The Investment Accelerator Effect: Rising demand and output encourages investment
in new capital machinery this helps to sustain the growth in the economy by increasing
long run aggregate supply.
Growth and Business Confidence: Economic growth normally has a positive impact on
company profits & business confidence good news for the stock market and also for the
growth of small and large businesses alike.
Rising national income boosts living standards
And an expanding economy provides the impetus for a rising level of employment and a
falling rate of unemployment. This has certainly been the case for the British economy over the
last decade.
Disadvantages of economic growth
There are some economic costs of a fast-growing economy. The two main concerns are
firstly that growth can lead to a pick up in inflation and secondly, that growth can have damaging
effects on our environment, with potentially long-lasting consequences for future generations.

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Inflation risk: If the economy grows too quickly there is the danger of inflation as
demand races ahead of aggregate supply. Producer then take advantage of this by raising
prices for consumers
Environmental concerns: Growth cannot be separated from its environmental impact.
Fast growth of production and consumption can create negative externalities (for
example, increased noise and lower air quality arising from air pollution and road
congestion, increased consumption of de-merit goods, the rapid growth of household and
industrial waste and the pollution that comes from increased output in the energy sector)
These externalities reduce social welfare and can lead to market failure. Growth that
leads to environmental damage can have a negative effect on peoples quality of life and
may also impede a countrys sustainable rate of growth. Examples include the
destruction of rain forests, the over-exploitation of fish stocks and loss of natural habitat
created through the construction of new roads, hotels, retail malls and industrial estates.
The trend rate of economic growth
Another way of thinking about the trend growth rate is to view it as a safe speed limit for
the economy. In other words, an estimate of how fast the economy can reasonably be expected
to grow over a number of years without creating an increase in inflationary pressure.

Above trend growth positive output gap: If the economy grows too quickly (much
faster than the trend) then aggregate demand will eventually exceed long-run aggregate
supply and lead to a positive output gap emerging (excess demand in the economy). This
can lead to demand-pull and cost-push inflation.
Below trend growth negative output gap: If the economy experiences a sustained
slowdown or recession (i.e. growth is well below the trend rate) then output will fall short
of potential GDP leading to a negative output gap. The result is downward pressure on
prices and rising unemployment because of a lack of aggregate demand.
Demand and supply factors influence growth of GDP
Many factors influence the rate of economic growth. Some factors, such as changes in
consumer and business confidence, aggregate demand conditions in the UKs trading partners,
and monetary and fiscal policy, tend to have a mainly temporary effect on growth. Other factors,

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such as the rates of population and productivity growth, have more enduring effects, and help to
determine the economys average growth rate over long periods of time.
Potential output in the long run depends on the following factors:
(1) The growth of the labour force e.g. those people able available and willing to find
employment .If the government can increase the number of people willing and able to actively
seek paid employment, then the employment rate increases leading to a higher output of goods
and services. The Government has invested heavily in a number of employment schemes
designed to raise employment including New Deal and reforms to the tax and benefit system.
Changes in the age structure of the population also affect the total number of people seeking
work. And we might also consider the effects that migration of workers into the UK from
overseas, including the newly enlarged European Union, can have on our total labour supply
(2) The growth of the nations stock of capital driven by the level of fixed capital
investment.
A rise in capital investment adds directly to GDP in the sense that capital goods have to
be designed, produced, marketed and delivered. Higher investment also provides workers with
more capital to work with. New capital also tends to embody technological improvements which
providing workers have sufficient skills and training to make full and efficient use of their new
capital inputs, should lead to a higher level of productivity after a time lag.
(3) The trend rate of growth of productivity of labour and capital. For most countries it is
the growth of productivity that drives the long-term growth. The root causes of improved
efficiency come from making markets more competitive and achieving better productivity
within individual plants and factories. Increased investment in the human capital of the
workforce is widely seen as essential if the UK is to improve its long run productivity
performance for example increased spending on work-related training and improvement in
the UK education system at all levels.
(4) Technological improvements are important because they reduce the real costs of supplying
goods and services which leads to an outward shift in a countrys production possibility frontier
Economic growth-Theories

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Adam Smith Inquiry into the Nature and Causes of the Wealth of Nations (1776):
Advocated division of labour, specialization (absolute advantage) & accumulation of
capital
Advocated Laissez Faire - minimum government interference
Emphasised importance of a stable legal framework, within the market could function
David Ricardo:
Formalised notion of diminishing returns, but did not take innovation into account
Showed some of the welfare gains from specialisation and international trade based on
comparative advantage
Robert Solow: Neo-classical growth model
Growth depends on capital accumulation - increasing the stock of capital goods to expand
productive capacity
Net investment and the need for sufficient saving to finance investment
Higher savings - postponing consumption to finance increased allocation of resources
towards investment
Capital widening: capital stock rising at rate which keeps pace with labour force growth.
Capital deepening: capital stock grows faster than labour force. Considered more
important.
Quality of capital goods - improvements due to R&D & innovation
Solow - a combination of capital deepening & technological improvement explains major trends
in economic growth

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1. Prediction - Adding more capital goods to a fixed amount of labour will lead to
diminishing returns to capital.
2. Increased capital accumulation drives the rate of return on capital down
3. Eventually, the rate of return may be so low that no further net capital accumulation takes
place.
4. In which case the rate of technological progress determined the rate of growth of output
5. Technological progress is assumed to be exogenous i.e. lies outside the growth model
Schumpter
Schumpeterian innovation - an explanation of technological progress
Schumpeter
Long waves of innovation - "gales of creative destruction"
Increased profits arise because of constant birth of new products and new markets.
Technology raises productivity by increasing quantity and quality of all those resources
to which it is applied.
New economic growth theory
Associated with economists such as Paul Romer and Paul Ormerod
Seeking to make technological progress endogenous.
A firm will not innovate unless it thinks it can steal a march on its competition & earn
higher profits.
Inconsistent with Neo-Classical assumption of perfect competition - no "abnormal
profits".
Attention shifted to conditions under which a firm will innovate most productively.
Endogenous growth theory says that government policy to increase capital or foster right kinds
of investment in physical capital can permanently raise economic growth.
If capital broadened to include human capital, law of diminishing returns may not apply -
increasing returns to investment from education & efficiency - innovation not necessary.
Extent of capacity usage - government encouragement of open markets


Government policies and economic growth
1. Open markets - internal and external competition in markets for goods and services

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2. Promotion of liberal capital market providing a flow of liquidity to finance investment
3. Protection of private property rights
4. Scale of government spending - possible crowding out of the private sector if government
spending is too
5. Efficiency of the tax and benefit system - may create disincentives which constrains the
active labour supply
6. Incentives for entrepreneurial activity
7. Investment in human capital - active labour market policies
8. Macro-economic stability and credibility of macro economic policy
Young, 1994, Asian tiger's success resulted from:
Rapid accumulation of capital (through high investment)
Labour (through population growth and increased labour-force participation)
Government policies of encouraging education, opening economy to foreign
technologies, promoting trade, keeping taxes low & encouraging savings (30% of GDP in
'tiger' economies)
Small state - government spending around 20% of GDP compared to over 50% in Europe
Macro stability can be measured by the volatility of key indicators:
1. Consumer price inflation (annual % change in prices)
2. Real GDP growth over one or more business cycles
3. Changes in measured unemployment / employment
4. Fluctuations in the current account of the balance of payments
5. Changes in government finances (i.e. the size of the fiscal deficit or surplus)
6. Volatility of short term policy interest rates and long term interest rates such as the
yield on government bonds
7. Stability of the exchange rate in currency markets
A stable economy provides a framework for an improved supply-side performance i.e.
Stable low inflation encourages higher investment which is a determinant of improved
productivity and non-price competitiveness
Control of inflation helps to main price competitiveness for exporters and domestic
businesses facing competition from imports

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Stability breeds higher levels of consumer and business confidence sentiment drives
spending in the circular flow
The maintenance of steady growth and price stability helps to keep short term and long
term interest rates low, important in reducing the debt-servicing costs of people with
mortgages and businesses with loans to repay
A stable real economy helps to anchor stable expectations and this can act as an incentive
for an economy to attract inflows of foreign direct investment
The four wheels of growth are:
Human resources (labor supply, education, discipline, motivation)
Natural resources (Land, minerals, fuels, environmental quality)
Capital formation (machines, factories, roads)
Technology science, engineering, management, entrepreneurship)
Economic growth inevitably rides on the four wheels of labor, natural resources, capital,
and technology. But the wheels may differ greatly among the countries, and some countries
combine them more effectively than others.
Economic Growth and Benefits
Increase in economic growth should enable more of everything to be produced.
Increases possibility of providing consumer goods for all.
More consumer goods, etc. could be equated with an increase in living standards.
Wealth generated may eventually trickle down to those who are poor by means of
income distribution taxes and benefits, etc.
Benefits:
Improved standards of living associated with increase in the availability of luxury goods:
TVs
Fridges and freezers
Swimming pools, etc.
In addition:
Infrastructure roads, rail, energy, water, communication networks
Health and education provision
All associated with a decent standard of living.

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Improvement in Welfare:
Welfare associated with well-being:
Welfare is improved by the provision of support services for those not necessarily able to
help themselves often on the margins of society.
Welfare includes:
Pensions
Benefits sickness, disability, etc.
Support maternity, holidays,
Housing
Infrastructure homes for the elderly
Such welfare provision often funded through income redistribution - taxes
Providing support for the elderly, homeless, orphaned and disadvantaged is something
only wealthy countries can afford to any great extent.
Economic growth can bring with it costs:
Not all income distributed equally.
Wealth often in the hands of a few.
Trickle down does not always seem to work in practice.
Corruption may reduce redistribution effects.
Growth funded in part by spending on weapons which do not benefit the population as
whole environmental problems. Expansion and growth brings with it the problems of
pollution often developing countries do not have the infrastructure to cope with the
waste generated nor the legislation or regulation to influence those who produce it.
ECONOMIC STABILITY:
Economic stability refers to an absence of excessive fluctuations in the macro economy.
An economy with fairly constant output growth and low and stable inflation would be considered
economically stable. An economy with frequent large recessions, a pronounced business cycle,
very high or variable inflation, or frequent financial crises would be considered economically
unstable. The United States is an example of an unstable economy.
Economic Stability can be attained through:
Decrease in price fluctuations

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Pre determined prices for goods
Demand and fore castings should be made aware of every now and then
Predetermination of demands
Developing the product substitutes.

In order to stabilize economy nations face two considerations in setting monetary and
fiscal policies: the appropriate level of aggregate demand and the best monetary fiscal mix. The
mix of fiscal and monetary policies helps determine the composition of GDP. A high investment
strategy would call for budget surplus along with low real interest rates.
MICRO AND MACRO ECONOMICS
Economics can be studied under two heads:
1) Micro Economics 2) Macro Economics
Microeconomics
It has been defined as that branch where the unit of study is an individual, firm or
household. It studies how individual make their choices about what to produce, how to produce,
and for whom to produce, and what price to charge. It is also known as the price theory is the
main source of concepts and analytical tools for managerial decision making. Various micro-
economic concepts such as demand, supply, elasticity of demand and supply, marginal cost,
various market forms, etc. are of great significance to managerial economic
Those who have studied Latin know that the prefix micro- means small, so it
shouldnt be surprising that microeconomics is the study of small economic units. The field of
microeconomics is concerned with things like:
Consumer decision making and utility maximization
Firm production and profit maximization
Individual market equilibrium
Effects of government regulation on individual markets
Externalities and other market side effects
Macroeconomics
Its not only individuals and forms who are faced with having to make choices.
Governments face many such problems. For e.g. how much to spend on health how much to
spend on services how much should go in to providing social security benefits. This is the same

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type of problem facing all of us in our daily lives but in different scales. It studies the economics
as a whole. It is aggregative in character and takes the entire economic as a unit of study. Macro
economics helps in the area of forecasting. It includes National Income, aggregate consumption,
investments, employment etc.
Macroeconomics can be thought of as the big picture version of economics. Rather
than analyzing individual markets, macroeconomics focuses on aggregate production and
consumption in an economy. Some topics that macroeconomists study are:
The effects of general taxes such as income and sales taxes on output and prices
The causes of economic upswings and downturns
The effects of monetary and fiscal policy on economic health
How interest rates are determined
Why some economies grow faster than others
The Relationship Between Microeconomics and Macroeconomics
There is an obvious relationship between microeconomics and macroeconomics in that
aggregate production and consumption levels are the result of choices made by individual
households and firms, and some macroeconomic models explicitly make this connection.
Most of the economic topics covered on television and in newspapers are of the macroeconomic
variety, but its important to remember that economics is about more than just trying to figure
out when the economy is going to improve and what the Fed is doing with interest rates.
DISTINCTION BETWEEN MICRO ECONOMICS AND MACRO ECONOMICS
Micro economics Macro economics
1. Evolution of micro economics took place
earlier than macro economics.
It evolved only after the publication of
keynes'book. Genral.theory of employment,
interest and money
2. It is branch of economics, which studies
individual economic variables like demand,
supply, price etc.
It is a branch of economics which studies
aggregate economic variables, like aggregate
demand, aggregate supply, price level etc.
3. It has a very narrow scope i.e. an individual,
a market etc.
It has a very wide scope i.e. a country.
4.Demand,supply,market forms etc.relate to Aggregate demand aggregate supply, national

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micro economics income etc.relate to macro economics.
5.It is helpful in analysis of an individual
economics unit like firm
It is helpful for analyzing the level of
employment, income, economic growth etc.
6. Theory of demand, theory of production,
price determination theory etc. develops from
micro economics.

Theory of national income, theory of
employment, theory of money, theory of
general price level etc. develop from macro
economics.



Here the behavior of the economy is studied as a whole and as matter of fact both macro
and micro economics are very inter-dependent in nature and both influence in decision making
and strategy formulating of an organization.
ROLE OF MARKETS AND GOVERNMENTS:
Introduction to markets
In ordinary language, the term market refers to a public place in which goods and
services are bought and sold. In economics, it has a different meaning. Different economists have
tried to define market in different ways. Cournot defines market as, "not any particular market
place in which things are bought and sold, but the whole of any region in which buyers and
sellers are in such free intercourse with each other that the prices of the same goods tend to
equality easily and quickly". To Ely, "Market means the general field within which the force
determining the price of particular product operate".
According to Benham," Market is any area over which buyers and sellers are in close
touch with one another, either directly or through dealers, that the price obtainable in one part of
the market affects the prices paid in other parts". Stonier and Hague explain the term market as
"any organisation whereby buyers and sellers of a good are kept in close touch with each other".
There is no need for a market to be in a single building.The only essential for a market is that all
buyers and sellers should be in constant touch with each other, either because they are in the
same building or because they are able to talk to each other by telephone at a moment's notice.
Thus a market has the following basic components.

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1. There should be buyers of the product. If a country consists of people who are very
poor, there can hardly be market for luxuries like cars, VCR etc.
2. A commodity should be offered for sale in the market. Otherwise there is no question
of buying the commodity. Therefore, existence of sellers is a necessity for any market.
3. Buyers and sellers should have close contact with each other.
4. There should be a price for the commodity. The exchange of commodities between
buyers and sellers occurs at a particular price which is mutually agreeable to both the
buyers and sellers.

Classification of market
Market may be classified into different types:


On the basis of area
Markets may be classified on the basis of area into local, national and international
markets. If the buyers and sellers are located in a particular locality, it is called as a local market,
e.g. fruits, vegetables etc. These goods are perishable; they cannot be stored for a long time; they
cannot be taken to distant places. When a commodity is demanded and supplied all over the
country, national market is said to exist. When a commodity commands international market or
buyers and sellers all over the world, it is called international market.Whether a market will be
local, national or international in character will depend upon the following factors:
(a) Nature of commodity;
(b) Taste and preference of the people;
(c) Availability of storage;
(d) Method of business;
(e) Political stability at home and abroad;
(f) Portability of the commodity.
On the basis of time
Time element has been used by Marshall for classifying the market. On the basis of time,
market has been classified into very short period, short period, long period and very long period.
Very short period market refers to the market in which commodities that are fixed in supply or

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are perishable are transacted. Since supply is fixed, only the changes in demand influence the
price. The short period markets are those where supply can be increased but only to a limited
extent. Long period market refers to a market where adequate time is available for changing the
supply by changing the fixed factors of production. The supply of commodities may be increased
by installing a new plant or machinery and the output can be changed accordingly. Very long
period or secular period is one in which changes take place in factors like population, supply of
capital and raw material etc.
On the basis of nature of transactions
Markets are classified on the basis of nature of transactions into two broad categories
viz., Spot market and future market. When goods are physically transacted on the spot, the
market is called as spot market. In case the transactions involve the agreements of future
exchange of goods, such markets are known as future markets.
On the basis of volume of business
Based on the volume of business, markets are broadly classified into wholesale and retail
markets. In the wholesale markets, goods are transacted in large quantities. Wholesale markets
are in fact, a link between the producer and the retailer while the retailer is a link between the
wholesaler and the consumer.
On the basis of status of sellers
During the process of marketing, a commodity passes through a chain of sellers and
middlemen. Markets can be classified into primary, secondary and terminal markets. The
primary market consists of manufacturers who produce and sell the product to the wholesalers.
The wholesalers who are an international link between the manufacturers and retailers constitute
secondary markets while the retailers who sell it to the ultimate consumer constitute the terminal
market.
On the basis of regulation
On this basis, market is classified into regulated and unregulated markets. For some
goods and services, the government stipulates certain conditions and regulations for their
transactions. Market of goods and services is called regulated market. On the other hand, goods
and services whose transactions are left to the market forces belong to unregulated market.
Regulations of market by the government become essential for those goods whose supply or
price can be manipulated against the interests of the general public.

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On the basis of competition
Markets are classified on the basis of nature of competition into perfect competition and
imperfect competition.
ROLE OF MARKETS:
Market is a mechanism through which buyers and sellers interact to determine prices and
exchange good and services.
In a country like United States, most of economic decisions are resolved through the
market. Market economy is an elaborate mechanism for coordinating people, activities and
businesses through a system of process and markets.
In general sense markets are places where buyers and sellers interact, exchange goods
and services and determine prices.
Markets are constantly solving the what, how and for whom. As they balance all the
forces operating on the economy, markets are finding market equilibrium of supply and demand.
Market equilibrium represents a balance among all the different buyers and sellers. By matching
sellers and buyers in each market a market economy solves the three problems of what, how and
for whom.
1. What goods and services will be produced should be determined first.
2. How things are produced is determined by competition among different Producers.
3. for whom things are produced who is consuming and how much depends in large part, on
the supply and demand in the markets for factors of production
ROLE OF GOVERNMENTS:
Monetary and Fiscal Policies
Modern economics is greatly influenced by Keynesian theories propounding the
increased role of governments in regulating and stabilizing markets to ensure stable growth.
Keynesian economics argues that private sector decisions sometimes lead to inefficient
macroeconomic outcomes and therefore advocates active policy responses by the public sector,
including monetary policy actions by the central bank and fiscal policy actions by the
government to stabilize output over the business cycle. In the Keynesian economic model, the
government has the very important job of smoothening out the business cycle bumps. They stress
on the importance of measures like government spending, tax breaks and hikes, etc. for the best
functioning of the economy.

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Monetary Policy works by lowering the interest rates, which attractive private
companies to invest in real assets which increase the aggregate demand indirectly, by raising the
private sector expenditure. The opposite is also done to reduce the money supply in the economy
so that inflationary tendencies are minimized and economy over-heating is prevented.
Fiscal Policy is more direct, but acts more slowly. It works by increasing demand for
goods. Government does the borrowings to build roads, buildings etc, does the tax cutting, and
tries to put more spending power in the hands of households.
Traditionally, the working of monetary policies can be summed up as: Central Bank lowers the
interest rates as a result injecting liquidity in the financial system. Commercial banks try to lend
the additional money leading to the falling of interest rates further. This leads to the fact that
risky business becomes profitable. Firms and houses, as a result, begin to buy more number of
goods, thereby increasing employment.
The financial tools available in the hands of the Reserve Bank of India to control the
monetary and fiscal policies are:
1. Bank Rate: It is the Discount Rate, rate which the central bank charges on loans and
advances to commercial banks (Short term).
2. Repo Rate: It is the rate at which the RBI lends money to commercial banks, a short term
for repurchase agreement. A reduction in the repo rate will help banks to get money at a
cheaper rate. It is equivalent to the discount rate of US. (Long term).
3. Reverse Repo Rate: It is the rate at which Reserve Bank of India (RBI) borrows money
from banks.
4. Cash Reserve Ratio (CRR): It indicates the amount of funds that the banks have to keep
with RBI. If RBI decides to increase the percent of this, the available amount with the
banks comes down. RBI is using this method to drain out the excessive money from the
banks
5. Statutory Liquidity Ratio (SLR): It is the amount a commercial bank needs to maintain in
the form of cash, or gold or govt. approved securities (Bonds) before providing credit to
its customers. SLR rate is determined and maintained by the RBI in order to control the
expansion of bank credit.
Thus, through the use of Monetary and Fiscal policies, the government can effectively
control the money supply and hence the demand fluctuations of the market. This is essential as

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growth cannot be uncontrolled. An uncontrolled spiral of growth invariably is built on shaky
foundations which are bound to cave in bringing everything crashing down. Until growth of the
economy is backed by strong fundamentals, the speculative trading would remain strictly short
term with the specter of a long term crash imminent. The sub-prime mortgage crisis caused by
speculative trading in realty is an apt example of such a scenario. This long term thinking is what
stabilizes growth and makes emerging economies an attractive destination since they have robust
fundamentals
Regulatory Responsibilities
The governments in emerging economies also shoulder regulatory responsibilities which
enable it to control various macro-economic aspects of the economy. Through regulation,
government can iron out the inconsistencies and inefficiencies of the market as well as shape the
economic environment as per the shifting global and local trends. Regulations are essential in
certain areas to ensure fair practices, preservation of rights and the empowerment of the citizens.
Government also holds in its grips the tariff regulations which enable it to preserve the
indigenous small scale industries from global competition as well as prevent dumping of inferior
goods on local markets. The presence of multinational companies and low cost markets abroad
having incentive to dump such rejected goods in the market can skew the prices and hence create
inefficiencies in the free market price discovery process as well. This kind of actions can
severely affect indigenous industries and can result in monopolies emerging. The regulation of
trade is another key focus area of policy since unrestricted trade can lead to local markets facing
inflation. The working of the CCI (Competition Commission of India), SEBI (Security Exchange
Board of India), IRDA (Insurance Regulatory and Development Authority and other such
regulatory bodies working in tandem with central and state government in India ensure that legal
and ethical practices are followed and the general public is given a fair deal.
Overall, we can see the central role taken up by government in controlling and shaping
the growth in emerging economies. While their involvement definitely has its benefits, there
needs to be a balance since open market policies work best when they have minimal intrusions
from external entities so that pure market forces determine the valuations and expectations of the
consumers. Stringent government regulation and high tariff walls lead to protectionist tendencies
which can choke private industries and mar the conducive environment for foreign investment.

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Stabilization and Growth. Perhaps most importantly, the federal government guides the
overall pace of economic activity, attempting to maintain steady growth, high levels of
employment, and price stability. By adjusting spending and tax rates (fiscal policy) or managing
the money supply and controlling the use of credit (monetary policy), it can slow down or speed
up the economy's rate of growth -- in the process, affecting the level of prices and employment.
The ideal market economy is one in which all goods and services are voluntarily
exchanged for money at market prices. Such a system squeezes the maximum benefits
out of a societys available resources without government intervention.
In the real world, however no economy conforms totally to the idealized world of the
smoothly functioning invisible hand. Rather every market economy suffers from
imperfections which lead to such ills as excessive pollution, unemployment and extremes
of wealth and poverty.
For that reason, no government anywhere in the world, no matter how conservative,
keeps its hands off the economy.
In modern economies government take on many tasks in response to the flaws in the
market mechanism.
The military, the police, the national weather service and high way construction are the
typical areas of government activity. Socially useful ventures such as space exploration
and scientific research benefit from government funding.
Government may regulate some businesses (such as banking and drugs) while
subsidizing others (such as education and health care).
Government also taxes their citizens and redistributes some of the proceeds to the elderly
and needy.
Governments operate by requiring people to pay taxes, obey regulations and consume
certain collective goods and services. Because of its coercive powers, the government can
perform functions that would not be possible under voluntary exchange.
Government coercion increases the freedoms and consumption of those who benefit
while reducing the incomes and opportunities of those who are taxed or regulated.
Governments have three main economic functions in a market economy:

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Government increase efficiency by promoting competition, curbing externalities like
pollution and providing public goods.
Governments promote equity by using tax and expenditure programs to redistribute
income to ward particular groups.
Governments foster macroeconomic stability and growth reducing unemployment and
inflation while encouraging economic growth through fiscal policy and monetary
regulation.
Imperfect competition:
One of the serious deviations from an efficient market comes from imperfect competition
or monopoly elements. Whereas under perfect competition no firm or consumer can affect
prices. Imperfect competition occurs when a buyer or seller can affect goods price.
Public goods:
The polar case of a positive externality is a public good. Public goods are commodities
which can be enjoyed by everyone and from which can be enjoyed by everyone and from which
no one can be excluded. A classic example is military.
The private provision of public good is insufficient the government must step in to
encourage the production of public goods.
Taxes:
The government must find the revenues to pay for its public goods and for its income
redistribution programs. Such revenues come from taxes levied on personal and corporate
incomes, on wages, on sales of consumer goods, and on other items.
Equity: Even the most efficient market system may generate great inequality. Economics can
however, analyze the costs and benefits of different redistributive systems. Economists have
devoted much time to analyzing whether different income redistribution devices (such as taxes
and food stamps) lead to social waste (E.g. people working less or buying drugs rather than
food). They have also studied whether giving poor people cash rather than goods is likely more
efficient way of reducing poverty.
Macroeconomic growth and stability:
Macroeconomic policies for stabilization and economic growth include fiscal policies (of
taxing and spending) along with monetary policies (which affect interest rates and credit

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conditions) since the development of micro economics have succeeded in curbing the worst
excesses of inflation and unemployment.
EXTERNALITIES
In economics, an externality (or transaction spillover) is a cost or benefit, not transmitted
through prices, incurred by a party who did not agree to the action causing the cost or benefit. A
benefit in this case is called a positive externality or external benefit, while a cost is called a
negative externality or external cost
Examples of positive externalities (beneficial externality, external benefit, external economy, or
Merit goods) include:
A beekeeper keeps the bees for their honey. A side effect or externality associated with
his activity is the pollination of surrounding crops by the bees. The value generated by the
pollination may be more important than the value of the harvested honey.
An individual planting an attractive garden in front of his or her house may provide
benefits to others living in the area, and even financial benefits in the form of increased property
values for all property owners. A public organization that coordinates the control of an infectious
disease preventing others in society from getting sick.
An individual buying a product that is interconnected in a network (e.g., a video cell
phone) will increase the usefulness of such phones to other people who have a video cell phone.
When each new user of a product increases the value of the same product owned by others, the
phenomenon is called a network externality or a network effect. Network externalities often have
"tipping points" where, suddenly, the product reaches general acceptance and near-universal
usage.
Sometimes the better part of a benefit from a good comes from having the option to buy
something rather than actually having to buy it. A private fire department that charged only those
people whose house fire they responded to would arguably provide a positive externality to the
entire community at the expense of an unlucky few who actually had to pay. Some form of
insurance could be a solution in such cases, as long as people can accurately evaluate the benefit
they have from the option.
Some studies find that home ownership creates a positive externality in that homeowners
are more likely than renters to become actively involved in the local community. A controlled
study on the topic, however, disputes that this effect is causal. Still this is often a justification

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given for why, in the US, interest paid on a home mortgage is an available deduction from the
income tax. Education creates a positive externality because more highly educated people are
less likely to engage in violent crime.
Adam Smiths invisible hand of the marketplace leads self-interested buyers and sellers in a
market to maximize the
Total benefit that society can derive from a market.
1. An externality refers to the uncompensated impact of one persons actions on the
wellbeing of a bystander.
2. Externalities cause markets to be inefficient, and thus fail to maximize total surplus.
When a person engages
3. In an activity that influences the well-being of a bystander and yet neither pays nor
receives any compensation for that effect.
4. When the impact on the bystander is adverse, the externality is called a negative
externality.
5. When the impact on the bystander is beneficial, the externality is called a positive
externality
Externality: a by-product of a transaction that affects someone not immediately involved in the
transaction.
Imply that the competitive equilibrium will not result in the social optimum
Imply that the competitive equilibrium will result in a dead weight loss
Create a role for government intervention
In market demand or supply schedules. Some of the benefits or costs of a good may spill over to
a Third party. It is also called third party effect.
1. Government can increase demand by providing subsidies like food stamps and education
grants to subsidize consumers.
2. Government can finance production of goods or services such as public education or public
health.
3. Government can increase supply by subsidizing production, such as higher education,
immunization programs or public hospitals.



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Externalities are common in virtually every area of economic activity. They are defined as third
party (or spill-over) effects arising from the production and/or consumption of goods and
services for which no appropriate compensation is paid. Externalities can cause market failure
if the price mechanism does not take into account the full social costs and social benefits of
production and consumption.
The study of externalities by economists has become extensive in recent years - not least
because of concerns about the link between the economy and the environment.
Externalities occur outside of the market i.e. they affect economic agents not directly
involved in the production and/or consumption of a particular good or service. They are also
known as spin-over or spill-over effects.
Private and social costs
Externalities create a divergence between the private and social costs of production.
Social cost includes all the costs of production of the output of a particular good or service. We
include the third party (external) costs arising, for example, from pollution of the atmosphere.
SOCIAL COST = PRIVATE COST + EXTERNALITY
For example: - a chemical factory emits wastage as a by-product into nearby rivers and
into the atmosphere. This creates negative externalities which impose higher social costs on
other firms and consumers. e.g. clean up costs and health costs.
Another example of higher social costs comes from the problems caused by traffic
congestion in towns, cities and on major roads and motor ways.
It is important to note though that the manufacture, purchase and use of private cars can
also generate external benefits to society. This why cost-benefit analysis can be useful in
measuring and putting some monetary value on both the social costs and benefits of production.
Market failure and externalities
When negative production externalities exist, marginal social cost > private marginal
cost. This is shown in the diagram below where the marginal social cost of production exceeds
the private costs faced only by the producer/supplier of the product. In our example a supplier of
fertiliser to the agricultural industry creates some external costs to the environment arising from
their production process.


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Why do externalities lead to market failure?
If it is assumed that the producer is interested in maximising profits - then only the
private costs and private benefits arising from their supply of the product are taken into
account. We can see from the diagram below that the profit-maximising level of output is at Q1.
However the socially efficient level of production would consider the external costs too. The
social optimum output level is lower at Q2.


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This leads to the private optimum output being greater than the social optimum level
of production. The producer creating the externality does not take the effects of externalities into
their own calculations. We assume that producers are only concerned with their own self
interest. In the diagram above, the private optimum output is when where private marginal
benefit = private marginal cost, giving an output of Q1. For society as a whole though the
social optimum is where social marginal benefit =social marginal cost at output Q2.The failure
to take into account the negative externality effects is an example of market failure.
Negative externalities lead markets to produce a larger quantity than is socially desirable.
Positive externalities lead markets to produce a smaller quantity than is socially desirable.
Negative Externalities
Negative externalities impact the third party negatively. An example is pollution, which
allows the polluter to enjoy lower production costs because the firm is passing along the cost of
pollution damage or clean up to society. Because the firm does not bear the entire cost, it will
over allocate resources to production. Correcting for negative externalities requires that
government get producers to internalize these costs.
1. Legislation can limit or prohibit pollution, which means the producers must bear costs of
antipollution efforts.
2. Specific taxes on the amounts of pollution can be assessed, which causes the firm to cut back
on pollution as well as provide funds for government cleanup.
A negative externality is an action of a product on consumers that imposes a negative side
effect on a third party; it is "social cost". Many negative externalities (also called "external
costs" or "external diseconomies") are related to the environmental consequences of production
and use. The article on environmental economics also addresses externalities and how they may
be addressed in the context of environmental issues.
Air pollution.
Water pollution by industries that adds poisons to the water, which harm plants,
Animals and humans.
Systemic risk describes the risks to the overall economy arising from the risks which the
banking system takes. A condition of moral hazard can occur in the absence of well-
designed banking regulation, or in the presence of badly designed regulation.
Consumption by one consumer causes prices to rise and therefore makes other consumers

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worse off, perhaps by reducing their consumption.
Externalities or spillover occur when some of the benefits or costs of production are not
fully reflected
Automobile exhaust
Cigarette smoking
Barking dogs (loud pets)
Loud stereos in an apartment building
Positive Externalities
Positive externalities refer to spillover benefits. It occurs when direct consumption by
some individuals impact third parties positively. Public health vaccinations and education are
two examples. Because some of the benefits accrue to others, individuals will demand too little
for themselves, and resources will be under allocated by the market. Correcting for spillover
benefits requires that the government somehow increase demand to increase benefits to socially
desirable amounts.
Immunizations
Restored historic buildings
Research into new technologies
Externalities, which occur in cases where the "market does not take into account the impact of an
Economic activity on outsiders." There are positive externalities and Negative externalities.
Positive externalities occur in Cases such as when a television program on family health
improves the Publics health. Negative externalities occur in cases
Such as when a companys process pollutes air or waterways. Negative Externalities can
be reduced by using government Regulations, taxes, or subsidies, or by using property rights to
force Companies and individuals to take the impacts of their Economic activity into account.
EXTERNALITIES: Impacts on third parties besides the buyer and seller.
Consumption Externalities: impacts on third parties as a result of the consumption of a good.
E.g. each infected Person who takes Drugs eliminates disease helps all of society, not Just the
drug company which provides the medicine.
Production Externalities: impacts on third parties as a result of the production of a good. E.g.
New discoveries & Innovations impact all of Society, not just the scientist who discovers them
and the firm who employs the Scientist (Streptomycin patent problem)

44

Market Power: The power of a single Company to change the price of a good or service in the
market place. Includes: MONOPOLY, MONOPOLISTIC COMPETITION, And BILATERAL
MONOPOLY. Examples: Drug Companies while they have Patents
Inequities: any economic, social or political mechanism that systematically causes one part of
the population to be worse off than another part of a population through time without the
possibility of correction. Examples: Poor Populations have greater vulnerability to TB due to
their economic and social conditions.

Dynamic Market Failure: the failure through time to achieve technological change and the
failure of the market to achieve stable, equilibrium outcomes. Examples: As a disease disappears
in a given locale:
lack of incentives for new drug development
Lack of treatment for those who are diseased
Both in the area and in other areas where pandemics may occur
Indivisibilities: a problem cannot be sub- divided into smaller pieces for the purpose of solving
the problem or marketing the solution Example: even one remaining infected person means no
cure has been achieved. Any plan to wipe out a disease means that a comprehensive worldwide
plan must be undertaken.
Information Asymmetry: decision makers do not have access to the same information which
leads to different definitions, boundaries, and solutions to problems to be solved and social
outcomes. Examples: indifference to disease,
Lack of education about how to treat diseases, and failure to understand the tradeoff between
private rights and public goods.
NEGATIVE CONSUMPTION EXTERNALITIES
Consumers can create externalities when they purchase and consume goods and services.
o Pollution from cars and motorbikes
o Litter on streets and in public places
o Noise pollution from using car stereos or ghetto-blasters
o Negative externalities created by smoking and alcohol abuse
o Externalities created through the mis-treatment of animals
o Vandalism of public property

45

o Negative externalities arising from crime
In these situations the marginal social benefit of consumption will be less than the marginal
private benefit of consumption. (i.e. SMB <PMB) This leads to the good or service being over-
consumed relative to the social optimum. Without government intervention the good or service
will be under-priced and the negative externalities will not be taken into account. Again there
will be a deadweight loss of economic welfare.

In the example shown in the chart above we illustrate the potentially negative effects of
people consuming cigarettes on other consumers. The disutility (dis-satisfaction) created leads to
a reduction in the overall social benefit of consumption. If the cigarette consumer only considers
their own private costs and benefits, then there will be over-consumption of the product. Ideally,
the socially efficient level of cigarette consumption will be lower (Q2). The issue is really which
policies/strategies are most appropriate in reducing the total level of cigarette consumption!
British economist A.C. Pigou was instrumental in developing the theory of externalities.
The theory examines cases where some of the costs or benefits of activities "spill over" onto
third parties. When it is a cost that is imposed on third parties, it is called a negative externality.
When third parties benefit from an activity in which they are not directly involved, the benefit is
called a positive externality. The study of such situations, a part of welfare economics, has been
an active area of research since Pigou's efforts early in the twentieth century.
There are standard examples given to illustrate both types of externalities. Pollution is a
typical case of negative externality. Let's say I operate a factory along a river, making foozle

46

dolls. As a byproduct of my manufacturing, I dump lots of foozle waste into the river. This is a
terrible cost to people downriver because, as everyone knows, foozle waste stinks to high
heaven.
If neither my customers nor I have to pay this cost, our choice as to how many foozle
dolls to produce will be, in a sense, incorrect. If we had to pay these costs, we would have
chosen a smaller number of dolls. Instead, we chose to produce "too many" dolls, while the
people downriver are forced to foot the bill for part of our activity.
Pigou recommended taxing activities that produce negative externalities. Emission taxes on
factories are an example of this approach. Another common policy adopted has been to regulate
the amount of the activity legally permitted. Laws that forbid loud parties after a particular time
of night illustrate this solution.
A positive externality will arise when some of the benefits of an activity are reaped by
those not directly involved. A typical example would be improving the appearance of one's
property. If I paint my house, not only do I benefit, but so do all of my neighbors, who now have
a nicer view. When such a positive externality exists, it can be contended that I will produce "too
little" of the activity in question, since I don't take into account the benefits to my neighbors.
The traditional policy responses to positive externalities have been for the state to
subsidize or require the activities in question. For example, the US government subsidizes
research into alternate energy sources. Primary education, often said to have positive
externalities such as producing "informed citizens," is mandatory (as well as subsidized) in most
countries.
Lionel Robbins challenged Pigou's analysis in the 1930s. Robbins pointed out that, as
utility is not measurable, it is invalid to compare levels of utility between different people, as
Pigou's analysis required. Robbins recommended using the criterion of Pareto optimality as the
basis of welfare economics. A policy has to make at least one person better off and none worse
off before economists can say it is unambiguously better. But Robbins held that if we just
assume people have an equal capacity for satisfaction, then economists still can recommend
certain state interventions.
Nobel Prize-winner Ronald Coase further undermined interventionist welfare analysis
with the publication of his paper, "The Problem of Social Cost," in 1960. Coase demonstrated

47

that as long as property rights are clearly defined and transaction costs are low, the individuals
involved in these situations can always negotiate a solution that internalizes any externality.
Consider the case of river pollution from the foozle factory. If the people downriver from
the factory have a property right in the river, the factory will have to negotiate with them in order
to legally discharge waste through their property. We can't say what solution the participants
might arrive at-the factory might shut down, the people downriver might be paid to move, or the
factory might install pollution control devices or simply compensate those affected for suffering
the pollution. What we can say is that, within a system of voluntary exchange, each party has
demonstrated that it prefers the solution arrived at to the situation that existed before their
negotiations.

Social pressure also plays a role in handling potential externalities. If I don't paint my
house, my neighbors will start to grouse. I may not get invited to the next block party. Hayek
contends that those who value liberty should prefer social pressure against "deviant" behavior to
outright bans. ("Deviant," in this case, meaning simply behavior of which many people
disapprove but which does not violate their right to life or property.) If I highly value having a
house painted mauve, I can ignore my neighbors' mocking glances and jeers. But if the
government regulates house colors, I'm stuck.



48

REFERENCES:

Introduction & Positive & Normative analysis
http://economics.about.com/od/economics-basics/a/Positive-Versus-Normative-Analysis-In-
Economics.htm
The themes of economics scarcity and efficiency
http://www.scribd.com
Three fundamental economic problems
http://www.scribd.com
societys capability Production possibility fronties (PPF)
http://www.scribd.com
http://en.wikipedia.org/wiki/File:Production_Possibilities_Frontier_Curve.svg
Productive efficiency Vs economic efficiency
http://economics.about.com/library/glossary/bldef-efficiency-wages.htm
http://tutor2u.net/economics/content/topics/competition/efficiency.htm
Economic growth & stability www.hm-treasury.gov.uk
Micro economies and Macro economies
http://economics.about.com/od/economics-basics/a/Microeconomics-Versus-the role of markets
and government
Reddy P.N. and Appanniah, H.R. Principles of Business Economics.
McGuigan, Moyer and Harris: Managerial Economics, West Publishing Company
http://www.iitk.ac.in/ime/MBA_IITK/avantgarde/?p=424
The role of markets and governments-
http://economics.about.com
www.tutor2u.com
www.rfe.org
Positive Vs negative externalities.
www.tutor2u.com
www.rfe.org



49



UNIT-II
Market
Definition: A market is any place where the sellers of a particular good or service can meet with
the buyers of that goods and service where there is a potential for a transaction to take place. The
buyers must have something they can offer in exchange for there to be a potential transaction.
"Market refers to arrangement, whereby buyers and sellers come in contact with each
other directly or indirectly, to buy or sell goods."
Classification or Types of Market - Chart














Demand Analysis:
Definition:
Demand refers to the quantities of a product that purchasers are willing and able to buy at
various prices per period of time, 'all other things being equal
Demand function

50

The demand equation is the mathematical expression of the relationship between the
quantity of a good demanded and those factors that affect the willingness and ability of a
consumer to buy the good. For example,
Q
d
=f(P; P
rg
, Y) is a demand equation where
Q
d
is the quantity of a good demanded,
P is the price of the good,
P
rg
is the price of a related good, and
Y is income;
Demand Schedule:
This lists the quantities of a good that buyers are willing to purchase at different prices
Demand Curve:
The relationship of price and quantity demanded can be exhibited graphically as the
demand curve. The curve is generally negatively sloped.

Shifts in Demand curve:
Four of the most important factors that can result in a change in demand are:
1. Change in Consumer Income
2. Change in Consumer Preferences
3. Change in the Price of Related Goods
4. Change in Expectations
Difference between Movement and Shift Along Demand Curve

51

A movement along a demand curve occurs when the ONLY factor that changes is price. Because
only price changes and price is the Y Axis, there is no physical need for any translation of the
demand curve. To find out the level of demand for the new price, you simply draw a line along
the price and where it intersects the demand curve would be level of demand.


The diagram above indicates how a movement along a demand curve is best illustrated in a
diagram. It is just an arrow along the demand curve in the correct direction. As price increases
the movement would be to the left, as price decreases the movement would be to the right.
If the quantity decreases it is known as contraction.
If the quantity increases it is known as expansion.
*assumption is that price is the only factor that changes* Ceteris Paribus
In this diagram the shift from demand curve D1 to demand curve D2 is represented by an
actual translation across the plane. This particular diagram features an inward shift to the left, or
a shrink in demand. An outward shift would be an increase in demand.
This shift is caused by any actual changes in the determinants of demand.


52

In this diagram the shift from demand curve D1 to demand curve D2 is represented by an
actual translation across the plane. This particular diagram features an inward shift to the left, or
a shrink in demand. An outward shift would be an increase in demand.
This shift is caused by any actual changes in the determinants of demand.
Why demand curve slopes downwards
(1) Law of diminishing marginal utility:
A consumer always equalizes marginal utility with price. The law states that a consumer
derives less and less satisfaction (utility) from the every additional increase in the stock of a
commodity. When price of a commodity falls the consumer's price utility equilibrium is
disturbed i.e. price becomes smaller than utility.
The consumer in order to restore the new equilibrium between price and utility buys more
of it so that the marginal utility falls with the rise in the amount demanded. So long the price of a
commodity falls, the consumer will go on buying more amount of it so as to reduce the marginal
utility and make it equal with new price.
Thus the shape and slope of a demand curve is derived from the slope of marginal utility
curve.

(2) Income effect:
Another cause behind the operation of law of demand is income effect. As the price of a
commodity falls, the consumer has to buy the same amount of the commodity at less amount of
money. After buying his required quantity he is left with some amount of money.
This constitutes his rise in his real income. This rise in real income is known as income
effect. This increase in real income induces the consumer to buy more of that commodity. Thus
income effect is one of the reasons why a consumer buys more at falling prices.
(3) Substitution effect:
When the price of a commodity falls, it becomes relatively cheaper than other
commodities. The consumer substitutes the commodity whose price has fallen for other
commodities which becomes relatively dearer.
For example with the fall in price of tea, coffees. Price being constant, tea will be
substituted for coffee. Therefore the demand for tea will go up.
(4) New consumers:

53

When the price of a commodity falls many other consumers who were deprived of that
commodity at the previous price become able to buy it now as the price comes within their reach.
For example the units of color TV. increases with a remarkable fall in price of it. The opposite
will happen with a rise in prices.
(5) Multiple use of commodity:
There are some commodities which have multiple uses. Their uses depend upon their
respective, prices. When their prices rise they are used only for certain selected purposes. That is
why their demand goes down.
For example electricity can be put to different uses like heating, lighting, cooling,
cooking etc. If its price falls people use it for other uses other than that. A rise in price of
electricity will force the consumer to minimize its use. Thus with a fall and rise in price of
electricity its demand rises and falls accordingly.
DETERMINANTS OF DEMAND
After having understood the nature of demand and law of demand, it is easy to ascertain
the determinants of demand. We have mentioned above that an individual demand for a
commodity depends on desire for the commodity and his capability to purchase it. The desire to
purchase is revealed by tastes and preferences of the individuals. The capability to purchase
depends upon his purchasing power, which in turn depends upon his income and price of the
commodity. Since an individual purchases a number of commodities, the quantity of a particular
commodity he chooses to purchase depends on the price of that particular commodity and prices
of the other commodities, as well as the relative amount of his income, or purchasing power.
So, the amount demanded (per unit of time) of a commodity depends upon
Prices of related commodities:
When a change in price of the other commodity leaves the amount demanded of the
commodity under consideration unchanged, we say that the two commodities are unrelated,
otherwise these are related. The related commodities are of two types substitutes and
complements. When the price of one commodity and the quantity demanded of the other
commodity move in the same direction (i.e., both increase together and decrease together).
Income of the individual:

54

The amount demanded of a commodity also depends upon the income of an individual.
With an increase in income, increased amount of most of the commodities in his consumption
bundle, though the extent of the increase may differ between commodities.
Tastes and preferences:
It is quite well that the change in tastes and preferences of consumers in favor of a
commodity results in smaller demand for the commodity. Modern business firms, which sell
product with different brand names, rely a great deal on influencing tastes and preferences of
households in favor of their products (with the help of advertisements, etc.) in order to bring
about increase in demand of their products.
Tastes of the consumers:
The amount demanded also depends on consumers taste. Tastes include fashion, habit,
customs, etc. A consumers taste is also affected by advertisement. If the taste for a commodity
goes up, its amount demanded is more even at the same price and vice-versa.
Wealth:
The amount demanded of a commodity is also affected by the amount of wealth as well
as its distribution. The wealthier are the people, higher is the demand for normal commodities. If
wealth is more equally distributed, the demand for necessaries and comforts is more. On the
other hand, if some people are rich, while the majority is poor, the demand for luxuries is
generally less.
Expectations regarding the future
If consumers expect changes in price of a commodity in future, they will change the
demand at present even when the present price remains the same. Similarly, if consumers expect
their incomes to rise in the near future, they may increase the demand for a commodity just now.


Climate and weather
The climate of an area and the weather prevailing there has a decisive effect on
consumers demand. In cold areas, woolen cloth is demanded. During hot summer days, ice is
very much in demand. On a rainy day, ice-cream is not so much demanded.
State of business

55

The level of demand for different commodities also depends upon the business conditions
in the country. If the country is passing through boom conditions, there will be a marked increase
in demand. On the other hand, the level of demand goes down during depression.
MACRO CONCEPTS OF DEMAND
Individual demand, firms demand and industry demand are the micro concepts of
demand. This is useful to manager in decision making as to determination of size of supplies etc.
However, a manger has to know the macro concepts of demand as he operates within the
macroeconomic environment. As such he much understands a few macro concepts of demand.
As a matter of fact, national demand may influence the industry demand which in its turn may
influence the firms demand. Some of the important macro-concepts of demand are illustrated
below.
Effective demand
This refers to the aggregate volume of demand in an economy, (size of the market),
which induces the manufacturers to adjust that demand by supply. Thus if demand is effective,
it should create employment, induce output and generate income in the economy.
Consumption demand
It is concerned with the demand for consumer goods i.e., consumption expenditure of a
nation which depends on national income.
Investment demand
It is another component of effective demand. It has reference to the demand for
investment goods i.e., investment expenditure in the national economy which is dependent on the
net return on investment.
Demand for money
This refers to desire to hold money (liquidity) in hand. In any of the three motives i.e.,
transaction, precaution or speculation. Accordingly, we may speak of transaction demand for
money to meet day-to-day exchange transactions. The precautionary demand for moneys to meet
contingency requirements. The speculative demand for money has got long-term business use; it
is mostly influenced by the market rate of interest. In fact, the rate of interest is the opportunity
costs of holding money in hand for speculative purposes.
Demand for bonds

56

Since money and bonds are substitutes, the demand for bonds is related to the demand for
money.
LAW OF DEMAND
Definition:
The law of demand states that other things being equal, as the price of a good increases,
the quantity demanded of that good decreases.
In economics, the law of demand is an economic law that states that consumers buy more
of a good when its price decreases and less when its price increases (ceteris paribus).
The greater the amount to be sold, the smaller the price at which it is offered must be, in
order for it to find purchasers.
Law of demand states that the amount demanded of a commodity and its price are
inversely related, other things remaining constant. That is, if the income of the consumer, prices
of the related goods, and tastes and preferences of the consumer remain unchanged, the
consumers demand for the good will move opposite to the movement in the price of the good.
What Does Law Of Demand Mean?
A microeconomic law that states that, all other factors being equal, as the price of a good
or service increases, consumer demand for the good or service will decrease and vice versa.

Assumptions to Law of Demand:
Every law will have limitation or exceptions. While expressing the law of demand, the
assumptions that other conditions of demand were unchanged. If remain constant, the inverse
relation may not hold well. In other words, it is assumed that the income and tastes of consumers
and the prices of other commodities are constant. This law operates when the commoditys price
changes and all other prices and conditions do not change. The main assumptions are

57

Habits, tastes and fashions remain constant
Money, income of the consumer does not change.
Prices of other goods remain constant
The commodity in question has no substitute
The commodity is a normal good and has no prestige or status value.
People do not expect changes in the prices.
Exceptions to the law of demand
1- Giffen goods
These goods came to be known as Giffen goods after the name of Sir Robert Giffen, a
notable English Economist. These goods constitute very inferior goods which are essential for a
minimum living. Law of Demand does not hold well in case of giffen goods. Robert Giffen
found that bread and meat were two important items of consumption of the workers in early 19th
century England.
As meat is superior to bread they can't afford to pay for meat. With the fall in price of
bread in the market they bought the same quantity at fewer prices. The money income so saved
was spent on the meat instead of bread.
Thus with a fall in price quantity of bread falls and with a rise in price quantity of bread
rises. This is contrary to the operation of Law of Demand. The demand curve of giffen goods
rises upward from left to right.
2. Prestigious goods:-
There are certain goods having prestige value. These goods are mainly consumed by the
richer sections of the society for the gain of pride and social distinction. The consumption of
prestigious goods is known as conspicuous consumption. According to Veblen some rich people
measure the utility of a commodity entirely by price. The greater the price of a commodity, the
greater its utility.
Diamond has got a very little value in use but has got a very great prestige value as its
price is extremely high. Poor people can't dream of its use. The richer people buy diamond so
long as its price is high. The moment its use comes to the income ability of the common people
diamond ceases to be an article of distinction.

58

The greater the price of diamond, the greater its utility because of its higher prestige
value. The consumer will buy less of diamonds at a low price because of the fall in prestige
value. Thus prestigious goods constitute another exception to the Law of Demand.
3. Speculation:- There are some commodities whose prices are expected to change in future.
People demand more when price of the commodity continues rising. People apprehend a further
rise in price in the future. To escape the further rise in price, they hurry to buy more even at a
high price.
The fear of price rise in future makes him buy more at a higher price. On the other hand
they buy less at fewer prices with a hope of further fall in future. Thus this expectation or
speculation constitutes another exception to the Law of Demand.
4. Ignorance about quality:-
Usually consumers judge the quality of a commodity from its price. A high priced
commodity is thought to have higher value than that of a low priced commodity.
LAW OF DEMAND AND CHANGES IN DEMAND
The law of demand states that, other things remaining same, the quantity demanded of a
good increases when its price falls and vice-versa. Note that demand for goods changes as a
consequence of changes in income, tastes etc. Hence, the demand may sometime expand or
contract and increase or decrease. In this context, let us make a distinction between two different
types of changes that affect quantity demanded, viz., expansion and contraction; and increase and
decrease.
While stating the law of demand i.e., while treating price as the causative factor, the
relevant terms are Expansion and Contraction in demand. When demand is changing due to a
price change alone, we should not say increase or decrease but expansion or contraction. If one
of the nonprice determinants of demand, such as the prices of other goods, income, etc. change &
thereby demand changes, the relevant terms are increase and decrease in demand. The expansion
and contraction in demand are shown in the diagram. You may observe that expansion and
contraction are shown on a single DD curve. The changes (movements) take place along the
given curve k.
LIMITATION FOR LAW OF DEMAND
Change in taste or fashion.
Change in income

59

Change in other prices.
Discovery of substitution.
Anticipatory change in prices.
Rare or distinction goods.
There are certain goods which do not follow this law. These include Veblen goods and Giffen
goods.
ELASTICITY OF DEMAND The degree to which demand for a good or service varies with its
price. Normally, sales increase with drop in prices and decrease with rise in prices. As a general
rule, appliances, cars, confectionary and other non-essentials show elasticity of demand whereas
most necessities (food, medicine, basic clothing) show inelasticity of demand (do not sell
significantly more or less with changes in price). Also called price demand elasticity. See also
cross price elasticity of demand.
TYPES OF ELASTICITY OF DEMAND
We may distinguish between the tree types of elasticitys, viz., Price Elasticity, Income
Elasticity and Cross Elasticity.
Price Elasticity
Price elasticity measures responsiveness of potential buyers to changes in price. It is the
ratio of percentage change in quantity demanded in response to a percentage change in price.
Price Elasticity = Proportionate change in amount demanded
-----------------------------------------------------------------
Proportionate change in price
Suppose the price of a particular brand of a radio set falls from Rs. 500 to Rs. 400 each,
i.e., 20 per cent fall. As a result of this fall in price, suppose further that the demand for the radio
sets has gone up from Rs. 400 to 600, i.e., 50 per cent. Elasticity of demand will be 50/20 or
2.5 percent. The concept of price elasticity can be used in comparing the sensitivity of the
different types of goods (e.g., luxuries and necessaries) to change in their prices. For example, by
this means we may find that the price elasticity for food grains, in general, is 0.5, whereas for
fruit it may be1.5. This means that the demand for food grains is less sensitive to price changes
than demand for fruit. Food is a necessary of life and people must buy almost the same quantity,
even if its price has risen. The consumer can, however, economize in fruit or any other
commodity included in the family budget. The elasticity of demand is always negative, although

60

by convention it is taken to be positive. It is negative because change in quantity demanded is in
opposite direction to the change in price. That is a fall in price is followed by rise in demand, and
vice versa. Hence, elasticity is always less than zero, unless of course the demand curve is
abnormal, i.e., sloping upward from right to left. Strictly speaking, in mathematical terms, there
should be minus sign (-) before figure indicating price elasticity. But by convention, for the sake
of simplicity, the minus sign is dropped in economics.
Types of Price Elasticity of Demand
Price Elasticity of demand can be defined as a measure of change in quantity demanded
to the corresponding change in price. Below are the various types of elasticity of demand
1. Elastic Demand If the change in price leads to greater change than proportional change in
demand then the demand for that good is price elastic. For example a 20% fall in price leads to a
30% increase in quantity demanded.
2. Inelastic Demand If the change in price leads to less than proportional change in demand
then the demand for that good is price inelastic. For example a 30% increase in price leads to a
15% fall in quantity demanded.
3. Unitary Demand - If the change in price leads to equal change in demand then the demand
for that good is unitary. For example a 10% increase in price leads to 10% decrease in demand.
4. Perfectly Elastic Demand It refers to a situation when any change in price will see quantity
demanded fall to zero.
5. Perfectly Inelastic Demand It refers to a situation when any change in price will not affect
the demand for a good that is quantity demanded will remain unchanged irrespective of change
in the price of that good.
Income Elasticity
Income Elasticity is a measure of responsiveness of potential buyers to change in income.
It shows how the quantity demanded will change when the income of the purchaser changes,
the price of the commodity remaining the same. It may be defined thus: The Income Elasticity
of demand for a good is the ratio of the percentage change in the amount spent on the commodity
to a percentage change in the consumers income, price of commodity remaining constant. Thus,
Income Elasticity = Proportionate change in the quantity purchased
----------------------------------------------------------------
Proportionate change in Income

61

While prices remain constant. It is equal to unity or one when the proportion of income
spent on good remains the same even though income has increased. It is said to be greater than
unity when the proportion of income spent on a good increases as income increases. It is said to
be less than unity when the proportion of income spent on a good decreases as income increases.
Generally speaking, when our income increases, we desire to purchase more of the things than
we were previously purchasing unless the commodity happens to be an inferior
good. Normally, then, since the income effect is positive, income elasticity of demand is also
positive. It is zero income elasticity of demand when change in income makes no change in
our purchases, and it is negative when with an increase in income, the consumer purchases less,
e.g.,in the case of inferior goods. It may be carefully noted that for any individual seller or firm,
the demand for the product as a whole may be inelastic. By lowering the price, as compared with
his rivals, the seller can infinitely increase the demand for his product. The demand curve will
thus be a horizontal line. Elasticity, viz., price elasticity and income elasticity, are valuable aids
in the measurement of demand for different commodities. As such they are also helpful in
measuring the incidence of taxation.
Cross Elasticity
Here, a change in the price of one good causes a change in the demand for another. Cross
elasticity of Demand for X and Y
= Proportionate change in purchases of commodity X
-------------------------------------------------------------------
Proportionate change in the price of commodity Y
This type of elasticity arises in the case of inter-related goods such as substitutes and
complementary goods. The two commodities will be complementary, if a fall in the price of Y
increases the demand for X and conversely, if a rise in the price of one commodity decreases the
demand for the other. They will be substitute or rival goods if a reduction in the price of Y
decreases the demand for X, and also if a rise in price of one commodity (say tea) increases the
demand for the other commodity (say coffee). The cross elasticity of complementary goods is
positive and that between substitutes, it is negative. It should, however, be remembered that cross
elasticity will indicate complementarities or rivalry only if the commodities in question figure in
the family budget in small proportions. Cross elasticity of demand can be used to indicate
boundaries between industries. Goods with high cross elasticity constitute one industry, whereas

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goods with low cross elasticity constitute different industries. It is not to be supposed that cross
elasticity represents reciprocal relationship. It is not a two-way street. The cross elasticity of a tea
with respect to coffee is not the same as that of coffee with respect to tea. The tastes of the
consumer, his money income and all prices except of the commodity Y are assumed to remain
constant
Determinants for Elasticity of Demand:
1. Substitutes of the commodity available:
If the substitutes of the commodity are available its elasticity if higher. If there are
no substitutes available the elasticity if less elastic.
2. Time period
Longer the time period, more elastic is the demand for a commodity.
for e.g.- in 1970s major oil producing countries increased the price of oil for the first time
which adversely affected the whole world. but now with so many substitutes of oil
available its demand is more elastic than it was earlier.


3. Proportion out of total expenditure
If the commodity absorbs a large amount of total expenditure its demand is more
elastic.eg- petrol. But if the commodity absorbs a small amount of total expenditure. its
demand is less elastic.eg- matchboxes
4. Necessity or comfort, luxury good
Necessity goods have a less elastic (or maybe perfectly inelastic) demand whereas
comforts and luxuries have a more elastic demand.
5. Addicted or habitual
If a person is addicted or habituated to a commodity, its demand is inelastic.
SUPPLYANALYSIS:
Definition:
In economics, supply is the amount of some product producers are willing and able to sell
at a given price all other factors being held constant. Usually, supply is plotted as a supply curve
showing the relationship of price to the amount of product businesses are willing to sell.
FACTORS DETERMINING SUPPLY

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1) Technology Changes
Technology aids a producer in minimizing his cost of production; mass
production is possible with technology
2) Resource Supplies
The producer also has to pay for other resources such as raw materials and labor.
if his money is short on supplying a certain number of products because of an increase in
resource supplies, then he has to reduce his supply.
3) Tax/ Subsidy
A producer aims to minimize his profit, but an increase in tax will only increase
his expenses, decreasing his capacity to buy resource supplies and forcing him to reduce
his supply.
4) Price of other goods produced
A producer may not only produce on product but other products as well. a
producer's money is limited and if he increases his supply in one product, he would have
to decrease his supply in the other product, not unless his sales increase.
Supply schedule
A supply schedule is a table which shows how much one or more firms will be willing to
supply at particular prices. The supply schedule shows the quantity of goods that a supplier
would be willing and able to sell at specific prices under the existing circumstances. Some of the
more important factors affecting supply are the goods own price, the price of related goods,
production costs, technology and expectations of sellers.
Price in
(1000s)
Qty
supplied in
tones
1 10
2 20
3 30
4 40
5 50
6 60
Supply Curve:

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The relationship of price and quantity supplied can be exhibited graphically as the supply
curve. The curve is generally positively sloped. The curve depicts the relationship between two
variables only; price and quantity supplied. All other factors affecting supply are held constant.
Supply Equation
The supply function is the mathematical
expression of the relationship between supply
and those factors that affect the willingness
and ability of a supplier to offer goods for
sale. For example,
Q
s
=f(P/P
rg
.S)
P=Price of good
Prg=price of related good
S=No. of producers
LAW OF SUPPLY
The law of supply states that the higher the price, the larger the quantity supplied, all other things
constant. The law of supply is demonstrated by the upward slope of the supply curve.
EXCEPTIONS TO LAW OF SUPPLY
1..... Rare goods
2..... Agricultural products
3..... Future expectations
4..... Inelastic Goods

ELASTICITY OF SUPPLY:
Elasticity of supply of a commodity is the degree of responsiveness of the quantity
supplies to changes in price. Like the elasticity of demand, the elasticity of supply is the relative
measure of the responsiveness of quantity supplied of a commodity to a change in its price.
The, greater the responsiveness of quantity supplied of a commodity to the change in its
price, the greater is its elasticity of supply. To be more precise, the elasticity of supply is defined
as a percentage change in the quantity supplied of a product divided by the percentage change in
price.
KINDS OF ELASTICITY OF SUPPLY:

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There are five types of Price Elasticity of supply elasticity of supply which are given
below
(I) perfectly elastic supply:
It is a case where a very slight change in price causes an Infinite change in supply. A
slight fall in prices brings quantity supplied to zero. In such a case the supply curve runs parallel
to X -axis. The supply curve takes the shape of a horizontal straight lit line. In the diagram given
below 'SS' is the supply curve which shows that an infinitesimally small change in price causes
an infinitely large change in the quantity supplied.
(2) Perfectly inelastic supply:
The supply of a commodity is said to be perfectly inelastic when the supply of
commodity is completely non-responsive to changes in price. It is a case where quantity supplied
remains the same despite the change in price. A perfectly inelastic supply curve is a vertical
straight line which is parallel to OY-axis. In the diagram given below 'SS' is the perfectly
inelastic supply curve that runs parallel to OY-axis.
(3) Relatively elastic supply:
The supply is relatively elastic when a given change in price produces more than
proportionate change in quantity supplied. A doubling in price will result in more than double the
quantity supplied. In the diagram shown below, a given change in price from OP to OP, is
attended by a much more change in supply, supply curve 'SS' is relatively
(4) Relatively inelastic supply:
When a certain change in price causes a smaller proportionate change in quantity
supplied of a Commodity, the supply is said to be relatively less elastic. The percentage change
in price is more than the percentage change in quantity supplied. In the diagram as shown, below
a rise in price from OP, to OP brings about less than proportionate change in supply from OS, to
OS. Hence the supply curve SS is relatively inelastic.
(5) Unitary elastic supply:
In such a situation the proportionate change in supply equals the proportionate change in
price. In the diagram given below SS is the unitary elastic supply curve. Increase in price from
OP to OP is accompanied by a proportionate change in supply from OS to OS.

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Determinants of Price Elasticity of Supply
1. Availability of materials
The limited availability of raw materials could limit the amount of a product that can be
produced.
2. Length and complexity of product
If the product is complex to manufacture, it becomes more inelastic.
3. Time to respond
If the producer has more time to respond to price changes, the product is more elastic.
4. Excess capacity
A producer with unused capacity will quickly respond to price changes
5. Inventories
A producer with a large number of products can quickly increase the amount of supply it
delivers to the market. -The number of substitutes - This determines how easily one person could
switch from one product to another and determines how elastic or inelastic a good is.
A demand curve is the graphical representation of the demand schedule for a commodity. It is
the graphic statement of an individual buyer's reaction on amount demanded at a given price in
the given point of time. A demand curve has got a negative slope. It slopes downwards from left
to right. A demand curve shows the maximum quantities per unit of time that consumers will buy
at various prices. In the words of Richard Lipsey "The curve which shows the relation between
the price of a commodity and the amount of that commodity the consumer wishes to purchase is
called Demand Curve.

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As with the demand curve, the convention of the supply curve is to display quantity
supplied on the x-axis as the independent variable and price on the y-axis as the dependent
variable.
Shifts in the Supply Curve
While changes in price result in movement along the supply curve, changes in other
relevant factors cause a shift in supply, that is, a shift of the supply curve to the left or right. Such
a shift results in a change in quantity supplied for a given price level. If the change causes an
increase in the quantity supplied at each price, the supply curve would shift to the right:

Shifts of Supply Curve:
There are several factors that may cause a shift in a good's supply curve. Some supply-
shifting factors include:
Prices of other goods - the supply of one good may decrease if the price of another good
increases, causing producers to reallocate resources to produce larger quantities of the
more profitable good.
Number of sellers - more sellers result in more supply, shifting the supply curve to the
right.
Prices of relevant inputs - if the cost of resources used to produce a good increases,
sellers will be less inclined to supply the same quantity at a given price, and the supply
curve will shift to the left.
Technology - technological advances that increase production efficiency shift the supply
curve to the right.

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Expectations - if sellers expect prices to increase, they may decrease the quantity
currently supplied at a given price in order to be able to supply more when the price
increases, resulting in a supply curve shift to the left.

MARKET EQUILIBRIUM:
The operation of the market depends on the interaction between suppliers and demanders.
Market equilibrium exists when quantity supplied is equal to quantity demanded.
Note that there is just one price where this is true! The equilibrium price is the price that
will generally prevail in a perfectly competitive market that is not subject to governmental
intervention. As you might remember from your chemistry classes, a system is in equilibrium
when there is no tendency for it to change under existing conditions. When a market is in
equilibrium, there is no tendency for the market price to change. In other words, the
equilibrium price is stable under the existing market conditions.
Consider, for example, the soybean market depicted in the following figure:

Demand, Supply, and Market Equilibrium
Market Equilibrium
The operation of the market depends on the interaction between suppliers and demanders.
Market equilibrium exists when quantity supplied is equal to quantity demanded.
Note that there is just one price where this is true! The equilibrium price is the price that
will generally prevail in a perfectly competitive market that is not subject to governmental

69

intervention. As you might remember from your chemistry classes, a system is in equilibrium
when there is no tendency for it to change under existing conditions. When a market is in
equilibrium, there is no tendency for the market price to change. In other words, the equilibrium
price is stable under the existing market conditions.
Consider, for example, the soybean market depicted in the following figure:
Under the existing conditions of supply and demand (the existing incomes for consumers,
prices of related goods, state of technology, input prices, and other conditions), the market price
of soybeans will be $2.50 per bushel. When farmers hear the farm report on the radio in the
morning, the price of soybeans will be quoted as being $2.50 per bushel. Agricultural products
such as apples, bread, or other items, are generally about their equilibrium prices.
If the equilibrium price is the price that is stable under existing conditions, that must
mean other prices will tend to be unstable. That is exactly the case. Consider what happens when
the market price is below the equilibrium price. At low prices, producers supply less and
consumers want to buy more than at the equilibrium price. This creates an excess demand, and
causes a shortage of the product. Imagine the situation at your local market if the minute supplies
of the product came in, frantic consumers immediately would scoop them up! What is the
manager of the store likely to do in such a situation? The manager would most likely raise prices.
When the market price is below the equilibrium price, consumers compete with each other in
order to grab the good deals. This puts upward pressure on the market price. Such pressure will
cease when the market price reaches the equilibrium price.
The shortage resulting from the price being below the equilibrium level is shown in the
following figure at the price of $1.75. The amount of the shortage is the difference between
quantity demanded and quantity supplied at that price. In this case, there is a shortage of 25,000
bushels (50,000 - 25,000).
Now consider what happens when the market price is above the equilibrium level. In this
case there is an excess supply, or surplus, of the product. At high prices, producers are willing to
produce more of the product, but consumers are willing to buy less than at the equilibrium price.
Excess supply, the condition where quantity supplied exceeds quantity demanded at the current
price, will result. Now imagine what happens at your local store. As inventories pile up on the
back shelves, managers will put the product on sale in order to unload some of it.

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As a result, market forces will pull the price down toward the equilibrium price. The
surplus resulting from the price being above the equilibrium level is shown below:


CONSUMER BEHAVIOR
Choice, Utility and Preferences
Consumer behavior theory tries to explain the relationship between price changes and
consumer demand. Utility is a concept used to denote the subjective satisfaction or usefulness
attained from consuming goods and services. This concept helps to explain how consumers
divide their limited income / resources among different choices of goods and services that help
attain them satisfaction (utility)
The issue however is how we are supposed to measure utility and how the value of utility
derived from various choices can be quantified.
Because of these issues, the consumer behavior theory has been reformulated and utility
is viewed as a way to describe preferences. It was recognized that all that mattered about utility
is whether one combination of choice had a higher utility than another; by how much higher or
lower didn't really matter
Preferences of consumers is the fundamental description important for analyzing choice
while utility is just a simple way of describing preferences
Total utility
The total satisfaction or fulfillment received by a consumer through the consumption of a
goods or services or a combination of both is defined as Total utility. For instance if a person

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consumes five units of a commodity and derives U1, U2, U3, U4, U5 utility from the successive
units of a good, his total utility will be,
Total utility increases with an increase in consumption, but as
consumption rises, total utility grows at a diminishing rate.
Every unit of a good or service has a marginal utility and
the total utility is a simple addition of all the marginal utilities of the units of goods or
services
All consumers want to achieve the maximum possible total utility for their spending and thus
they look to combine different bundles of goods and services. With their limited resources,
consumers make various choices in order to increase their total utility with each additional unit
of consumption.


Marginal utility
As discussed above all consumers attempt to maximize their total utility from the goods
and services they consume. This process of optimization leads the consumers to consider the
marginal utility of acquiring additional units of the product or service and of acquiring one
product or service as opposed to another.
Product characteristics and individual tastes and preferences apart from available
resources (money) determine direct demand. Utility is maximized when products are bought at
levels such that relative prices equal the relative marginal utility derived from consumption.
TU = U1+ U2 +U3+ U4+ U5

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The marginal utility of a good is the increase in total utility gained by consuming one
additional unit of that good, for a given level of consumption of other goods
Law of diminishing marginal utility
We have discussed earlier that with an increase in consumption total utility increases but
at a slower and slower rate. Law of diminishing marginal utility explains this concept.
The law of diminishing marginal utility says that as consumption rises the marginal utility of
consuming the next unit is less than the previous one. Accordingly the marginal utility of good
decreases as more and more units of that good are consumed as shown in the table and figure
below:
Quantity of Good Total Utility (TU) Marginal Utility (MU)
1 10 10
2 19 9
3 27 8
4 34 7
5 40 6



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Equimarginal Utility
The dollar value of a consumers marginal utility from consuming additional unit of a
product is called the marginal benefit. It is the maximum price that a consumer will pay for an
additional unit and will fall as consumption increases. When different products are available a
consumer will ensure that the last dollar spent on each product gives an equal marginal utility
(MU) per dollar spent.
For two products A and B this can be expressed as:
MU
A
/P
A .
MU
B
/P
B
MUA =marginal utility of product A;
MUB =marginal utility of product B
PA =price of product A;
PB =price of product B
To illustrate, let us take a case of a boy who wants to buy fruits and has $6 to spend. He
finds that apples and oranges are available. While apples cost $2 per kilogram, oranges are
available for $1 per kilogram. The marginal utilities of the first three kilograms of apples are $3,
$2.50 and $2 respectively and the marginal utilities of the first 3 kilograms of oranges are $2.00,
$1.25 and $1 respectively. The boy would achieve maximum utility by buying 2 kilograms of
apples and 2 kilograms of oranges as the marginal utility of the last kilogram of each per dollar
price is 1.25. In simpler words, if Apples cost costs twice as much as Oranges, then buy Apples
only when the marginal utility derived from it is at least twice as great as Oranges' marginal
utility.
Indifference Curve Analysis
As we know that the consumer is able to rank bundles of goods and services based on the
utility he derives from them. This makes possible joining together of all these bundles that give
the consumer equal utility / satisfaction.
The curve drawn on these bundles or combinations of goods and services is known as
indifference curve.
At all points across the indifference curve the consumer derives same level of utility. And
thus the consumers are indifferent because they do not care which of the bundles on the
indifference curve they have.

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Compare the consumption bundles shown on the figure above. The indifference curve I1
tells us that Bundles A, B and C give the consumer equal satisfaction. Bundle E contains fewer
bananas and fewer apples than Bundle B, and therefore Bundle B (and A and C) must be
preferred to Bundle E. Similarly Bundle D contains more bananas and more apples than Bundle
B, and therefore Bundle D must be preferred to Bundle B (and A and C). While bundle D should
be on a higher indifference curves as it gives more utility to the consumer, E should be on a
lower curves as it gives lesser utility.

The indifference curves are convex to the origin as because to keep the consumers utility
constant he must be compensated with increasingly larger amounts of good X for each additional
unit of good Y he is giving up.
This concept stems from the fact of diminishing marginal utility and is explained below
in Marginal rate of substitution
Slope of an Indifference curve is given by:

Marginal Rate of Substitution = MU
A
/MU
B

where MUA and MUB are marginal utility derived from the last unit consumed of good A and B
respectively

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All of the points along an indifference curve represent combinations of goods / services that
are equally satisfying to the consumer
The amount of one unit of good that a consumer is prepared to forego for one extra unit
of another good is known as the marginal rate of substitution. The marginal rate of substitution
of good A for good B is the number of good A the consumer is willing to give up to gain another
unit of good B without affecting total satisfaction. A diminishing marginal rate of substitution of
good B for good A implies that the consumer is willing to give up diminishing quantities of good
A to gain each additional good B. This means that if it takes, say, n extra units of good A to
convince a consumer to give up one unit of good B, it will take more than another n extra good A
to persuade her to give up yet another unit of good B.
Suppose the following combinations of fruits give the consumer equal satisfaction:
Apples Oranges
20 1
15 2
11 3
8 4
The marginal rate of substitution of oranges for apples falls from 5 to 4 to 3, showing that
the consumer is more willing to give up apples for an additional orange when the consumer has a
lot of them.
Budget Constraint
The bundle of goods and services that the consumer can afford depends on two factors namely;
Price of the goods; and
Income of the consumer
Further to ascertain the bundles affordable by the consumer we assume that both the above
factors are fixed which implies that the two factors are independent of the choice of consumption
bundle
The budget line thus is a line drawn on all points that is affordable to the consumer, assuming
that all income is spend

76


As shown in figure above, with a given income and prices of goods, if a consumer spends
all his income on apples, he or she can afford to buy A apples. Alternatively, the consumer could
buy B bananas, or an intermediate bundle such as E.
Consumer Equilibrium
Individuals (consumers in this case) make their choices about the quantity of goods and
services to be consumed with the objective to maximize their total utility. But in maximizing
total utility they face several constraints, the foremost being the individuals income level and
the prices of the goods and services that he desires to consume. These constraints as discussed
above forms the budget line of the consumer.
The consumer's effort to maximize total utility, subject to the budget line, includes
decisions about how much he would consume of the goods and services and the combination of
goods and services at which the consumer maximizes its total utility is called consumer
equilibrium.
A consumer facing the budget line (fixed income and given market prices of goods) can
come to a point (or equilibrium) of maximum satisfaction or utility only by acting in the
following manner.
Each product is demanded up to the point where the marginal utility for every unit of
money spent on it is exactly the same as the marginal utility of the spent on any other good. This
fundamental condition of consumer equilibrium can be written in terms of Marginal Utilities
(MU) and Prices (P) of the different goods in the following compact way.

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MU GOOD1 /P1=MU GOOD2/P2=MUGOOD3/P3 = Common MU per unit of income.
To maximize utility the consumers spread out their expenditures in such a way that the marginal
rate of substitution is equal to the relative price of the good X as in the figure above. To represent
it numerically:
=MU
X
/MU
Y =
P
X
/P
Y
Thus combining the budget line with indifference curves, we can ascertain the
consumption bundle which a consumer will choose. To further illustrate consider the earlier
example of choice between apples and bananas and the figure below:


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Now let assume that all income is spent. Since the bundle W lies on the highest
achievable indifference curve, W will be chosen. At this point the consumer chooses to buy qa
apples and qb bananas. Bundle F is unaffordable as it doesnt touch the budget line and lies
above it. Now though bundles such as G and H are affordable, but as they lie on a lower
indifference curve and provide lower utility they will not be chosen. The bundle W maximizes
the consumers utility given the budget line and indifference curves.
Income and Substitution effect
If the price of a good increase whiles everything remaining same, the budget line rotates
around the other good thus bringing down the consumer to a lower indifference curve

As shown in the figure above, when the price of bananas rises, the consumer can buy less of
them though if he chooses to spend all his income on apples, he could buy just as many apples as
before. So the budget line will rotate around A from AB to AB' and the consumers consumption
bundle will change from W to W'.
As seen here, the rise in the price of bananas has led the consumption of bananas to fall from
qb to qb. This change in the consumption bundle of the goods chosen by the consumer can be
divided into two effects:
Firstly, bananas become relatively more expensive compared with apples, and so $1 spent
on bananas is less effective at increasing utility than $1 spent on apples. The consumer
will therefore tend to substitute apples for bananas to some extent.
Secondly, the increase in the price of bananas has made the consumer worse off by
reducing his/ her real income as the consumer can buy less in total when the price of one
good increases.

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Substitution Effect
The substitution effect of the price change is the change in demand for the good/ services
caused by the change in relative prices, holding the level of real income or utility of consumers
constant.
Income Effect
The income effect of the price change is the change in demand for the good caused by the
change in the real income of consumers as the price of a good change.


Analysing Substitution effect and Income Effect
The income and substitution effects can be separated and analyzed by drawing a
hypothetical budget line which has the slope of the new budget line and which is tangential to the
old indifference curve.
By using the old indifference curve we hypothetically keep real income constant thereby
keeping the level of utility constant.
Refer the figure below:

Continuing with our earlier illustration with the change in budget line with price rise we
can analyze the income and substitution effects by drawing in the hypothetical budget line HH.
This line reflects the new relative prices but the old level of utility (real income). Thus the
difference between qb and qb is purely caused by the new relative prices. This is the
substitution effect.

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The difference between qb and qb is due to the change in real income as the relative
prices are held constant. This is the income effect.
The shift from the old consumption bundle to the intermediate bundle with the same utility
is the substitution effect

The income effect is the change from the intermediate bundle to the final bundle



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PRODUCTION FUNCTION
Short run Production Function:
Short run is the time period in which output can be varied only by
changing the variable inputs, like labor. The inputs that remain fixed are called
fixed inputs or fixed factors.
Short run production function is a relation between inputs and output
for a given technology in which output can be varied by changing one factor
(say labor) only. All other factors remain fixed. Mathematically Q=f(L),i.e.
output is a function of labor. Or output is a function of labor keeping capital
constant.
Long Run Production Function :
Long run is the time period in which distinction between fixed variable
inputs disappears. All inputs are variable. So output can be varied by changing
all the inputs simultaneously.
Long run production function is a relation between inputs output for a
given technology in which output can be varied by altering all factor inputs
simultaneously. Here, factor ratio remains constant.
COBB DOUGLAS PRODUCTION FUNCTION:
Difficulties and criticisms
Dimensional analysis
The CobbDouglas model is criticized by some Austrian economists, such as William
Barnett II, on the basis of dimensional analysis. They argue it does not have meaningful or
economically reasonable units of measurement unless however, other economists in reply to
Barnett have argued that the units used are not fundamentally more unnatural than other units
commonly used in physics such as log temperature or distance squared.
Lack of micro foundations
The CobbDouglas production function was not developed on the basis of any
knowledge of engineering, technology, or management of the production process. It was instead
developed because it had attractive mathematical characteristics, such as diminishing marginal
returns to either factor of production and the property that expenditure on any given input is a

82

constant fraction of total cost. Crucially, there are no micro foundations for it. In the modern era,
economists try to build models up from individual agents acting, rather than imposing a
functional form on an entire economy. However, many modern authors have developed models
which give CobbDouglas production function from the micro level; many new Keynesian
models, for example.
[5]
It is nevertheless a mathematical mistake to assume that just because the
CobbDouglas function applies at the micro-level, it also always applies at the macro-level.
Similarly, it is not necessarily the case that a macro CobbDouglas applies at the disaggregated
level.

RETURNS TO SCALE:
The laws of returns to scale are often confused with returns to scale. By returns to
scale is meant the behavior of production or returns when all productive factors are increased or
decreased simultaneously and in the same ratio. When all inputs are changed in the same
proportion, we call this as a change in scale of production. The way total output changes due to
change in the scale of production is known as returns to scale. Thus, whereas in the short-run
change in output is associated with the change in factor proportions, and change in output in the
long-run is associated with change in the scale of production. Thus returns to scale is the long-
run concept. A layman would perhaps expect that with doubling of all productive factors, the
output will also double and with trebling of factors of production, production would also be
trebled, and so on. But actually this is not so. In other words, when all inputs are increased in the
same proportion, the total product may increase at an increasing rate, or a constant rate or
diminishing rate. Accordingly the returns to scale could be increasing, constant, or
decreasing.
Definition
The law of returns to scale describes the relationship between outputs and the scale of
inputs in the long-run when all the inputs are increased in the same proportion.
According to the Roger Miller, the law of returns to scale refers to the relationship
between the changes in output and proportionate change in all factors of production. The firm
increases its scale of production by using more space, more machines and laborers (as a input) in
the factory, to meet a long-run change in demand.
Assumptions:

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All factors (inputs) are variable but enterprise is fixed.
A worker works with given tools and implements.
Technological changes are absent.
There is perfect competition.
The product is measured in quantities.

Three different cases
Increasing returns to scale
Constant returns to scale and
Decreasing returns to scale.


Increasing returns to Scale:
This situation occurs if a percentage increases in all inputs results in a greater percentage
change in output. For e.g. a 10 % increase in all inputs causes a 20% increase in output.
By increasing its scale, the firm may be able to use new production methods that were
infeasible at the smaller scale. For instance, the firm may utilize sophisticated, highly efficient,
large-scale factories. It also may find it advantageous to exploit specialization of labor at the
large scale. This is shown in the following example.
Inputs (Units) Output (Units)
2 capital +2 Labor 200
4 Capital +4 Labor 500
The table shows that the input is increasing by 100%, on the other hand the output is
increased by 150%. This shows the increasing returns to scale. As changes in the output is more
than the change in input.
Causes of Increasing Returns to scale
1. Indivisibilities: According to economist like Caldor, learner, knight and Joan Robinson, an
important cause of indivisibility. Indivisibility means that certain factors are available only in
some minimum sizes. Certain inputs particularly machinery, management etc. are available in
large and lumpy units. Such inputs cannot be divided into small sizes to suit the small scale of
production. For e.g. there cannot be half a machine, half a computer or half a manager. Such
inputs have to be employed even if the scale of production is small. Therefore, as the scale of

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production increases, these indivisible factors are utilized better and more efficiently. This leads
to increasing returns to scale.
2. Greater Specialization: As the scale of production increases, the efficiency of labor increases
due to division of labor and specialization of labor. Similarly, when the scale of production
increases, it becomes possible to use specialized machines and the services of specialized and
expert management. This results in productivity of inputs leading to increasing returns to scale.
According to Prof. Chamberlin returns to scale in the initial stages increases due to the fact that
the firm can introduce the specialization of labor and machinery.

Constant returns to Scale
Constant returns to Scale: It occurs if a given percentage change in all inputs results in an equal
percentage in output. For instance, if all inputs are doubled, output also doubles; a 10% increase
in inputs would imply a 10% increase in output; and so on. Under constant returns, the firms
inputs are equally productive whether or smaller or larger levels of output are produced.
A common example of constant returns to scale occurs when a firm can easily replicate its
production process.
For, instance a manufacturer of electrical company finds that it can double its output by
replicating its current plant and labor force, that is, by building an identical plant beside the old
one.
Similarly, chain of dry cleaners can increase its volume of service by increasing its
number of outlets (with designated number of workers per outlets). So long as all necessary
inputs are readily available the firm can increase in proper proportion to inputs via replication,
and constant returns to scale will hold. This can be explained in the following example.
Inputs (Units) Output (Units)
2 capital +2 Labor 200
4 Capital +4 Labor 400
The above example shows that as the inputs (i.e. labor and capital) increased to 100%,
output also increased to 100%.
Causes of constant Returns to scale
1. Limits of Economies of scale: Increasing returns to Scale cannot go on indefinitely. There is
a limit to these economies of scale When the economies of scale are exhausted and diseconomies
are yet to start, there may be a briefs phase of constant returns to scale.

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2. Economies of Scale: It refers to the situation which increases in the scale of production give
rise to certain benefits to the producers.
3. Divisibility of Inputs: Constant returns to scale may occur in certain productive activities
where the factors of production are perfectly divisible. For example, we may double the output
by setting up two plants (factories) which use the same quantity and the same type of workers,
machinery, raw materials and other inputs.

Decreasing Returns to scale:
It occurs if a given percentage increase in all inputs results in a smaller percentage
increase in output. The most common explanation for decreasing Returns involves organization
factors in very large firms. As the scale of firms increases, the difficulties in Coordinating and
monitoring the many management functions. Coordinating production and distribution of 12
products manufactured in four separate plants typically means incurring additional costs tor
management and information systems that would be unnecessary in a firm one-quarter size. As a
result, proportional increases in output require more than proportional increases in inputs. The
following example will explain decreasing returns to scale.
Inputs (Units) Output (Units)
2 capital +2 Labor 200
4 capital +4 Labor 300
The above shows, that inputs ate increases to 100% but the increase output is 50%, which
shows that there is decreasing returns to scale.
Causes of Decreasing Returns to scale.
1. Complexity of management: Increase in the scale of production on beyond a point may
create the problem of proper management, leading to a decrease in managerial efficiency. Large
scale of production creates the problem of lack of proper, larger bureaucracy, red tapism, lengthy
Chain of Communication and command between the top management and men on the production
line. As a consequence of all these, the overall efficiency of management decreases.
2. Entrepreneur is a fixed factor: According to some economist decreasing returns to scale
arise because entrepreneur is a fixed and indivisible factor. An increase in scale may come to a
point where the abilities and Skills of the entrepreneur may be fully utilized. An increase in the
scale beyond this point may decrease the efficiency of the entrepreneur. This gives rise to
diseconomies of scale.

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3. Exhaustibility of Natural Resources: Another factor responsible for the diminishing returns
in some activities is the limitation of natural sources. For example, if we double the fishing fleet,
the number of fish Catch will not double because the availability of fish may decrease when
fishing is carried out on an increasing scale.
ECONOMIES OF SCALE:














Internal economies:
Alfred Marshall made a distinction between internal and external economies of scale.
When a company reduces costs and increases production, intern.al economies of scale have been
achieved.
External economies:
External economies of scale occur outside of a firm, within an industry. Thus, when an
industry's scope of operations expands due to, for example, the creation of a better transportation
network, resulting in a subsequent decrease in cost for a company working within that industry,
external economies of scale are said to have been achieved. With external ES, all firms within
the industry will benefit.
Economies of Scale occur due to:
Lower input costs:

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When a company buys inputs in bulk - for example, potatoes used to make French fries at
a fast food chain - it can take advantage of volume discounts.
Costly inputs:
Some inputs, such as research and development, advertising, managerial expertise and
skilled labor are expensive, but because of the possibility of increased efficiency with such
inputs, they can lead to a decrease in the average cost of production and selling. If a company is
able to spread the cost of such inputs over an increase in its production units, ES can be realized.
Specialized inputs:
As the scale of production of a company increases, a company can employ the use of
specialized labor and machinery resulting in greater efficiency. This is because workers would be
better qualified for a specific job - for example, someone who only makes French fries - and
would no longer be spending extra time learning to do work not within their specialization
(making hamburgers or taking a customer's order). Machinery, such as a dedicated French fry
maker, would also have a longer life as it would not have to be over and/or improperly used.
Techniques and Organizational inputs:
With a larger scale of production, a company may also apply better organizational skills
to its resources, such as a clear-cut chain of command, while improving its techniques for
production and distribution. Thus, behind the counter employees at the fast food chain may be
organized according to those taking in-house orders and those dedicated to drive-thru customers.



Learning inputs:
Similar to improved organization and technique, with time, the learning processes related
to production, selling and distribution can result in improved efficiency - practice makes perfect!
Diseconomies of scale occur due to:
As we mentioned before, diseconomies may also occur. They could stem from inefficient
managerial or labor policies, over-hiring or deteriorating transportation networks (external DS).
Furthermore, as a company's scope increases, it may have to distribute its goods and services in
progressively more dispersed areas. This can actually increase average costs resulting in
diseconomies of scale

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Internal economies of scale are a product of how efficient a firm is at producing; they are those
economies of scale which a firm has direct control over. They relate to the change in average
production cost for a firm as it increases its total output. As output increases, the average cost per
unit will fall until the firm reaches its minimum efficient scale, where the firm has maximized its
efficiency in production and any additional unit will cause the average cost to rise. In such, a
firm in a competitive market will hypothetically produce at its Minimum Efficient Scale (MES);
a point where its long run average total cost is the lowest
An example of a firm utilizing internal economies of scale is when a company is cut in
size but the remaining firms still hold the same amount of final output. Therefore the company
has become more efficient in production and has experienced internal economies of scale.
Six main types of internal economies of scale can be defined.
1. Technical economies.
They are found mostly in plants and arise mostly because neither the capital cost nor the
running cost of plants increase in proportion to their size. The main idea is to spread the
fixed costs over as large output as possible, so Average Fixed Cost decreases.
2. Managerial or administrative economies
It arises because the same people can usually manage with bigger output, so average
administrative cost decreases when production increases. Large firms can employ
specialists, which leads to the increase in efficiency.
3. Financial economies
It arises because e.g. the interest rate for getting a loan is higher for smaller firm that for
larger one. This is because large firms have large assets and banks trust them more. It is
also relatively easier for large firms to raise their share-capital by issuing shares.


4. Marketing economies.
They are available both in purchases of raw material and in selling of the product. A large
firm may have a bulk discount when purchasing raw materials. In terms of promotion, to
large firms the average cost is smaller, because the prices of advertisements are the same
for all firms; hence the large firms can afford costs of sales promotion without causing
much difference in their profit shares.

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5. Social economies.
They may be developed into two groups: those that build up the goodwill of the
community and so attract customer (sponsorship), and those that develop the loyalty of
the firm's employers (Christmas bonuses)
6. Risk-bearing economies.
They are the firm's ability to bear losses. If one part of the company has a loss, other parts
of the company can support it. If the company sustains a loss, it has enough capital to
overcome it.
Dis- economies of scale can be internal and external.
Internal diseconomies of scale are
1. Technical
2.Managerial
3.Commercial
4.Financial and risk bearing.
These diseconomies arise due internal situation.
EXTERNAL ECONOMIES OF SCALE:
External Economies of Scale are the benefits that a firm gains from being located in the
same area as other similar industries. These include:
1. Close-by suppliers reduces deliver times and transport costs.
2. There is a pool of labour with specialist skills that the industry needs.
3. Specialist training courses developed by local colleges to meet industry needs.
4. Other specialist services may develop (e.g. machine repair, delivery firms etc.)
5. If an area has a good name for high quality goods, firms will benefit from that
reputation.
6. Firms co-operate to promote the industry. They may even form trade associations or
joint research from which they can all gain.


External diseconomies arises due to outside situations i.e. expansions of the industry.
1. Cheaper raw materials and capital equipment
2.Technological

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3.Skilled labor development
4.Growth of ancillary industries
5.and better transportation and marketing facilities

COST ANALYSIS:
Opportunity cost:
It may be defined as the expected returns from the second best use of the resources which
are forgone due to the scarcity of resources.
Actual cost:
The total money expenses recording in the books of accounts
Business cost:
Business cost includes all the expenses which are incurred to carry out a business.
Full cost:
It includes business cost, opportunity and normal profit
Explicit cost:
Explicit costs are those costs which fall under actual or business costs entered in the
books of accounts.
Implicit cost:
Implicit cost do not take the form of cash outlays
Out of pocket cost:
The items of expenditure which involve cash payments or cash transfer are known as out
of pocket costs.
Book cost:
Book cost which are entered in the books of accounts
Fixed cost:
Fixed cost are those which are fixed in volume for a certain given Output/scale of
production.
Variable cost:
Variable cost are those which vary according to the level of production
Marginal cost:
It is the addition to total cost due to the addition of one unit of output.

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Short run cost:
Short run cost are those cost which vary according to the variation in output
Incremental cost:
It arises due to change in scale of production, introduction of a new product and
Replacement of a worn out plant and machinery.
Sunk cost:
Sunk costs are those cost which cannot be changed.
Historical cost:
It includes all the past expenditure incurred for the production of goods and services.
Replacement cost:
It refers to the outlay which has to be made for replacing an old asset.
Private cost:
Private costs are those which are incurred by an individual/firm on the purchase of goods
and services from the market.
Private cost =explicit cost +implicit cost
Social cost:
It is the total cost borne by the society due to production of a commodity.
Short run cost function:-
The short run is defined as a period of time in which output of a firm can
be increased or decreased by changing the amt of variable factors such as labor,
raw materials, chemicals, fuel etc
Total fixed & variable cost in the short run:-
Total Fixed cost:-
Fixed costs are those which are independent of output, i.e. they do not
change with changes in output. Even if the firm closes down for some time in
the short run but remains in business these costs have to be borne by it.
EXAMPLE: - charges such as contractual rent, insurance fee, maintenance cost, property
tax, interest on the borrowed, funds etc



92





93




94




Average variable cost:
Average variable cost is the total variable cost divided by no. of units of output produced.

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AVC = TVC/Q
Average variable cost the variable cost per unit of output.
Average Total cost:
Average Total cost or simply what is called average cost is the total cost divided by number
of unit of output produced.
ATC = Total cost / Output.



The marginal cost curve (MC)
A marginal cost that graphically represents the relation between marginal
cost incurred by a firm in the short-run product of a good or service and the
quantity of output produced.
This curve is constructed to capture the relation between marginal cost
and the level of output, holding other variables, like technology and resource
prices, constant. The marginal cost curve is U-shaped.
Marginal cost is relatively high at small quantities of output, then as

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production increases, declines, reaches a minimum value, then rises. The
marginal cost is shown in relation to marginal revenue, the incremental amount
of sales that an additional product or service will bring to the firm.
This shape of the marginal cost curve is directly attributable to increasing,
then decreasing marginal returns (and the law of diminishing marginal returns
-Diminishing returns). Marginal cost equal w/MPL. For most production
processes the marginal product of labor initially rises, reaches a maximum
value and then continuously falls as production increases.
Thus marginal cost initially falls, reaches a minimum value and then
increases.

LongRun Costs
Long-run average total cost curve.
In the short-run, some factors of production are fixed. Corresponding to each different
level of fixed factors, there will be a different short-run average total cost curve ( SATC). The
average total cost curve is just one of many SATCs that can be obtained by varying the amount of
the fixed factor, in this case, the amount of capital.
Long-run average total cost curve. In the long-run, all factors of production are variable,
and hence, all costs are variable. The long-run average total cost curve ( LATC) is found by
varying the amount of all factors of production. However, because each SATC corresponds to a
different level of the fixed factors of production, the LATC can be constructed by taking the
lower envelope of all the SATCs, as is illustrated in Figure 1


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Figure 1 Short- and long-run average total cost curves

The LATC is shown to be tangent to each of five different SATCs, labeled SATC
1
through
SATC
5
. In general, there will be a large number of SATCs, each of which corresponds to a
different level of the fixed factors the firm can employ in the short-run. Because there is such a
large number of SATCsmore than just the five illustrated in Figure 1 the lower envelope of
all the SATCs, which makes up the LATC, can be approximated by a smooth, U-shaped curve.
Economies of scale. The U-shape of the LATC, depicted in Figure 1 , reflects the
changing costs of production that the firm faces in the long-run as it varies the level of its factors
of production and hence the level of its output. At low levels of output, a firm can usually
increase its output at a rate that exceeds the rate at which it increases its factor inputs. When this
situation occurs, the firm's average total costs are falling, and the firm is said to be experiencing
economies of scale.
At higher levels of output, the firm may find that its output increases at the same rate at
which it increases its factor inputs. In this case, the firm's average total costs remain constant,
and the firm is said to experience constant returns to scale. At even higher output levels, the
firm's output will tend to increase at a rate that is below the rate at which it increases its factor
inputs. In this situation, average total costs are rising, and the firm is said to experience
Diseconomies of scale.
The firm's minimum efficient scale is the level of output at which economies of scale
end and constant returns to scale begin.


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PRODUCTION FUNCTION

Production process involves the transformation of inputs into output. The inputs could
be land, labour, capital, entrepreneurship etc. and the output could be goods or services. In a
production process managers take four types of decisions: (a) whether to produce or not, (b)
how much output to produce, (c) what input combination to use, and (d) what type of
technology to use.
Suppose we want to produce apples. We need land, seedlings, fertilizer, water, labour,
and some machinery. These are called inputs or factors of production. The output is apples.
In general a given output can be produced with different combinations of inputs. A
production function is the functional relationship between inputs and output. It shows the
maximum output which can be obtained for a given combination of inputs. It expresses the
technological relationship between inputs and output of a product.
In general, we can represent the production function for a firm as: Q =f (x1, x2, .,xn)
Where Q is the maximum quantity of output, x1, x2, .,xn are the quantities of various
inputs, and f stands for functional relationship between inputs and output. For the sake of clarity,
let us restrict our attention to only one product produced using either one input or two inputs. If
there are only two inputs, capital (K) and labour (L), we write the production function as: Q =f
(L, K)
This function defines the maximum rate of output (Q) obtainable for a given rate of
capital and labour input. It may be noted here that outputs may be tangible like computers,
television sets, etc., or it may be intangible like education, medical care, etc. Similarly, the inputs
may be other than capital and labour. Also, the principles discussed in this unit apply to
situations with more than two inputs as well.
Economic Efficiency and Technical Efficiency
We say that a firm is technically efficient when it obtains maximum level of output from
any given combination of inputs. The production function incorporates the technically efficient
method of production. A producer cannot decrease one input and at the same time maintain the
output at the same level without increasing one or more inputs. When economists use production

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functions, they assume that the maximum output is obtained from any given combination of
inputs. That is, they assume that production is technically efficient.
On the other hand, we say a firm is economically efficient, when it produces a given
amount of output at the lowest possible cost for a combination of inputs provided that the prices
of inputs are given. Therefore, when only input combinations are given, we deal with the
problem of technical efficiency; that is, how to produce maximum output. On the other hand,
when input prices are also given in addition to the combination of inputs, we deal with the
problem of economic efficiency; that is, how to produce a given amount of output at the lowest
possible cost.
One has to be careful while interpreting whether a production process is efficient or
inefficient. Certainly a production process can be called efficient if another process produces the
same level of output using one or more inputs, other things remaining constant. However, if a
production process uses less of some inputs and more of others, the economically efficient
method of producing a given level of output depends on the prices of inputs. Even when two
production processes are technically efficient, one process may be economically efficient under
one set of input prices, while the other production process may be economically efficient at other
input prices.
Let us take an example to differentiate between technical efficiency and economic
efficiency. An ABC company is producing readymade garments using cotton fabric in a certain
production process. It is found that 10 percent of fabric is wasted in that process. An engineer
suggested that the wastage of fabric can be eliminated by modifying the present production
process. To this suggestion, an economist reacted differently saying that if the cost of wasted
fabric is less than that of modifying production process then it may not be economically efficient
to modify the production process.
Short Run and Long Run
All inputs can be divided into two categories: i) fixed inputs and ii) variable inputs. A
fixed input is one whose quantity cannot be varied during the time under consideration. The time
period will vary depending on the circumstances. Although any input may be varied no matter
how short the time interval, the cost involved in augmenting the amount of certain inputs is
enormous; so as to make quick variation impractical. Such inputs are classified as fixed and
include plant and equipment of the firm.

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On the other hand, a variable input is one whose amount can be changed during the
relevant period. For example, in the construction business the number of workers can be
increased or decreased on short notice. Many builder firms employ workers on a daily wage
basis and frequent change in the number of workers is made depending upon the need. The
amount of milk that goes in the production of butter can be altered quickly and easily and is thus
classified as a variable input in the production process.
Whether or not an input is fixed or variable depends upon the time period involved. The
longer the length of the time period under consideration, the more likely it is that the input will
be variable and not fixed. Economists find it convenient to distinguish between the short run and
the long run. The short run is defined to be that period of time when some of the firms inputs
are fixed. Since it is most difficult to change plant and equipment among all inputs, the short run
is generally accepted as the time interval over which the firms plant and equipment remain
fixed. In contrast, the long run is that period over which all the firms inputs are variable. In
other words, the firm has the flexibility to adjust or change its environment.
Production processes of firms generally permit a variation in the proportion in which
inputs are used. In the long run, input proportions can be varied considerably. For example, at
Maruti Udyog Limited, an automobile dye can be made on conventional machine tools with
more labour and less expensive equipment, or it can be made on numerically controlled machine
tools with less labour and more expensive equipment i.e. the amount of labour and amount of
equipment used can be varied.
On the other hand, there are very few production processes in which inputs have to be
combined in fixed proportions. Consider, Ranbaxy or Smith-Kline-Beecham or any other
pharmaceutical firm. In order to produce a drug, the firm may have to use a fixed amount of
aspirin per 10 gm of the drug. Even in this case a certain (although small) amount of variation in
the proportion of aspirin may be permissible. If, on the other hand, no flexibility in the ratio of
inputs is possible, the technology is described as fixed proportion type. We refer to this extreme
case later in this unit, but as should be apparent, it is extremely rare in practice.

PRODUCTION FUNCTION WITH ONE VARIABLE INPUT
Consider the simplest two input production process - where one input with a fixed
quantity and the other input with is variable quantity. Suppose that the fixed input is the service

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Number of
workers
(L)
Total output (TP)
(thousands per year)
(Q)
Marginal product
(MP = W Q/W L)
Average
product
(AP = Q/L)

0

1

2

3

4

5

6

7

8

0

10

28

54

76

90

96

96

92



10

18

26

22

14

6

0

4



10

14

18

19

18

16

13.5

11.5
of machine tools, the variable input is labour, and the output is a metal part. The production
function in this case can be represented as:
Q =f (K, L)
Where Q is output of metal parts, K is service of five machine tools (fixed input), and L
is labour (variable input). The variable input can be combined with the fixed input to produce
different levels of output.
Total, Average, and Marginal Products
The production function given above shows us the maximum total product (TP) that can
be obtained using different combinations of quantities of inputs. Suppose the metal parts
company decides to know the output level for different input levels of labour using fixed five
machine tools. Table 7.1 explains the total output for different levels of variable input. In this
example, the TP rises with increase in labour up to a point (six workers), becomes constant
between sixth and seventh workers, and then declines.
Table 7.1: Total, Average and Marginal Products of labour (with fixed capital at five
machine tools)












Two other important concepts are the average product (AP) and the marginal product
(MP) of an input. The AP of an input is the TP divided by the amount of input used to produce
this amount of output. Thus AP is the output-input ratio for each level of variable input usage.
The MP of an input is the addition to TP resulting from the addition of one unit of input, when

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the amounts of other inputs are constant. In our example of machine parts production process,
the AP of labour is the TP divided by the number of workers. AP
L
=Q/L
As shown in Table 7.1, the AP first rises, reaches maximum at 19, and then declines
thereafter. Similarly, the MP of labour is the additional output attributable to using one
additional worker with use of other input (service of five machine tools) fixed.
MP =W Q/ W L
Where W means the change in. For example, from Table 7.1 for MP4 (marginal
product of 4th worker) WQ =7654 =22 and WL =43 =1.
Therefore, MP =(22/1) =22. Note that although the MP first increases with addition of
workers, it declines later and for the addition of 8th worker it becomes negative (4).



Figure 7.1: Relationship between TP, MP, and AP curves and the three stages of
production

















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The graphical presentation of total, average, and marginal products for our example of
machine parts production process is shown in Figure 7.1.
Relationship between TP, MP and AP Curves
Examine Table 7.1 and its graphical presentation in Figure 7.1. We can establish the
following relationship between TP, MP, and AP curves.
1a) If MP >0, TP will be rising as L increases. The TP curve begins at the origin,
increases at an increasing rate over the range 0 to 3, and then increases at a decreasing rate.
The MP reaches a maximum at 3, which corresponds to an inflection point (x) on the TP curve.
At the inflection point, the TP curve changes from increasing at an increasing rate to increasing
at a decreasing rate.
b) If MP =0, TP will be constant as L increases. The TP is constant between workers 6 and 7.
c) If MP <0, TP will be declining as L increases. The TP declines beyond
7. Also, the TP curve reaches a maximum when MP =0 and then starts declining when MP <0.
2. MP intersects AP (MP =AP) at the maximum point on the AP curve.
This occurs at labour input rate 4.5. Also, observe that whenever MP >AP, the AP is rising
(upto number of workers 4.5) it makes no difference whether MP is rising or falling. When
MP <AP (from number of workers 4.5), the AP is falling. Therefore, the intersection must
occur at the maximum point of AP. It is important to understand why. The key is that AP
increases as long as the MP is greater than AP. And AP decreases as long as MP is less than
AP. Since AP is positively or negatively sloped depending on whether MP is above or below
AP, it follows that MP =AP at the highest point on the AP curve.
This relationship between MP and AP is not unique to economics. Consider a cricket
batsman, say Sachin Tendulkar, who is averaging 50 runs in 10 innings. In his next innings he
scores a 100. His marginal score is 100 and his average will now be above 50. More precisely, it
is 54 i.e. (50 * 10 +100) / (10+1) =600/11. This means when the marginal score is above the

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average, the average must increase. In case he had scored zero, his marginal score would be
below the average, and his average would fall to 45.5 i.e. 500/11 is 45.45. Only if he had scored
50 would the average remain constant, and the marginal score would be equal to the average.
The Law of Diminishing Marginal Returns
The slope of the MP curve in Figure 7.1 illustrates an important principle, the law of
diminishing marginal returns. As the number of units of the variable input increases, the other
inputs held constant (fixed), there exists a point beyond which the MP of the variable input
declines. Table 7.1 illustrates this law. Observe that MP was increasing up to the addition of
4th worker (input); beyond this the MP decreases. What this law says is that MP may rise or stay
constant for some time, but as we keep increasing the units of variable input, MP should start
falling. It may keep falling and turn negative, or may stay positive all the time. Consider
another example for clarity. Single application of fertilizers may increase the output by 50%, a
second application by another 30% and the third by 20% and so on. However, if you were to
apply fertilizer five to six times in a year, the output may drop to zero.
Three things should be noted concerning the law of diminishing marginal returns.
1. This law is an empirical generalization, not a deduction from physical or biological laws.
2. It is assumed that technology remains fixed. The law of diminishing marginal returns
cannot predict the effect of an additional unit of input when technology is allowed to
change.
3. It is assumed that there is at least one input whose quantity is being held constant (fixed).
In other words, the law of diminishing marginal returns does not apply to cases where
all inputs are variable.
Stages of Production
Based on the behaviour of MP and AP, economists have classified production into three stages:
Stage 1: MP >0, AP rising. Thus, MP >AP.
Stage 2: MP >0, but AP is falling. MP <AP but TP is increasing (because MP >0).
Stage 3: MP <0. In this case TP is falling.
These results are illustrated in Figure 7.1. No profit-maximizing producer would produce
in stages I or III. In stage I, by adding one more unit of labour, the producer can increase the AP
of all units. Thus, it would be unwise on the part of the producer to stop the production in this

105

stage. As for stage III, it does not pay the producer to be in this region because by reducing the
labour input the total output can be increased and the cost of a unit of labour can be saved.
Thus, the economically meaningful range is given by stage II. In Figure 7.1 at the point
of inflection (x), we saw earlier that MP is maximised. At point y, since AP is maximized, we
have AP =MP. At point z, TP reaches a maximum. Thus, MP =0 at this point. If the variable
input is free then the optimum level of output is at point z where TP is maximized. However, in
practice no input will be freely available. The producer has to pay a price for it. Suppose the
producer pays Rs. 200 per worker per day and the price of a unit of output (say one apple) is Rs.
10. In this case the producer will keep on hiring additional workers as long as (Price of a unit of
output) * (marginal product of labour) >(price of a unit of labour) That is, marginal revenue of
product (MRP) of labour >P
Production Function L
On a similar analogy, (price of a unit of output) * (marginal product of capital) >(price of
a unit of capital) That is, marginal revenue of product (MRP) of capital >P
The left side denotes the increase in revenue and the right side denotes the increase in the
cost of adding one more unit of labour. As long as the increment to revenues exceeds the
increment to costs, the profit of the producer will increase. As we increase the units of labour, we
see that MP diminishes. We assume that the prices of inputs and output do not change. In this
case, as MP declines, revenues will start falling, and a point will come when the increase in
revenue equals the increase in cost. At this point the producer will stop adding more units of
input. With further addition, since MP declines, the additional revenues would be less than the
additional costs, and the profit of the producer would decline.
Thus, profit maximization implies that a producer with no control over prices will
increase the use of an input until Value of marginal product (MP) =Price of a unit of variable
input.
PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS
Now we turn to the case of production where two inputs (say capital and labour) are
variable. Although, we restrict our analysis to two variable inputs, all of the results hold for
more than two also. We are restricting our analysis to two variable inputs because it simply
allows us the scope for graphical analysis. When analysing production with more than one
variable input, we cannot simply use sets of AP and MP curves like those discussed in section

106

7.3, because these curves were derived holding the use of all other inputs fixed and letting the
use of only one input vary. If we change the level of fixed input, the TP, AP and MP curves
would shift. In the case of two variable inputs, changing the use of one input would cause a shift
in the MP and AP curves of the other input. For example, an increase in capital would probably
result in an increase in the MP of labour over a wide range of labour use.
Production Isoquants
In Greek the word iso means equal or same. A production isoquant (equal output
curve) is the locus of all those combinations of two inputs which yields a given level of output.
With two variable inputs, capital and labour, the isoquant gives the different combinations of
capital and labour, that produces the same level of output. For example, 5 units of output can be
produced using either 15 units of capital (K) or 2 units of labour (L) or K=10 and L=3 or K=5
and L=5 or K=3 and L=7. These four combinations of capital and labour are four points on the
isoquant associated with 5 units of output as shown in Figure 7.2. And if we assume that capital
and labour are continuously divisible, there would be many more combinations on this isoquant.
Now let us assume that capital, labour, and output are continuously divisible in order to
set forth the typically assumed characteristics of isoquants. Figure 7.3 illustrates three such
isoquants. Isoquant I show all the combinations of capital and labour that will produce 10 units
of output. According to this isoquant, it is possible to obtain this output if K units of capital and
L units of labour inputs are used. Alternately, this output can also be obtained if K units of
capital and L units of labour inputs or K units of capital and L units of labour are used.
Similarly, isoquant II shows the various combinations of capital and labour that can be used to
produce 15 units of output. Isoquant III shows all combinations that can produce 20 units of
output. Each capital- labour combination can be on only one isoquant. That is, isoquants cannot
intersect. These isoquants are only three of an infinite number of isoquants that could be drawn.
A group of isoquants is called an isoquant map. In an isoquant map, all isoquants lying above
and to the right of a given isoquant indicate higher levels of output. Thus, in Figure 7.3 isoquant
II indicates a higher level of output than isoquant I, and isoquant III indicates a higher level of
output than isoquant II.
Figure 7.2: Production Isoquant: This isoquant shows various combinations of capital
and labour inputs that can produce 5 units of output.

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0












Figure 7.3: Isoquant Map: These isoquants shows various combinations of capital
and labour inputs that can produce 10, 15, and 20 units of output.



In general, isoquants are determined in the following way. First, a rate of output, say
Q, is specified. Hence the production function can be written as = f (K,L) Those
combinations of K and L that satisfy this equation define the isoquant for output rate Q .


Marginal Rate of Technical Substitution
As we have seen above, generally there are a number of ways (combinations of inputs)

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that a particular output can be produced. The rate, at which one input can be substituted for
another input, if output remains constant, is called the marginal rate of technical substitution
(MRTS). It is defined in case of two inputs, capital and labour, as the amount of capital that
can be replaced by an extra unit of labour, without affecting total output.
MRTS for K = K
L L
It is customary to define the MRTS as a positive number, since WK/WL, the slope of the
isoquant, is negative. Over the relevant range of production the MRTS diminishes. That is,
more and more labour is substituted for capital while holding output constant, the absolute
value of WK/WL decreases. For example, let us assume that 10 pairs of shoes can be
produced using either 8 units of capital and 2 units of labour or 4 units each of capital and of
labour or 2 units of capital and 8 units of labour. From Figure 7.4 the MRTS of labour for
capital between points a and b is equal to WK/WL =(48) / (42) =4/2 =2 or | 2 |. Between
points b and c, the MRTS is equal to 2/4 = or | |. The MRTS has decreased because
capital and labour are not perfect substitutes for each other. Therefore, as more of labour is
added, less of capital can be used (in exchange for another unit of labour) while keeping the
output level constant.
Figure 7.4: Marginal Rate of Technical Substitution



109


There is a simple relationship between MRTS of labour for capital and the marginal
product MP and MP of capital and labour respectively. Since along an isoquant, the level of
output remains the same, if WL units of labour are substituted for WK units of capital, the
increase in output due to WL units of labour (namely, WL * MPL) should match the decrease in
output due to a decrease of WK units of capital (namely, WK * MPK). In other words, along
an isoquant, WL * MPL =WK * MPk which is equal to K= L
However, as we have seen earlier WK/WL is equal to MRTSL for K, and hence, we
get the following expression for MRTS of L for K as the ratio of the corresponding marginal
products.
MRTSL for K =MP L
MP K
There are vast differences among inputs in how readily they can be substituted for one
another. For example, in some extreme production process, one input can perfectly be
substituted for another; whereas in some other extreme production process no substitution is
possible. On the other hand, in most of the production processes what we see is imperfect
substitution of inputs. These three general shapes that an isoquant might have are shown in
Figure 7.5. In panel I, the isoquants are right angles implying that the two inputs a and b must
be used in fixed proportion and they are not at all substitutable. For instance, there is no
substitution possible between the tyres and a battery in an automobile production process. The
MRTS in all such cases would, therefore, be zero. The other extreme case would be where the
inputs a and b are perfect substitutes as shown in panel II. The isoquants in this category will
be a straight line with constant slope or MRTS. A good example of this type would be natural
gas and fuel oil, which are close substitutes in energy production. The most common
situation is presented in panel III. The inputs are imperfect substitutes in this case and the
rate at which input a can be given up in return for one more unit of input b keeping the
output constant diminishes as the amount of input b increases.





110





Figure 7.5: Three General Types of Shapes of Isoquants

















The Economic Region of Production
Isoquants may also have positively sloped segments, or bend back upon themselves, as
shown in Figure 7.6. Above OA and below OB, the slope of the isoquants is positive, which
implies that increase in both capital and labour are required to maintain a certain output rate. If
this is the case, the MP of one or other input must be negative. Above OA, the MP of capital is
negative. Thus output will increase if less capital is used, while the amount of labour is held
constant. Below OB, the MP of labour is negative.
Thus, output will increase if less labour is used, while the amount of capital is held
constant. The lines OA and OB are called ridge lines. And the region bounded by these ridge

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lines is called economic region of production. This means the region of production beyond the
ridge lines is economically inefficient.




112


Figure 7.6: Economic Region of Production













THE OPTIMAL COMBINATION OF INPUTS
In the above section you have learned that any desired level of output can be produced
using a number of different combinations of inputs. As said earlier in the introduction of this unit
one of the decision problems that concerns a production process manager is, which input
combination to use. That is, what is the optimal input combination? While all the input
combinations are technically efficient, the final decision to employ a particular input combination
is purely an economic decision and rests on cost (expenditure). Thus, the production manager can
make either of the following two input choice decisions:
1. Choose the input combination that yields the maximum level of output with a given level
of expenditure.
2. Choose the input combination that leads to the lowest cost of producing a given level of
output.
Thus, the decision is to minimize cost subject to an output constraint or maximize the
output subject to a cost constraint. We will now discuss these two fundamental principles.
Before doing this we will introduce the concept isocost, which shows all combinations of inputs
that can be used for a given cost.

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Isocost Lines
Recall that a universally accepted objective of any firm is to maximise profit. If the firm
maximises profit, it will necessarily minimise cost for producing a given level of output or
maximise output for a given level of cost. Suppose
there are 2 inputs: capital (K) and labour (L) that are
variable in the relevant time period. What
combination of (K,L) should the firm choose in order to
maximise output for a given level of cost?
If there are 2 inputs, K,L, then given the price of
capital (P ) and the price of labour (P ), it is possible to
determine the alternative combinations of (K,L) that can be purchased for a given level of
expenditure. Suppose C is total expenditure, then
C=P * L +P * K
This linear function can be plotted on a graph.
If only capital is purchased, then the maximum amount that can be bought is C/Pk shown
by point A in figure 7.7. If only labour is purchased, then the maximum amount of labour that
can be purchased is C/PL shown by point B in the figure. The 2 points A and B can be joined by
a straight line. This straight line is called the isocost line or equal cost line. It shows the
alternative combinations of (K,L) that can be purchased for the given expenditure level C. Any
point to the right and above the isocost is not attainable as it involves a level of expenditure
greater than C and any point to the left and below the isocost such as P is attainable, although it
implies the firm is spending less than C. You should verify that the slope of the isocost is1



EXAMPLE:
Consider the following data:
PL =10, Pk =20 Total Expenditure =200.
Let us first plot the various combinations of K
and L that are possible. We consider only the
case when the firm spends the entire budget of

114

200. The alternative combinations are shown in the figure (7.8).
Figure 7.8: Shifting of Isocost







The slope of this isocost is . What will happen if labour becomes more expensive say P
increases to 20? Obviously with the same budget the firm can now purchase lesser units of
labour. The isocost still meets the Yaxis at point A (because the price of capital is unchanged),
but shifts inwards in the direction of the arrow to meet the X-axis at point C. The slope
therefore changes to 1. You should work out the effect on the isocost curve on the following:
(i) Decrease in the price of labour
(ii) Increase in the price of capital
(iii) Decrease in the price of capital
(iv) Increase in the firms budget with no change in the price of labour and capital
[Hint: The slope of the isocost will not change in this case]

Optimal Combination of Inputs: The Long Run
When both capital and labour are variable, determining the optimal input rates of capital
and labour requires the technical information from the production function i.e. the isoquants be
combined with market data on input prices i.e. the isocost function. If we superimpose the
relevant isocost curve on the firms isoquant map, we can readily determine graphically as to
which combination of inputs maximise the output for a given level of expenditure.
Consider the problem of minimising the cost of a given rate of output. Specifically if the
firm wants to produce 50 units of output at minimum cost. Two production isoquants have been
drawn in Figure 7.9. Three possible combinations (amongst a number of more combinations) are
indicated by points A, Z and B in Figure 7.9. Obviously, the firm should pick the point on the

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lower isocost i.e point Z. In fact, Z is the minimum cost combination of capital and labour. At Z
the isocost is tangent to the 50 unit isoquant.
Alternatively, consider the problem of maximising output subject to a given cost amount.
You should satisfy yourself that among all possible output levels, the maximum amount will be
represented by the isoquant that is tangent to the relevant isocost line. Suppose the budget of the
firm increases to the amount shown by the
higher of the two isocost lines in Figure 7.9,
point Q or 100 units of output is the
maximum attainable given the new cost
constraint in Figure 7.9.
Figure 7.9: Optimal combination of
inputs

Regardless of the production
objective, efficient production requires that the isoquant be tangent to the isocost function. If the
problem is to maximise output, subject to a cost constraint or to minimise cost for a given level
of output, the same efficiency condition holds true in both situations. Intuitively, if it is possible
to substitute one input for another to keep output constant while reducing total cost, the firm is
not using the least cost combination of inputs. In such a situation, the firm should substitute one
input for another.
For example, if an extra rupee spent on capital generates more output than an extra rupee
spent on labour, then more capital and less labour should be employed. At point Q in Figure 7.9,
the marginal product of capital per rupee spent on capital is equal to the marginal product of
labour per rupee spent on labour. Mathematically this can be shown as








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Whenever the 2 sides of the above equation are not equal, there are possibilities that input
substitutions will reduce costs. Let us work with numbers. Suppose PL =10, Pk =20, MPL =50
and MPk =40. Thus, we have 50 / 10 >40/ 20.
This cannot be an efficient input combination, because the firm is getting more output per
rupee spent on labour than on capital. If one unit of capital is sold to obtain 2 units of labour (Pk
=20, PL =10), net increase in output will be 602. Thus the substitution of labour for capital
would result in a net increase in output at no additional cost. The inefficient combination
corresponds to a point such as A in Figure 7.9. At that point two much capital is employed. The
firm, in order to maximize profits will move down the isocost line by substituting labour for
capital until it reaches point Q. Conversely, at a point such as B in figure 7.9 the reverse is true -
there is too much labour and the inequality will hold This means that the firm generates more
output per rupee spent on capital than from rupees spent on labour. Thus a profit maximising
firm should substitute capital for labour. Suppose the firm was operating at point B in Figure 7.9.
If the problem is to minimize cost for a given level of output (B is on the isoquant that
corresponds to 50 units of output), the firm should move from B to Z along the 50-unit isoquant
thereby reducing cost, while maintaining output at 50. Alternatively, if the firm wants to
maximize output for given cost, it should more from B to Q, where the isocost is tangent to the
100-unit isoquant. In this case output will increase from 50 to 100 at no additional cost. Thus
both the following decisions: (a) the input combination that yields the maximum level of output
with a given level of expenditure, and (b) the input combination that leads to the lowest cost of
producing a given level of output are satisfied at point Q in Figure 7.9. You should be satisfied
that this is indeed the case.
The isocost-isoquant framework described above lends itself to various applications. It
demonstrates, simply and elegantly, when relative prices of inputs change, managers will
respond by substituting the input that has become relatively less expensive for the input that has
become relatively more expensive. On average, we know that compared to developed countries
like the US, UK, Japan and Germany, labour in India is less expensive. It is not surprising
therefore to find production techniques that on average, use more labour per unit of capital in
India than in the developed world. For example, in construction activity you see around you in
your city, inexpensive workers do the job that in developed countries is performed by machines.

117

One application of the isocost-isoquant framework frequently cited is the response of
industry to the rapidly rising prices of energy products in the 1970s. (Remember the oil price
shock of 1973 and again of 1979). Most prices of petrol and petroleum products increased
across the world, and as our analysis suggests, firms responded by conserving energy by
substituting other inputs for energy.
RETURNS TO SCALE
Another important attribute of production function is how output responds in the long
run to changes in the scale of the firm i.e. when all inputs are increased in the same proportion
(by say 10%), how does output change. Clearly, there are 3 possibilities. If output increases by
more than an increase in inputs (i.e. by more than 10%), then the situation is one of increasing
returns to scale (IRS). If output increases by less than the increase in inputs, then it is a case of
decreasing returns to scale (DRS). Lastly, output may increase by exactly the same proportion
as inputs. For example a doubling of inputs may lead to a doubling of output. This is a case of
constant returns to scale (CRS).




Isoquants
can also
be used to
depict
returns to
scale
(Figure
7.10)

118

Panel A shows constant returns to scale. Three isoquants with output levels 50,100 and
150 are drawn. In the figure, successive isoquants are equidistant from one another along the
ray 0Z. Panel B shows increasing returns to scale, where the distance between 2 isoquants
becomes less and less i.e. in order to double output from 50 to 100, input increase is less than
double. The explanation for panel C, which exhibits decreasing returns to scale, is analogous.
There is no universal answer to which industries will show what kind of returns to scale.
Some industries like public utilities (Telecom and Electricity generation) show increasing returns
over large ranges of output, whereas other industries exhibit constant or even decreasing returns
to scale over the relevant output range. Therefore, whether an industry has constant, increasing
or decreasing returns to scale is largely an empirical issue.


119

PRODUCTION FUNCTION

Production process involves the transformation of inputs into output. The inputs could
be land, labour, capital, entrepreneurship etc. and the output could be goods or services. In a
production process managers take four types of decisions: (a) whether to produce or not, (b)
how much output to produce, (c) what input combination to use, and (d) what type of
technology to use.
Suppose we want to produce apples. We need land, seedlings, fertilizer, water, labour,
and some machinery. These are called inputs or factors of production. The output is apples.
In general a given output can be produced with different combinations of inputs. A
production function is the functional relationship between inputs and output. It shows the
maximum output which can be obtained for a given combination of inputs. It expresses the
technological relationship between inputs and output of a product.
In general, we can represent the production function for a firm as:
Q =f (x1, x2, .,xn)
Where Q is the maximum quantity of output, x1, x2, .,xn are the quantities of various
inputs, and f stands for functional relationship between inputs and output. For the sake of clarity,
let us restrict our attention to only one product produced using either one input or two inputs. If
there are only two inputs, capital (K) and labour (L), we write the production function as: Q =f
(L, K)
This function defines the maximum rate of output (Q) obtainable for a given rate of
capital and labour input. It may be noted here that outputs may be tangible like computers,
television sets, etc., or it may be intangible like education, medical care, etc. Similarly, the inputs
may be other than capital and labour. Also, the principles discussed in this unit apply to
situations with more than two inputs as well.
Economic Efficiency and Technical Efficiency
We say that a firm is technically efficient when it obtains maximum level of output from
any given combination of inputs. The production function incorporates the technically efficient
method of production. A producer cannot decrease one input and at the same time maintain the
output at the same level without increasing one or more inputs. When economists use production

120

functions, they assume that the maximum output is obtained from any given combination of
inputs. That is, they assume that production is technically efficient.

On the other hand, we say a firm is economically efficient, when it produces a given
amount of output at the lowest possible cost for a combination of inputs provided that the prices
of inputs are given. Therefore, when only input combinations are given, we deal with the
problem of technical efficiency; that is, how to produce maximum output. On the other hand,
when input prices are also given in addition to the combination of inputs, we deal with the
problem of economic efficiency; that is, how to produce a given amount of output at the lowest
possible cost.
One has to be careful while interpreting whether a production process is efficient or
inefficient. Certainly a production process can be called efficient if another process produces the
same level of output using one or more inputs, other things remaining constant. However, if a
production process uses less of some inputs and more of others, the economically efficient
method of producing a given level of output depends on the prices of inputs. Even when two
production processes are technically efficient, one process may be economically efficient under
one set of input prices, while the other production process may be economically efficient at other
input prices.
Let us take an example to differentiate between technical efficiency and economic
efficiency. An ABC company is producing readymade garments using cotton fabric in a certain
production process. It is found that 10 percent of fabric is wasted in that process. An engineer
suggested that the wastage of fabric can be eliminated by modifying the present production
process. To this suggestion, an economist reacted differently saying that if the cost of wasted
fabric is less than that of modifying production process then it may not be economically efficient
to modify the production process.
Short Run and Long Run
All inputs can be divided into two categories: i) fixed inputs and ii) variable inputs. A
fixed input is one whose quantity cannot be varied during the time under consideration. The time
period will vary depending on the circumstances. Although any input may be varied no matter
how short the time interval, the cost involved in augmenting the amount of certain inputs is

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enormous; so as to make quick variation impractical. Such inputs are classified as fixed and
include plant and equipment of the firm.
On the other hand, a variable input is one whose amount can be changed during the
relevant period. For example, in the construction business the number of workers can be
increased or decreased on short notice. Many builder firms employ workers on a daily wage
basis and frequent change in the number of workers is made depending upon the need. The
amount of milk that goes in the production of butter can be altered quickly and easily and is thus
classified as a variable input in the production process.
Whether or not an input is fixed or variable depends upon the time period involved. The
longer the length of the time period under consideration, the more likely it is that the input will
be variable and not fixed. Economists find it convenient to distinguish between the short run and
the long run. The short run is defined to be that period of time when some of the firms inputs
are fixed. Since it is most difficult to change plant and equipment among all inputs, the short run
is generally accepted as the time interval over which the firms plant and equipment remain
fixed. In contrast, the long run is that period over which all the firms inputs are variable. In
other words, the firm has the flexibility to adjust or change its environment.
Production processes of firms generally permit a variation in the proportion in which
inputs are used. In the long run, input proportions can be varied considerably. For example, at
Maruti Udyog Limited, an automobile dye can be made on conventional machine tools with
more labour and less expensive equipment, or it can be made on numerically controlled machine
tools with less labour and more expensive equipment i.e. the amount of labour and amount of
equipment used can be varied.
On the other hand, there are very few production processes in which inputs have to be
combined in fixed proportions. Consider, Ranbaxy or Smith-Kline-Beecham or any other
pharmaceutical firm. In order to produce a drug, the firm may have to use a fixed amount of
aspirin per 10 gm of the drug. Even in this case a certain (although small) amount of variation in
the proportion of aspirin may be permissible. If, on the other hand, no flexibility in the ratio of
inputs is possible, the technology is described as fixed proportion type. We refer to this extreme
case later in this unit, but as should be apparent, it is extremely rare in practice.

PRODUCTION FUNCTION WITH ONE VARIABLE INPUT

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Number of
workers
(L)
Total output (TP)
(thousands per year)
(Q)
Marginal product
(MP = W Q/W L)
Average
product
(AP = Q/L)

0

1

2

3

4

5

6

7

8

0

10

28

54

76

90

96

96

92



10

18

26

22

14

6

0

4



10

14

18

19

18

16

13.5

11.5
Consider the simplest two input production process - where one input with a fixed
quantity and the other input with is variable quantity. Suppose that the fixed input is the service
of machine tools, the variable input is labour, and the output is a metal part. The production
function in this case can be represented as:
Q =f (K, L)
Where Q is output of metal parts, K is service of five machine tools (fixed input), and L
is labour (variable input). The variable input can be combined with the fixed input to produce
different levels of output.

Total, Average, and Marginal Products
The production function given above shows us the maximum total product (TP) that can
be obtained using different combinations of quantities of inputs. Suppose the metal parts
company decides to know the output level for different input levels of labour using fixed five
machine tools. Table 7.1 explains the total output for different levels of variable input. In this
example, the TP rises with increase in labour up to a point (six workers), becomes constant
between sixth and seventh workers, and then declines.
Table 7.1: Total, Average and Marginal Products of labour (with fixed capital at five
machine tools)













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Two other important concepts are the average product (AP) and the marginal product
(MP) of an input. The AP of an input is the TP divided by the amount of input used to produce
this amount of output. Thus AP is the output-input ratio for each level of variable input usage.
The MP of an input is the addition to TP resulting from the addition of one unit of input, when
the amounts of other inputs are constant. In our example of machine parts production process,
the AP of labour is the TP divided by the number of workers. AP
L
=Q/L
As shown in Table 7.1, the AP first rises, reaches maximum at 19, and then declines
thereafter. Similarly, the MP of labour is the additional output attributable to using one
additional worker with use of other input (service of five machine tools) fixed.
MP =W Q/ W L
Where W means the change in. For example, from Table 7.1 for MP4 (marginal
product of 4th worker) WQ =7654 =22 and WL =43 =1.
Therefore, MP =(22/1) =22. Note that although the MP first increases with addition of
workers, it declines later and for the addition of 8th worker it becomes negative (4).

Figure 7.1: Relationship between TP, MP, and AP curves and the three stages of
production

124























The graphical presentation of total, average, and marginal products for our example of
machine parts production process is shown in Figure 7.1.



Relationship between TP, MP and AP Curves
Examine Table 7.1 and its graphical presentation in Figure 7.1. We can establish the
following relationship between TP, MP, and AP curves.

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1a) If MP >0, TP will be rising as L increases. The TP curve begins at the origin,
increases at an increasing rate over the range 0 to 3, and then increases at a decreasing rate.
The MP reaches a maximum at 3, which corresponds to an inflection point (x) on the TP curve.
At the inflection point, the TP curve changes from increasing at an increasing rate to increasing
at a decreasing rate.
b) If MP =0, TP will be constant as L increases. The TP is constant between workers 6 and 7.
c) If MP <0, TP will be declining as L increases. The TP declines beyond
7. Also, the TP curve reaches a maximum when MP =0 and then starts declining when MP <0.
2. MP intersects AP (MP =AP) at the maximum point on the AP curve.
This occurs at labour input rate 4.5. Also, observe that whenever MP >AP, the AP is rising
(upto number of workers 4.5) it makes no difference whether MP is rising or falling. When
MP <AP (from number of workers 4.5), the AP is falling. Therefore, the intersection must
occur at the maximum point of AP. It is important to understand why. The key is that AP
increases as long as the MP is greater than AP. And AP decreases as long as MP is less than
AP. Since AP is positively or negatively sloped depending on whether MP is above or below
AP, it follows that MP =AP at the highest point on the AP curve.
This relationship between MP and AP is not unique to economics. Consider a cricket
batsman, say Sachin Tendulkar, who is averaging 50 runs in 10 innings. In his next innings he
scores a 100. His marginal score is 100 and his average will now be above 50. More precisely, it
is 54 i.e. (50 * 10 +100) / (10+1) =600/11. This means when the marginal score is above the
average, the average must increase. In case he had scored zero, his marginal score would be
below the average, and his average would fall to 45.5 i.e. 500/11 is 45.45. Only if he had scored
50 would the average remain constant, and the marginal score would be equal to the average.

The Law of Diminishing Marginal Returns
The slope of the MP curve in Figure 7.1 illustrates an important principle, the law of
diminishing marginal returns. As the number of units of the variable input increases, the other
inputs held constant (fixed), there exists a point beyond which the MP of the variable input
declines. Table 7.1 illustrates this law. Observe that MP was increasing up to the addition of
4th worker (input); beyond this the MP decreases. What this law says is that MP may rise or stay
constant for some time, but as we keep increasing the units of variable input, MP should start

126

falling. It may keep falling and turn negative, or may stay positive all the time. Consider
another example for clarity. Single application of fertilizers may increase the output by 50%, a
second application by another 30% and the third by 20% and so on. However, if you were to
apply fertilizer five to six times in a year, the output may drop to zero.
Three things should be noted concerning the law of diminishing marginal returns.
4. This law is an empirical generalization, not a deduction from physical or biological laws.
5. It is assumed that technology remains fixed. The law of diminishing marginal returns
cannot predict the effect of an additional unit of input when technology is allowed to
change.
6. It is assumed that there is at least one input whose quantity is being held constant (fixed).
In other words, the law of diminishing marginal returns does not apply to cases where
all inputs are variable.

Stages of Production
Based on the behaviour of MP and AP, economists have classified production into three stages:
Stage 1: MP >0, AP rising. Thus, MP >AP.
Stage 2: MP >0, but AP is falling. MP <AP but TP is increasing (because MP >0).
Stage 3: MP <0. In this case TP is falling.
These results are illustrated in Figure 7.1. No profit-maximizing producer would produce
in stages I or III. In stage I, by adding one more unit of labour, the producer can increase the AP
of all units. Thus, it would be unwise on the part of the producer to stop the production in this
stage. As for stage III, it does not pay the producer to be in this region because by reducing the
labour input the total output can be increased and the cost of a unit of labour can be saved.
Thus, the economically meaningful range is given by stage II. In Figure 7.1 at the point
of inflection (x), we saw earlier that MP is maximised. At point y, since AP is maximized, we
have AP =MP. At point z, TP reaches a maximum. Thus, MP =0 at this point. If the variable
input is free then the optimum level of output is at point z where TP is maximized. However, in
practice no input will be freely available. The producer has to pay a price for it. Suppose the
producer pays Rs. 200 per worker per day and the price of a unit of output (say one apple) is Rs.
10. In this case the producer will keep on hiring additional workers as long as


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(Price of a unit of output) * (marginal product of labour) >(price of a unit of labour) That is,
marginal revenue of product (MRP) of labour >P
Production Function L
On a similar analogy, (price of a unit of output) * (marginal product of capital) >(price of a unit
of capital) That is, marginal revenue of product (MRP) of capital >P
The left side denotes the increase in revenue and the right side denotes the increase in the
cost of adding one more unit of labour. As long as the increment to revenues exceeds the
increment to costs, the profit of the producer will increase. As we increase the units of labour, we
see that MP diminishes. We assume that the prices of inputs and output do not change. In this
case, as MP declines, revenues will start falling, and a point will come when the increase in
revenue equals the increase in cost. At this point the producer will stop adding more units of
input. With further addition, since MP declines, the additional revenues would be less than the
additional costs, and the profit of the producer would decline.
Thus, profit maximization implies that a producer with no control over prices will
increase the use of an input until Value of marginal product (MP) =Price of a unit of variable
input.
PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS
Now we turn to the case of production where two inputs (say capital and labour) are
variable. Although, we restrict our analysis to two variable inputs, all of the results hold for
more than two also. We are restricting our analysis to two variable inputs because it simply
allows us the scope for graphical analysis. When analysing production with more than one
variable input, we cannot simply use sets of AP and MP curves like those discussed in section
7.3, because these curves were derived holding the use of all other inputs fixed and letting the
use of only one input vary. If we change the level of fixed input, the TP, AP and MP curves
would shift. In the case of two variable inputs, changing the use of one input would cause a shift
in the MP and AP curves of the other input. For example, an increase in capital would probably
result in an increase in the MP of labour over a wide range of labour use.

Production Isoquants
In Greek the word iso means equal or same. A production isoquant (equal output
curve) is the locus of all those combinations of two inputs which yields a given level of output.

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With two variable inputs, capital and labour, the isoquant gives the different combinations of
capital and labour, that produces the same level of output. For example, 5 units of output can be
produced using either 15 units of capital (K) or 2 units of labour (L) or K=10 and L=3 or K=5
and L=5 or K=3 and L=7. These four combinations of capital and labour are four points on the
isoquant associated with 5 units of output as shown in Figure 7.2. And if we assume that capital
and labour are continuously divisible, there would be many more combinations on this isoquant.
Now let us assume that capital, labour, and output are continuously divisible in order to
set forth the typically assumed characteristics of isoquants. Figure 7.3 illustrates three such
isoquants. Isoquant I show all the combinations of capital and labour that will produce 10 units
of output. According to this isoquant, it is possible to obtain this output if K units of capital and
L units of labour inputs are used. Alternately, this output can also be obtained if K units of
capital and L units of labour inputs or K units of capital and L units of labour are used.
Similarly, isoquant II shows the various combinations of capital and labour that can be used to
produce 15 units of output. Isoquant III shows all combinations that can produce 20 units of
output. Each capital- labour combination can be on only one isoquant. That is, isoquants cannot
intersect. These isoquants are only three of an infinite number of isoquants that could be drawn.
A group of isoquants is called an isoquant map. In an isoquant map, all isoquants lying above
and to the right of a given isoquant indicate higher levels of output. Thus, in Figure 7.3 isoquant
II indicates a higher level of output than isoquant I, and isoquant III indicates a higher level of
output than isoquant II.

Figure 7.2: Production Isoquant: This isoquant shows various combinations of capital
and labour inputs that can produce 5 units of output.









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0





Figure 7.3: Isoquant Map: These isoquants shows various combinations of capital
and labour inputs that can produce 10, 15, and 20 units of output.



In general, isoquants are determined in the following way. First, a rate of output, say
Q, is specified. Hence the production function can be written as = f (K,L) Those
combinations of K and L that satisfy this equation define the isoquant for output rate Q .

Marginal Rate of Technical Substitution
As we have seen above, generally there are a number of ways (combinations of inputs)
that a particular output can be produced. The rate, at which one input can be substituted for
another input, if output remains constant, is called the marginal rate of technical substitution
(MRTS). It is defined in case of two inputs, capital and labour, as the amount of capital that
can be replaced by an extra unit of labour, without affecting total output.

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MRTS for K = K
L L
It is customary to define the MRTS as a positive number, since WK/WL, the slope of the
isoquant, is negative. Over the relevant range of production the MRTS diminishes. That is,
more and more labour is substituted for capital while holding output constant, the absolute
value of WK/WL decreases. For example, let us assume that 10 pairs of shoes can be
produced using either 8 units of capital and 2 units of labour or 4 units each of capital and of
labour or 2 units of capital and 8 units of labour. From Figure 7.4 the MRTS of labour for
capital between points a and b is equal to WK/WL =(48) / (42) =4/2 =2 or | 2 |. Between
points b and c, the MRTS is equal to 2/4 = or | |. The MRTS has decreased because
capital and labour are not perfect substitutes for each other. Therefore, as more of labour is
added, less of capital can be used (in exchange for another unit of labour) while keeping the
output level constant.
Figure 7.4: Marginal Rate of Technical Substitution







131










There is a simple relationship between MRTS of labour for capital and the marginal
product MP and MP of capital and labour respectively. Since along an isoquant, the level of
output remains the same, if WL units of labour are substituted for WK units of capital, the
increase in output due to WL units of labour (namely, WL * MPL) should match the decrease in
output due to a decrease of WK units of capital (namely, WK * MPK). In other words, along
an isoquant, WL * MPL =WK * MPk which is equal to K= L
However, as we have seen earlier WK/WL is equal to MRTSL for K, and hence, we
get the following expression for MRTS of L for K as the ratio of the corresponding marginal
products.
MRTSL for K =MP L
MP K
There are vast differences among inputs in how readily they can be substituted for one
another. For example, in some extreme production process, one input can perfectly be
substituted for another; whereas in some other extreme production process no substitution is
possible. On the other hand, in most of the production processes what we see is imperfect
substitution of inputs. These three general shapes that an isoquant might have are shown in
Figure 7.5. In panel I, the isoquants are right angles implying that the two inputs a and b must
be used in fixed proportion and they are not at all substitutable. For instance, there is no
substitution possible between the tyres and a battery in an automobile production process. The
MRTS in all such cases would, therefore, be zero. The other extreme case would be where the
inputs a and b are perfect substitutes as shown in panel II. The isoquants in this category will
be a straight line with constant slope or MRTS. A good example of this type would be natural

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gas and fuel oil, which are close substitutes in energy production. The most common
situation is presented in panel III. The inputs are imperfect substitutes in this case and the
rate at which input a can be given up in return for one more unit of input b keeping the
output constant diminishes as the amount of input b increases.



Figure 7.5: Three General Types of Shapes of Isoquants

















The Economic Region of Production
Isoquants may also have positively sloped segments, or bend back upon themselves, as
shown in Figure 7.6. Above OA and below OB, the slope of the isoquants is positive, which
implies that increase in both capital and labour are required to maintain a certain output rate. If
this is the case, the MP of one or other input must be negative. Above OA, the MP of capital is
negative. Thus output will increase if less capital is used, while the amount of labour is held

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constant. Below OB, the MP of labour is negative.
Thus, output will increase if less labour is used, while the amount of capital is held
constant. The lines OA and OB are called ridge lines. And the region bounded by these ridge
lines is called economic region of production. This means the region of production beyond the
ridge lines is economically inefficient.



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Figure 7.6: Economic Region of Production














THE OPTIMAL COMBINATION OF INPUTS
In the above section you have learned that any desired level of output can be produced
using a number of different combinations of inputs. As said earlier in the introduction of this unit
one of the decision problems that concerns a production process manager is, which input
combination to use. That is, what is the optimal input combination? While all the input
combinations are technically efficient, the final decision to employ a particular input combination
is purely an economic decision and rests on cost (expenditure). Thus, the production manager can
make either of the following two input choice decisions:
3. Choose the input combination that yields the maximum level of output with a given level
of expenditure.
4. Choose the input combination that leads to the lowest cost of producing a given level of
output.
Thus, the decision is to minimize cost subject to an output constraint or maximize the
output subject to a cost constraint. We will now discuss these two fundamental principles.
Before doing this we will introduce the concept isocost, which shows all combinations of inputs
that can be used for a given cost.

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Isocost Lines
Recall that a universally accepted objective of any firm is to maximise profit. If the firm
maximises profit, it will necessarily minimise cost for producing a given level of output or
maximise output for a given level of cost. Suppose there are 2 inputs: capital (K) and labour (L)
that are variable in the relevant time period. What combination of (K,L) should the firm choose
in order to maximise output for a given level of cost?
If there are 2 inputs, K,L, then given the
price of capital (P ) and the price of labour (P ), it is
possible to determine the alternative combinations of
(K,L) that can be purchased for a given level of
expenditure. Suppose C is total expenditure, then
C=P * L +P * K
This linear function can be plotted on a graph.

If only capital is purchased, then the maximum amount that can be bought is C/Pk shown
by point A in figure 7.7. If only labour is purchased, then the maximum amount of labour that
can be purchased is C/PL shown by point B in the figure. The 2 points A and B can be joined by
a straight line. This straight line is called the isocost line or equal cost line. It shows the
alternative combinations of (K,L) that can be purchased for the given expenditure level C. Any
point to the right and above the isocost is not attainable as it involves a level of expenditure
greater than C and any point to the left and below the isocost such as P is attainable, although it
implies the firm is spending less than C. You should verify that the slope of the isocost is1



EXAMPLE:
Consider the following data:
PL =10, Pk =20 Total Expenditure =200.
Let us first plot the various combinations of K and L that are possible. We consider only
the case when the firm spends the entire budget of 200. The alternative combinations are shown
in the figure (7.8).

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Figure 7.8: Shifting of Isocost













The slope of this isocost is . What will happen if labour becomes more expensive say P
increases to 20? Obviously with the same budget the firm can now purchase lesser units of
labour. The isocost still meets the Yaxis at point A (because the price of capital is unchanged),
but shifts inwards in the direction of the arrow to meet the X-axis at point C. The slope
therefore changes to 1. You should work out the effect on the isocost curve on the following:
(v) Decrease in the price of labour
(vi) Increase in the price of capital
(vii) Decrease in the price of capital
(viii) Increase in the firms budget with no change in the price of labour and capital
[Hint: The slope of the isocost will not change in this case]

Optimal Combination of Inputs: The Long Run

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When both capital and labour are variable, determining the optimal input rates of capital
and labour requires the technical information from the production function i.e. the isoquants be
combined with market data on input prices i.e. the isocost function. If we superimpose the
relevant isocost curve on the firms isoquant map, we can readily determine graphically as to
which combination of inputs maximise the output for a given level of expenditure.

Consider the problem of minimising the cost of a given rate of output. Specifically if the
firm wants to produce 50 units of output at minimum cost. Two production isoquants have been
drawn in Figure 7.9. Three possible combinations (amongst a number of more combinations) are
indicated by points A, Z and B in Figure 7.9. Obviously, the firm should pick the point on the
lower isocost i.e point Z. In fact, Z is the minimum cost combination of capital and labour. At Z
the isocost is tangent to the 50 unit isoquant.
Alternatively, consider the problem of maximising output subject to a given cost amount.
You should satisfy yourself that among all possible output levels, the maximum amount will be
represented by the isoquant that is tangent to the relevant isocost line. Suppose the budget of the
firm increases to the amount shown by the higher of the two isocost lines in Figure 7.9, point Q
or 100 units of output is the maximum attainable given the new cost constraint in Figure 7.9.
Figure 7.9: Optimal combination of inputs










Regardless of the production objective, efficient production requires that the isoquant be
tangent to the isocost function. If the problem is to maximise output, subject to a cost constraint
or to minimise cost for a given level of output, the same efficiency condition holds true in both

138

situations. Intuitively, if it is possible to substitute one input for another to keep output constant
while reducing total cost, the firm is not using the least cost combination of inputs. In such a
situation, the firm should substitute one input for another.
For example, if an extra rupee spent on capital generates more output than an extra rupee
spent on labour, then more capital and less labour should be employed. At point Q in Figure 7.9,
the marginal product of capital per rupee spent on capital is equal to the marginal product of
labour per rupee spent on
labour. Mathematically this
can be shown as
Whenever the
2 sides of the above equation are
not equal, there are possibilities
that input substitutions will reduce costs. Let us work with numbers. Suppose PL =10, Pk =20,
MPL =50 and MPk =40. Thus, we have 50 / 10 >40/ 20.
This cannot be an efficient input combination, because the firm is getting more output per
rupee spent on labour than on capital. If one unit of capital is sold to obtain 2 units of labour (Pk
=20, PL =10), net increase in output will be 602. Thus the substitution of labour for capital
would result in a net increase in output at no additional cost. The inefficient combination
corresponds to a point such as A in Figure 7.9. At that point two much capital is employed. The
firm, in order to maximize profits will move down the isocost line by substituting labour for
capital until it reaches point Q. Conversely, at a point such as B in figure 7.9 the reverse is true -
there is too much labour and the inequality will hold This means that the firm generates more
output per rupee spent on capital than from rupees spent on labour. Thus a profit maximising
firm should substitute capital for labour. Suppose the firm was operating at point B in Figure 7.9.
If the problem is to minimize cost for a given level of output (B is on the isoquant that
corresponds to 50 units of output), the firm should move from B to Z along the 50-unit isoquant
thereby reducing cost, while maintaining output at 50. Alternatively, if the firm wants to
maximize output for given cost, it should more from B to Q, where the isocost is tangent to the
100-unit isoquant. In this case output will increase from 50 to 100 at no additional cost. Thus
both the following decisions: (a) the input combination that yields the maximum level of output
with a given level of expenditure, and (b) the input combination that leads to the lowest cost of

139

producing a given level of output are satisfied at point Q in Figure 7.9. You should be satisfied
that this is indeed the case.
The isocost-isoquant framework described above lends itself to various applications. It
demonstrates, simply and elegantly, when relative prices of inputs change, managers will
respond by substituting the input that has become relatively less expensive for the input that has
become relatively more expensive. On average, we know that compared to developed countries
like the US, UK, Japan and Germany, labour in India is less expensive. It is not surprising
therefore to find production techniques that on average, use more labour per unit of capital in
India than in the developed world. For example, in construction activity you see around you in
your city, inexpensive workers do the job that in developed countries is performed by machines.


One application of the isocost-isoquant framework frequently cited is the response of industry to
the rapidly rising prices of energy products in the 1970s. (Remember the oil price shock of 1973
and again of 1979). Most prices of petrol and petroleum products increased across the world,
and as our analysis suggests, firms responded by conserving energy by substituting other inputs
for energy.
RETURNS TO SCALE
Another important attribute of production function is how output responds in the long
run to changes in the scale of the firm i.e. when all inputs are increased in the same proportion
(by say 10%), how does output change. Clearly, there are 3 possibilities. If output increases by
more than an increase in inputs (i.e. by more than 10%), then the situation is one of increasing
returns to scale (IRS). If output increases by less than the increase in inputs, then it is a case of
decreasing returns to scale (DRS). Lastly, output may increase by exactly the same proportion
as inputs. For example a doubling of inputs may lead to a doubling of output. This is a case of
constant returns to scale (CRS).

140




















Isoquants can also be used to depict returns to scale (Figure 7.10)
Panel A shows constant returns to scale. Three isoquants with output levels 50,100 and
150 are drawn. In the figure, successive isoquants are equidistant from one another along the
ray 0Z. Panel B shows increasing returns to scale, where the distance between 2 isoquants
becomes less and less i.e. in order to double output from 50 to 100, input increase is less than
double. The explanation for panel C, which exhibits decreasing returns to scale, is analogous.
There is no universal answer to which industries will show what kind of returns to scale.
Some industries like public utilities (Telecom and Electricity generation) show increasing returns
over large ranges of output, whereas other industries exhibit constant or even decreasing returns
to scale over the relevant output range. Therefore, whether an industry has constant, increasing
or decreasing returns to scale is largely an empirical issue.

141

Cobb-Douglas Production Function
In economics, the Cobb-Douglas functional form of pro-duction functions is widely used
to represent the relation-ship of an output to inputs. It was proposed by Knut Wicksell (1851 -
1926), and tested against statistical evi-dence by Charles Cobb and Paul Douglas in 1928.
In 1928 Charles Cobb and Paul Douglas published a study in which they modeled the
growth of the Ameri-can economy during the period 1899 - 1922. They con-sidered a simplified
view of the economy in which pro-duction output is determined by the amount of labor in-volved
and the amount of capital invested. While there are many other factors affecting economic
performance, their model proved to be remarkably accurate.
The function they used to model production was of the form: P (L, K) = bLK
where: P =total production (the monetary value of all goods produced in a year)
L =labor input (the total number of person-hours worked in a year)
K =capital input (the monetary worth of all machinery, equipment, and buildings)
b =total factor productivity
and are the output elasticities of labor and capital, respectively. These values are
constants determined by available technology.
Output elasticity measures the responsiveness of output to a change in levels of either
labor or capital used in production, ceteris paribus. For example if = 0.15, a 1% increase in
labor would lead to approximately a 0.15% increase in output.
Further, if: + = 1, the production function has constant returns to scale. That is, if L and K
are each increased by 20%, then P increases by 20%.
Returns to scale refers to a technical property of production that examines changes in
output subsequent to a proportional change in all inputs (where all inputs increase by a constant
factor). If output increases by that same proportional change then there are constant returns to
scale (CRTS), sometimes referred to simply as returns to scale. If output increases by less than
that proportional change, there are decreasing returns to scale (DRS). If output increases by more
than that proportion, there are increasing returns to scale (IRS)
However, if + < 1, returns to scale are decreasing, and if + > 1, returns to scale are
increasing. Assuming perfect competition, and can be shown to be labor and capitals share
of output.
Assumptions Made

142

If the production function is denoted by P =P (L, K), then the partial derivative L is the
rate at which production changes with respect to the amount of labor. Economists call it the
marginal production with respect to labor or the marginal productivity of labor. Likewise, the
partial derivative K is the rate of change of production with respect to capital and is called the
marginal productivity of capital.
In these terms, the assumptions made by Cobb and Douglas can be stated as follows:
1. If either labor or capital vanishes, then so will production.
2. The marginal productivity of labor is proportional to the amount of production per unit of
labor.
3. The marginal productivity of capital is proportional to the amount of production per unit
of capital.
Solving
Because the production per unit of labor is L, assumption 2 says that PL = PL for some
constant . If we keep K constant (K =K0), then this partial differential equation becomes an
ordinary differential equation: dPdL = PL
This separable differential equation can be solved by re-arranging the terms and
integrating both sides:
P1 dP = L1 dL
ln(P ) = ln(cL)
ln(P ) = ln(cL)
And finally, P (L, K0) = C1(K0)L (1)
where C1(K0) is the constant of integration and we write it as a function of K0 since it could
depend on the value of K0.
Similarly, assumption 3 says that KP = KP
Keeping L constant(L =L0), this differential equation can be solved to get:
P (L0, K) = C2(L0)K (2)
And finally, combining equations (1) and (2):
P (L, K) = bLK (3)
where b is a constant that is independent of both L and K.
Assumption 1 shows that > 0 and > 0.
Notice from equation (3) that if labor and capital are both increased by a factor m, then

143

P (mL, mK) = b(mL)(mK)
= m+ bLK
= m+ P (L, K)
If + = 1, then P (mL, mK) = mP (L, K), which means that production is also increased
by a factor of m, as discussed earlier in Section 1.


Usage
This section will demonstrate the usage of the production formula using real world data.
An Example
Year 1899 1900 1901 1902 1903 1904 1905 ... 1917 1918 1919 1920
P 100 101 112 122 124 122 143 ... 227 223 218 231
L 100 105 110 117 122 121 125 ... 198 201 196 194
K 100 107 114 122 131 138 149 ... 335 366 387 407
Table 1: Economic data of the American economy during the period 1899 - 1920 [1]. Portions
not shown for the sake of brevity
Using the economic data published by the government, Cobb and Douglas took the year
1899 as a baseline, and P , L, and K for 1899 were each assigned the value 100. The values for
other years were expressed as percentages of the 1899 figures. The result is Table 1.
Next, Cobb and Douglas used the method of least squares to fit the data of Table 1 to the
function:
P (L, K) =1.01(L0.75)(K0.25) (4)
For example, if the values for the years 1904 and 1920 were plugged in:
P (121, 138) = 1.01(1210.75)(1380.25) 126.3
P (194, 407) = 1.01(1940.75)(4070.25) 235.8
which are quite close to the actual values, 122 and 231 respectively.
The production function P (L, K) = bLK has subsequently been used in many settings,
ranging from individual firms to global economic questions. It has become known as the Cobb-
Douglas production function. Its domain is {(L, K) : L 0, K 0} because L and K represent
labor and capital and are therefore never negative.
Difficulties

144

Even though the equation (4) derived earlier works for the period 1899 - 1922, there are
currently various concerns over its accuracy in different industries and time periods.
Cobb and Douglas were influenced by statistical evidence that appeared to show that
labor and capital shares of total output were constant over time in developed countries; they
explained this by statistical fitting least-squares regression of their production function.
However, there is now doubt over whether constancy over time exists.
Neither Cobb nor Douglas provided any theoretical reason why the coefficients and
should be constant over time or be the same between sectors of the economy. Remember that the
nature of the machinery and other capital goods (the K) differs between time-periods and
according to what is being produced. So do the skills of labor (the L).
The Cobb-Douglas production function was not developed on the basis of any knowledge
of engineering, technology, or management of the production process. It was instead developed
because it had attractive mathematical characteristics, such as diminishing marginal returns to
either factor of production.
Crucially, there are no micro foundations for it. In the modern era, economists have
insisted that the micro-logic of any larger-scale process should be explained. The C-D production
function fails this test.
For example, consider the example of two sectors which have the exactly same Cobb-
Douglas technologies:
if, for sector 1,
P1 = b(L1)(K1 )
and, for sector 2,
P2 = b(L2)(K2 ), that, in general, does not imply that
P1 +P2 =b(L1 + L2)(K1 + K2)
his holds only if L1 =K1 and + = 1, i.e. for constant returns to scale technology.
L2 K2
It is thus a mathematical mistake to assume that just because the Cobb-Douglas function
applies at the micro-level, it also applies at the macro-level. Similarly, there is no reason that a
macro Cobb-Douglas applies at the disaggregated level.



145



146

Market Equilibrium
A particularly notable feature of market economies is the effect of the price mechanism
on demand and supply. The price mechanism determines the equilibrium in the market and
consists of the interplay of the forces of supply and demand in determining the prices at which
commodities will be bought and sold in the market. Market equilibrium is the situation, where at
a certain price level, the quantity supplied and the quantity demanded of a particular commodity
are equal. Thus, the market can clear, with no excess supply or demand, and there is no tendency
to change in either price or quantity. Diagrammatically, market equilibrium occurs where the
demand and supply curves intersect, at the point where the quantity demanded is exactly equal to
the quantity demanded. Let us first consider the case where there is excess demand, where the
current price is below that of equilibrium, as shown in Figure 1:










(0Q1). Competition among buyers for the limited quantity of goods available means that
consumers will start bidding up the price. The rise in the price results in an expansion in supply
and a contraction in demand (movement along the curves towards the equilibrium point). This
will continue to occur as long as there is excess demand. Eventually, we will reach the
intersection of the supply and demand curves, where at price 0Pe, the quantity supplied 0Qe
exactly equals the quantity demanded by consumers.
In Figure 2, the quantity supplied at price 0P1 (0Q2) exceeds the quantity demanded.
Thus, we have a situation of excess supply or a glut in the market. In order to remove excess
supply, sellers will offer to sell at a lower price. The fall in the price results in an expansion of

147

demand, and a contraction in supply (movement along the curves towards the equilibrium point).
This will continue to occur as long as there is excess supply, until we reach the intersection of
supply and demand, where at price 0Pe, the market clears, that is, the quantity supplied and
demanded is equal.










The equilibrium price and quantity will be changed if there is a shift in either or both of
the supply or demand curve. Shifts in the supply and demand curves are caused by changes in
conditions behind supply and demand not price changes.
For example, an increase in demand means that more of a good will be demanded at the
same price. Factors that may cause an increase in demand include a rise in the price of substitute
goods and a fall in the price of complementary goods, higher prices expected in the future, a
good becoming more fashionable and rising consumer incomes. Because the demand curve shifts
to the right, the quantity demanded exceeds the quantity supplied. Competition among buyers
will begin to force the limited quantity of the good in question up, causing an expansion in
supply and a contraction in demand. This will continue to occur until the market clears again at a
new equilibrium point both the equilibrium price and quantity have risen. Similarly, a decrease
in demand will lower both the equilibrium price and quantity.
An increase or decrease in supply will also affect the equilibrium position. An increase in
supply shifts the supply curve to the right, thus lowering equilibrium price while raising
equilibrium quantity. A decrease in supply, which shifts the supply curve to the left, however,
raises equilibrium price and lowers equilibrium quantity. As mentioned earlier, the price or

148

market mechanism plays the most important function in determining the solutions to the
economic problem in market economies. The price determined in the market conveys important
information that helps in providing answers to the questions about the production, distribution
and exchange of goods and services in the economy. Producers will only produce those goods
and services for which there is consumer demand. The quantity of goods and services produced
and sold, is determined through the interaction of supply and demand, resulting in the
equilibrium price and quantity. Increasing demand for good X will be translated into a higher
market price, which will signal producers to reallocate resources away from other areas of
production, in order to produce more of product X.
In addition, it is said that the market mechanism also ensures efficiency in allocation in
the economy. The demand curve gives us an indication of the value that consumers place on a
certain product, while the supply curve gives us an indication of the producers cost in supplying
that product. The market mechanism ensures that equilibrium is reached at the intersection of
those two curves.
In conclusion, the market forces of supply and demand interact to bring about the
equilibrium price, clearing the market of excess demand or supply. In this way, it is said that the
market mechanism achieves consistency between the plans and outcomes for consumers and
producers without explicit coordination.














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UNIT-III
PRODUCT AND FACTOR MARKET
PRODUCT MARKET DEFINITION:
A market used to exchange a final good or service. Product markets exchange consumer
goods purchased by the household sector, capital investment goods purchased by the business
sector, and goods purchased by government and foreign sectors. A product market, however,
does NOT include the exchange of raw materials, scarce resources, factors of production, or any
type of intermediate goods. The total value of goods exchanged in product markets each year is
measured by gross domestic product. The demand side of product markets includes consumption
expenditures, investment expenditures, government purchases, and net exports. The supply side
of product markets is production of the business sector.
Markets that exchange final goods and services, that is, the output that is combined into
gross domestic product. The buyers of this production are the four macroeconomic sectors--
household, business, government, and foreign. The seller of this production is primarily the
business sector. A substantial part of macroeconomics is devoted to explaining how and why
gross domestic product exchanged through product markets rises or falls. Product markets, also
termed output or goods markets, are one of three primary sets of macroeconomic markets. The
other two are resource markets and financial markets.
Product markets take center stage in the macroeconomic analysis of the economy. First
and foremost, product markets provide a direct indication of the level of aggregate output, or
gross domestic product. This also suggests how and why the level of aggregate output changes as
the economy moves through the ups and downs of business cycles. Furthermore, the product
markets indirectly shed a little light on the macroeconomic problems of inflation and
unemployment.
Main Features of Perfect Competition

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The following are the characteristics or main features of perfect competition :-
1. Many Sellers
In this market, there are many sellers who form total of market supply. Individually,
seller is a firm and collectively, it is an industry. In perfect competition, price of commodity is
decided by market forces of demand and supply. i.e. by buyers and sellers collectively. Here, no
individual seller is in a position to change the price by controlling supply. Because individual
seller's individual supply is a very small part of total supply. So, if that seller alone raises the
price, his product will become costlier than other and automatically, he will be out of market.
Hence, that seller has to accept the price which is decided by market forces of demand and
supply. This ensures single price in the market and in this way, seller becomes price taker and
not price maker.
2. Many Buyers
Individual buyer cannot control the price by changing or controlling the demand. Because
individual buyer's individual demand is a very small part of total demand or market demand.
Every buyer has to accept the price decided by market forces of demand and supply. In this way,
all buyers are price takers and not price makers. This also ensures existence of single price in
market.
3. Homogenous Product
In this case, all sellers produce homogeneous i.e. perfectly identical products. All
products are perfectly same in terms of size, shape, taste, colour, ingredients, quality, trade marks
etc. This ensures the existence of single price in the market.
4. Zero Advertisement Cost
Since all products are identical in features like quality, taste, design etc., there is no scope
for product differentiation. So advertisement cost is nil.
5. Free Entry and Exit
There are no restrictions on entry and exit of firms. This feature ensures existence of
normal profit in perfect competition. When profit is more, new firms enter the market and this
leads to competition. Entry of new firms competing with each other results into increase in
supply and fall in price. So, this reduces profit from abnormal to normal level.

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When profit is low (below normal level), some firms may exit the market. This leads to
fall in supply. So remaining firms raise their prices and their profits go up. So again this ensures
normal level of profit.
6. Perfect Knowledge
On the front of both, buyers and sellers, perfect knowledge regarding market and pricing
conditions is expected. So, no buyer will pay price higher than market price and no seller will
charge lower price than market price.
7. Perfect Mobility of Factors
This feature is essential to keep supply at par with demand. If all factors are easily mobile
(moveable) from one line of production to another, then it becomes easy to adjust supply as per
demand.
Whenever demand is more additional factors should be moved into industry to increase supply
and vice versa. In this way, with the help of stable demand and supply, we can maintain single
price in the Market.
8. No Government Intervention
Since market has been controlled by the forces of demand and supply, there is no
government intervention in the form of taxes, subsidies, licensing policy, control over the supply
of raw materials, etc.
9. No Transport Cost
It is assumed that buyers and sellers are close to market, so there is no transport cost. This
ensures existence of single price in market.
Main Features of imperfect Competition
1. Large number of buyers and sellers:
Large numbers of sellers exist in the market. Individually they have a small share in the
market.
2. Product Differentiation:
In a monopolistically competitive market, the products of different sellers are
differentiated on the basis of brands. Product differentiation gives rise to an element of
monopoly to the producer over the competing product. As such the producer of the competing
brand can increase the price of his product knowing full well that his brand-loyal customers are
not going to leave him. This is possible only because the products have no perfect substitutes.

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Since however all the brands are of close substitutes to one another, the seller will lose some of
his customers to his competitors. Thus the market is a mix of monopoly and perfect competition.
3. Entry and Exit of firms:
New firms are free to enter the market and existing firms are free to quit at any given
period of time
4. Promotion Techniques:
Sellers attempt to promote their products not by cutting prices but by incurring high
expenditure on publicity and advertisement and other sale promoting techniques. This type of
competition is known as non-price competition.
Imperfect competition is the competitive situation in any market where the conditions
necessary for perfect competition are not satisfied.
Forms of imperfect competitions are:
Monopoly
Monopolistic
Oligopoly
Oligopsony
Duopoly
Bilateral Monopoly
Monopsony
Duopsony
CLASSIFICATION OF MARKET
Market may be classified into different types:
On the basis of area
Markets may be classified on the basis of area into local, national and international
markets. If the buyers and sellers are located in a particular locality, it is called as a local market,
e.g. fruits, vegetables etc. These goods are perishable; they cannot be stored for a long time; they
cannot be taken to distant places. When a commodity is demanded and supplied all over the
country, national market is said to exist. When a commodity commands international market or
buyers and sellers all over the world, it is called international market. Whether a market will be
local, national or international in character will depend upon the following factors: (a) nature of

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commodity; (b) taste and preference of the people; (c) availability of storage; (d) method of
business; (e) political stability at home and abroad; if) portability of the commodity.
On the basis of time
Time element has been used by Marshall for classifying the market. On the basis of time,
market has been classified into very short period, short period, long period and very long period.
Very short period market refers to the market in which commodities that are fixed in supply or
are perishable are transacted. Since supply is fixed, only the changes in demand influence the
price. The short period markets are those where supply can be increased but only to a limited
extent. Long period market refers to a market where adequate time is available for changing the
supply by changing the fixed factors of production. The supply of commodities may be increased
by installing a new plant or machinery and the output can be changed accordingly. Very long
period or secular period is one in which changes take place in factors like population, supply of
capital and raw material etc.
On the basis of nature of transactions
Markets are classified on the basis of nature of transactions into two broad categories
viz., Spot market and future market. When goods are physically transacted on the spot, the
market is called as spot market. In case the transactions involve the agreements of future
exchange of goods, such markets are known as future markets.
On the basis of volume of business
Based on the volume of business, markets are broadly classified into wholesale and retail
markets. In the wholesale markets, goods are transacted in large quantities. Wholesale markets
are in fact, a link between the producer and the retailer while the retailer is a link between the
wholesaler and the consumer.

On the basis of status of sellers
During the process of marketing, a commodity passes through a chain of sellers and
middlemen. Markets can be classified into primary, secondary and terminal markets. The
primary market consists of manufacturers who produce and sell the product to the wholesalers.
The wholesalers who are an international link between the manufacturers and retailers constitute
secondary markets while the retailers who sell it to the ultimate consumer constitute the terminal
market.

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On the basis of regulation
On this basis, market is classified into regulated and unregulated markets. For some
goods and services, the government stipulates certain conditions and regulations for their
transactions. Market of goods and services is called regulated market. On the other hand, goods
and services whose transactions are left to the market forces belong to unregulated market.
Regulations of market by the government become essential for those goods whose supply or
price can be manipulated against the interests of the general public.
On the basis of competition
Markets are classified on the basis of nature of competition into perfect competition and
imperfect competition.
http://www.econ.yale.edu/~gjh9/econ115b/slides11_4perpage.pdf
MARKET EFFICIENCY:
In the real world, markets cannot be absolutely efficient or wholly inefficient.
It might be reasonable to see markets as essentially a mixture of both, wherein daily
decisions and events cannot always be reflected immediately into a market. If all
participants were to believe that the market is efficient, no one would seek extraordinary
profits, which is the force that keeps the wheels of the market turning.
Types of Market efficiency:
However, there are 2 identified classifications of the Market Efficiency, which are aimed
at reflecting the degree to which it can be applied to markets.







Operationally (or) Internally Efficient:
In which an investor can do transactions as cheaply as possible. This would include
brokerage, commissions and other charges.
Pricing or externally efficient:
Market Efficiency
Operationally (or)
Internally Efficient
Pricing (or)
Externally efficient

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In which an investor can expect that stock prices at all times reflect all available
information that is relevant to the evaluation of the stocks.
Degrees of Market Efficiency:
1. Strong efficiency - This is the strongest version, which states that all information in a market,
whether public or private, is accounted for in a stock price. Not even insider information could
give an investor an advantage.
2. Semi-strong efficiency - This form of EMH implies that all public information is calculated
into a stock's current share price. Neither fundamental nor technical analysis can be used to
achieve superior gains.
3. Weak efficiency - This type of EMH claims that all past prices of a stock are reflected in
today's stock price. Therefore, technical analysis cannot be used to predict and beat a market.
ECONOMIC COSTS OF IMPERFECT COMPETITION:
The cost of inflated prices
Imperfect competitors reduce outputs and raise prices-most vividly seen in monopoly
market.
A monopolist is not a wicked firm-it does not rob people or force its goods down
consumers throats.
It is the sole seller and raises its price above marginal cost that is P>MC this also happens
in Oligopoly and monopolistic
Consumer surplus :
The gap between the total
utility of a good and its total market
value is called consumer surplus.
Dead weight loss:
The loss in real income or
consumer and producer surplus that
arises because of monoploy tarriffs,
quotas and distotions.
Three approaches to reduce the
harmful effects of monopolistic
practices:

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Economic regulation:
Used by government to control monopolistic practice that allows specialized regulatory
agencies to oversee the prices, outputs, entry and exit of firms in regulated industries.
Eg : Public utilities and transportation.
Price control
Entry and exit conditions
Standard of services
Antitrust Policies :
Laws thar prohobit certain kinds of behavior or curb certain market structures.
Encouraging competition:
To avoid anti competitive absuses.
Thus the monopolists make their output scare and there by driveup price and increase
profits.
FACTOR MARKET:
A market used to exchange the services of a factor of production: labor, capital, land ,
and entrepreneurship. Factor markets, also termed resource markets, exchange the services of
factors, NOT the factors themselves. For example, the labor services of workers are exchanged
through factor markets NOT the actual workers. Buying and selling the actual workers is not
only slavery (which is illegal) it's also the type of exchange that would take place through
product markets, not factor markets. More realistically, capital and land are two resources than
can be and are legally exchanged through product markets. The services of these resources,
however, are exchanged through factor markets. The value of the services exchanged through
factor markets each year is measured as national income.
Resources must be used in the production process to produce goods and services.
Resources are also called factors of production. The major factors are: labor, capital, land and
entrepreneurship. The first three factors listed are traded in the factor market where the
equilibrium quantity of the factor and the factor price are determined. The entrepreneurship
factor creates firms and hires the other factors. Most factor markets are competitive, that is, there
are many buyers and sellers.
Labor Market:

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In this market, human resources are traded. Most labor is traded on a contract, called a
job; some labor is traded on a temporary daily basis called casual labor. Human Capital. is an
individual's skills obtained from education, experience and training. The price of labor is wage
rate.
Capital Market:
Capital is the funds that firms use to buy and operate their production process. In this
market, people lend and borrow to finance the purchase of capital goods. The price of capital is
interest rate.
Land Market:
Land consists of all the resources given to us by nature. It included natural gas, water,
mineral, etc.
A market used to exchange the services of a factor of production: labor, capital, land ,
and entrepreneurship. Factor markets, also termed resource markets, exchange the services of
factors, NOT the factors themselves. For example, the labor services of workers are exchanged
through factor markets NOT the actual workers. Buying and selling the actual workers is not
only slavery (which is illegal) it's also the type of exchange that would take place through
product markets, not factor markets. More realistically, capital and land are two resources than
can be and are legally exchanged through product markets. The services of these resources,
however, are exchanged through factor markets. The value of the services exchanged through
factor markets each year is measured as national income.
Factor market analysis
An analysis of the structure and equilibrium determination of markets that exchange the
services of productive resources. This analysis highlights principles and concepts that tend to be
most commonly associated with factor markets (also termed resource markets), including
monopsony and bilateral monopoly. Marginal revenue product is a key concept on the demand
side of the factor market. Marginal factor cost is a key concept on the supply side of the factor
market.
http://glossary.econguru.com/economic-term/factor+market,+efficiency
Factor demand is a derived demand. It is derived from demand for products that factors are used
to produce.
Marginal Revenue Product (MRP)

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The marginal revenue product, MRP, is the the additional revenue generated by
employing an additional unit of a factor.
MRP =change in total revenue / change in the quantity of the factor
Since change in total revenue/ change in quantity of output =Marginal revenue (MR); and
change in the quantity of output/change in quantity of a factor=Marginal product (MP). Then:
MRP =MR X MP
Value of Marginal Product (VMP)
VMP equals to price (P) of a unit of output multiplied by the marginal product (MP) of the
factor of product.
VMP =P X MP
In perfect competition: P =MR, therefore, MRP =VMP
As stated in the law of diminishing returns, MP will eventually decrease as the quantity
of factor increases in the short run. On the other hand, MR in non-perfect competitive market is
also downward sloping. Therefore, MRP and VMP are downward sloping. The marginal revenue
generated by each factor and the factor's per unit cost (factor price) determine the quantity of
factor demanded by a firm. The factor demand curve is downward sloping. As the price of a
factor increases, less factor will be demanded.
To maximize profit, a firm hires up to the point at which the MRP (VMP in Perfect
competition) equals the factor price.
Hiring rule:
MRP >P of the factor: firm should continue to hire more factors.
MRP =P of the factor: firm should stop hiring at the unit of factor.
MRP <P of the factor: firm should reduce the quantity of factors
Demand of Labor
Applying the basic concepts discussed in the previous section in the labor market. Based
upon our discussion, firms' demand MRP =MR X MP. Therefore, firm's demand for labor
depends upon marginal revenue generated from each unit of output and the productivity of each
labor unit.
MR: Marginal revenue will increase as price of output increases, Firm will demand more
labor when output's price gets higher.

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MP: Productivity increase will increase demand for labor also. If there is a technological
advance, causing the labor proportion to machinery changes, labor demand will change. If more
labor is needed per machinery, labor demand will increase, otherwise, labor demand will
decrease as machine replaces human labor. Investment in human capital, such as training and
education, can increase productivity, too. Therefore, high skill workers face a higher demand
than low skill workers.
Supply of Labor
The main determinant of labor supply is the wage rate. At the lower portion of the supply
curve, people are willing to supply more labor hours when wage increases. However, labor
supply curve will bend backwards at the higher wage rate, indicating a negative relationship
between wage rate and labor supply quantity. This is due to the income effect. As people gets
richer, they need time to spend their income. So they will take time off from work to enjoy life.
Less labor hours will be supplied as a result.
Other determinants of Labor supply are:
1. Adult population: increase in population will increase work force, and labor supply.
2. Preferences: as more woman or retired people choose to work, labor supply increases.
3. Time in school and training: when people spend more time in school, the low skill labor
supply decrease, and high skill labor supply increases.
Labor Market Equilibrium
The labor market equilibrium determines the wage rate and employment.
If the wage rate exceeds the equilibrium wage rate, there is a surplus of labor and wage
will fall. If the wage rate is less than the equilibrium wage rate, there is a shortage of labor and
wage will rise.
http://staffwww.fullcoll.edu/fchan
A product market is selling and buying final goods consumed by consumers.
A factor market is buying and selling intermediate goods consumed by producers.
Factor market equilibrium - demand for factor =supply of factor.
Product market equilibrium _ demand for product =supply of product.
Partial equilibrium - it is achieved when at a particular equilibrium condition in factor
market the product market also achieved equilibrium condition. It is known as Pareto Optimality.
Supply and Demand Equilibrium

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Even though the concepts of supply and demand are
introduced separately, it's the combination of these
forces that determine how much of a good or service
is produced and consumed in an economy and at
what price. These steady-state levels are referred to
as the equilibrium price and quantity in a market.
In the supply and demand model, the equilibrium
price and quantity in a market is located at the
intersection of the market supply and market demand
curves. Note that the equilibrium price is generally referred to as P* and the market quantity is
generally referred to as Q*.




Market Forces Result in Economic Equilibrium
Conversely, consider a situation where the
price in a market is higher than the equilibrium price.
If the price is higher than P*, the quantity supplied in
that market will be higher than the quantity
demanded at the prevailing price, and a surplus will
result. (This time, the size of the surplus is given by
the quantity supplied minus the quantity demanded.)
When a surplus occurs, firms either accumulate
inventory (which costs money to store and hold) or
they have to discard their extra output. This is clearly not optimal from a profit perspective, so
firms will respond by cutting prices and production quantities when they have the opportunity to
do so. This behavior will continue as long as a surplus remains, again bringing the market back
to the intersection of supply and demand.


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http://economics.about.com/od/market-equilibrium/ss/Supply-And-Demand-
Equilibrium_5.htm
GENERAL EQUILIBRIUM:
A general equilibrium represents a whole economy rather than just a part of one.
It may contain many different kinds of labor, machines and land, all of which are serving
as inputs to produce dozens of different kinds of computers, hundreds of different
specifications of automobiles, and so on.
The general equilibrium of markets therefore determines prices and outputs so that the
marginal utility of each good to consumer equals the marginal cost of each good to the
society.
Ratios of marginal utilities of goods for all consumes are equal to the relative prices of
those goods.
The ratios of marginal costs of goods produced by firms are equal to the relative prices of
those goods.
The relative marginal revenue products of all inputs are equal for all firms and all goods
and are equal to those inputs relative prices.



Conditions of a competitive general equilibrium:
These conditions fall naturally into two categories; first relating to consumers,
corresponds to the upper section of the loop. While the second concerning production
corresponds to the lower section.
a) Consumer Equilibrium:
Consumer should maximize their utility by equalizing the marginal utility per dollar of
spending MU
1
/ MU
2 =
P
1
/P
2
The ratio of marginal utilities of two goods is equal to the ratio of their prices.
b) Producers Equilibrium:
The output condition for producers is that the level of output is set so that the price of
each good equals the marginal cost of that good.
MC
1
/MC
2 =
P
1
/P
2

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The equation says that, in a competitive economy, the ratio of the marginal costs of two
final products is equal to their price ratio.
EFFICIENCY OF COMPETITIVE MARKETS:
Income Distribution and Poverty
The Utility Possibilities Frontier
Somehow, the goods and services produced in every society get distributed among its
citizens. But why do some get more than others? What are the sources of inequality? Should the
government change the distribution generated by the market? Should the goal be a distribution
that is equitable, and what does that mean?
The Utility Possibilities Frontier
In discussing distribution, we should talk not about the distribution of things but about
the distribution of utility or well-being. Utility is not directly observable or measurable, but
thinking about it as if it were can help us understand some of the ideas that underlie debates
about distribution.
Suppose that society were made up of just two people, I and J, and that all the assumptions of
perfect competition held. The curve below would then show all the combinations of Is utility
and J s utility that were possible given their societys resources and technology.
This is the utility possibilities frontier. All points on the frontier are efficient (i.e., I cannot
be made better off without making J worse off) but they may not all be equally desirable. In
theory, the perfectly competitive market system would lead society to one of the points on the
frontier, but the actual point reached would depend on Is and J s initial endowments of wealth,
skills, and so forth.

In practice, the market solution leaves
some people out. The rewards of a market system
are linked to productivity and not all people are
equally productive. As a result, societies make
some provision for the poor. Society makes a
judgment that those who are better off should give
up some of their rewards so that those at the

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bottom can have more than the market system would allocate to them. This redistribution is
undertaken because the members of the society think it is fair, or just.
Since utility is neither observable nor measurable, most discussions of social policy
center on the distribution of income or the distribution of wealth as indirect measures of utility.
While these are imperfect measures, they have no clear substitutes and are therefore the
measures used.


























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UNIT-IV
PERFORMANCE OF AN ECONOMY MACRO ECONOMICS
CIRCULAR FLOW OF INCOME
In this simplified image, the relationship between the decision-makers in the circular flow
model is shown. Larger arrows show primary factors, whilst the red n,.0p;smaller arrows show
subsequent or secondary factors.
In economics, the terms circular flow of income or circular flow refer to a simple
economic model which describes the reciprocal circulation of income between producers and
consumers. In the circular flow model, the inter-dependent entities of producer and consumer are
referred to as "firms" and "households" respectively and provide each other with factors in order
to facilitate the flow of income. Firms provide consumers with goods and services in exchange
for consumer expenditure and "factors of production" from households. More complete and
realistic circular flow models are more complex. They would explicitly include the roles of
government and financial markets, along with imports and exports.
Human wants are unlimited and are of recurring nature therefore, production process
remains a continuous and demanding process. In this process, household sector provides various
factors of production such as land, labor, capital and enterprise to producers who produce by
goods and services by co-coordinating them. Producers or business sector in return makes
payments in the form of rent, wages, interest and profits to the household sector. Again
household sector spends this income to fulfill its wants in the form of consumption expenditure.
Business sector supplies those goods and services produced and get income in return of it. Thus
expenditure of one sector becomes the income of the other and supply of goods and services by
one section of the community becomes demand for the other. This process is unending and forms
the circular flow of income, expenditure and production.
A continuous flow of production, income and expenditure is known as circular flow of
income. It is circular because it has neither any beginning nor an end. The circular flow of

165

income involves two basic principles: - 1.In any exchange process, the seller or producer
receives the same amount what buyer or consumer spends. 2. Goods and services flow in one
direction and money payment to get these flow in return direction, causes a circular flow.
Circular flows are classified as: Real Flow and Money Flow. Real Flow- In a simple
economy, the flow of factor services from households to firms and corresponding flow of goods
and services from firms to households s known to be as real flow.
Assume a simple two sector economy- household and firm sectors, in which the
households provides factor services to firms, which in return provides goods and services to
them as a reward. Since there will be an exchange of goods and services between the two sectors
in physical form without involving money, therefore, it is known as real flow.
Money Flow- In a modern two sector economy, money acts as a medium of exchange
between goods and factor services. Money flow of income refers to a monetary payment from
firms to households for their factor services and in return monetary payments from households to
firms against their goods and services. Household sector gets monetary reward for their services
in the form of rent, wages, interest, and profit form firm sector and spends it for obtaining
various types of goods to satisfy their wants. Money acts as a helping agent in such an exchange.
Asumptions
The basic circular flow of income model consists of seven assumptions:
1. The economy consists of two sectors: households and firms.
2. Households spend all of their income (Y) on goods and services or consumption (C).
There is no saving (S).
3. All output (O) produced by firms is purchased by households through their expenditure
(E).
4. There is no financial sector.
5. There is no government sector.
6. There is no overseas sector.
7. It is a closed economy with no exports or imports.
The Circular Flow
The Circular Flow

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The product market is a key component of the
circular flow model of the economy. The circular flow
captures the continuous movement of production,
income, and factor payments between producers and
consumers.
A basic representation of the circular flow is
displayed to the right. The four components of this
simple model are: household sector, business sector,
product markets, and resource markets. The household
sector at the far left contains the consuming
population of the economy. The business sector at the far right includes all of the producers.
The product markets at the top of the flow direct production from the business sector to
the household sector in exchange for payment flowing in the opposite direction. The resource
markets at the bottom of the flow direct factor services from the household sector to the business
sector in exchange for payment flowing in the opposite direction.
The circular flow indicates that the income used by the household sector to purchase
goods through the product markets is obtained by selling factor services through the resource
markets. It also indicates that the revenue used by the business sector to pay for factor services
obtained through the resource markets is generated by selling goods through the product markets.
Aggregate Equilibrium
It is often convenient to combine the thousands of individual microeconomic product
markets used to exchange a wide assortment of final goods and services throughout the economy
into an abstract aggregation. Demand in the aggregate product market reflects the expenditures
made by buyers in the individual markets. And supply in the aggregate product market reflects
the total production sold in the individual markets.
Equilibrium in the aggregate product market is an essential aspect of macroeconomic
analysis. In particular, overall macroeconomic equilibrium, which includes both short-run
equilibrium and long-run equilibrium, requires aggregate product market equilibrium. This exists
if total expenditures on gross domestic product is equal to the total amount of gross domestic
product available.


167

However, this does not mean every individual product market is in equilibrium. One
might have a bit of a shortage and another a bit of a surplus. As long as the shortages and
surpluses balance out, meaning aggregate production is equal to aggregate expenditures, then the
aggregate product market is in equilibrium
TWO SECTOR MODEL
In the simple two
sector circular flow of
income model the state of
equilibrium is defined as a
situation in which there is
no tendency for the levels
of income (Y),
expenditure (E) and output
(O) to change, that is: Y =
E =O
This means that the expenditure of buyers (households) becomes income for sellers
(firms). The firms then spend this income on factors of production such as labour, capital and
raw materials, "transferring" their income to the factor owners. The factor owners spend this
income on goods which leads to a circular flow of income.
THREE SECTOR MODEL
It includes household sector,
business sector and government sector. It
will study a circular flow income in these
sectors excluding rest of the world
i.e. closed economy income. Here
flows from household sector and
producing sector to government
sector are in the form of taxes. The
income received from the
government sector flows to

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producing and household sector in the form of payments for government purchases of goods and
services as well as payment of subsides and transfer payments. Every payment has a receipt in
response of it by which aggregate expenditure of an economy becomes identical to aggregate
income and makes this circular flow and unending.
FOUR SECTOR MODEL
A modern monetary economy comprises a network of four sector economy these are-
1.Household sector 2.Firms or Producing sector 3.Government sector 4.Rest of the world sector.
Each of the above sectors receives some payments from the other in lieu of goods and services
which makes a regular flow of goods and physical services. Money facilitates such an exchange
smoothly. A residual of each market comes in capital market as saving which inturn is invested
in firms and government sector. Technically speaking, so long as lending is equal to the
borrowing i.e. leakage is equal to injections, the circular flow will continue indefinitely.
However this job is done by financial institutions in the economy. Reference- S. Dinesh
Introduction to Macro Economics .
FIVE SECTOR MODEL
Table 1 All leakages and injections in five sector model
LEAKAGES INJECTION
Saving (S) Investment (I)
Taxes (T) Government Spending (G)
Imports (M) Exports (X)










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Circular flow of income diagram
The five sector model of the circular flow of income is a more realistic representation of
the economy. Unlike the two sector model where there are six assumptions the five sector
circular flow relaxes all six assumptions. Since the first assumption is relaxed there are three
more sectors introduced. The first is the Financial Sector that consists of banks and non-bank
intermediaries who engage in the borrowing (savings from households) and lending of money. In
terms of the circular flow of income model the leakage that financial institutions provide in the
economy is the option for households to save their money. This is a leakage because the saved
money cannot be spent in the economy and thus is an idle asset that means not all output will be
purchased. The injection that the financial sector provides into the economy is investment (I) into
the business/firms sector. An example of a group in the finance sector includes banks such as
Westpac or financial institutions such as Suncorp.
The next sector introduced into the circular flow of income is the Government Sector that
consists of the economic activities of local, state and federal governments. The leakage that the
Government sector provides is through the collection of revenue through Taxes (T) that is
provided by households and firms to the government. For this reason they are a leakage because
it is a leakage out of the current income thus reducing the expenditure on current goods and
services. The injection provided by the government sector is Government spending (G) that
provides collective services and welfare payments to the community. An example of a tax
collected by the government as a leakage is income tax and an injection into the economy can be
when the government redistributes this income in the form of welfare payments, that is a form of
government spending back into the economy.
The final sector in the circular flow of income model is the overseas sector which
transforms the model from a closed economy to an open economy. The main leakage from this
sector are imports (M), which represent spending by residents into the rest of the world. The
main injection provided by this sector is the exports of goods and services which generate
income for the exporters from overseas residents. An example of the use of the overseas sector is
Australia exporting wool to China; China pays the exporter of the wool (the farmer) therefore
more money enters the economy thus making it an injection. Another example is China
processing the wool into items such as coats and Australia importing the product by paying the
Chinese exporter; since the money paying for the coat leaves the economy it is a leakage.

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In terms of the five sector circular flow of income model the state of equilibrium occurs
when the total leakages are equal to the total injections that occur in the economy. This can be
shown as:
Therefore since the leakages are equal to the injections the economy is in a stable state of
equilibrium. This state can be contrasted to the state of disequilibrium where unlike that of
equilibrium the sum of total leakages does not equal the sum of total injections. By giving values
to the leakages and injections the circular flow of income can be used to show the state of
disequilibrium. Disequilibrium can be shown as:
S +T +M I + G + X
Therefore it can be shown as one of the below equations where:
Total leakages >Total injections Or
Total Leakages <Total injections
The effects of disequilibrium vary according to which of the above equations they belong to.
If S +T +M >I +G +X the levels of income, output, expenditure and employment will
fall causing a recession or contraction in the overall economic activity. But if S +T +M <I +G
+X the levels of income, output, expenditure and employment will rise causing a boom or
expansion in economic activity.
To manage this problem, if disequilibrium were to occur in the five sector circular flow
of income model, changes in expenditure and output will lead to equilibrium being regained. An
example of this is if:
S +T +M >I +G +X the levels of income, expenditure and output will fall causing a
contraction or recession in the overall economic activity. As the income falls (Figure 4)
households will cut down on all leakages such as saving, they will also pay less in taxation and
with a lower income they will spend less on imports. This will lead to a fall in the leakages until
they equal the injections and a lower level of equilibrium will be the result.
The other equation of disequilibrium, if S +T +M <I +G +X in the five sector model
the levels of income, expenditure and output will greatly rise causing a boom in economic
activity. As the households income increases there will be a higher opportunity to save therefore
saving in the financial sector will increase, taxation for the higher threshold will increase and
they will be able to spend more on imports. In this case when the leakages increase they will

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continue to rise until they are equal to the level injections. The end result of this disequilibrium
situation will be a higher level of equilibrium.
Significance of Study of Circular Flow of Income
1. Measurement of National Income- National income is an estimation of aggregation of
any of economic activity of the circular flow. It is either the income of all the factors of
production or the expenditure of various sectors of economy. However, aggregate amount
of each of the activity is identical to each other.
2. Knowledge of Interdependence- Circular flow of income signifies the interdependence of
each of activity upon one another. If there is no consumption, there will be no demand
and expenditure which inturn restricts the amount of production and income.
3. Unending Nature of Economic Activities- It signifies that production, income and
expenditure are of unending nature, therefore, economic activities in an economy can
never come to a halt. National income is also bound to rise in future. 4.Injections and
Leakages
Reference- A General Approach to Macroeconomic Policy.--121.54.17.134

Difference between Real Flow and Money Flow
1. Real flow is the exchange of goods and services between household and firms whereas
money flow is the monetary exchange between two sectors.
2. In real flow household sector supplies raw material, land, labour, capital and enterprise to
firms and in return firms sector provides finished goods and services to household sector.
Whereas in money flow, firm sector gives remuneration in the form of money to
household sector a wages and salaries, rent, interest etc.
3. Difficulties of barter system for the exchange of goods and factor services between
households and firms sector in real flow, whereas no such difficulty or inconvenience
arise in money flow.
4. When goods and services flow from one sector of the economy to another. it is known as
real flow.
Phases or Stages of Circular Flow of Income
Production, consumption expenditure and generation of income are the three basic
economic activities of an economy that go on endlessly and are titled as circular flow of income.

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Production gives rise to income, income gives rise to demand for goods and services; such a
demand gives rise to expenditure and expenditure induces for further production. The whole
process forms the basis for circular flow of income and related activities- production, income and
expenditure are known as phases or stages of circular flow of income.
Production Income Expenditure Production.
1. Production Phase - Production means creation of utility to satisfy human wants. It involves
the co-ordination of all the factors of production in some desired ratio. This job is performed by a
producer or firm who takes an initiative with the motive of earning profits. He hires land, labour,
capital and an organization and makes them payment in the form of rent, wages and salaries and
interest. This phase is to produce goods and services and after selling them, it generates income.
2. Income Phase - Producing firms earn revenue from the sale of goods and services produced
by them. Whole of the earning is divided between factors provided by household sector in the
form of rent, wages, interest and profits. Such an income is classified into three parts:-
Compensation of employees- Wages, salaries, commission, bonus etc. Operating Surplus-
Profits, rent, interest, royalty etc. Mixed Income- Income of self- employed Thus production
takes the shape of income of household sector.
3. Expenditure Phase - Household sector spends its income to satisfy unlimited and recurring
human wants. Any saving out of total income takes the shape of investment on capital goods that
helps in generating the income of the economy. Expenditure becomes the income of producing
sector that promotes further the uninterrupted flow of income.
METHODS OF MEASURING NATIONAL INCOME:
In national income estimates, by definition, we have to count all those goods and services
produced in the country and exchanged against money during the year. Thus, whatever is
produced is either used for consumption or saving. Thus national output can be computed at any
of the three levels, namely, production, distribution and expenditure. Accordingly, three methods
of estimating national income may be used, viz, the output method, income method and
expenditure method.
Output Method
This method measures the output of the country and is also called as the inventory
method. It involves the assessment, through census, of the gross value of production of goods

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and services produced in different economic sectors by all the productive enterprises in the
economy. The symbolic expression for this method may be given as follows:
Y =(P
r
-D) +(S-T) +(X M) +(R-P) 2.1
Where
Y =national income
P
r
=domestic output of all production sectors
D =depreciation allowance
S =subsidies
T =indirect taxes
X =exports
M =imports
R =receipt from abroad
P =payment made abroad
When using this method, there are certain precautions that we must take against the
danger of double counting. To avoid double counting, we must add only the final products. Raw
materials and intermediate goods should not be added as that would lead to double counting.
There are two approaches to avoid the possibility of double counting in the measurement
of national income.
1. Final goods method
2. Value added method
In the final goods method of estimating national income, only the final value of goods
and services are computed, ignoring all intermediate transactions. Intermediate goods are
involved in the process of producing final goods the final flow of output purchased by
consumers. Thus, the final output includes the value of intermediate goods.
In the value added method, a summation of the increase in value, at each separate
production stage, leading to output in the final form is used for estimating the national income.
From the total value created at a given stage, we should thus subtract all the costs of materials
and intermediate goods not produced in that stage. In other words, the value of inputs at a given
stage should be deducted from the value of output.
Census of Income Method

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In this method, the income of all factors of production is added together. The data are
compiled from books of accounts, reports, and published accounts. The following classification
of income is considered as comprehensive, (a) wages and salaries, (b) supplemental labour
income (social security etc) (c) earnings of self-employed or professional income, (d) dividends,
(e) undistributed profits (retained earnings of firms), (f) interest, (g) rent, (h) profit of state
enterprises. However, transfer payments like gift subsidies, etc. should be subtracted from the
total factor income. Thus, national income is equal to the factor income minus transfer payments.
This method is also known as factor cost method. Thus, the national income of a country
at factor cost is equivalent to the sum total of disbursements of their factors income which can
be symbolically expressed as:
Y =(w +r +i +) +(X M) +(R-P) 2.2
Where
Y =national income
w =wages
r =rent
i =interest
=profits
X =exports
M =imports
R =receipt from abroad,
P =payment made abroad

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The Expenditure or Outlay Method
National income on the expenditure side is equal to the value of consumption plus
investment. In this method, we have to estimate private and pubic expenditure on consumer
goods and services, add the value of investment in fixed capital and stocks, with due
consideration for net positive or negative inventories, and add the value of exports and deduct the
value of imports. This method is not as popular as the previous ones. To express it in symbolic
terms,
Y =(C+I+G) +(X M) +(R-P) 2.3
Where
C =consumption expenditure
I =investment expenditure
G =government purchases
X =exports
M =imports
R =receipt from abroad
P =payment made abroad
Now that we have discussed the three methods of estimating national income, let us
discuss the Keynesian theory of estimating national income in detail.
In Keyness analytical framework, the entire economy is divided into four sectors, viz.,
household sector, firms or business sector, government sector, and foreign sector. When we
discussed the circular flow of income, we discussed the two sector, three sector, and four sector
model. Let us recall the two sector model.
When an economy is in the state of equilibrium the following conditions must be
fulfilled.
Factor payments =Wages +Interest +Rent +Profit
Wages +Interest +Rent +Profit =Household Income
Value of output =Factor Payments
Household income =Household Expenditure
Household Expenditure =Value of output
The amount of goods and services that firms produce constitute the Aggregate Supply
(AS). Its value equals factor payments. The household expenditure represents the Aggregate

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Demand (AD). According to Keynesian theory of income determination, the equilibrium is
reached where aggregate demand (AD) equals the aggregate supply (AS).
CONCEPTS OF NATIONAL INCOME:
National income is the sum total of wages, rent, interest, and profit earned by the factors
of production of a country in a year. Thus it is the aggregate values of goods and services
rendered during a given period counted without duplication.
Below are given some of the important concepts of national income.
1. Gross Domestic Product at Market Price.
2. Gross National Product at Market Price.
3. Net Domestic Product at Market Price.
4. Net National Product at Market Price.
5. Net Domestic Product at Factor Cost.
6. Net National Product at Factor Cost.
7. Gross Domestic Product at Factor Cost.
8. Gross National Product at Factor Cost.
9. Private Income.
10. Personal Income
11. Disposable Income.
(1) Gross Domestic Product at Market Price (GDP at MP):-
Gross domestic product at market price is the aggregate money value of the final goods
and services produced within the country's own territory. So as to calculate GDP at MP all goods
and services produced in the domestic territory are multiplied by their respective prices.
Symbolically GDP at MP =PXQ. Where P is market price and Q is final goods and services.
GDP includes only those goods which come to the market for sale. The values of final goods are
only expressed in money terms. Value of depreciation and transfer payments are not included in
GDP at MP. The value of second hand goods is excluded from gross domestic product.
[Gross Domestic Product at Market Price = value of gross domestic output - value of
intermediate consumption]
(2) Gross National Product of Market Price (GNP at MP):-
Gross national product at market price is broade and comprehensive concept. GNP at MP
measures the money value of all the final products produced annually in a counter plus net factor

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income from abroad. In short GNP is GDP plus net factor incomes earned from abroad. Net
factor incomes is derived by reducing the factor incomes earned by foreigners from the country,
in question from the factor incomes earned by the residents of that country from abroad.
[Gross National Product at Market Price =Gross domestic product at market price +Net factor
income from abroad.]
(3) Net Domestic Product at Market Price (NDP at MP):-
Net domestic product- at market price is the difference between Net National Product at
market price and net factor income from abroad. Net domestic product at market price is the
difference been GNP at market price minus depreciation and net factor incomes from abroad.
[Net Domestic Product at Market Price =GNP at MP - Depreciation - Net factors income form
abroad]
(4) Net National Product at Market Price (NNP at MP):-
Net National product measures the net money value of final goods and services at current
prices produced in a year in a country. It is the gross national product at market price less
depreciation. In production of output capital assets are constantly used up. This fixed capital
consumption is called depreciation. Depreciation constitutes loss of value of fixed capital. Thus
net national product is the net money value of final goods and services produced in the course of
a year. Net money value can be arrived at by excluding depreciation allowance from total output.
[NNP at MP =GNP at MP - Depreciation]
(5) Net Domestic Product at Factor Cost (NDP at FC):-
Net Domestic product of factor cost or domestic income is the income earned by all the
factors of production within the domestic territory of a country during a year in the form of
wages, interest, profit and rent etc. Thus NDP at FC is a territorial concept. In other words NDP
at factor cost is equal to NNP at FC less net factor income from abroad.
[NDP at FC =NNP at FC - Net factor income from abroad]
(6) Net National Product at Factor Cost (NNP at FC)
Net national product at factor cost is the aggregate payments made to the factors of
production. NNP at FC is the total incomes earned by all the factors of production in the form of
wages, profits, rent, interest etc. plus net factor income from abroad. NNP at FC is the NDP at
FC plus net factor income from abroad. NNP at FC can also be derived by excluding
depreciation from GNP at FC.

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[NNP at FC =NDP at FC +Net Factor Income from abroad]


(7) Gross Domestic Product at Factor Cost (GDP at FC):
Gross Domestic Product at factor cost refers to the value of all the final goods and
services produced within the domestic territory of a country. If depreciation or consumption of
fixed capital is added to the net domestic product at factor cost, it is called Gross domestic
Product at Factor cost.
[GDP at FC =NDP at FC - Depreciation]
(8) Gross National Product at Factor Cost (GNP at FC):-
Gross national product at factor cost is obtained by deducting the indirect tax and adding
subsidies to GNP at market price or Gross national Product at factor cost is obtained by adding
net factor incomes from abroad to the GDP at factor cost.
[GNP at FC =GNP at MP - Indirect tax +Subsidies] or, [GNP at FC =GDP at FC +Net Factor
Income from abroad]
(9) Private Income:-
Private income means the income earned by private individuals from any source whether
productive or unproductive. It can be arrived at from NNP at factor cost by making certain
additions and deduction. The additions include (a) transfer earnings from Govt, (b) interest on
national debt (c) current transfers from rest of the world. The deductions include (a) Income from
property and entrepreneurship (b) savings of the non- departmental undertakings (e) social
security contributions. In order to arrive at private income the above additions and subtraction
are to be made to and from NNP at factor Cost.
[Private Income =NNP at FC +transfer payments +Interest on public debt - social securities -
profits and surpluses of public undertakings]
(10) Personal Income:-
Personal Income is the total income received by the individuals of country from all
sources before direct taxes. Personal income is not the same as National Income, because
personal income includes the transfer payments where as they are not included in national
income. Personal income includes the wages, salaries, interest and rent received by the

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individuals. Personal income is derived by excluding undistributed corporate profit taxes etc.
from National Income.
[Personal Income =Private Income - Saving of Private enterprise - Corporate tax]
(11) Disposable Income:-
Disposable income means the actual income which can be spent on consumption by
individuals and families. It refers to the purchasing power of the house hold. The whole of
disposable income is not spent on consumptions; a part of it is paid in the form of direct tax.
Thus disposable income is that part of income, which is left after the exclusion of direct tax.
[Disposable Income =Personal Income - Direct tax]
DETERMINATION OF NATIONAL INCOME:
Keynesian Model of Income Determination in a Two Sector Economy
Introduction
This model assumes that the aggregate supply curve is perfectly elastic up to the full
employment level of output after which it becomes perfectly inelastic. Hence price level, until
the full employment level, will be determined solely by the height of the supply curve. Hence,
the price variable gets less attention while entire focus is on the determination of equilibrium
level of income, which is determined solely by the aggregate demand.
Aggregate Demand in a Two Sector Economy
The following are the postulations for the above analysis.
1. The prices are constant or invariable
2. Given the price level, the firms are willing to sell any amount of the output at that price
level
3. The short run aggregate supply curve is perfectly elastic or flat
4. Investment is assumed to be autonomous and thus independent of the income level
5. There exist only two sectors in the economy, the households and the firms
Aggregate demand is the total amount of goods demanded in an economy. The aggregate
demand function can be expressed as
AD =C +I
Where, C =aggregate demand for consumers goods
I =aggregate demand for investment goods


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Determination of equilibrium income or output in a Two Sector Economy
In the most basic terms, an economy can be said to be in equilibrium when the production plans
of the firms and the expenditure plans of the households are realized.
Below are the postulations of the analysis
1. There exists only two sectors of the economy, there is no government sector and foreign
sector
2. All the factors of production are owned by the households who sell the factor services to
earn an income. With a part of this income, they purchase goods and services and save
the rest
3. As there is no government in the economy there are no taxes and subsidies and no
government expenditure
4. As there are no foreign sectors in the economy there are no exports and imports and
external inflows and outflows
5. As far as the firms are concerned there are no undistributed profits
6. All the prices are constant and does not change
7. The technology and the supply of capital are given
8. According to Keynesian theory, there are two approaches, they are Aggregate Demand -
Aggregate Supply Approach and Saving Investment Approach
The Keynesian Model of Income Determination in a Three Sector Economy - Introduction
of the Government Sector
Introduction
The action of government relating to its expenditures, transfers and taxes is called the
fiscal policy. Here we focus on three fiscal policy models which are in increasing order of
complexity, with the emphasis being on the government expenditure, taxation and the income
level.
Determination of Equilibrium Income or Output In a Three Sector Economy
Though the government is involved in a variety of activates three of them are of greater
relevance to us in the present context. Hence we will focus on these activities of the government,
which are discussed below:
1. Government Expenditure

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This includes goods purchased by the central, state and the local government and also the
payments made to the government employees.
2. Transfers
These are those government payments which do not involve any direct services by the
recipient for instance welfare payments, unemployment insurance and others.
3. Taxes
These include taxes on property, income and goods. Taxes can be classified into two
categories, direct taxes and indirect taxes. Direct taxes are levied directly and include
personal income and corporate income tax. They are paid as a part of the price of the
goods.
We simplify our analysis by making a few postulations, which are as follows.
1. The government purchases factor services from the household sector and goods and
services from the firms.
2. Transfer payment includes subsidies to the firms and pensions to the household sector.
3. The government levels only direct taxes on the household sector. We here introduce the
notion of an income leakage and an injection. In a two sector model, a part of the current
income stream leaked out as saving whereas injections in the form of investment were
injected into the system.
In a three sector model taxes, like saving, are income leakages whereas government expenditures
like investment are injections.
Solution
The equilibrium condition in the three sector economy is given as
Y = C +I +G
The Keynesian Model of Income Determination in a Four Sector Economy
Determination of Equilibrium income or output in a Four Sector
The inclusion of the foreign sector in the analysis influences the level of aggregate demand
through the export and import of goods and services. Hence it is necessary to understand the
factors that influence the exports and imports.
The volume of exports in any economy depends on the following factors:
1. The prices of the exports in any domestic economy relative to the price in the other
countries.

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2. The income level in the other economies.
3. Tastes, Preferences, customs and traditions in the other economies.
4. The tariff and trade policies between the domestic economy and the other economies.
5. The domestic economys level of imports.
.The equilibrium condition is given as
Y = C +I +G +X M
In equilibrium in a four sector model, leakages equal injections or
C +I +G +X = C +S +T +M


AGGREGATE DEMAND (AD) CURVE
In macroeconomics, the focus is on the demand and supply of all goods and services
produced by an economy. Accordingly, the demand for all individual goods and services is also
combined and referred to as aggregate demand. The supply of all individual goods and services
is also combined and referred to as aggregate supply. Like the demand and supply for individual
goods and services, the aggregate demand and aggregate supply for an economy can be
represented by a schedule, a curve, or by an algebraic equation
The aggregate demand curve represents the total quantity of all goods (and services) demanded
by the economy at different price levels. An example of an aggregate demand curve is given in
Figure 1 .

Figure 1 An aggregate demand curve

The vertical axis represents the price level of all final goods and services. The aggregate price
level is measured by either the GDP deflator or the CPI. The horizontal axis represents the real

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quantity of all goods and services purchased as measured by the level of real GDP. Notice that
the aggregate demand curve, AD, like the demand curves for individual goods, is downward
sloping, implying that there is an inverse relationship between the price level and the quantity
demanded of real GDP.
The reasons for the downward-sloping aggregate demand curve are different from the reasons
given for the downward-sloping demand curves for individual goods and services. The demand
curve for an individual good is drawn under the assumption that the prices of other goods remain
constant and the assumption that buyers' incomes remain constant. As the price of good X rises,
the demand for good X falls because the relative price of other goods is lower and because
buyers' real incomes will be reduced if they purchase good X at the higher price. The aggregate
demand curve, however, is defined in terms of the price level. A change in the price level implies
that many prices are changing, including the wages paid to workers. As wages change, so do
incomes. Consequently, it is not possible to assume that prices and incomes remain constant in
the construction of the aggregate demand curve. Hence, one cannot explain the downward slope
of the aggregate demand curve using the same reasoning given for the downward-sloping
individual product demand curves.
Reasons for a downward-sloping aggregate demand curve.
Three reasons cause the aggregate demand curve to be downward sloping. The first is the
wealth effect. The aggregate demand curve is drawn under the assumption that the government
holds the supply of money constant. One can think of the supply of money as representing the
economy's wealth at any moment in time. As the price level rises, the wealth of the economy, as
measured by the supply of money, declines in value because the purchasing power of money
falls. As buyers become poorer, they reduce their purchases of all goods and services. On the
other hand, as the price level falls, the purchasing power of money rises. Buyers become
wealthier and are able to purchase more goods and services than before. The wealth effect,
therefore, provides one reason for the inverse relationship between the price level and real GDP
that is reflected in the downward-sloping demand curve.
A second reason is the interest rate effect. As the price level rises, households and firms
require more money to handle their transactions. However, the supply of money is fixed. The
increased demand for a fixed supply of money causes the price of money, the interest rate, to
rise. As the interest rate rises, spending that is sensitive to rate of interest will decline. Hence, the

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interest rate effect provides another reason for the inverse relationship between the price level
and the demand for real GDP.
The third and final reason is the net exports effect. As the domestic price level rises,
foreign-made goods become relatively cheaper so that the demand for imports increases.
However, the rise in the domestic price level also means that domestic-made goods are relatively
more expensive to foreign buyers so that the demand for exports decreases. When exports
decrease and imports increase, net exports (exports - imports) decrease. Because net exports are a
component of real GDP, the demand for real GDP declines as net exports decline.
Changes in aggregate demand.
Changes in aggregate demand are represented by shifts of the aggregate demand curve.
An illustration of the two ways in which the aggregate demand curve can shift is provided in
Figure 2 .

Figure 2 Shifts of the aggregate demand curve

A shift to the right of the aggregate demand curve. from AD
1
to AD
2
, means that at the
same price levels the quantity demanded of real GDP has increased. A shift to the left of the
aggregate demand curve, from AD
1
to AD
3
, means that at the same price levels the quantity
demanded of real GDP has decreased.
Changes in aggregate demand are not caused by changes in the price level. Instead, they
are caused by changes in the demand for any of the components of real GDP, changes in the
demand for consumption goods and services, changes in investment spending, changes in the
government's demand for goods and services, or changes in the demand for net exports.
Consider several examples. Suppose consumers were to decrease their spending on all
goods and services, perhaps as a result of a recession. Then, the aggregate demand curve would
shift to the left. Suppose interest rates were to fall so that investors increased their investment

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spending; the aggregate demand curve would shift to the right. If government were to cut
spending to reduce a budget deficit, the aggregate demand curve would shift to the left. If the
incomes of foreigners were to rise, enabling them to demand more domestic-made goods, net
exports would increase, and aggregate demand would shift to the right. These are just a few of
the many possible ways the aggregate demand curve may shift. None of these explanations,
however, has anything to do with changes in the price level.
AGGREGATE SUPPLY (AS) CURVE
The aggregate supply curve depicts the quantity of real GDP that is supplied by the
economy at different price levels. The reasoning used to construct the aggregate supply curve
differs from the reasoning used to construct the supply curves for individual goods and services.
The supply curve for an individual good is drawn under the assumption that input prices remain
constant. As the price of good X rises, sellers' per unit costs of providing good X do not change,
and so sellers are willing to supply more of good X-hence, the upward slope of the supply curve
for good X. The aggregate supply curve, however, is defined in terms of the price level.
Increases in the price level will increase the price that producers can get for their products and
thus induce more output. But an increase in the price will also have a second effect; it will
eventually lead to increases in input prices as well, which, ceteris paribus, will cause producers
to cut back. So, there is some uncertainty as to whether the economy will supply more real GDP
as the price level rises. In order to address this issue, it has become customary to distinguish
between two types of aggregate supply curves, the short-run aggregate supply curve and the
long-run aggregate supply curve.
Short-run aggregate supply curve.
The short-run aggregate supply (SAS) curve is considered a valid description of the
supply schedule of the economy only in the short-run. The short-run is the period that begins
immediately after an increase in the price level and that ends when input prices have increased in
the same proportion to the increase in the price level.
Input prices are the prices paid to the providers of input goods and services. These input
prices include the wages paid to workers, the interest paid to the providers of capital, the rent
paid to landowners, and the prices paid to suppliers of intermediate goods. When the price level
of final goods rises, the cost of living increases for those who provide input goods and services.
Once these input providers realize that the cost of living has increased, they will increase the

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prices that they charge for their input goods and services in proportion to the increase in the price
level for final goods.
The presumption underlying the SAS curve is that input providers do not or cannot take
account of the increase in the general price level right away so that it takes some timereferred to
as the short-runfor input prices to fully reflect changes in the price level for final goods. For
example, workers often negotiate multi-year contracts with their employers. These contracts
usually include a certain allowance for an increase in the price level, called a cost of living
adjustment (COLA). The COLA, however, is based on expectations of the future price level
that may turn out to be wrong. Suppose, for example, that workers underestimate the increase in
the price level that occurs during the multi-year contract. Depending on the terms of the contract,
the workers may not have the opportunity to correct their mistaken estimates of inflation until the
contract expires. In this case, their wage increases will lag behind the increases in the price level
for some time.
During the short-run, sellers of final goods are receiving higher prices for their products,
without a proportional increase in the cost of their inputs. The higher the price level, the more
these sellers will be willing to supply. The SAS curvedepicted in Figure 1 (a)is therefore
upward sloping, reflecting the positive relationship that exists between the price level and the
quantity of goods supplied in the short-run.

Figure 1The aggregate supply curve

Long-run aggregate supply curve.
The long-run aggregate supply (LAS) curve describes the economy's supply schedule
in the long-run. The long-run is defined as the period when input prices have completely
adjusted to changes in the price level of final goods. In the long-run, the increase in prices that

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sellers receive for their final goods is completely offset by the proportional increase in the prices
that sellers pay for inputs. The result is that the quantity of real GDP supplied by all sellers in the
economy is independent of changes in the price level. The LAS curvedepicted in Figure 1
(b)is a vertical line, reflecting the fact that long-run aggregate supply is not affected by
changes in the price level. Note that the LAS curve is vertical at the point labeled as the natural
level of real GDP. The natural level of real GDP is defined as the level of real GDP that arises
when the economy is fully employing all of its available input resources.
Changes in aggregate supply.
Changes in aggregate supply are represented by shifts of the aggregate supply curve.
An illustration of the ways in which the SAS and LAS curves can shift is provided in Figures 2 (a)
and 2 (b). A shift to the right of the SAS curve from SAS
1
to SAS
2
of the LAS curve from LAS
1
to
LAS
2
means that at the same price levels the quantity supplied of real GDP has increased. A shift
to the left of the SAS curve from SAS
1
to SAS
3
or of the LAS curve from LAS
1
to LAS
3
means that
at the same price levels the quantity supplied of real GDP has decreased

Figure 2Shifts of the aggregate supply curve

Like changes in aggregate demand, changes in aggregate supply are not caused by
changes in the price level. Instead, they are primarily caused by changes in two other factors. The
first of these is a change in input prices. For example, the price of oil, an input good, increased
dramatically in the 1970s due to efforts by oil-exporting countries to restrict the quantity of oil
sold. Many final goods and services use oil or oil products as inputs. Suppliers of these final
goods and services faced rising costs and had to reduce their supply at all price levels. The
decrease in aggregate supply, caused by the increase in input prices, is represented by a shift to

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the left of the SAS curve because the SAS curve is drawn under the assumption that input prices
remain constant. An increase in aggregate supply due to a decrease in input prices is represented
by a shift to the right of the SAS curve.
A second factor that causes the aggregate supply curve to shift is economic growth.
Positive economic growth results from an increase in productive resources, such as labor and
capital. With more resources, it is possible to produce more final goods and services, and hence,
the natural level of real GDP increases. Positive economic growth is therefore represented by a
shift to the right of the LAS curve. Similarly, negative economic growth decreases the natural
level of real GDP, causing the LAS curve to shift to the left.
MACRO ECONOMIC EQUILIBRIUM:
A state of national economic activity
wherein aggregate demand is met by aggregate
supply. Significant movement on either side will
affect prices, employment and resources.


COMPONENTS OF AGGREGATE
DEMAND:
The national income and employment in the short run in an economy depend upon
aggregate Demand and aggregate supply. The concept of aggregate demand and aggregate
supply was coined by J.M.Keynes a notable English Economist. He showed the mutual
relationship between aggregate demand and aggregate supply determines the level of income and
employment in a free market Economy, to him the deficiency of aggregate demand relative to
aggregate supply of output at full employment of resources given rise to Unemployment.
Aggregate demand is the total expenditure which the consumers, producers and
government are willing to make on goods and services in a year. The aggregate demand (AD)
Comprises of four components (i) consumption demand (ii) Investment demand (iii) Government
expenditure on final good, and services and (iv) Net of exports over imports consumption
expenditure is denoted by C, investment expenditure by I and Govt expenditure by G and exports
by Xn. The net exports is calculated by the difference between X-M=Xn
Thus Aggregate demand (AD) =C+I+G+Xn

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Consumption demand:
The demand for consumer goods and services depends on the propensity to consume and
the level of income of the community. Propensity to consume refers to the general income
consumption relationship. It represents functional relationship between two aggregates, i.e. total
consumption and total income it indicates the proportion of the aggregate income that shall spent
on consumption at various levels of income.
Investment demand:
Investment demand is another component of Aggregate demand. Investment means
buying of new physical capital assets such as machinery, tools, equipment, buildings.
Expenditure on the stock of consumer goods and ratio materials is also considered as investment.
The investment demand depends on two factors.
(i) Marginal efficiency of capital
(ii) The rate of interest.
The marginal efficiency of capital (MEC) refers to the expected profitability of a capital
asset. It may be defined as the highest rate of return over cost expected from the marginal or
additional unit of a capital asset. Between the two factors rate of interest is comparatively sticky
and does not frequently charge in the short run. Given the rate of interest changes in investment
demand in the short run occur due to the changes in marginal efficiency of capital. Thus
investment demand depends on the profitability from the employment of additional capital unit.
Government purchases:
The Government expenditure on final goods and services constitutes another component
of aggregate demand. The Govt purchases goods and services for two purposes. Firstly the Govt
spends on the infrastructure like construction of highways, flood control project, education,
communication etc. This is the developmental expenditure of the Govt, secondly the Govt, spend
on police and public administration, defence and other social services.
The first type of Govt, expenditure resembles private investment expenditure and the
second type resembles private consumption expenditure. There expenditures are not productive
as it does not help in producing further goods. Govt, also make expenditure on social security
measures like old age pension sickness benefits, subsidies etc. This type of expenditure is call
cash transfer or transfer payment.

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It is important to note the Govt; expenditure is independent of national income an
autonomous in nature like private investment expenditure.
Net Exports:
Export means shipping goods to foreign countries for it represents foreign demand for
country's product. The export revenue i.e. the amount of expenditure on the goods of the
exporting country by the foreign people adds to the total expenditure of aggregate demand in the
exporting country's economy.
Thus exports are like investment expenditure as both create income and demand for good.
As against the export imports of a country generate demand for foreign goods. Therefore imports
constitute leakage from the domestic flow of income and reduce domestic aggregate demand.
Thus net exports over imports (X - M) of a country are a component of aggregate demand
COMPONENTS OF NATIONAL INCOME:
Compensation of employees
Proprietors Income
Corporate profits
Rental Income of Persons
Net Interest
MULTIPLIER EFFECT:
Every time there is an injection of new demand into the circular flow there is likely to be
a multiplier effect. This is because an injection of extra income leads to more spending, which
creates more income, and so on. The multiplier effect refers to the increase in final income
arising from any new injection of spending.
The size of the multiplier depends upon households marginal decisions to spend, called
the marginal propensity to consume (mpc), or to save, called the marginal propensity to save
(mps). It is important to remember that when income is spent, this spending becomes someone
elses income, and so on. Marginal propensities show the proportion of extra income allocated to
particular activities, such as investment spending by UK firms, saving by households, and
spending on imports from abroad. For example, if 80% of all new income in a given period of
time is spent on UK products, the marginal propensity to consume would be 80/100, which is
0.8.

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The following general formula to calculate the multiplier uses marginal propensities, as
follows: 1/1-mpc
Hence, if consumers spend 0.8 and save 0.2 of every 1 of extra income, the multiplier will be:
1/1-0.8
=1/0.2
=5
Hence, the multiplier is 5, which means that every 1 of new income generates 5 of extra
income.
The multiplier effect in an open
economy
As well as calculating the multiplier in terms of how extra income gets spent, we can also
measure the multiplier in terms of how much of the extra income goes in savings, and other
withdrawals. A full open economy has all sectors, and therefore, three withdrawals savings,
taxation and imports.
This is indicated by the marginal propensity to save (mps) plus the extra income going to
the government - the marginal tax rate (mtr) plus the amount going abroad the marginal
propensity to import (mpm).
By adding up all the withdrawals we get the marginal propensity to withdraw (mpw). The
multiplier can now be calculated by the following general equation:
1/1- mpw
When to refer to a multiplier effect
The multiplier concept can be used any situation where there is a new injection into an
economy. Examples of such situations include:
1. When the government funds building of a new motorway
2. When there is an increase in exports abroad
3. When there is a reduction in interest rates or tax rates, or when the exchange rate falls.
The downward or 'reverse' multiplier

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A withdrawal of income from the circular flow will lead to a downward multiplier effect.
Therefore, whenever there is an increased withdrawal, such as a rise in savings, import spending
or taxation, there is a potential downward multiplier effect on the rest of the economy.
DEMAND SIDE POLICY:
Demand-side economics stimulates demand to promote economic growth in times of
economic downturn. Key features of demand-side economics include monetary policy and
government spending on infrastructure or wage-based tax cuts to promote spending. This type of
economics is also referred to as Keynesianism or New Keynesian economics after the economist
John Maynard Keynes, who popularized the theory.
Objectives of monetary policy:
1. Ensuring price stability:
Monetary policy is best suited to the achievement of price stability.
Price stability means reasonable rate of inflation. A high degree of inflation has adverse
effects on the economy. Inflation raises the cost of living of the people and hurts the poor most.
Due to higher rate of inflation value of money is rapidly falling; people do not have many
incentives to save. This lowers the rate of saving on which investment and economic growth
depend. At last a high rate of inflation encourages businessman to invest in the productive assets
such as gold, jewellery, real estate,etc
An expert committee on monetary reforms headed by late Prof. S. Chakravarty
suggested 4 percent rate of inflation as reasonable rate of inflation and recommended that
monetary policy by RBI should be so formulated that ensures that rate of inflation does not
exceed per cent per annum
2. To encourage economic growth:
Promoting economic growth is another important objective of the monetary policy. In the
past reserve Bank has been criticized that it pursued the objective of achieving price stability and
neglected the objective of promoting economic growth. Monetary policy can promote economic
growth through ensuring adequate availability of credit and lower cost of credit. First they have
to finance their requirements of working capital and for importing needed raw materials and
machines from abroad. Secondly they need credit for financing investment in projects for
building fixed capital. Easy availability of credit at low interest rate stimulates investment and
thereby quickens economic growth.

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3. To ensure stability of exchange rate of the rupee
The changes in capital inflows and capital outflows and changes in demand for and
supply of foreign exchange particularly US dollar arising from the imports and exports cause
great fluctuations in the foreign exchange of rupee. In order to prevent large depreciation and
appreciation of foreign exchange rate reserve bank has to take suitable monetary measures to
ensure foreign exchange stability. To arrest the fall in value of rupee reserve bank
1. Raised the bank rate from 7 percent to 8 percent and thus sending signals to the banks to
raise their lending rates.
2. Cash reserve ratio was raised from 7 percent to 7.5 percent to reduce liquidity in the
banking system.
FISCAL POLICY:
Definition Government spending policies that influence macroeconomic conditions. These
policies affect tax rates, interest rates and government spending, in an effort to control the
economy.
What is Fiscal Policy? Fiscal policy is the means by which a government adjusts its levels of
spending in order to monitor and influence a nations economy.
Fiscal policy and Monetary policy go hand in hand with each other. Both are
interdependent on each other.
Before the Great Depression in the United States, the governments approach to the
economy was laissez faire. But following the Second World War, it was determined that the
government had to take a proactive role in the economy to regulate unemployment, business
cycles, inflation and the cost of money. By using a mixture of both monetary and fiscal policies
(depending on the political orientations and the philosophies of those in power at a particular
time, one policy may dominate over another), governments are able to control economic
phenomena.
Objectives of Fiscal Policy
1. To achieve desirable price level:
The stability of general prices is necessary for economic stability. The maintenance of a
desirable price level has good effects on production, employment and national income. Fiscal
policy should be used to remove; fluctuations in price level so that ideal level is maintained.
2. To Achieve desirable consumption level:

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A desirable consumption level is important for political, social and economic
consideration. Consumption can be affected by expenditure and tax policies of the government.
Fiscal policy should be used to increase welfare of the economy through consumption level.
3. To Achieve desirable employment level:
The efficient employment level is most important in determining the living standard of
the people. It is necessary for political stability and for maximization of production. Fiscal policy
should achieve this level.
4. To achieve desirable income distribution:
The distribution of income determines the type of economic activities the amount of
savings. In this way, it is related to prices, consumption and employment. Income distribution
should be equal to the most possible degree. Fiscal policy can achieve equality in distribution of
income.
5. Increase in capital formation:
In under-developed countries deficiency of capital is the main reason for under-
development. Large amounts are required for industry and economic development. Fiscal policy
can divert resources and increase capital.
6. Degree of inflation:
In under-developed countries, a degree of inflation is required for economic
development. After a limit, inflationary be used to get rid of this situation.













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UNIT-V
UNEMPLOYMENT
CAUSES OF UNEMPLOYMENT
The main causes of unemployment - including: demand deficient, structural, frictional
and real wage unemployment.
Different Causes of Unemployment
1. Frictional Unemployment:
This is unemployment caused by the time people take to move between jobs, e.g.
graduates or people changing jobs. There will always be some frictional unemployment in an
economy because information isn't perfect and it takes time to find work.
2. Structural Unemployment
This occurs due to a mismatch of skills in the labor market it can be caused by:
Occupational immobility. This refers to the difficulties in learning new skills applicable
to a new industry, and technological change, e.g. an unemployed farmer may struggle to
find work in high tech industries.
Geographical immobility. This refers to the difficulty in moving regions to get a job,
e.g. there may be jobs in London, but it could be difficult to find suitable accommodation
or schooling for their children.
Technological change. If there is the development of labor saving technology in some
industries, then there will be a fall in demand for labor.
Structural change in the economy. The decline of the coal mines due to a lack of
competitiveness meant that many coal miners were unemployed; however they found it
difficult to get jobs in new industries such as computers.
3. Classical or Real Wage Unemployment:
This occurs when wages in a competitive labor market are pushed above the equilibrium,
e.g. at W2 the supply of labor (Q3) is greater than the demand for labor (Q2).
Wages could be pushed above the equilibrium level by minimum wages or trades unions.
This is sometimes known as disequilibrium unemployment.

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4. Voluntary Unemployment
This occurs when people choose to remain unemployed rather than take jobs available.
For example, if benefits are generous, people may prefer to stay on benefits rather than get work.
Frictional unemployment is also a type of voluntary unemployment as they are choosing to wait
until they find a better job.


5. Demand Deficient or Cyclical Unemployment
Demand deficient unemployment occurs when the economy is below full capacity.
For example, in a recession Aggregate Demand (AD) will fall leading to a decline in
output and negative economic growth.
With a fall in output firms will employ less workers because they are producing less
goods. Also some firms will go out of business leading to large scale redundancies.
In recessions, unemployment tends to rise rapidly as firms lay off workers.
DEFINITION OF 'OKUN'S LAW'
The relationship between an economy's unemployment rate and its gross national product
(GNP). Twentieth-century economist Arthur Okun developed this idea, which states that when
unemployment falls by 1%, GNP rises by 3%. However, the law only holds true for the U.S.
economy, and only applies when the unemployment rate falls between 3-7.5%. Other version of
Okun's Law focus on a relationship between unemployment and GDP, whereby a percentage
increase in unemployment causes a 2% fall in GDP.
IMPACT OF INFLATION:
Inflation is caused due to several economic factors:
When the government of a country print money in excess, prices increase to keep up with
the increase in currency, leading to inflation.
Increase in production and labor costs, have a direct impact on the price of the final
product, resulting in inflation.
When countries borrow money, they have to cope with the interest burden. This interest
burden results in inflation.
High taxes on consumer products, can also lead to inflation.

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Demands pull inflation, wherein the economy demands more goods and services than
what is produced.
Cost push inflation or supply shock inflation, wherein non availability of a commodity
would lead to increase in prices.
Problems
The problems due to inflation would be:
When the balance between supply and demand goes out of control, consumers could
change their buying habits, forcing manufacturers to cut down production.
The mortgage crisis of 2007 in USA could best illustrate the ill effects of inflation.
Housing prices increases substantially from 2002 onwards, resulting in a dramatic
decrease in demand.
Inflation can create major problems in the economy. Price increase can worsen the
poverty affecting low income household,
Inflation creates economic uncertainty and is a dampener to the investment climate
slowing growth and finally it reduce savings and thereby consumption.
The producers would not be able to control the cost of raw material and labor and hence
the price of the final product. This could result in less profit or in some extreme case no
profit, forcing them out of business.
Manufacturers would not have an incentive to invest in new equipment and new
technology.
Uncertainty would force people to withdraw money from the bank and convert it into
product with long lasting value like gold, artifacts.
Inflation in India Economy
India after independence has had a more stable record with respect to inflation than most
other developing countries. Since 1950, the inflation in Indian economy has been in single digits
for most of the years
Between 1950-1960
The inflation on an average was at 2.00%
Between 1960-1970
The inflation on an average was at 7.2%
Between 1970-1980

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The inflation on an average was at 8.5%.
Inflation At Present
Inflation in India a menace a few years ago is at a 30 year low. The inflation ended at a
low of 0.61% in the week ended May 9, 2009 this after reaching a 16 year high of 12.91 % in
August 2008, bringing in a sigh of relief to policymakers.
REASONS;
1. Increase in Demand and fall in supply causes rise in prices.
2. A Growing Economy has to pass through Inflation.
3. Lack of Competition and Advanced Technology (increases cost of production and rise in
price)
4. Defective Monetary and Fiscal Policy (In India its fine)
5. Hoarding (when traders hoard goods with intention to sell later at high prices)
6. Weak Public Distribution System
DEMAND AND SUPPLY FACTORS :
Topic: The Factors that affect the Demand and Supply for goods and services in markets:
Some of factors that affect the demand for goods and services given ceteris paribus are
the following:
(1)Changes in the Price of a good or service
(2)Changes in consumers Income spent on goods and services
(3)Changes in the Tastes/Preferences of consumers for goods/services
(4)Changes in the Prices of related goods and services: Substitutes and Complements
(5)Changes in government fiscal policy (spending and taxation) and monetary policy
(interest rate etc)
(6)Natural disasters (storms, hurricanes, earthquakes, tornadoes, floods etc)
(7)Scientific discoveries (medical, chemical etc)
(8)Advertising or Commercial ads
(9)Changes in the growth rate of a Population
(10)The #of consumers in a market
(11)Seasonality (Christmas, Easter, Valentines Day etc)
(12)Sociological factors (age, sex, education, marriage etc)

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Concisely expressed the above factors that influence demand can be expressed as
follows: D =(P, M, T, Prg, Gp, N, S, A, P, #C, S, Sf)
Some of factors that affect the supply for goods and services are the following:
1. Changes in the Price of a good or service
2. Changes in Technology (or the State of the Art) of business firms
3. Changes in the Tastes/Preferences of consumers for goods/services
4. Changes in consumers Income spent on goods and services
5. The #of business firms in an industry
6. Changes in the Prices of related goods and services
7. The Costs of factor inputs of firms (labor, capital etc)
8. Seasonality (Christmas, Easter, Valentines day etc)
9. Commercial ads or Advertising
10. Scientific Discoveries (medical, inventions, chemicals etc)
11. Natural Disasters
12. Government fiscal and monetary policies
13. The rate of growth of the Population
14. Sociological factors (age, sex, education, marriage etc)
Concisely expressed the above factors that influence the supply schedule or curve can be
expressed as follows:
S=( P, M , T, Ty, #F, Prg, Cf, Gp, N, S, A, P, S, Sf)
The non-price factors that cause a rightward or outward shift or a leftward or inward
shift in the demand schedule (curve) for a good or service are the following:
SOME NON-PRICE FACTORS THAT AFFECT A DEMAND SCHEDULE
(1)Changes in consumers Income spent on goods and services
(2)Changes in the Tastes/Preferences of consumers for goods/services
(3)Changes in the Prices of related goods and services: Substitutes and Complements
(4)Changes in government fiscal policy (spending and taxation) and monetary policy
(interest rate etc)
(5)Natural disasters (storms, hurricanes, earthquakes, tornadoes, floods etc)
(6)Scientific discoveries (medical, chemical etc)
(7)Advertising or Commercial ads

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(8)Changes in the growth rate of a Population
(9)The #of consumers in a market
(10)Seasonality (Christmas, Easter, Valentines Day etc)
(11)Sociological factors (age, sex, education, marriage etc)
PS: The changes in the price of a good or service in any market will only cause a
movement along a consumers demand curve (schedule) given that all the non-price factors are
held constant or given ceteris paribus. Thus a change in the price of a good or service will only
cause a change in the quantity demanded or Qd of a good or service in a market in a given time
period given the assumption of ceteris paribus. See diagram (graph) of demand curve for DVD
players discussed in class.
The non-price factors that cause a rightward or outward shift or a leftward or inward
shift in the supply schedule (curve) for a good or service are the following:
SOME NON-PRICE FACTORS THAT AFFECT A SUPPLY SCHEDULE (Please see
corresponding diagrams illustrating the appropriate shifts in a firms supply curve (schedule)
discussed in class)
(1)Changes in Technology (or the State of the Art) of business firms
(2)Changes in the Tastes/Preferences of consumers for goods/services
(3)Changes in consumers Income spent on goods and services
(4)The #of business firms in an industry
(5)Changes in the Prices of related goods and services
(6)The Costs of factor inputs of firms (labor, capital etc)
(7)Seasonality (Christmas, Easter, Valentines day etc)
(8)Commercial ads or Advertising
(9)Scientific Discoveries (medical, inventions, chemicals etc)
(10)Natural Disasters
(11)Government fiscal and monetary policies
(12)The rate of growth of the Population
(13)Sociological factors (age, sex, education, marriage etc)
S=( M , T, Ty, #F, Prg, Cf, Gp, N, S, A, P, S, Sf)
PS: The changes in the price of a good or service in any market will only cause a
movement along a firms supply curve (schedule) given that all the non-price factors are held

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constant or given ceteris paribus. Thus a change in the price of a good or service will only cause
a change in the quantity supplied or Qs for a good or service in a market in a given time period
given the assumption of ceteris paribus. See diagram (graph) of supply curve for DVD players
discussed in class.
INFLATION AND UNEMPLOYMENT TRADE OFF
The Tradeoff Between Inflation and Unemployment
Okun's Law describes a clear relationship between unemployment and national output, in
which lowered unemployment results in higher national output. Such a relationship makes
intuitive sense: as more people in a nation work it seems only right that the output of the nation
should increase. Building on Okun's law, another economist, A. W. Phillips, discovered a
relationship between unemployment and inflation. The chain of basic ideas behind this belief
follows: as more people work the national output increases, causing wages to increase, causing
consumers to have more money and to spend more, resulting in consumers demanding more
goods and services, finally causing the prices of goods and services to increase. In other words,
Phillips showed that unemployment and inflation shared an inverse relationship: inflation rose as
unemployment fell, and inflation fell as unemployment rose. Since two major goals for economic
policy makers are to keep both inflation and unemployment low, Phillip's discovery was an
important conceptual breakthrough, but also posed a troublesome challenge: how to keep both
unemployment and inflation low, when lowering one results in raising the other?



The Phillips Curve

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It is important to remember that the Phillips curve depicted above is simply an example.
The actual Phillips curve for a country will vary depending upon the years that it aims to
represent.
Notice that the inflation rate is represented on the vertical axis in units of percent per
year. The unemployment rate is represented on the horizontal axis in units of percent. The curve
shows the levels of inflation and unemployment that tend to match together approximately, based
on historical data. In this curve, an unemployment rate of 7% seems to correspond to an inflation
rate of 4% while an unemployment rate of 2% seems to correspond to an inflation rate of 6%. As
unemployment falls, inflation increases.
The Phillips curve can be represented mathematically, as well. The equation for the
Phillips curve states inflation =[(expected inflation) B] x [(cyclical unemployment rate) +
(error)] where B represents a number greater than zero that represents the sensitivity of inflation
to unemployment. While the Phillips curve is theoretically useful, however, it less practically
helpful. The equation only holds in the short term. In the long run, unemployment always returns
to the natural rate of unemployment, making cyclical unemployment zero and inflation equal to
expected inflation.
Problems with the Phillips Curve and
Stagflation
In fact, the Phillips curve is not even theoretically perfect. In fact, there are many
problems with it if it is taken as denoting anything more than a general relationship between

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unemployment and inflation. In particular, the Phillips curve does a terrible job of explaining the
relationship between inflation and unemployment from 1970 to 1984. Inflation in these years
was much higher than would have been expected given the unemployment for these years.
Such a situation of high inflation and high unemployment is called stagflation. The
phenomenon of stagflation is somewhat of a mystery, though many economists believe that it
results from changes in the error term of the previously stated Phillips curve equation. These
errors can include things like energy cost increases and food price increases. But no matter its
source, stagflation of the 1970's and early 1980's seems to refute the general applicability of the
Phillips curve.
The Phillips curve must not be looked at as an exact set of points that the economy can
reach and then remain at in equilibrium. Instead, the curve describes a historical picture of where
the inflation rate has tended to be in relation to the unemployment rate. When the relationship is
understood in this fashion, it becomes evident that the Phillips curve is useful not as a means of
picking an unemployment and inflation rate pair, but rather as a means of understanding how
unemployment and inflation might move given historical data.
SHORT RUN AND LONGRUN PHILIPS CURVE
Short Run Philips Curve
The Short run Philips curve is down-ward sloping, showing an inverse relationship
between unemployment (u) and inflation. A decrease in interest rates can only be brought about
by an increase in interest rates (another reason why Economics is a dismal science - just wait, it
gets worse). At any time, the government/Central Bank can determine which interest rate to use,
and the economy will adjust to have the unemployment rate that meets the curve at that interest
rate.

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Long Run Philips Curve
The Long run Philips curve is perfectly vertical, the idea being that in the long run, the
Philips curve will assume that form. If the government stays at any point on the short run Philips
curve for any significant period of time, people will begin to expect that particular rate of
inflation and wages will increase to adjust for that expectation, spurring another round of
inflation. This increases the inflation process, raising the inflation rate. To mirror this, the short
run Philips curve shifts rightward (with low levels of unemployment and high interest rate) until
the point the economy reaches the long run Philips curve (a shift from SRPC1 to SRPC2).
Vicious Spiral Upward
As a result of this shift, the new position involves just as high an interest rate as before,
but the unemployment rate has returned to its natural position. The natural unemployment rate
is the rate of unemployment that would cause no shift in the short run Philips Curve, and is
somewhere around 10%. This is, for most political situations, an unacceptably high
unemployment, hence the need to artificially reduce it by increasing interest rate. Hence, the
economy enters a spiral in which interest rates continually increase for only temporary decreases
in unemployment (told you it gets worse).

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Vicious Spiral Downward
The opposite is also true. If the government persistently sets the interest rate below the
position where the short and long run Philips curves cross, then there will be higher than normal
unemployment. If this is held for a significant period of time, the short run Philips curve will
begin to shift downward, resulting in continually decreasing inflation for temporarily higher-
than-normal unemployment. However, the suffering that such an economic policy, while
effective, would bring to people is politically unpopular, and the general trend has been to rising
inflation rates.

SUPPLY SIDE POLICIES
Definition of Supply Side Economics
Supply Side economics is the branch of economics that considers how to improve the
productive capacity of the economy. It tends to be associated with Monetarist, free market
economics. These economists tend to emphasize the benefits of making markets, such as labor
markets more flexible. However, some supply side policies can involve government intervention
to overcome market failure
Supply Side Policies are government attempts to increase productivity and shift
Aggregate Supply (AS) to the right.
Benefits of Supply Side Policies
1. Lower Inflation.
Shifting AS to the right will cause a lower price level. By making the economy more
efficient supply side policies will help reduce cost push inflation.
2. Lower Unemployment
Supply side policies can help reduce structural, frictional and real wage unemployment
and therefore help reduce the natural rate of unemployment.
3. Improved economic growth
Supply side policies will increase the sustainable rate of economic growth by increasing
AS.
4. Improved trade and Balance of Payments.

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By making firms more productive and competitive they will be able to export more. This
is important in light of the increased competition from S.E. Asia.
Diagram Showing effect of Supply Side
Policies




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Classical view of LRAS shifting to the right.

Keynesian view of LRAS shifting to the right.
Supply Side Policies
Most supply side policies aim to enable the free market to work more efficiently by
reducing govt interference.
1. Privatization.
This involves selling state owned assets to the private sector. It is argued that the private
sector is more efficient in running business because they have a profit motive to reduce costs and
develop better services.
2. Deregulation
This involves reducing barriers to entry in order to make the market more competitive.
For example BT used to be a Monopoly but now telecommunications is quite competitive.
Competition tends to lead to lower prices and better quality of goods / service.
3. Reducing Income Taxes.
It is argued that lower taxes (income and corporation) increase the incentives for people

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to work harder, leading to more output.
However this is not necessarily true, lower taxes do not always increase work incentives
(e.g. if income effect outweighs substitution effect)
4. Increased education and training
Better education can improve labor productivity and increase AS. Often there is under-
provision of education in a free market, leading to market failure. Therefore the govt may need to
subsidize suitable education and training schemes. However govt intervention will cost money,
requiring higher taxes, It will take time to have effect and govt may subsidize the wrong types of
training
5. Reducing the power of Trades Unions
This should
a) Increase efficiency of firms e.g. less time lost to strikes
b) Reduce unemployment ( if labor markets are competitive)
6. Reducing State Welfare Benefits
This may encourage unemployed to take jobs.
7. Providing better information about jobs this may also help reduce frictional unemployment
8. Deregulate financial markets to allow more competition and lower borrowing costs for
consumers and firms.
9. Lower Tariff barriers this will increase trade
10. Removing unnecessary red tape and bureaucracy which add to a firms costs
11. Improving Transport and infrastructure.
Due to market failure this is likely to need govt intervention to improve transport and
reduce congestion. This will help reduce firms costs.
12 Deregulate Labor Markets
This is said to be an important objective for the EU to increase competitiveness.
E.g. Make it easier to hire and fire workers.
Basic Propositions of supply side Economics:
1. Incentives to save and invest
2. Cost push effect of the tax wedge
3. Underground economy
4. Tax revenue and laffer curve.

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THE DEMAND FOR MONEY:
The demand for money is affected by several factors, including the level of income,
interest rates, and inflation as well as uncertainty about the future. The way in which these
factors affect money demand is usually explained in terms of the three motives for demanding
money: the transactions, the precautionary, and the speculative motives.
Transactions motive.
The transactions motive for demanding money arises from the fact that most
transactions involve an exchange of money. Because it is necessary to have money available for
transactions, money will be demanded. The total number of transactions made in an economy
tends to increase over time as income rises. Hence, as income or GDP rises, the transactions
demand for money also rises.
Precautionary motive.
People often demand money as a precaution against an uncertain future. Unexpected
expenses, such as medical or car repair bills, often require immediate payment. The need to have
money available in such situations is referred to as the precautionary motive for demanding
money.
Speculative motive.
Money, like other stores of value, is an asset. The demand for an asset depends on both
its rate of return and its opportunity cost. Typically, money holdings provide no rate of return
and often depreciate in value due to inflation. The opportunity cost of holding money is the
interest rate that can be earned by lending or investing one's money holdings. The speculative
motive for demanding money arises in situations where holding money is perceived to be less
risky than the alternative of lending the money or investing it in some other asset.
Interest rates and demand for money:
When interest rates rise relative to the rates that can be earned on money deposits, people
hold less
money. When
interest rates
fall, people
hold more

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money. The logic of these conclusions about the money people hold and interest rates depends
on the peoples motives for holding money.












Determinants of Demand for Money:
1. Real GDP
2. Price Level
3. Expectations
4. Transfer Costs
5. Preferences
MONEY SUPPLY
Definition
The total supply of money in circulation in a given country's economy at a given time.
There are several measures for the money supply, such as M1, M2, and M3. The money supply is
considered an important instrument for controlling inflation by those economists who say that
growth in money supply will only lead to inflation if money demand is stable. In order to control
the money supply, regulators have to decide which particular measure of the money supply to
target. The broader the targeted measure, the more difficult it will be to control that particular
target. However, targeting an unsuitable narrow money supply measure may lead to a situation
where the total money supply in the country is not adequately controlled.

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There are several definitions of the supply of money. M1 is narrowest and most
commonly used. It includes all currency (notes and coins) in circulation, all checkable deposits
held at banks (bank money), and all traveler's checks. A somewhat broader measure of the
supply of money is M2, which includes all of M1 plus savings and time deposits held at banks.
An even broader measure of the money supply is M3, which includes all of M2 plus large
denomination, long-term time depositsfor example, certificates of deposit (CDs) in amounts
over $100,000. Most discussions of the money supply, however, are in terms of the M1
definition of the money supply.









Factors Affecting money Supply
in India:
1. Net Bank credit to the Government
2. Bank credit to commercial sector
3. Foreign Exchange Assets
4. Government currency liabilities to the public
5. Non monetary liabilities of the Banking Sector

MONEY MARKET
EQUILIBRIUM:
We can see this in the diagram
below. The equilibrium interest
rate is I*, where the supply of money
is equal to the demand for money.

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If the rate of interest were above the equilibrium, then there would be an excess supply of
money. People would have a higher level of money balances than they needed. They would use
this excess money to invest, by perhaps buying securities or other assets. This would drive the
price of securities up










ROLE OF MONETARY POLICY :
The monetary policy in a developing economy will have to be quite different from that of
a developed economy mainly due to different economic conditions and requirements of the two
types of economies.
A developed country may adopt full employment or price stabilization or exchange
stability as a goal of the monetary policy.
But in a developing or underdeveloped country, economic growth is the primary and
basic necessity. Thus, in a developing economy the monetary policy should aim at promoting
economic growth, the monetary authority of a developing economy can play a vital role by
adopting such a monetary policy which creates conditions necessary for rapid economic growth.
Monetary policy can serve the following developmental requirements of developing economies.
1. Developmental Role:
In a developing economy, the monetary policy can play a significant role in accelerating
economic development by influencing the supply and uses of credit, controlling inflation, and
maintaining balance of payment.
Once development gains momentum, effective monetary policy can help in meeting the
requirements of expanding trade and population by providing elastic supply of credit.

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2. Creation and Expansion of Financial Institutions:
The primary aim of the monetary policy in a developing economy must be to improve its
currency and credit system. More banks and financial institutions should be set up, particularly in
those areas which lack these facilities.
The extension of commercial banks and setting up of other financial institutions like
saving banks, cooperative saving societies, mutual societies, etc. will help in increasing credit
facilities, mobilizing voluntary savings of the people, and channelizing them into productive
uses.
It is also the responsibility of the monetary authority to ensure that the funds of the
institutions are diverted into priority sectors or industries as per requirements of development
plan of the country.
3. Effective Central Banking:
To meet the developmental needs the central bank of an underdeveloped country must
function effectively to control and regulate the volume of credit through various monetary
instruments, like bank rate, open market operations, cash-reserve ratio etc.
Greater and more effective credit controls will influence the allocation of resources by
diverting savings from speculative and unproductive activities to productive uses.
4. Integration of Organized and Unorganized Money Market:
Most underdeveloped countries are characterized by dual monetary system in which a
small but highly organized money market on the one hand and large but unorganized money
market on the other hand operate simultaneously.
The unorganized money market remains outside the control of the central bank. By
adopting effective measures, the monetary authority should integrate the unorganized and
organized sect ors of the money market.



5. Developing Banking Habits:
The monetary authority of a less developed country should take appropriate measures to
increase the proportion of bank money in the total money supply of the country. This requires

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increase in the bank deposits by developing the banking habits of the people and popularizing the
use of credit instruments (e.g, cheques, drafts, etc.).
6. Monetization of Economy:
An underdeveloped country is also marked by the existence of large non-monetized
sector. In this sector, all transactions are made through barter system and changes in money
supply and the rate of interest do not influence the economic activity at all. The monetary
authority should take measures to monetize this non-monetized sector and bring it under its
control.
7. Integrated Interest Rate Structure:
In an underdeveloped economy, there is absence of an integrated interest rate structure.
There is wide disparity of interest rates prevailing in the different sectors of the economy and
these rates do not respond to the changes in the bank rate, thus making the monetary policy
ineffective.
The monetary authority should take effective steps to integrate the interest rate structure
of the economy. Moreover, a suitable interest rate structure should be developed which not only
encourages savings and investment in the country but also discourages speculative and
unproductive loans.
8. Debt Management:
Debt management is another function of monetary policy in a developing country. Debt
management aims at (a) deciding proper timing and issuing of government bonds, (b) stabilizing
their prices, and (c) minimizing the cost of servicing public debt.
The monetary authority should conduct the debt management in such a manner that
conditions are created "in which public borrowing can increase from year to year and on a big
scale without giving any jolt to the system.
And this must be on cheap rates to keep the burden of the debt low."However, the
success of debt management requires the existence of a well- developed money and capital
market along with a variety of short- term and long-term securities.
9. Maintaining Equilibrium in Balance of Payments:
The monetary policy in a developing economy should also solve the problem of adverse
balance of payments. Such a problem generally arises in the initial stages of economic

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development when the import of machinery, raw material, etc., increase considerably, but the
export may not increase to the same extent.
The monetary authority should adopt direct foreign exchange controls and other measures
to correct the adverse balance of payments.
10. Controlling Inflationary Pressures
Developing economies are highly sensitive to inflationary pressures. Large expenditures
on developmental schemes increase aggregate demand. But, output of consumer's goods does not
increase in the same proportion. This leads to inflationary rise in prices.
Thus, the monetary policy in a developing economy should serve to control inflationary
tendencies by increasing savings by the people, checking expansion of credit by the banking
system, and discouraging deficit financing by the government.
11. Long-Term Loans for Industrial Development:
Monetary policy can promote industrial development in the underdeveloped countries by
promoting facilities of medium-term and long-term loans to the manufacturing units. The
monetary authority should induce these banks to grant long-term loans to the industrial units by
providing rediscounting facilities. Other development financial institutions also provide long-
term productive loans.
12. Reforming Rural Credit System:
Rural credit system is defective and rural credit facilities are deficient in the
underdeveloped countries. Small cultivators are poor, have no finance of their own, and are
largely dependent on loans from village money lenders and traders who generally exploit the
helplessness, ignorance and necessity of these poor borrowers. The monetary authority can play
an important role in providing both short-term and long term credit to the small arrangements,
such as the establishment of cooperative credit societies, agricultural banks etc.